Elisabeth, Anthony and I have our home in Palm Beach County, and we’re worried.
Nationwide, the number of permits to build new homes have just suffered the single biggest decline in any month since September 1999.
And the number of new housing starts last month plunged 10.8% in the West, 10.5% in the Midwest, and 7.5% in the Northeast.
The only region that held up relatively well was here in the South.
But I’m afraid that may not last for long. This county is one of the epicenters of the housing bubble — much like Orange County in California … Fairfax County in Virginia … plus a half dozen other hot spots across the USA.
So we could also be among the most vulnerable to the housing slowdown that is apparently spreading nationwide.
My fear is that if the bust strikes here, it has the potential to cause more financial damage than the combined cost of the Category-3 hurricanes that have struck the area — Frances, Jeanne and Wilma.
In our family, we keep most of our money in cash equivalents and we have no debt. We see our house primarily as our home — not an investment to buy and sell.
Still, it is an asset. And we’re not about to sit by passively if its value starts to deflate like a leaky tire, or worse, like a popped balloon. I’ll tell you more about our plans in a moment. But first, let me tell you …
How Our Neighbors, Friends
And Relatives Are Building
Giant Real Estate Pyramids
You’ve seen something similar with your own eyes, I’m sure. But let me also share with you what I see.
One of our neighbors just moved for the second time in less than a year. They loved their homes. But they wanted to cash in, take out a bigger mortgage, and reinvest the money in an even larger property — all with the goal of getting rich quicker.
Friends of our friends have done something similar, but with greater frequency and bigger leverage. They’re stepping up on multiple tracks, owning several houses simultaneously, upgrading them to larger ones as quickly as they can, and taking on massively bigger mortgages each step of the way.
Meanwhile, a young relative of ours is using a similar strategy in the commercial real estate market. She barely has enough income to cover monthly expenses. But she owns more real estate than I dreamed of owning when I was her age.
To them, all this is perfectly normal. Their basic rationale: “Everyone’s dong it. So why shouldn’t we?”
Apparently, they haven’t been paying attention to the latest real estate ads in the Palm Beach Post. The ads are touting seller concessions, free cruises if you buy condo conversions, and a host of other deals that were rarer than hen’s teeth just a couple of months ago.
And, unfortunately, our neighbors or friends don’t see the relevance of past history.
The Real Estate Balloon I See Now Reminds Me of the Giant Stock Bubble My Family Witnessed in 1929
My father became a stock broker, or “customer’s man,” in early 1929.
His older brother, Al, who had also worked on Wall Street, encouraged him to get the job.
And in later years, when Dad joined a Wall Street research firm, their younger brother Ruby, an aspiring cartoonist at age 13, helped them illustrate their reports.
Here’s how Dad described the situation in the stock market in 1929:
“Some of my boss’ customers were buying stocks with as little as 10% margin, borrowing the balance from their broker. Then, as the stock market ramped up, they parlayed one position into the next, building a giant pyramid. They thought they were rich. But up to 90% of their wealth was pure debt.
“Once a week, my brother and I used to go to the office of the New York Federal Reserve downtown. We wanted to be the first on line to get the Fed’s weekly release on broker loans.
“As long as the total amount of broker loans outstanding was going up, we figured stocks would go up. But as soon as the number started leveling off or falling, we figured that was a sign the market would go down.
“Sure enough, the lenders (mostly banks) began scrutinizing the borrowers more carefully and brokers began to discourage pure speculation. They didn’t mean to burst the bubble. But that was the end result.
“We figured stocks might go down, but like everyone else, we were shocked by the utter fury of the decline. The market crashed more than 10% and that’s all it took to wipe out the 90%-margined accounts. They lost 100% of their equity overnight. The mirage of wealth disappeared. And it happened in just 24 hours!
“Not all stock investors were in that position. But a substantial minority of speculators were. And that’s all that it took to transform what could have been a good thing into an inferno of losses.”
My view today: Real estate is very different from stocks. It certainly does not rise or fall as quickly. But …
The Parallels to the 1929
Stock Market Crash Are
Too Numerous to Ignore
First, we see a similar kind of pyramid strategy.
In the stock market, there’s no such thing as 10% margin any more, at least not through normal channels.
The main reason: After the Crash of ’29, the New York Stock Exchange ended that practice, requiring investors to put up at least 50% equity and allowing them to borrow no more than 50%.
But in the housing market, 20% down on a home was the norm for many years, and in the 1990s, mortgages with just 10% down become widely available. Worse, now in the 2000s, no-money-down mortgages are common.
So overall, I think it’s safe to say that the average leverage used to buy most homes in America today is actually greater than the leverage used to buy most stocks in the late 1920s.
Second, like in the 1929 situation, even if the majority of investors have not used leverage to that extreme, all it takes is a substantial minority of overzealous borrowers to cause a boom and bust.
Third, like the amount of money going into broker loans back then, the amount of money going into mortgages today is critical. If mortgages become more expensive or less readily available, it could end the rise in home values and precipitate a sharp decline.
My neighbors and friends don’t see it that way. They believe the national real estate boom still has momentum. Further, they believe that demographic trends, including a big migration to this region from colder climates, will support real estate values regardless of what happens nationally. At worst, they see prices going up less swiftly or leveling off temporarily. I hope they’re right.
But I fear they may be wrong.
New Evidence of a Housing Bust
Is Now Pouring in From All Sides
I told you how building permits and housing starts have just plunged. Those were October numbers.
And November looks like it could be just as bad: The National Association of Home Builders has just reported that their Housing Market Index, a measure of building activity nationwide, has plunged from 68 in October to 60 in November, the first advance indication of how this month is shaping up. The decline in their single-family sales index is even steeper — from 74 in last month to 66 in November.
We see especially steep declines in some of the hottest markets of the country. For example …
In Northern Virginia, existing home sales in October dropped 28% compared to last October, the largest percentage decrease of the year.
If this were a one-time event, it would not raise alarm. But the October sales decline comes on the heels of a 14% decline in September and an 8% decline in August.
Or, if this situation were limited strictly to one area, it would also not be as worrisome. But it seems to be happening, in varying degrees, in most of the once-hot markets. Another example …
In Sacramento, California, sales of new homes have dropped 40% over the past three months compared with the same period last year, according to the local Building Industry Association.
It’s the sharpest decline the group has seen for the August-October period since 1989-1990. Meanwhile, cancellations of pending home sales have spiked because investors got cold feet, couldn’t qualify for a loan or couldn’t sell another property fast enough.
According to the Sacramento Bee, “builders are now enforcing the anti-speculator clause in their sales contracts and are canceling deals if they learn a buyer is an investor, not a primary resident. At the same time, lenders are beginning to scrutinize loan applications more closely, meaning some marginally qualified borrowers now find it more difficult to use the most aggressive, riskiest forms of financing.”
Is this also happening near you?
Check your local paper. Look at the real estate section. Check the ads and compare them to the ads that were running just a few months ago. If you’re not in one of the boomtowns of America, the decline may have not reached you yet … but it could in the very near future.
Interest-Rate Hikes are
Bursting The Housing
Bubble Nationwide
It’s true that real estate is all about location, and every local situation is different.
It’s also true, however, that real estate, especially in the single-family home and condo markets, is all about financing.
But the cost of financing is not set locally. It’s set at a national level.
When rates go up in South Florida, Northern Virginia or California, they also go up in Iowa, Ohio and Nebraska.
And that’s what’s happening right now. The average rate on a 30-year fixed rate mortgage has just reached 6.37% nationally, and should soon be well over 6.5%.
Last year, even with the lowest rates in nearly a half-century, homes were becoming virtually unaffordable. Now, as rates rise — and mortgage terms get tougher at the same time — is it any surprise that sales are falling?
Why This Is Not Just
A Small, Passing Blip
Another common theory I hear frequently is that this is just another, temporary pause. “Last time the market was soft for a short while,” they say, “it was the ideal time to buy. Anyone who bought then has now made a bloody fortune.”
Perhaps. But the hard data show that the situation we’re in today is both
(a) the product of a multi-decade build-up and
(b) an unusually extreme situation compared to previous periods.
One economist who has done a very thorough job of documenting these two facets is Paul L. Kasriel, Director of Economic Research at the Northern Trust Company in Chicago.
Mr. Kasriel, who believes in “the economics of what is, rather than what you might like it to be,” doesn’t seem to buy the argument that we’re just going through another ordinary cycle.
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For instance, he points out that U.S. households are deep in the red.
They used to have a big surplus in their income and expenditures.
But now, they’re spending $531 billion more than they earn each year, the biggest household budget deficit in history.
What’s worse, U.S. households have financed their huge deficits with massive borrowing.
In fact, for every dollar of assets they owned (at market value), they used to have just 7 cents in debt.
Now they have over 18 cents on the dollar in debt. And that’s despite the record-high market value of their real estate. If real estate values fall, their debt burdens will grow accordingly.
Meanwhile, most bankers would have you believe that they are not exposed to a real estate and mortgage bust … that they’ve pawned off most of the risk to investors.
Not so, according to Kasriel’s data, which stretches back over the past half century.
In fact, many U.S. banks have essentially transformed themselves into mortgage companies:
Back in 1987, only about one third (33%) of their earning assets were related to mortgages. Now, that figure is nearing two thirds (62%).
This is not good. It means that, like the 1929 stock-market crash, a housing bust today could have a severe impact on many of the nation’s banks, especially the ones that have been the most aggressive in the mortgage boom.
What also seems to concern Kasriel is the fact that a big portion of the money has come from abroad.
Indeed, from what I can tell, the biggest single source of financing to support the U.S. housing boom has been coming from overseas, especially in the last few years.
As a result, foreigners now own 26% of U.S. assets. Back in 1987, they had only 8.8%.
The overall picture that emerges is not a pretty one: Americans using their homes as the vehicle of a speculative buying frenzy … financed by massive amounts of debt … putting the nation’s largest banks at risk … and leaving the entire nation vulnerable to the whims of foreign investors.
This is not a picture that you can afford to ignore any longer.
What to Do
I have never advocated selling your home. For most people, the home is a lot more than just an investment.
Investment property, however, needs to be sold, especially if the income is not good or the debt load is big.
And for property that you are unable or unwilling to sell, seek protection.
The Short Real Estate Profunds is a handy vehicle. We haven’t bought it ourselves yet because it’s so new. But we’re going to look into it seriously.
The fund is designed to increase in value when the U.S. real estate sector declines and to decrease when the sector rises. Specifically, the fund seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones U.S. Real Estate Index.
In other words, the idea is that when real-estate related stocks go down, this mutual fund goes up, and vice-versa. And more likely than not, if those stocks are going down, it does not augur well for real estate properties in general, probably yours included.
I would not recommend trying to hedge against the full value of your property. That would be overkill. But a partial hedge may be a good idea right now.
Here’s another excellent alternative: For money you can afford to risk, invest in the next big boom. As money shifts out of the housing markets, it is bound to move into new areas that are leading the rise in inflation, especially natural resources.
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Good luck and God bless!
Martin
About MONEY AND MARKETS
MONEY AND MARKETS (MAM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Larry Edelson, Tony Sagami and other contributors. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MAM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MAM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Contributors include Marie Albin, John Burke, Michael Burnick, Beth Cain, Amber Dakar, Scot Galvin, Michael Larson, Monica Lewman-Garcia, Julie Trudeau and others.
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