Real Estate/Credit Deflation 16: The Next Dozen Shoes to Drop

By: Steve Moyer | Fri, May 9, 2008
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"If the shoe fits, it's too expensive." ~ Adrienne Gusoff

I was offered a very nice position with Fisher Investments of Woodside, California last year and, although I passed on the opportunity, I truly respect their money management track record. At the same time, I have noticed from their website that they are comparing the current equity market with the set-up which existed in 1992; they see this as a brief cyclical downturn prior to a multi-year bull market run rather than an unfolding, post-triple-bubble economic downward spiral. In fact, as I look through the site's archives, the Fisher research team (60 strong, and plenty bright) doesn't address post-bubble possibilities in any way, shape or form. They have a major blind spot -- that being the collapse of real estate values and related securities in the U.S (and beyond) and the economic ramifications thereof. I guess they're too busy trying to figure out why the stock market isn't rallying enough based on attractive P/E ratios, favorable bond-to-earnings yields, low interest rates, wanton monetary policy and other irrelevant indicators. The answer is it's all being trumped by contagious real estate deflation.

This is no cyclical downturn, friends. This is post-bubble-bubble-bubble time in the U.S. (and now we've added deflating China and India stock bubbles to the mix). When the happy talkers on CNBC tell you about real estate or investment cycles "since World War II" or yammer on about "typical bear markets," just know that that's why bubbles inflate in the first place; few know (or want to know) anything about investment manias, credit implosions or deflationary depressions. Few know that bubbles go bust with frightening consequences, or that housing bubble deflation is the most onerous one of them all (because far more people own houses than stocks). The "don't worry -- values will always go up!" crowd, emboldened by some sense that the Fed will surely "take care" of everything, will be the one turning bitter in the months and years ahead, while asset preservationists rule the roost.

Before I move on, please take a moment to read a signature piece related to our real estate/credit deflation premise. Penned by Michael "Mish" Shedlock, this is the article I'll be sending from here on out when hyperinflationists write in to say "The Fed will never allow a deflationary depression!" As we've maintained from the beginning, the problem is much too big for the Fed to contain, and Mish's article reflects that. I couldn't agree more with his conclusions. To wit:

While I'm at it, Mish is on fire right now, and he has his finger firmly on the pulse of what is taking place in the U.S. economy. I suggest you bookmark and read his blog each day (or as time allows):

Onward: In response to a request from one of our readers, I decided to make like a cobbler and throw out the next dozen shoes to drop as real estate and credit deflation take greater hold. I accept the challenge, and understand that these answers might have some bearing on a 2008-2009 investment decision or two. So here goes:

1. The Fed won't turn around rapidly developing and contagious "depression psychology." Can't, isn't and won't. Picture Bernanke, Paulson and the other United States' Economic Dictators standing around an emptying toilet bowl, frantically using their bare hands to keep water from going down the drain. Such is the case of these Dictators vs. the awesome force that is real estate/credit deflation.

When home values are declining and banks are afraid to lend money (to borrowers AND to each other), it makes no difference what desperate "policymakers" do; Bernanke, Paulson and friends don't have the power to force people to borrow and banks to lend. The market does that. That confidence is waning, and it's not coming back until few think it ever will.

2. Nothing will stop real estate values from continuing their decline; they will continue to fall, from coast to coast, category to category, setting up an eventual "crash" when a global systemic event takes the entire market out at the knees. Just laugh in the face of those who say real estate is bottoming now or will bottom "later this year," in 2009 or any other time in the next five years (at least). Certainly there won't be a "bottom" until a meltdown of one sort or another comes to pass and until most conclude that buying real estate is a losing proposition. Anyone who says we've reached bottom in the meanwhile surely has something to sell you (probably real estate or stocks).

THERE IS ABSOLUTELY NOTHING TO SUGGEST THAT THINGS ARE IMPROVING IN THIS ARENA; IN FACT, as lenders get more skittish, financing gets tougher to find by the day and more cash down is required, THINGS ARE GETTING MARKEDLY WORSE. REAL ESTATE VALUES ARE IN FULL DECLINE, AND THERE IS A LONG WAY TO GO. It's the top of the second, not the bottom of the eighth.

Credit Suisse projects that by 2012, 12.7% of houses in the United States -- roughly 6.5 million homes or ONE IN EIGHT -- will have been foreclosed upon (I think it will eventually be worse than that). Regardless, that projection alone is enough to cause significant strain on the U.S. economy, and that strain will only lead to more asset deflation. Suffice to say post-bubble real estate deflation has a long way to go, my friends.

Property sales require a willing buyer, a motivated-enough seller and an agreeable lender and there aren't now -- nor will there be -- enough of these folks to go around for possibly a generation. Buyers, in particular, will become ever-harder to come by.

When "the government" starts bulldozing entire tracts of houses -- and they will at some point -- in an attempt to do SOMETHING about chronic and persistent housing oversupply and blight, we'll start talking about "the bottom." Until then, there is no bottom.

3. "I can't get financing." Despite my protestations, a client recently decided to buy a $4 million property direct from an acquaintance of his; a property/price combination he thought was too good to pass up. Tellingly, no lender came close to offering him the loan he expected. They either weren't interested in the loan at all or wanted a lot more money down and a much higher interest rate, not to mention his first-born male child as collateral. Once he got a sense of what the new rules of the game were, he quickly decided to pass on the "great opportunity."

A few months from now there might be another buyer, and she'll need even more cash to make the deal. By then, she'll be familiar with the financing landscape and will want a correspondingly lower price. Lo and behold, and assuming the seller is motivated enough to reduce the price again, even fewer lenders will want to make the loan. And so on down the deflationary line. It's part of the process, and happening as we speak. Most buyers don't realize it until one lender after another says thanks, but no thanks.

Get used to the refrain. Each month will bring additional categories of loans lenders will no longer be willing to make. For example, financing for condominiums (except within mature, well-established projects) is already almost impossible to get, which is sure to knock condo values down another 30-40%.

The Fed may lower short-term rates, but as we're learning, that doesn't mean lenders will follow suit. Now that they're back to imputing risk, they want higher returns, and the only way to achieve that is to raise interest rates, no matter the Fed. Truth is, the Fed has little to do with market interest rates for real estate.

The Catch-22 is that as real estate deflation continues to unfold, those intelligent enough to have 10 or 20% down (or more) plus cash in the bank to back up the purchase won't be stupid enough to throw good money after bad via buying market real estate. Only complete dunderheads are buying now and the dunderhead contingent grows tinier by the day.

4. Banks will be under more pressure, and bank failures will follow. When the stock market's countertrend rally is finished and the summer/fall dive in the market takes hold, the cover story will likely be centered around failing financial institutions -- large and small -- and the "We Don't Have Enough Fingers for the Dike!" Fed. As one leak is plugged, three more will appear, and market confidence will be shattered as all major asset classes fall in value at roughly the same time. Nothing like a major headline run on the bank (or several) to get Americans heading into full-on depression mode.

5. The "Wealth Effect" will morph into the "Broke Effect." The U.S. economy boomed and the stock market benefited from artificial, Fed-induced 2003-2007 reflation, mostly because folks felt wealthy due to phony home value "increases." This meant boomtimes in real estate, a seemingly healthy economy, further expected value increases, little incentive to save and an American cultural rush to "borrow to buy things." Now that home equity is disappearing by the day, homeowners saddled with too much debt feel ever poorer, not wealthier, and they'll do what most people do when they feel broke: They'll watch every penny and say no to more debt.

6. Consumers will spend less with each passing month. The downturn in retail sales will become increasingly pronounced and force scores of bankruptcies in the retail sector. Face it, cash-strapped Americans, getting clobbered each week by the high cost of food and gasoline, forced to buy things with money they don't have (I'm talking cash, not disappearing credit), and already saddled with too much debt, have no choice but to snap shut their pocketbooks. More importantly, they're in the process of discovering that almost any discretionary purchase will cost them less next year. Discount retailers might weather the storm, but the more optional the purchase, the worse-off the retailer will be. Not only will retailers be unable to pass along rising costs to their customers, price cuts, discounts, coupons, giveaways, close-outs and going-out-of-business sales will become the only way to attract increasingly tight-fisted consumers in the United States.

Obviously, retailers who opened outlets from coast to coast to take advantage of the borrow-to-buy-things spending spree of 2003-2007 will not be able to withstand such a striking reversal of fortunes. Look for going-out-of-business sales, sudden store closures, an epidemic of empty storefronts and rashes of bankruptcies (including a few "headline" big box names). Shopping mall and shopping center values will quickly get clobbered.

7. The commercial real estate value decline will intensify. The homebuilding index led the way downhill in 2005 and home values soon followed suit; the same is now true in the commercial real estate game. Values on the commercial side have held up fairly well through the 2nd half of 2007 but commercial and office REIT's are now getting hammered (there's your fair warning) and the commercial mortgage sector is in the process of joining the growing default party. Seasoned real estate investors are increasingly willing to wait on the sidelines; they see the handwriting on the wall and are happy to look for better deals. They MAY buy, but only at risk-premium discounts (i.e., higher capitalization rates) and that means lower prices.

As real estate deflation takes further hold, no commercial real estate category will be spared. Current investors will have their own problems to deal with (rising vacancies, lack of fresh leasing interest and declining rents) and they'll lose interest in buying until THEY think the shakeout is complete (best guess: April of, oh, 2018).

Interestingly, apartment rents have increased solidly in 2007 and into 2008 as housing sales have come to a standstill and folks choose to rent (or have to), but that trend will reverse itself soon enough. The last time the U.S. experienced a deflationary depression, residential rents fell for 18 consecutive years. Expect the same or worse this time around. The market has held up fairly well for residential income property, but it won't be immune to deflationary real estate forces. If you don't sell your residential income property given everything you know now, you'll have no one to blame but yourself as values decline and management headaches multiply. It's still a very good time to get out.

8. U.S. real estate deflation is now the world's real estate deflation. To make matters worse, much of the rest of the Western world is now experiencing the same, steep housing price drop/credit crunch. Real estate deflation has arrived on a worldwide scale and the pressure on the global economy and banking will be too great to hold back the spreading deflationary forces. Central bankers cannot and will not control the outcome, try as they might to slow it down during the plague's early stages.

9. Yes, your area will be hit, too. It's just a matter of time. Each passing month brings another state or two -- and more counties within each state -- afflicted by real estate and credit deflation. Here in the Bay Area, for instance, San Francisco, San Mateo, Palo Alto, Marin County and the Oakland and Berkeley Hills have held up reasonably well in terms of median price, while neighboring communities get pimp-slapped one after another. Alas, it's only a matter of time until the cancer spreads. First off, the number of sales in less-impacted areas is down substantially (fewer stupid buyers willing to pay last year's prices). Second, instead of "discounting to sell," frustrated but well-heeled sellers just take those properties off the market while they "wait for things to rebound and prices to go back up;" so entrenched is their view that values will keep going up, with occasional pauses along the way. In this case, it'll be like waiting for Godot.

Years from now, those sellers will end up either selling at lower prices (when things are significantly worse), walking away when they find themselves hopelessly underwater, or sitting in rocking chairs, waxing nostalgic about the time their property was worth two, three or four times what it has become.

10. Stock markets around the globe will face ever-more downward pressure, dragged down by real estate and banking woes in the United States and beyond. When the real estate pain becomes bad enough, those markets will crash, too. Will a stock market crash cause a bigger real estate crash, or vice versa? The answer is yes.

It doesn't really matter which is the chicken and which is the egg. With credit and real estate markets collapsing worldwide, a woeful lack of consumer confidence, ever-greater effects on the consumer and the economy (not to mention employment), people will be in no mood to buy stocks. There might be a countertrend rally or two yet to come, but the late-2007 "top" is in and the post-triple-bubble deflationary drift will be overwhelmingly down. When the majority of people realize that the global economy has no chance of turning itself around, the United States stock market will crash and world markets will follow, causing real estate and other asset values to ratchet down even further.

11. Local and state governments and school districts, already under pressure, will feel the crunch more each day, and deficits, layoffs and bankruptcies will follow. Declining property values + far fewer transactions = significantly less revenue for state and local governments. It will be interesting to watch overtaxed and cash-squeezed citizens battle state and municipal entities as politicians try to float more bonds and work to raise taxes and fees in order to offset huge reductions in revenue. Meanwhile, necessary layoffs and budget cuts in the public sector will just add to the post-bubble, deflationary pressure.

12. One bad thing leads to five others. Falling home prices will affect confidence which will affect buying psychology which will affect home sales which will affect the economy which will affect employment which will affect creditworthiness which will affect availability of credit which will affect earnings which will affect stock values which will affect social mood which will affect employment which will affect consumer spending which will affect home prices which will affect confidence which will affect buying psychology which will affect home sales which will affect.....Ah, hell, you get the picture.

If your neighbors can't connect the dots by now, there's really not much hope for them. I'm just glad you're here, reading stuff like this, taking good care of the eggs in your basket. Risk is everywhere, and something inside of you is telling you to be alert to the possibility. You're in a very select group, and I applaud you for it.



Steve Moyer

Author: Steve Moyer

Steve Moyer,

Steve Moyer is a columnist and assistant editor of the monthly newsletter, Ponder This.... ( He has been an investment real estate broker since 1982. Contact Steve at

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