One Million Opportunities

Last week the headlines screamed that the number of homes foreclosures had passed the million mark [See, for instance, Homes in Foreclosure Top One Million at CNN/Money]

Some see a train wreck the size of the global economy. Smarter people see one million opportunities.

We all know the story of how the opportunities were created. Housing prices started going up after the Internet Stock crash of 2001 because the Federal Reserve set interest rates too low and left them their too long. Stupid people were egged on my news media, real-estate agents (my friend John calls them land pimps), banks and mortgage companies, friends and relatives to believe that housing prices would always go up at 10 to 20% per year. A house was no longer just a place to live in, it was a money machine. Why, it was such a sure thing you could buy a house without a down and be rich in almost no time.

I've seen smarter people who believe a carpenter can raise the dead.

Some people worked and saved and did not fall for the flim-flam. Now they have downs and if they can buy a house at the right price they can eliminate their rental expense. They can build equity the old fashioned, reliable way: by spending less than they make and paying down the mortgage.

It is a good thing. The profligate are punished and the thrifty rewarded.

Not every house in foreclosure is a good buy. You have to ask yourself, what is the real value of this house, and how does that compare to the asking price? Just like stocks. I always ask myself, before buying or selling a stock, what is the market capitalization of the company, and if I were going to buy the whole company, would that be a price I like?

Not everyone should buy a house just because the price is right. It takes energy or money, and sometimes both, to keep up a house. Things go wrong, things wear out. Taxes have to be paid, and they will eat up the original purchase price of the house in the long run. Don't kid yourself, all land in the U.S. is just rented from the government, and taxes are the rental payments.

And people are out there hunting and buying. April used home figures were released today [See April Pending Home Sales Rise As Prices Tumble] and they reflect what I've been hearing anecdotally in California. If a home is for sale and it is priced right, it can sell quickly. People who are trying to sell for imaginary prices, their properties will just sit.

There are scenarios that could make buying homes now look stupid, but they are becoming increasingly unlikely. Buy a home at the right price and ugly scenarios are balanced by some pretty bright ones. Some distressed sellers may sell so cheap that a non-distressed seller to have some equity, aside from a down, pretty quickly.

Most in demand: homes near workplaces or on public transportation routes.

Housing Market Distortions

Most traditionalist economists believe that markets are always in equilibrium. I believe that markets are almost always out of equilibrium. The questions speculators have to answer correctly are: how much, and in which direction.

Comparing the housing market and the stock market can give a lot of insight into causes of disequilibrium. The stock market can be broken down into stocks that are heavily traded and stocks that are thinly traded. To a large extent the national housing market behaves like a heavily traded stock, but local markets trade more like thinly traded stocks.

Another useful dichotomy: is the trading auction style, or swap style? By swap style I mean the traditional markets as described by Adam Smith: a rational (or at least savvy) person at each end, trading something of value, when there is an elastic supply of the two items (one usually being money) to be traded.

Today there is an almost 10 month supply of unsold houses on the U.S. national market. Two years ago houses more often than not sold the day they were put on the market; houses under construction sold before construction began. Yet the economy is arguably stronger on the whole today that it was two years ago. Anyone who argues that the housing market, or sale prices of housing, is always at equilibrium is saying nothing. They are defining equilibrium to be whatever happens. Same for stock prices.

Suppose you are going to buy something; it could be a stock or a house. As long as the price is rising and continuing to rise it makes sense to buy as soon as possible. Maybe normally you would save up a 20% down to get a good interest rate on a mortgage; but with prices increasing, it makes more economic sense to put 5% down and pay a higher interest rate now, rather than waiting two (or ten) years to save up the down.

The same becomes true when prices are falling. Why buy house now, even if you want it and think it will be a good long term investment, if you think you can buy it for 5% or 10% less if you just wait 6 months?

Rising prices accelerate demand, which in turn makes prices rise more. That is one reason why stock prices and housing prices tend to be out of equilibrium. Falling prices tend to dampen immediate demand, which in turn causes prices to fall more. That is the other main reason prices are usually out of equilibrium. These tendencies are the basis of macroeconomic cycles and of stock market price fluctuations that may last hours, weeks or even years (or, with super-fast computerized program trades, fractions of a second).

Auction systems aggravate these trends, partly because of human psychology and partly because they create a short-term artificial scarcity or surplus. Price swings in thinly traded, illiquid stocks display this.

Buyers in the housing market aren't going to be in a hurry until prices start rising again. The exact turning point won't be obvious, partly because it will take place in different localities at different times. The willingness, and ability, of lenders to finance purchases may stall or accelerate the process of finding a bottom.

But there will be a bottom. Strangely, the longer it takes to reach it, and the deeper the retreat in prices is, the more people will think there is no bottom.

When Will Housing Recover?

Here in California, you can feel the panic. It is beginning to look like housing prices are not going to drop substantially, except in a few specific localities.

And why should they? Despite the building frenzy between 2001 and 2006, there is an overall shortage of housing in California. Right now it is hard to find rentals, much less reasonable rentals. Plenty of houses are for sale, but the prices can't be said to be bargains.

I know many couples around the state who have high incomes ($50,000 per year or higher), live in apartments, and have been hoping to buy a house for years. 2007 finally seemed like the year of the promised decreases in house prices. Some individual houses for resale have lowered their asking prices, but statistics for April show that the median statewide housing price was flat compared to year-earlier.

If housing prices were to drop, buyers would step in. As people stop hoping to save by waiting for a drop, the market overhang will be absorbed.

Since prices did not drop, even most of the fools who bought in 2006 have not lost any money.

There are some exceptions, mostly large housing developments built in 2006 in the outer reaches of the Central Valley.

All this fits into a pretty pleasant macroeconomic picture. Jobs are plentiful. For those who are steady workers and have saved a down payment, 30 year interest rates are historically low, near 6%. Having heard horror stories of people who bought housing on at adjustable rates, sane people are thinking about how nice steady monthly interest payments would work out over 30 years.

It does not appear that things are much worse in the United States as a whole. Immigrants, legal and illegal, create a constant push into the housing market. Some areas like Florida were severely overbuilt, and some cities have lost jobs and will continue to have weak housing markets as a result. But already the New York City and Boston housing markets are heading back up.

As to the subprime mortgage market, it is a problem for the fools who did the lending, but its impact on the California market will be marginal at best. There are people with real money who want those homes, especially if they can get them at even the slightest of discounts.

The only thing that could substantially depress prices in California as a whole is a recession. But with employment solid, consumer spending okay, and the rest of the world's economies booming, that is an unlikely possibility.

Note to the Dow is at record levels. That means some people who were worried about the value of their portfolios back in 2002 (even if they did not over invest in Internet stocks) are not so worried.

In a way it is too bad. Housing is astonishingly expensive in California. It is hard for people to get started just out of college, or if they are spendthrifts. But those have always been the choices: spend or save and invest. A job, few years of saving, a down, and a thirty year mortgage: that was a formula for success 40 years ago, and it is still a formula for success.

Construction Workers and the 2007 Economy

I am not as worried about the 2007 economy as some, despite my reputation for gloom and doom. I acknowledge the downside risks, of course. In one particular, construction worker employment, I think the risk is typically overstated.

No doubt that the construction of new housing has slowed down and is not likely to perk up significantly in 2007. But did you or any of your friends try to get a contractor to do major repairs, additions or alterations in 2005 and 2006? Everyone was busy; pricing verged on extortion; projects started months behind schedule and sometimes ended years behind schedule.

So while there is not pent-up demand for new homes, I think there is plenty of pent-up demand for construction workers. Overtime will be cut back (if it has not already been) so many workers will have smaller paychecks. In California many overworked Mexicans may simply take a nice vacation back to their hometown, where many are building a house of their own. There will be increased competition in the repair, alter, and addition market, which will be great for frustrated home owners.

Real estate workers (dirt pimps, my friend John calls them) are seeing smaller paychecks, but that is just part of the game. Many new real estate agents who came on board in 2004 and 2005 would never have survived under normal positions. It's disappointing to have a real estate license and be lining up for a job at WalMart or Target, I'm sure, but good times will come again and at least you'll already have the license. Smaller paychecks should remind people of the importance of saving during good times, a lesson much of America seems to have forgotten.

I believe it is a bit early to be buying stock in home construction companies, given the uncertainty going forward, but if you do buy now at least you'll be buying the stock for way less than what people were paying for it back in 2004 and 2005.

Live and learn. A down cycle is just a good time to mentally flip the chart and see it as a rising inverse. Laid off by a big construction company? Hopefully you saved some money during the boom. Get your contractor license, print up some business cards, and knock on some doors. Do good work, put your customers before yourself, and soon people will be knocking at your door. Adapt and thrive.

I'll be on vacation a few days, then back to share more with you in 2007.