A Sticky Cycle

Back when the housing bust was still in full swing, we frequently mentioned that the incessant bottom calling may be premature, especially from a longer term perspective. Experience showed that housing cycles can be very 'sticky', both on the way up and on the way down.

While a real estate bubble expands, 'wealth' is seemingly created ex nihilo. Credit expansion and rising home prices egg each other on, an effect amplified by financial innovations such as mortgage refinancing and home equity credit lines. What really expands is not wealth however, but the money supply. It should be obvious that the 'wealth effect' this produces is a fiction, but due to the persistence of the cycle, there is a tendency for people to begin to regard the gains as real and permanent.

With respect to the 'stickiness' aspect, consider that e.g. Doug Noland (the credit analyst of the Prudent Bear fund) already started looking askance at the balance sheets of GSEs like Fannie Mae and Freddie Mac as far back as 1998. Noland presented a thought experiment at the time: what if the value of Fannie's portfolio were to decline by just 3% or 4%? He pointed out that its equity would be completely wiped out and rightly noted that this extremely overleveraged entity represented a danger to US tax payers.

Noland drew attention to the fact that the GSEs tended to swing into action whenever a confidence crisis hit the stock market, such as in 1998 when the Russian and LTCM crisis struck. The GSEs would help with system reliquification by stepping up their purchases of mortgages from commercial banks. In essence, they used their nimbus of invulnerability, provided by the well-known fact that they would definitely be bailed out if push ever came to shove, to rescue the still evolving asset bubble on such occasions. Around the same time when Noland began to talk about these activities and the associated risks, the Fed started to accept GSE debt in its open market operations, introducing outright monetization of mortgage debt. This method has a long tradition – it is essentially a modern day version of what the French revolutionaries did with the assignat.

And yet, it would take another decade before the thin capital buffers of the GSEs provoked their implosion into outright bankruptcy when the credit expansion and housing cycle finally turned down. If not for massive monetary pumping, a string of bailout measures and the introduction of new accounting rules, they may well have taken several of the largest US commercial banks with them.

The contraction that follows on the heels of a major real estate bubble is often just as sticky as the previous expansion was. The reason (as e.g. Japan demonstrated) is that someone has to bear large losses once the phantom wealth disappears – whether the losses are admitted to or not. Among those hit the hardest are usually both commercial banks, as well as their major debtors – households that see their home equity disappear and turn negative as prices return to earth.

A comparison of bank credit outstanding: Japan's commercial bank credit growth eventually went negative after the bubble era – click to enlarge.

The illusory accounting profits of the boom were very large, and the subsequent  losses are essentially their mirror image. One therefore ends up with a banking system unwilling and incapable of restarting the inflationary lending cycle (mind, it would be capable in theory, but in practice it would maneuver itself into an even more vulnerable position) and scarred would-be borrowers who are no longer interested in burdening themselves with debt that might come back and haunt them in the future.

Skeptics Overruled by Rising Prices?

We subsequently watched with awe as Bernanke's 'QE'-driven echo bubble grew ever larger, eventually beginning to take house prices back up as well,  in spite of still widespread mortgage delinquencies.

However, as our resident real estate expert Ramsey Su (who has been active in the RE business for decades) never tires to point out, there is no reason to believe that the echo bubble is any more stable than its predecessor, as it largely depends on all sorts of government interventions, with the Fed's money printing and interest rate manipulation the most important. While fewer and fewer people voiced skepticism over time, Ramsey has kept at it,inter alia warning that Wall Street firms buying up homes in REO-to-rental schemes don't represent organic demand, and in fact only serve to price out potential first time buyers.

Moreover, the ever higher pile of new rules and regulations bedeviling the mortgage industry has slowly but surely created housing finance socialism, with government-subsidized entities such as the carcasses of the GSEs completely dominating the market.

Who is served by rising house prices? In the end they are the outgrowth of an attempt to resurrect the illusory wealth of the expired bubble. They may help 'repair' credit that the bust has revealed to be unsound. However, this ultimately means that unsound investments are not liquidated. Instead there is an attempt to reestablish what is essentially an unsustainable charade.

However, in spite of the recovery in prices, there has always been one market segment that has painted a more worrisome picture and probably reflects the true state of housing demand better – namely new home sales and the new mortgage applications associated with them. While a recovery of sorts was initially underway in new home sales as well, it never developed much momentum. The most recent data release appears especially unkind in terms of the recovery meme.

New home sales: a weak recovery, followed by a period of sideways movement, lately punctuated by what may well be the beginning of a new downtrend – click to enlarge.

Looking at the percentage change in new home sales reported on Wednesday, a more than 14% decline was recorded in March, one of the worst showings in quite some time. Similar to the sharp decline in early 2013, it may turn out to be an outlier, but one must keep in mind that the composite index of new mortgage applications (refinancing and purchase applications combined) is plumbing new lows, while purchase applications alone are very close to the low end of their post bubble range.

A large percentage change – following a 4.5% decline in February, a roughly 14.5% decline follows in March - click to enlarge.

It seems a good bet that if new home sales continue to remain this weak or weaken even further, prices will eventually reverse again as well. Regarding  the REO-to-rental schemes that have pushed prices higher, we refer you to Ramsey's countless detailed observations with respect to the problems these investments entail. They make their long term viability doubtful, especially in light of how far prices have already risen from their lows in many regions.

Below is a comparison chart of Japanese real estate prices in the last years of the bubble era as well as the post bubble era to prices in the US, Spain and the UK. Keep in mind that Japan's situation is of course in many ways unique, so this is not meant to suggest that prices elsewhere will necessarily follow the same path. It is e.g. already certain that there won't be a similarly relentless decline in prices in the US or the UK, as an intermittent recovery has already taken place. Spain's situation may come closest to the relentlessness of the price declines seen in Japan, not least because it has analogous demographic problems. Mainly though this chart is meant to illustrate the potential 'stickiness' of the cycle on account of the huge amount of financial damage real estate bubbles tend to mete out.

Japan's house price bubble and bust compared to the US, Spain and the UK. Note the charts are already a bit dated and fail to include the recoveries seen in the US and the UK in the meantime (prices in Spain have continued to decline) – click to enlarge.

Conclusion:

It is probably best not to pin too much hope on the echo bubble effects that have been in evidence since the Case-Shiller house price index bottomed out. The fat lady may yet sing another aria before long.

The MBA purchase applications index – testament to the continued absence of first time buyers, many of whom have been either been priced out of the market, or are simply unable to qualify for loans or deal successfully with the huge amount of red tape associated with mortgage applications nowadays – click to enlarge.

Charts by: St. Louis Fed, Bank of Japan, Calculated Risk