Let's Get Real about Real
Aug 29, 2008
Once again, real estate market
watchers have pounced on a shred of seemingly positive news to
proclaim that the long sought "bottom" is in sight.
The routine is becoming extremely stale, but somehow the media
never seems to tire of it. This time the "good" news
was that the percentage declines in national home prices (according
to Case Shiller) in July were not as large as they were
in June. Although the report contained many other negative data
points, including increased inventories and a spike in foreclosure
sales, it was the slowing declines that got spotlight. Talk about
grasping at straws. The truth is that real estate has been grossly
overvalued for years, and the adjustment process back to realistic
pricing has only just begun. The problem is few among us seem
to appreciate the magnitude of this adjustment and its implication
for an economy dependant on inflated assets values.
By most accounts, the decade long housing boom began in 1996
and finally went poof in mid-2006. In January 1996, the Case
Shiller 10 city composite home price index stood at 76. By June
2006 it had tripled to 226, by far the largest increase in U.S.
history. Since then, the index has pulled back by 20% to 180.
For those who believed that home prices could never retreat nationally,
this 20% correction is more than enough. In reality, it's just
the down payment.
When real estate prices were expected to rise in perpetuity,
the price of a house had two components, one representing shelter
and the other investment. The shelter component was the actual
utility and desirability of the house and the investment component
was the expected future appreciation. My guess is that at the
peak of the real estate mania, a $500,000 house might have been
comprised of $250,000 for the shelter component and $250,000
for the investment component.
In effect, the appreciation potential, and the ability of the
homeowner to tap into it though refinancing and home equity loans,
offset the real costs of home ownership, such as mortgage payments,
taxes, insurance, and maintenance. So the main reason a buyer
would commit to a mortgage that would soak up 50% of his disposable
income was that he expected to recover most of that outlay through
future appreciation. Absent the expectation of that windfall,
buyers would not have been willing to pay such staggering prices
for houses or commit to burdensome mortgage payments.
Lenders were caught in the same delusion. Since they too believed
prices could only rise, lending standards were thrown out the
window. If the collateral (the house) were to always rise in
value, what difference would it make if the buyer made the payments?
In effect, instead of relying on the borrower's ability to pay
to mitigate its risk, lenders merely relied on the house's ability
However, now that real estate prices are falling, lenders are
beginning to rely solely on the borrower's ability to pay. As
this trend continues, lending standards will tighten and mortgages
will be brought back into line with the incomes of borrowers.
In addition, down payments will be larger to reflect the greater
likelihood of losses should loans end up in foreclosure. When
prices were rising the foreclosure risk was negligible. However,
now that foreclosures are soaring and recovery rates are less
than 50 cents on the dollar, those risks are enormous.
So with falling real estate prices, mortgages are much less appealing
to both borrowers and lenders. The only solution is for home
prices to fall to where they are cheap enough for buyers to afford
the mortgage payments (both interest and principal) without relying
on appreciation, teaser rates, or negative amortization, and
save enough for a down payment that would protect a lender in
the event of default. In addition, the collapse of the mortgage
securitization market means houses must be cheap enough for our
limited pool of domestic savings to supply the funding, as we
will likely lose access to much of the foreign funding that fueled
Of course we need to be honest about the winners and losers of
this credit crunch. Just because mortgage money becomes scarce
and lending standards tighten does not mean people will not be
able to buy houses - it simply means they will pay a lot less
for them and that fewer new houses will be built. Therefore it
is sellers, builders and those holding or insuring existing mortgages
who lose, while buyers win big. That is because despite higher
interest rates and larger down payments, they end up borrowing
a lot less money. In the end they will become true homeowners
rather than indentured servants. If home ownership truly
is the American dream that so many realtors profess, then the
ongoing collapse in home prices will be a dream come true.
For a more in depth analysis
of our financial problems and the inherent dangers they pose
for the U.S. economy and U.S. dollar denominated investments,
read my book "Crash Proof: How to Profit from the Coming
Economic Collapse." Click here
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Aug 29, 2008
C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
Mr. Schiff is one of
the few non-biased investment advisors (not committed solely to
the short side of the market) to have correctly called the current
bear market before it began and to have positioned his clients
accordingly. As a result of his accurate forecasts on the U.S.
stock market, commodities, gold and the dollar, he is becoming
increasingly more renowned. He has been quoted in many of the
nation's leading newspapers, including The Wall Street Journal,
Barron's, Investor's Business Daily, The Financial Times, The
New York Times, The Los Angeles Times, The Washington Post, The
Chicago Tribune, The Dallas Morning News, The Miami Herald, The
San Francisco Chronicle, The Atlanta Journal-Constitution, The
Arizona Republic, The Philadelphia Inquirer, and the Christian
Science Monitor, and has appeared on CNBC, CNNfn., and Bloomberg.
In addition, his views are frequently quoted locally in the Orange
Mr. Schiff began his investment career as a financial consultant
with Shearson Lehman Brothers, after having earned a degree in
finance and accounting from U.C. Berkley in 1987. A financial
professional for seventeen years he joined Euro Pacific
in 1996 and has served as its President since January 2000. An
expert on money, economic theory, and international investing,
he is a highly recommended broker by many of the nation's financial
newsletters and advisory services.