Why are there no homebuyers?

House prices will continue to drop. The reason is simply supply and demand. There are lots of houses for sale and too few buyers. Why are their too few buyers? Lets list the reasons

1) The speculative buyers are gone. Speculative buyers are non-existent when prices are dropping. They know there is no point in buying until prices level off. They were probably at least 10% of the market at the top of the bubble.

2) The subprime and other uncreditworthy buyers can no longer get loans even if they wanted them. They were at least 20% of the market at the top of the bubble.

3) Before the bust, you didn't need a down-payment. Now you do. A 20% downpayment on an average $200K house is $40K. In addition, many banks now want to see enough liquid resources, cash, bonds etc, to cover 6 months of principal and interest. That adds another $6K for this house. How many people have $46K sitting around in cash? We don't need to speculate. A Met Life study was just published on this. The question was, "How long could you meet your financial obligations if you lost your job. Only 15% of people said longer than 6 months. For people younger than age 44, the natural home buyer demographic, the percentage is 9.5%. But to put down a 20% down payment you would really need this answer to be at least a year. The number who answered that was 10% overall and 5% for those under age 44. How horrifying is that statistic for those hoping the housing market will rebound? The stringent requirements on down payment and liquid resources now being demanded by banks can be met by about 5% of the natural home buying population!

4) If people had money before the bust, they probably lost much of it in the stock market. If you were young and were saving up money to eventually buy a house, you probably had most of that in the stock market. That is what your financial advisor would have told you to do. If you are young, you want a "risky" portfolio they said. You probably have about 40% less now.
If indeed you just lost 40% of your wealth, you are probably not looking to make major purchase, especially an asset that is still falling dramatically in value. In addition, you are probably worried about losing your job in this terrible economy. So why buy until the economy recovers and you are sure your job is safe.

So to sum up, about 70% of households do not have enough liquid savings to buy a house. This may be even higher for the subset of people that no not already own a house. The supply of possible home buyers is probably only 1/5 of what it was at the top. The supply of homes is only down about 20% from the peak. So supply and demand imbalances mean that house prices will continue to fall until a balance is reached. There is only two ways out of this situation. One is to wait several years for people to save money and for house prices to fall to more affordable levels. The other is for the government to subsidize housing and bring the uncreditworthy back into the market. I don't see that happening given all the anger at these junk mortgages being made in the first place.

Now there is mortgage insurance and FHA for people with no down payments but that adds more in fees on top of higher mortgage rates for people with poor credit. These people are probably paying 8% interest rates including MI. Why not wait? If you wait, you can save money to increase your down-payment, improve your credit score and in addition benefit from the fall in house prices. In addition, there is talk that the Obama administration will offer 4.5% fixed rate mortgages to help move housing inventory. If you wait a couple of years, save money, get a much lower interest rate and benefit from a 20% drop in home prices, you might reduce your mortgage payment by almost half.

So waiting is the obvious thing to do. Because of this, house prices should drop for another few years.

How to scam the Geithner plan

The Geithner plan is nothing but a scam to stick the taxpayer with the losses that should go to the banks' shareholders first and the banks' bondholders second.

Basically the plan works like this. The Fed or Treasury loans money to some investor. This is a no-recourse loan with say 3% down on the part of the investor.

Yves at Naked Capitalism has already started this thread so lets take her example.

Lets say the bank, Citi for example, has an asset with face value $100MM carried on the books at $80MM and which is currently getting markets bids at $30MM. Lets say that it turns out to be worth $50MM and that it takes 5 years for this to become evident. So if Citi is forced to selling into the market now or mark-to-market they will take a $70MM loss or an additional $50MM loss from the present write-down. If they hold to maturity, they will lose $50MM total and $30MM from the current mark.

Now if some investor shows up and wants to make a bid at $75MM with the Fed's borrowed money, they are risking only $2.25MM (3%) of their own money. Citi now has to write down $5MM more on this sale. This plan saves them $25MM.

In this case, the investor loses their bet and ends up losing $2.25MM. The bank has the $5MM write down and the taxpayers loses $22.75MM. Clearly the bank is getting the best deal.

But what if no investor wants to bid? How can the banks scam this system? It is not hard to come up with ways. Let me list a few possibilities:

1) The bank could make a no-recourse loan to the investor. Now the investor really has nothing to lose. The bank can only lose the difference between their mark and the bid plus the loan to the investor.

2) Another way that Yves brings up is for the bank to sell a CDS to the investor that pays off if the assets go bad.

3) The investor bids high with intent to lose in some quid-pro-quo with the bank. Maybe the bank will give them a loan at low interest rate or some other favor. This would probably be completely undetectable.

4) The investor could just buy call options on the bank's common stock and then bid for all of their crummy assets at face value or even higher. How about that!? They would be throwing away all of their investment purposefully in order to buy a large piece (maybe even all) of a clean bank. This way would maximize taxpayer losses. It would not even have the involve conspiracy with the bank. It is really just a way of using the enormous leverage to manipulate the stock price of the bank.

The reason why it is so easy to think of ways to scam this system is that it is inherently a scam from the beginning. These hedge investors are sophisticated and are sure to find ways of hedging their exposure so that is a chance of a big return with no risk. It is a complete hand-out to them. It is obviously a hand-out to the banks. That is the whole point. The taxpayer is the fish at the table. They are obviously going to get screwed one way or the other. This plan stinks of corruption and must be rejected.

The tide is turning

It is easy to conclude that Americans are stupid. How could they vote Bush into office twice? How can they not understand how Washington really operates as one party dedicated to maintaining the dominance of the financial elite. Well, Americans are not really stupid. Rather, they are just distracted. Americans work harder than any other people. A typical couple with children both work 40 hours a week or more. They have a long commute on top of that and when they are home, need to do all the business of running a household as well as spending some time with the family. In the their meager spare time, they try to relax. Most don't feel that they need to fully understand the functioning of the financial system or deep questions of political philosophy. When it comes to politics, most make up their minds quickly. They go with their gut. They certainly don't have time to do in depth research into the issues. That is what the news is for right? Well, that is the other problem. The news has become dominated by large corporations and doesn't offer a wide spectrum of opinions. This isn't conspiracy theory. They are just businesses and have learned that the most profitable business model is to focus on feel-good entertainment not highly controversial subjects. News stations have learned that you get more viewers when you focus on Eliot Spitzer's sex scandal than the UN oil for food scandal or the travesty in stealth bail outs of powerful financial firms.

But the times are a changing. People laid off from work, suddenly find themselves with more time to think about why they are out of work. The moral and financial bankruptcy of our way of life is becoming all to obvious. It was common sense after all, that a unsustainable trend could not continue. House prices couldn't rise forever with wages being stagnant. The Chinese wouldn't finance our over-consumption forever. Every adult who has ever dealt with their own household budget gets this now. That is why 45% of Americans think we will have a repeat of the Great Depression. This number is perhaps only 10% for actual economists who are supposed to know better. However what economists think doesn't matter. It is the spending and investment habits of ordinary Americans that will determine if demand returns enough to support the economy. If people think we will have a Depression and act accordingly, you can be assured that we will.

The Obama/Geithner/Summers/Bernanke plan of financial engineering our way out of this crisis has zero support. The people don't buy it. The markets don't buy it and even the news organizations, for example New York Times's Paul Krugman don't buy it.

It is all pretty simple when you look at the big picture. The wealthy class of the world, the net savers, made bad loans to the net borrowers and that money has been spent or transferred to others. Those loans will default and the money is not coming back. Therefore the wealthy lending class has lost much of their wealth. The Obama plan so far has been to make pretend that the money is not yet lost. If we could all just clap our hands and wish Tinkerbelle would come back to life, then Tinkerbelle will come back to life. And that might work, if people really are stupid, if they are able to ignore the fact that they are out of work and keep spending in an unsustainable way. If they can only ignore that their house and stocks have fallen in value by half. This of course is ridiculous. The Obama plan is on its last legs.

This wonderful video shows an interview of Brad Sherman, Democrat from California, telling the CNBC hosts that the emperor has no clothes. The Zeitgeist is prominantly on display. The CNBC hosts represent the old way of thinking; that the system must be propped up at all cost to avoid an apocalypse. This populist uprising will lead to the end of capitalism as we know it, they say. Sherman doesn't buy it. A system where capitalists can make outrageous profits but need the tax payer to remove all the downside risk is not capitalism at all.

What is wrong with the Wall Street culture?

Goldman Sachs put on a little dog and pony show today to explain to the witless public that they had almost no net exposure to AIG and so the bail out of AIG was NOT a de facto bailout of Goldman.

This is how it works. Goldman and AIG had a special business relationship. Goldman bought junk mortgages from fraudulent, predatory lenders and other toxic assets and bundled them into securities to sell to some unsuspecting fool such as a municipal pension fund in Norway . To convince these utter marks that Goldman had some skin in the game, they held on to some of the mortgage exposure. See, if they are good enough for Goldman, they are good enough for your stupid Norwegian backwater. Except, they didn't really keep the exposure on the books. No way! They aren't stupid. They hedged this exposure with AIG. They bought insurance contracts with AIG, the so called credit default swaps (CDSs). So if the shit hits the fan in the mortgage market, Goldman will be OK even if the Norwegians get their cold white asses handed to them.

But then their business partner, AIG, started to look kind of sickly. Whoops. Looks like that hedge might not be reliable. How do we hedge our hedge? At this point there was no one else willing to write a big insurance contract against mortgage defaults since they were already defaulting. No one sells flood insurance during a flood. If AIG goes down, Goldman would as well. How would Goldman get out of this one? By shorting the bejesus out of AIG, that's how! They took out CDSs on AIG that would pay out if AIG went down. That's right. They bet that their business partner would fail so that if they did, on the whole, they would come out OK. So in the end, says Goldman, we couldn't care either way what happened to AIG, the fools getting foreclosed on or those dumb Norwegians. We took responsibility for our company and made sure that we would come out OK regardless what happened. So we are innocent of all these accusations of needing a stealth bailout.

What really amazes me is that they thought this would somehow convince people to leave them alone. See, we didn't need a bailout. We already bet that AIG would fail. In fact we bet that all of you would fail. We have no exposure to any of you. We are betting against Norway as we speak. Pretty sure they are going down. We should know since we are the ones that sold them all this garbage.

This culture of Wall Street is now about forming business relationships and then making sure you have no "exposure" to the fate of these partners. That is, business relationships are now like some disease that you are get "exposed to". Prudent business policy now is to actively bet against your business partner's very survival so that if they go down, you come out just fine. What kind of culture are we breeding on Wall Street. It is everyone for themselves. No one trusts anyone. No one is willing to form normal business relationships where you and your partner are truly in the same boat. Goldman's meeting today displayed this more clearly than I have seen before. The amazing thing is that didn't even consider that what they were admitting to was worse than what they were trying to defend their company against.

The Great Steve Keen

Steve Keen wrote an article in February called The Roving Cavaliers of Credit which struck me as pretty brilliant and very deep.

The idea's expressed by Keen in this article perhaps are not novel but, as is frequently the case, sometimes brilliant writing is about summarizing what is already known, pointing out the importance of a particular point of view and demonstrating what the consequences must be.

Keen is an economist, that is, he has a Ph.D. in economics, but might be described as a rouge economist. He thinks most of what passes for economics is bunk; a view I happen to share. He wrote a book called "Debunking Economics: The Naked Emperor of the Social Sciences".

The main idea in his "Cavaliers" essay is that we don't actually have a fiat currency controlled by the whim and printing presses of central banks like many believe. Rather we have a debt based currency. Debt is money. Steve's blog is appropriately called Debt Watch. Therefore, the quantity of money and also economic growth has more to do with the willingness of people and institutions to borrow more so than the actions of the central bank. Eventually of course a debt frenzy has to reach a point where no one wants to borrow anymore even if interest rates are zero. No more debt is taken on and so no more money is created. At that point, deflation must occur and there is nothing a central bank can do about it.

The root cause of the crisis

I have been trying to distill the most elemental cause of this great bust. There have been many things suggested such as: too easy monetary policy by the Fed, government intervention in the housing market, excessive greed by Wall Street, deregulation of financial markets etc.

Clearly, all of these things contributed. Most however are really cogs in the feedback machine. What is the root cause of it all?

Actually Alan Greenspan suggested what I think is the best explanation.

The US built up so much debt simply because it was cheap to borrow. Interest rates like all prices in a market economy are set by supply and demand. Now, its is true that central banks can manipulate certain rates in the short term. However most central banks claim to be targeting inflation. That means that they raise rates when they see inflation rising and cut rates when they see it ebbing which usually occurs when recession seems imminent. So in this view, central bankers don't really have much freedom. The best interest rate is the one that allows economic growth with low and stable inflation.

Long term interest rates are set in the market place and depend on the supply of loanable funds and the demand for loans. The interest rate is just the price where supply and demand meet. If inflation is high, fixed income investors demand a higher interest rate.

But inflation, at least the measure reported by the government, has been dropping even since the recession of the early 80s. The best explanation of why is probably the globalization phenomena and the cheap wages of developing countries like China and India. These countries provided cheap labor which resulted in cheaper priced goods which put an end to the wage-price spiral that dominated in the 1970s.

So when interest rates dropped, US debt doubled from 150% of GDP in the early 80s to nearly 300% now. Since the interest rate was lower, this large debt load was serviceable. For the household sector, debt service as percent of personal disposable income went from 11% to 14% which doesn't look as extreme as the total debt increase.

Now unfortunately this debt binge led to financial bubbles and the rest is history. However, the key economic feature is the disinflationary impact of the cheap labor from emerging markets providing a major source of global supply.

However, I think there is another economic phenomenon which gets much less notice. This is the rise of savings capital. The last 50 years has seen a huge increase in the percent of total assets held by institutions rather than individual. For example, pension funds, banks, insurance companies, central banks now hold the majority of the worlds financial assets. The decrease in inflation starting around 1980 accentuated this even further. The inflation which preceded it decimated the value of the fixed income investments held by these institutions. The disinflation which followed did the opposite. As interest rates fell, bonds rose in value. Stocks rose in value as well since 1982 marked a secular low point in the stock market. These institutions held many long dates bonds earning 15% interest rates or higher. These high rates were formerly offset by high rates of inflation but not these became excessively high real returns. The ultimate savers, institutions, got richer.

As these savings institutions got richer, they had more to invest and most had a mandate to invest mostly in fixed income investments. That is, they need to lend out their capital and they did. Low inflation and rising loanable funds, and low interest rates led to more debt for US households and businesses. The final bit was probably due to poor monetary policy as Greenspan juiced the market after the Tech crash, but the bigger debt bubble had been growing ever since inflation started to fall.

So in summary, the debt deflation that we are seeing now has its roots in the rise and fall of the Great Inflation of the 1970s combined with globalization of labor. Both of these pieces were needed and they are related since globalization is one of the things leading to lower inflation. If inflation did not moderate, interest rates would have stayed high and little new debt would have been take on. If there was no cheap foreign labor, the boom would have been arrested by rising wage inflation which would have led to higher interest rates.

What a real stress test would look like

When Tim Geithner announced that banks would undergo a stress test, the press briefly took the view that he was being justifiably firm with the banks. If they could not perform under a dire economic scenario then they would be nationalized, the press figured. Financial bloggers, of course, were not fooled.

A few weeks later they announced the parameters of what such a stress test would look like. Here they are.



Lets focus on their more "adverse" scenario rather than their baseline scenario. The more adverse scenario is a GDP decline of -3.3% in 2009 and +0.5% in 2010. Average unemployment rate of 8.9% in 2009 and 10.3% in 2010. House price declines of -22% in 2009 and -7 in 2010.

First, GDP. Their adverse scenario is only one year of GDP decline. A -3.3% decline is about the same as the recessions in 1974 and 1982. Those were bad recessions but not once-every-50-years type events. For example in the great depression, the GDP decline in the four years following 1929 was -8.6%, -6.4%, -13%, -1.3% for a cumulative decline from 1929 to 1933 of -27%. The annualized GDP decline in the Q4 of 2008 alone was -6.3%. Q1 of 2009 is looking about the same.

Unemployment in the Great Depression reached 25%. Here is a plot of the unemployment rate back to 1948



The stress test is an average of 8.9% in 2009 and 10.3% in 2010. That would be about the same as 1982. It is 8.1% already in the beginning of March 2009.

Finally, lets look at house price declines of 22% in 2009 and 7% in 2010 which would be a 27% cumulative drop from here. This is about what I predict from extrapolating the Case-Shiller index.

So we can see that the adverse scenario is really not much worse than the 1982 or 1974 recessions with house price declines added on. Is this really a good representative of what the worse case scenario is going to be like? We have already shown that the Great Depression was far worse but that should not be surprising. Comparing to 1974 or 1982 is really not a good idea either. The 1974 recession was caused by the oil shock when OPEC raised oil prices considerably. It was alleviated when OPEC agreed to lower prices which lead to a quick recovery. The 1982 recession was engineered by Volcker's Federal Reserve in order to bring inflation down. In that case, ending the recession was easy. They just lowered interest rates and the economy came back strongly. Obviously we can't do that now since interest rates are already zero.

Is there any way that we can estimate what an adverse economic scenario would look like besides saying that it is likely to be worse than 1982 but better than the Great Depression? Well, actually we can. The key is focusing on other recessions in history that followed severe financial crises. Economists Reinhart and Rogoff wrote a paper on the economic aftermath of financial crises. They found about 20 cases and present statistical results that are relevant to what a stressed scenario would look like for the US over the next few years.

Here are some relevant statistics. The average house price decline from peak to trough was -35.5%. Ours seems likely to be slightly worse than that, maybe -40%. That is not surprising since housing was the main feature of our crisis. The worst, Hong Kong in 1997, was -53%.

The average GDP decline from peak to trough was -9.3%. The worst was the US in the Great Depression, about -27%, as we have said. The Fed's adverse estimate of -3.3% is only worse than 3 out of 15 (20%) of the historical examples. Seems hardly adverse. That is more like the rosey scenario.

The average INCREASE in the unemployment rate from peak to trough was 7%. Since we started at 5% unemployment, that would be 12% unemployment, worse than 1982 but not nearly as bad as the Great Depression. But that is just the averages not the adverse or worse than average case.

So now we can answer the question of what an adverse scenario would look like. Lets define that as roughly the 75 percentile (the average for the worst half) from this sample of post financial crises historical examples.

This would be (estimated from R&R's figures):

Real GDP peak to trough decline: -12% (3 years peak to trough)
Peak Unemployment: 16% (5 years peak to trough)
Real house price declines: -42% (7 years peak to trough)

Anyone think the banks would survive under this kind of scenario?

The old hood, Silverlake

The neighborhood in LA that we used to live in is called Silverlake. Silverlake is a hip, gentrifying area along Hollywood boulevard between Hollywood and downtown. It was the about at the epicenter of the LA housing bubble. I was looking on Zillow.com today to see how real estate is doing. Well here is an example

811 Silver Lake Blvd
1228 square feet
3 beds, 3 baths



Since 2000, it has been sold seven different times!

Here is the sales history
--------------------
11/24/2008 $304,500
11/27/2007 $602,295
11/15/2006 $704,000
08/05/2005 $650,000
10/01/2002 $321,000
04/09/2002 $258,306
12/21/2000 $262,500

Here is a chart so you can appreciate the trajectory better.



The house price appreciation from start to finish is exactly 2% per year.

Now my wife and I rented a place about the same size in the same neighborhood for $1200/month. When this place sold for $704K in 2006, it would have had a monthly mortgage payment of about $4200/month. What were people thinking!?

The 10-year PE ratio

One good valuation technique is the 10-year PE ratio. That is the current real price of the S&P 500 divided by the average of the last 10 years of real earnings per share. This is better than the trailing twelve month PE since it smooths over periods of excessive profitability or un-profitability. The following chart (from Robert Shiller's data) shows this ratio back to the 1880s. The red line shows the median value 15.68 and the blue line is at 10 which appear to be around where the troughs occur. Some were worse than this for example in 1921. Right now we are at 12.95 (S&P 500 = 745) which is somewhat below average but somewhat higher than most troughs. To reach PE(10)=10, the S&P 500 would fall to 575 or another 23%. To reach the lowest ever PE(10)=4.78, it would drop to 275 or another 63%. Lets hope that doesn't happen.



There is another way to look at this however. It is possible that the inflation correction is incorrect. There is an alternative inflation measure which claims to be closer to what was used for most of US history. This is from Shadowstats . The Shadowstats inflation measure is much higher than the government reported inflation rate, especially for the past few years. The following plot is the same as above but with the alternative Shadowstats CPI inflation correction applied to both earnings and price. The effect of this is that it makes stocks look cheaper since the correction to the current price is larger than the correction to 10-year earnings.



Which is correct if any? I don't know but would guess that the best measure is probably somewhere in between.

Conclusions: stocks are probably approaching their lows and buying solid blue chip companies is likely the right thing to do. Certainly, selling now look like the wrong thing to do.

The TALF. What hath God wrought?

The New York times has a fascinating article on the Fed's new program. The Term Asset-Backed Securities Loan Facility or TALF is an attempt to jump-start lending in the economy. The reason for the credit crunch is not that traditional banks like Bank of America are not lending. The Fed has a fairly firm grip on the balls of the CEOs of these banks since all are on the verge of government takeover. If the Fed says lend, they say "How much?".

The trouble is that over the past few decades a new banking system has arisen. This so called "Shadow Banking System", a term coined by PIMCO's Paul McCully, is just the network set up to securitize credit instruments and move them off bank balance sheets and onto the balance sheets of hedge funds, insurance companies, pension funds and any other investors looking for fixed income type investments. Many but not all of these loans are made by commercial banks. There are also finance companies like AIG's American General Finance or GE's GE Capital. Hedge funds and investment banks were also involved in credit creation and securitization. Someone willing to start a small business could go directly to a hedge fund for capital rather that to Bank of America.

This shadow banking system has collapsed. More accurately, it still exists but has dramatically reduced the amount of credit that it is willing to extend. Insurance companies and pension funds are saying "thanks but no thanks" to those BBB rated tranches of securitized auto loans. They will stick with US Treasuries, thank you very much.

The Fed has concluded that growth cannot resume while this major source of lending has been shut off. So its solution is to try to get it going again by subsidizing it.

It works basically like this. From the New York Times.

"Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment."

So in essence, the Fed is creating a new system of unregulated or lightly regulated banks from the stock of hedge funds and private equity investors around the world. To a hedge fund, it might look like this. You borrow at 2% and buy assets yielding 12%. Maybe your loss rate on these would be 6% so your final yield is 6% with a Net Interest Margin of 4%. Now you get to leverage this by a factor of 10. Now you are making 40% return on invested capital before expenses and taxes. Expenses for running a large fund are small. A team of 20 hot-shot hedge fund guys might run a fund with $10B of capital taking on $100B in assets making $40B on profits per year. They might pay themselves 2% of assets and 20% of profits which is $2B/year + $8B = $10B/year leaving $30B/year in pretax profits for the investors which is a 30% return. The 20 hedge fund guys each make half a billion per year if it is divided equally. If something goes horribly wrong and these credit instruments result in massive losses, the investors lose all of their invested capital but are not on the hook for the losses. The Fed (or maybe the taxpayer) is on the hook for the losses. If the hedge fund makes their expected profit for say three years before the shit hits the fan, they still make $1.5B each and then need to look for new jobs.

Some would say that the cause of the crisis was too much borrowing, too much leverage and too much greed. The Fed's solution appears to be more borrowing, more leverage and more greed. Somehow, I don't think the American people are going to like that plan.