Housing Market will Keep Declining for Another Five to Eight Years

[FRED]

Assuming the best but getting the worst

Dear iTulip,

So I'm reading my favorite financial news source Yahoo! Finance and come across this article Your House: Breaking the Bank that says:

If you've been reading Money Magazine for any length of time, you surely get that saving for retirement should be your top financial priority. Even so, the past decade's easy appreciation in home values has made such fundamental advice seem, well, a lot less urgent.

Or so suggests a National Bureau of Economic Research paper recently published in the Journal of Monetary Economics. Comparing results from the biennial University of Michigan Health and Retirement study, researchers found that, excluding home and business equity, 51- to 56-year- olds hold less wealth than the same age group did in 1992.

"These boomers look richer, but a lot of that wealth is because one asset [their house] revalued," says co-author Annamaria Lusardi, a professor of economics at Dartmouth. "Excluding housing, people have very little in other wealth components."

It goes on to say:

• My home value may have more than doubled during the boom, but real estate markets have also been known to suffer prolonged stagnation, even downturns.
• Selling my house and buying a smaller one may not leave me flush with cash.
• I may not be able to tap my equity and invest it for even better returns.

Now they tell me! Until this article, every single story I've read since as long as I can remember said a house is the best way to build wealth. A house was the closest thing possible to a guaranteed investment.

I have nearly all of my retirement money sunk into my house and I plan to retire in a few years. How will I retire? Houses are not selling in my area and I have no other source of retirement money. All of my friends are in the same position. I bet my problem is common. What does this mean for the economy?

Signed,

Cornered in California

Dear Cornered,

The bad news is you have indeed been duped into putting far too much of your savings into your home. The good news is... you are not alone!

Over the years you've probably read dozens of articles extolling the great rise in household wealth in the U.S. over the past 20 years. We developed this chart in our article about USA, Inc. to show just where the all that much touted household net worth is located on the household balance sheet, along with who has it and who doesn't, and how much of that is liquid–that is, can actually be spent, versus how much is tied up in an asset that must be sold or put up as collateral for a loan before the owner has cash to spend.

As you can see, only the top percentiles have much in the way of total net worth. The mean level of total net worth is $227,000. Of that, only $46,000 is liquid, with $62,000 tied up in real estate and only $16,000 invested in IRAs and Keochs. Real estate makes up the majority of net worth all the way up to the 90th percentile. Only when you reach the 95th percentile do you see home equity merely equal to liquid net worth. This is why cash-out refis have been so important over the past few years as a source of cash for home owners. These loans allow households to turn an illiquid asset into cash. Of course, every time a homeowner does that, the bank owns more of their home and they own less, and they are one step farther away from being true home owners.

With illiquid home equity comprising so much of household net worth, what happens now as home-equity loans and lines of credit top 8 percent and home prices fall and, thus, home equity, too? Where will liquidity come from if it becomes too expensive to extract diminishing home equity?

To get an idea of the impact so far and the possible future impact, let's refer back to our January 2005 model and see where we are in the Housing Bubble Correction process. This chart correlates a decline in home equity extraction with a seven step housing bubble correction that takes place over about ten years.

Our January 2005 prediction of declining home equity extraction

By this January 2005 estimate, with respect to timing, the housing market bubble areas should be exiting Step C and approaching Step D:

Step C: After prices have declined for two years, large numbers of buyers who purchased near the top of the market will begin to feel the psychological effects of being underwater on their mortgage. They will be less inclined to borrow money, or to spend money fixing up their home, as home improvement value increases will be swallowed up by general market price declines. There will still be profits to be made by those who bought very early in the previous boom cycle, but fewer people will have this option.

As transaction volumes continue to fall, demand for housing-related employment will decline too. The first signs of labor market distress will start to show up, as more and more of that 43% of the private sector who found jobs in the housing industry are no longer needed. Coincidentally, major employers—such as the U.S. auto industry—will be going through major restructuring, adding to pressures on housing prices in some areas. Some home owners will need to sell at a loss in order to move to regions of the country where the labor picture is better, and will do this if they have enough equity and are not paying cash out of pocket to cover their remaining mortgage obligations. These sales will further depress home prices.

Step D: Three years into the decline, marginal home buyers will learn what owning a home really costs, versus renting when housing prices are declining and jobs are more scarce. Rent is a fixed cost, whereas home ownership presents many variable costs, including increased interest payments on ARMs, and rising tax, insurance, and energy costs. Also, upkeep for the average home typically costs five to ten percent of the price of the home, annually. As prices fall, homeowners will have less access to home equity loans. Many will not be able to afford repair and maintenance expenses. Homes in some neighborhoods—and in some cases, entire neighborhoods—will begin to look neglected, further depressing prices.

The most recent Kennedy-Greenspan report on home equity extraction shows home equity in fact slowing nearly at the same rate as our January 2005 model anticipated.

Actual chart of home equity extraction as of Q1 2007

Recent press reports show many US home markets showing Step C and others Step D symptoms, although housing markets are not expected to be fully in Step D until home equity extraction falls to zero in 2008.

Foreclosures a blight on Manteca
Monday, Aug 27, 2007

They were once symbolic of the American Dream. Now they are eyesores.

Front yards full of weeds and dead grass, along with boarded up or broken windows, are the signs of houses in foreclosure in this Central Valley town where commuters came in search of homes they could afford.

Housing Takes Affect on Job Market
Monday, Aug 27, 2007

The nation's housing slump and credit squeeze could mean the construction industry will shed more than a-million jobs in the coming months. An official with the National Association of Home Builders said the job cuts could be deeper than those made during the 1990s recession.

National Home Prices Drop for First Time
Monday, Aug 27, 2007

When you think about places hardest hit by the current housing slowdown, states such as California, Nevada and Florida come to mind.

But now new figures indicate that a contained real estate bubble is spreading, and it's affecting home prices across the country.

If our models continue to hold up as well in the future as they have over the previous two and half years, then the housing market and economy still have to complete steps D, E, F, and G of decline before the market bottoms out. Our model is for a 10 year downturn, starting from the top in June 2005. That means we have another five to eight years to go.

Finally, to answer your question, you are only "cornered" if you are not in a position to ride out another five to eight years or so of housing market correction. That may mean working longer than you expected and delaying your retirement. We know this may not be welcome news, but we believe our readers are better off prepared for the worst while hoping for the best than they are assuming the best and getting the worst.

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[GRG55]

Re: Assuming the best but getting the worst

...If our models continue to hold up as well in the future as they have over the previous two and half years, then the housing market and economy still have to complete steps D, E, F, and G of decline before the market bottoms out. Our model is for a 10 year downturn, starting from the top in June 2005. That means we have another five to eight years to go...

This morning more debt vehicle handgrenades went off imbedding additional shrapnel in the balance sheets of selected banks (Barclay's and State Street being the most recent sinners to visit the confessional). iTulip predicted the concentration of toxic credit risk in "weak hands". However, we seem to be moving up the food chain to the most prominent financial institutions that comprise the core of the banking systems in countries around the world.

The consensus is that Central Bankers cannot pull another LTCM rescue as the risk is too widely distributed and they can't "save" everyone. However, with national banking systems seemingly under threat the political pressure for more intervention is rising fast.

US real estate is the asset behind a very substantial portion of these credit instruments. It is uncertainty about the future value of that collateral that seems the root cause of much of the problem in global banking. It seems increasingly likely that the Fed/Treasury/Congress will try to save the banks by aggressively trying to prop up the collateral value of US real estate (Mr. Paulson...it's Bill Gross calling). Would the success of such a move "short-circuit" the iTulip model, or just extend the time it takes to play out?

[hayfield]

Re: Housing Market will Keep Declining for Another Five to Eight Years

A ten year downturn, followed by what? The 2015-2020 portion of the MEW prediction suggests net repayment of debt, not a recovery.

Can you clarify?

[EJ]

Re: Housing Market will Keep Declining for Another Five to Eight Years

A ten year downturn, followed by what? The 2015-2020 portion of the MEW prediction suggests net repayment of debt, not a recovery.

Can you clarify?

I agree with Hudson on this point:

EJ: Rapid and sustained growth in nominal and real net worth since 1981 has been responsible for the declining savings rate for over 20 years. That trend reversed with the end of the housing bubble in 2005. Do you see savings rates rising or consumption declining, or both, from here? If so, what role should government have in mitigating this if any?
Hudson: We will see both more saving and less consumption. It's important to keep in mind that when measuring the performance of the US economy you calculate total returns not regular returns. That's because the U.S. economic policy is designed to encourage citizens to see asset appreciation was the way to get rich, not by trying to develop a secure income and save. The incentives are to go into debt buying assets.

EJ: How will households save if we're going into recession and household debt levels are so high?
Hudson: This will not be saving in the traditional sense of putting money into bank or brokerage accounts. Saving will be in the form of repaying debts. This saving will not produce more liquidity but rather will amortize existing debt. There will also be further inflation via dollar depreciation.

Recent Hudson interview...

Meaning, in the context of Ka-Poom Theory, after a brief period of disinflation in the next year or two, we experience a period of inflation and debt repayment. The remainder of the decline in the housing market comprises the Ka-Poom entire cycle, which lasts five to eight years.

[dbarberic]

Re: Housing Market will Keep Declining for Another Five to Eight Years

Meaning, in the context of Ka-Poom Theory, after a brief period of disinflation in the next year or two, we experience a period of inflation and debt repayment. The remainder of the decline in the housing market comprises the Ka-Poom entire cycle, which lasts five to eight years.

So during the next Poom phase, it sounds like stagflation through 2014-2017. But what happens after that? Do you see this Poom period of stagflation as a "rebuilding the public balance sheet" through increased savings or debt reduction as Dr. Hudson suggests and then the ka-poom is recycled again; or are we in uncharted water at this point, with something more evil approaching (e.g. hyper-inflation/depression/etc).

[hayfield]

Re: Housing Market will Keep Declining for Another Five to Eight Years

I'm wondering, does your model take into account population growth, or decline? I say that because housing growth is predicated on population growth (aside for the small market for second homes), and that is predicated on (1) birth rate and (2) immigration.

Birth rate for naturalized citizens is now nearing parity with death rate.

That leaves immigration as the primary driver for growth.

Globalization is providing an incentive to stay in one's country of origin instead of moving to the US for a purported better opportunity. And when Joe6Pack can no longer afford the lawn maintenance service or the dry cleaning bill, not only do the lowest paid immigrants leave, but J6P competes with the immigrant he will be competing for the low-paying service jobs.

If population growth takes a dive, then demand for new houses will dive right along with it, leading to further depreciation in values. Perhaps one could argue that all the houses that need to be built in the US are already built.

But maybe the model already accounts for demographic changes...

[jk]

Re: Housing Market will Keep Declining for Another Five to Eight Years

Meaning, in the context of Ka-Poom Theory, after a brief period of disinflation in the next year or two, we experience a period of inflation and debt repayment.

this is a curious kind of inflation, isn't it? inflation makes one think that leverage should be beneficial, that you'd want to take on debt to pay back in those shrinking future dollars. but apparently not during the hypothesized poom. the most likely intervening variable, it seems to me, is that while prices will be rising, incomes will be nominally stagnant or barely growing, while shrinking in real terms. so the price of labor won't be rising. what prices will be rising? not house prices, at least not in real terms. so the declining value of the dollar will be reflected in the rising prices of: imported goods, especially oil, energy more broadly speaking, commodities both industrial and agricultural, thus food, and perhaps some financial assets. which? nominations?

[EJ]

Re: Housing Market will Keep Declining for Another Five to Eight Years

this is a curious kind of inflation, isn't it? inflation makes one think that leverage should be beneficial, that you'd want to take on debt to pay back in those shrinking future dollars. but apparently not during the hypothesized poom. the most likely intervening variable, it seems to me, is that while prices will be rising, incomes will be nominally stagnant or barely growing, while shrinking in real terms. so the price of labor won't be rising. what prices will be rising? not house prices, at least not in real terms. so the declining value of the dollar will be reflected in the rising prices of: imported goods, especially oil, energy more broadly speaking, commodities both industrial and agricultural, thus food, and perhaps some financial assets. which? nominations?

Where oh where is Sailor Moon?
He posted once then sailed away.
I surely hope he returns soon,
In few words, had much to say.

[fogger]

Re: Housing Market will Keep Declining for Another Five to Eight Years

Today's situation is unprecedented. This analysis reminds me of an enlightened view of linear progression: we know it's never linear, so this is an attempt to anticipate.

I'm pretty sure a very significant reset button is about to be hit. It's going to be amazing. We are resetting 5000 year old hierarchical structures.

I don't know what's going to be on the other side, but today's linear progressions will not be a guide.

JMO.

[jk]

Re: Housing Market will Keep Declining for Another Five to Eight Years

Where oh where is Sailor Moon?
He posted once then sailed away.
I surely hope he returns soon,
In few words, had much to say.

ej,

the charts in the link you posted show [implicitly] both incomes and home prices rising at the inflation rate. it shows homes doubling in nominal value in 5 years. it shows incomes growing so as to cut a nominally fixed mortgage payment in half as a percent of income.

but housing is in a long term correction and will continue to drop in real terms, and likely nominal terms as well. similarly, incomes have been stagnant and are likely to remain so. meanwhile, rising commodity [especially energy] costs as well as the diversion of income from consumption to debt repayment will produce a drag on gdp, again undermining attempts to raise incomes.

so what happens when you redraw those things with the assumption that incomes do not keep up with inflation, that gdp is sluggish andthat home prices are falling even as the hypothesized fixed-rate mortgage payments remain constant?
it appears that the result would be stagflation, but one a bit different from that of the 70's: more stag relative to the flation. in your curves, the hypothesized family with the fixed rate mortgage payment will see its living standards improve as the mortgage decreases relative to income. [you assume all prices rising at a similar rate, so other family costs rise no faster than family income.] but it appears more likely that living standards will fall as incomes are stagnant and the costs of essentials -- food, heating and cooling, transportation, clothing [mostly imported] -- rise.

as to my question above about what financial assets rise -- how could i forget? alt energy, infrastructure, commodities, health and biotech.

[EJ]

Re: Housing Market will Keep Declining for Another Five to Eight Years

ej,

the charts in the link you posted show [implicitly] both incomes and home prices rising at the inflation rate. it shows homes doubling in nominal value in 5 years. it shows incomes growing so as to cut a nominally fixed mortgage payment in half as a percent of income.

but housing is in a long term correction and will continue to drop in real terms, and likely nominal terms as well. similarly, incomes have been stagnant and are likely to remain so. meanwhile, rising commodity [especially energy] costs as well as the diversion of income from consumption to debt repayment will produce a drag on gdp, again undermining attempts to raise incomes.

so what happens when you redraw those things with the assumption that incomes do not keep up with inflation, that gdp is sluggish andthat home prices are falling even as the hypothesized fixed-rate mortgage payments remain constant?
it appears that the result would be stagflation, but one a bit different from that of the 70's: more stag relative to the flation. in your curves, the hypothesized family with the fixed rate mortgage payment will see its living standards improve as the mortgage decreases relative to income. [you assume all prices rising at a similar rate, so other family costs rise no faster than family income.] but it appears more likely that living standards will fall as incomes are stagnant and the costs of essentials -- food, heating and cooling, transportation, clothing [mostly imported] -- rise.

as to my question above about what financial assets rise -- how could i forget? alt energy, infrastructure, commodities, health and biotech.

The charts are mine from a piece I wrote for AlwaysOn Network, December 29, 2005, Inflation is Dead! Long Live Inflation!. When my friend Tony Perkins, who runs AlwaysOn, moved to a new platform, he had all the old content deleted. Writers were warned and we moved our stuff to our own servers. Unfortunately, we didn't move the comments. The comments on the seven step housing bubble correction prediction from Jan. 2005, six months before the top of the housing bubble, were especially colorful. There were hundreds along the lines of "That will never happen!" along with a few readers who said, "Oh, yeh. I'll be mowing the lawn of my neighbor's abandoned house."

The 100% inflation scenario piece, as Fogger Notes, is an attempt to model a non-linear progression, as extrapolation of the past is clearly not going to work. History, unique antecedents, politics, among other factors, feed into the model. It is one of several possible "Poom" scenarios. Keeping in mind the old adage, "All models are wrong, but some are useful," the benefit of putting a model like this out there so early is that we have time to gauge the model against actual and adjust as needed.

The 100% over six years inflation model does not assume prices rise across board. "In this model both nominal income and home value double. In reality, since so much inflation has already happened in real estate and high interest rates will increase the real cost of borrowing, home prices are likely to rise more slowly, flatten out, or even decline."

In the comments, unfortunately now gone, we also worked out how the purchasing power of a person now making $100,000 a year might look in this differential inflation environment, where the prices of imports, imports with US competition, non-traded goods, and goods typically purchased with cash versus credit, inflate at different rates. As you point out, one's nominally higher income does not make one richer, but everyone is paying down their debts faster, reducing the rate of debt defaults and dampening the unemployment surge. It creates other kinds of risks, but they are far more manageable in the short run that a US 1930s or Japanese 1990s style debt deflation. The inflationary Poom can over a few years accomplish what 16 years of muddling in Japan hasn't. A deal will need to be cut with FIRE Economy political interests, much as one was cut in the 1933 when gold was recalled and an instantaneous 30% inflation created via the re-pricing of gold, and depreciation of financial assets was accepted as an alternative to the kinds of political debt deflation outcomes that were occurring across Europe. And to make matters even more politically expedient, an inflationary episode can be blamed on the Chinese or some other outside cause. This is also a theme I address in Can the U.S. have a "Peso Problem"?

The reference to Sailor Moon was his astute comment about how a closing gap between input and output prices in the system trends toward increasing inflation.

[GRG55]

Re: Housing Market will Keep Declining for Another Five to Eight Years

Today's situation is unprecedented. This analysis reminds me of an enlightened view of linear progression: we know it's never linear, so this is an attempt to anticipate.

I'm pretty sure a very significant reset button is about to be hit. It's going to be amazing. We are resetting 5000 year old hierarchical structures.

I don't know what's going to be on the other side, but today's linear progressions will not be a guide.

JMO.

I can remember the '73/74 market crash, the slow growth & high inflation '70's, the oil embargo "crisis", Volckers 21% interest rates, just a few examples - all described as "unprecendented" (and equally unsettling) at the time. We'll get to "the other side" in due course. You are perfectly correct though - none of EJ's charts look very linear...

[Chris Coles]

Re: Housing Market will Keep Declining for Another Five to Eight Years

The problems are largely hidden. What underlies is the fact that when a manufacturer moves their production to, say, China or India to cut costs, it is not just that the "local" employee is out of a job and unable to pay their way, the manufacturing facility is dismantled as well. So the employee defaults on their payments and the banking system takes a hit on the balance sheet. But the real problem is there is no way back. You cannot hit the "reset" button because there is no wiring to the button, it was dismantled along with the manufacturing facility.

In the 1930's it was not until the economy had ground to a near complete halt that it became clear that, without direct input into the economy, nothing was going to happen. Then, the input was by building infrastructure, roads, dams, bridges all paid for by the government. But this time, unlike then when the manufacturing facility was still there, now it is all long gone to.... where ever... and the government will be nigh on bankrupt too. To pay their way out of the hole you will be in, the government must inevitably set off an inflationary boom caused by printing money they do not have. Re-creating the lost manufacturing base is going to take a half century at least, and, to even be able to start that process, your economy will have to be fully competitive with the likes of China and India. Those grand cost cutting ideas are going to come back and haunt you as now you will have to be able to re-create industry at the same base costs. Now see how low your real estate values will have to fall to achieve that.

That is the underlying problem.

You all need to think through what you can purchase that will hold value against a collapse of your currency, real estate and stocks.

And, futures will not do the trick. Me, I would hold reality. Whatever it is put it in your own store to hold for real. Not as any sort of figment, or someone else's promise for the future which might turn to dust as you open your fingers.

The best to hold is Copyright. Those of us that are authors will smile all the way through this. Easily created. Almost nil cost to store. Easy to turn into cash. Long shelf life. Everyone reads books. Next best thing to food.

Smile Eric.