This is an excerpt from an article posted by David J. Merkel posted on both Barry Ritholtz’s blog, the Big Picture, and his own, the Aleph Blog. The full article can be found either here (Aleph Blog) or here (Big Picture).
By David J. Merkel. David is Chief Economist and Director of Research of Finacorp Securities. He writes daily commentary at Aleph blog.
Excerpt: "This piece completes a series that I started RealMoney, and continued at my blog. For those with access to RealMoney, I did an article called The Fundamentals of Market Tops, where I concluded in early 2004 that we weren’t at a top yet. For those without access, Barry Ritholtz put a large portion of it at his blog. I then wrote another piece at RM applying the framework to residential housing in mid-2005, and I came to a different conclusion: yes, residential real estate [RRE] was near its top. Recently, I posted a piece a number of readers asked me to write: The Fundamentals of Market Bottoms, where I concluded we weren’t yet at a bottom for the equity markets.
This piece completes the series for now, and asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?
Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different. The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors. At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up. There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.
As a friend of mine once said, “To make a stock go to zero, it has to have a significant slug of debt.” The same is true of RRE and that is what differentiates tops from bottoms. At tops, no one cares about the level of debt or financing terms. The rare insolvencies that happen then are often due to fraud. But at bottoms, the only thing that investors care about is the level of debt or financing terms.
Why Do RRE Defaults Happen?
It costs money to sell a home – around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That’s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.
As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom….
Examining Economic Actors as We near the Bottom
Starting at the bottom of the housing “food chain,” I’m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.
This presumes that the remaining banks are in good shape, with adequate capacity to lend. That’s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions....
The Bottom Is Coming, But I Wouldn’t Get Too Happy Yet
There are reasons to think that we are at or near the bottom now:
• What little lending is being done is being done on relatively sound terms.
• Securitization has slowed dramatically.
• The major homebuilders do trade for 50-125% of book value, generally. The question is how much remains to be written down.
But I don’t think we are there yet, and here is why:
• Foreclosures are still increasing.
• The inventory of unsold homes continues to rise. At the bottom, inventories will have started to shrink, but are not yet to normal inventory levels. (There is also significant dark supply, or shadow inventory as well.)
• The inventory of depository financial institutions in trouble continues to rise. Regulatory triage is only beginning.
• The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.
• The US Government will try some more policy ideas after the election.
• We aren’t seeing a lot of speculative buying yet.
• The biggest booms have had the biggest busts, but affordability is yet to be restored in what were the hottest markets.
My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.
Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now...
Entire article here.