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March 15, 2007

Housing: Game Over
by Gary Carmell

This article originally appeared at Red County Magazine.

I am going to get right to the point. Housing, especially in California, is dead money for many years to come. Game over. It's that simple.

In March 2005, I stated that anyone buying a house in Orange County should have a 10-year horizon and be comfortable with having lost paper wealth during that period of time. Virtually every investment boom/bubble has the same characteristics: The perception that easy money can be made with little risk is reinforced by the media and "cocktail chatter" which serves to suck in the public (the "dumb money"). Those that believe they are very smart want to display their intelligence by sharing with others how well their investments are doing. Those not in the game feel like they are stupid and not keeping up with their neighbors who are on the path to the American Dream. Other characteristics of an investment mania are a lot of borrowing, fraud at the tail end of the boom, questionable quality supply of whatever is in high demand, and then a crash.

Prior to the housing boom, the most recent financial bubble was the dot com/telecom craze of 1995-2000. Let's compare the two:

DOT COM & TELECOM

Public Participation: Enormous numbers of day traders.
Borrowing: Huge margin debt and massive corporate spending on technology.
Fraud: Illegal IPO allocation, fraudulent accounting, and now back dating of stock options. Just think of Enron and Worldcom.
Questionable Supply: Junk companies going public in which most of them failed.
Crash: NASDAQ dropped 80%

HOUSING

Public Participation: Large numbers of condo flippers and investor/speculators.
Borrowing: Extraordinary amount of mortgage lending much of which is highly risky given the repayment terms and interest rate risk.
Fraud: Widespread appraisal fraud and false information provided on loan applications encouraged by shady mortgage brokers. Massive accounting irregularities by Fannie Mae and Freddie Mac.
Questionable Supply: Massive numbers of condo conversions of basic apartments and a large amount of new condo construction.
Crash: Housing prices are falling rapidly in areas that have experienced great appreciation, inventory is exploding, and new home sales have dropped 25% from its peak.

Supply and demand are out of balance. Second home buyers and speculators are no longer buying. In many cases they are selling. Inventory of new and existing homes for sale is at a record level and it is taking longer and longer to sell homes.

According to basic economic laws, the only way to clear the market is by lowering prices. Major builders have been very aggressive and have taken a two-prong approach:

Offer incentives like upgrades or subsidized interest rates
Slash prices (particularly in high cost areas like California)

LESSONS FROM MARKETS PAST

My firm had an extensive history in the manufactured housing industry and we have learned valuable lessons during past markets that can be applied to the current market.

Like today's home builders, we were faced with the formidable challenge of selling new homes in a soft market that were competing with lower priced resales. We reduced our prices and individual home sellers were often forced to follow. As their equity and financial security began to dissipate, many sought litigation to recoup their losses and assuage their fears. With similar circumstances prevailing in this market, I predict a rash of lawsuits against builders, particularly condo developers and apartment converters in communities that only sold a portion of the units and rented the remaining units.

Another important lesson relates to lending. In 1999, with the lending spigot turned on full blast, lending peaked at $13.5 billion. Shortly thereafter, the insidiousness of poor lending practices and outright fraud materialized. Wall Street investors recoiled. Lending dried up. Home prices fell.

EXOTIC LENDING

According to the Federal Reserve, total outstanding home loans increased from $5.1 trillion in 2000 to $9.8 trillion in 2006. This explosive growth has been fueled over the last six years by an exotic array of repayment and interest rate options that have been created to assure every living and breathing individual could buy a home, whether or not they were financially and emotionally prepared.

You don't have a down payment? No problem. We'll either arrange for 100% financing or get a foundation to gift you a down payment. Don't worry about the fees they are making on the transaction or that their foundation is endowed with money gifted to it by homebuilders.

You have credit card debt you need to pay off? No problem, we'll lend you 125% of the value of your home and consolidate all your debt.

You're worried that you may not have enough income to qualify for the loan? No sweat, we'll fill out a "stated income" loan where the lender doesn't verify your income and instead just takes your word for it. You do make $95,000 per year, right?

From 1970 - 1981, the U.S. homeownership rate was between 64.3% and 66.0%.

From 1982 - 1994, it ranged from 63.5% to 64.4%. Since 1995, however it has gone from 64.2% to 69.2%, an enormous increase in market share for owner-occupied housing.

My assertion is that all investment manias have the common characteristics of the perception of easy profits with little or no risk, loose lending standards, and outright fraud and deceit. This housing boom has been fueled by a mortgage finance bubble on an unprecedented scale that will have enormous economic implications as it unwinds. With Federal Reserve Chairman Ben Bernanke acknowledging the risk of an economic slowdown due to a deflating housing market, long-term interest rates have very little risk of moving much higher.

When you read my article in 2015 don't be surprised if the value of Southern California homes has not changed from where they were at the peak in 2005. Meanwhile, enjoy your home; remember that its primary purpose is for shelter and satisfaction and not necessarily a source of wealth creation. On the other hand, it may be hard to find an apartment over the next decade as the allure of home ownership begins to fade and financing tightens up.

Gary Carmell
CWS Capital Partners LLC