Submitted by Tyler Durden
It’s one thing for contrarian financial websites to accurately predict the transitory phase and housing price dead cat bounces which are only sustained by the unholy trinity of foreclosure bottlenecks (which are simply supply-side subsidies), offshore money laundering into US real estate (thanks to the NAR’s AML requirement exemption) and Wall Street-as-a-Landlord (through REO-to-Rent and other Fed-funded programs): after all the point of such correct analyses is to be ignored and blasted as conspiracy theories until they are proven, inevitably, correct.
But when a former Goldman executive and the previous head of its housing research team comes out with a shocking analysis so contrary to what the same individual would do in his “former life” when he would be extolling the inevitably rise of home prices from here to eternity and beyond, and also throw in an open letter to none other than president Obama, predicting at least a 15% crash in home prices in the next three years, a move which would without debt catalyze the next US recession, it is time for everyone to pay attention.
Meet Joshua Pollard, who in February 2009 took over coverage of US Housing at Goldman Sachs at the tender age of 24. We can only assume he was given the responsible position because everyone else in his team who had, bullishly, covered housing right into the Lehman crash, was fired. But regardless of Pollard’s career and how he got to where he is now, what is more important is that in a report released today, the former Goldmanite has cautioned Obama on the economic impact of an imminent 15 % decline in home prices over the next three years.
In short. the former Goldmanite says that “House prices are 12% overvalued today. They have already started to decline. Today’s misvaluation matches the excess of 2006-07, just before the Great Recession… 5 of the last 7 US recessions were led by a weakening housing market… I am lamentably confident that home prices will fall by 15% within three years.” Or, as some may call it, crash.
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While we provide his entire extended analysis of just how this crash will take place, here is the punchline, which incidentally is spot on: when all is said and done, it will be “never-before-seen public policy reactions that determine when and where prices eventually trough.”
In other words, if the timing of Pollard’s forecast is correct, the last thing on anyone’s mind in mid-2015 will be a rate hike. Instead, what people will be talking about, if and when the housing market crash begins, is how to finally engage in Bernanke’s favorite para-dropping activity…
Here is how Pollard classifies the three stages of home price decline:
3 Stages of the home price decline
Unless the calculus of history is a poor guide, there is a 60% chance that home values decline materially, in fact, the correction is already underway. This probability rises when new negative shocks emerges. The home price decline will be defined by 3 Stages:
Stage I: Hot to Cool: Active since Summer 2013*, Price growth is slides across the country as flippers lose money outright in the red-hot investor markets (NYC, San Francisco and Las Vegas); New home absorption rates – sales per community – are declining; investors slow their home purchases; total home sales decline year over year; developers lose pricing power, press outlets shift from positive to mixed about the health of the housing market.
Stage II: Demand to Supply: Small shocks convert demand pools into supply ripples. A first wave of investors begin trimming prices to get ahead of future declines; discounts increase to incentivize purchasers as purchasers increase their delays for better deals; developers reduce land budgets as cancellations tick up; major financial press outlets take a more negative tone toward housing lowering confidence overall.
Stage III: Deflation & Response: Falling home prices create a negative deflationary feedback loop that foreshadows a once-in-a-lifetime policy response. Deflationary economics take full hold; leveraged bets on real estate unwind in quarterly ripples due to the public reporting cycle & asset manager redemption schedules; willingness to lend shrinks; the broader consumer finally understands it is a bad time to buy a home, a shrinking housing market negatively impacts jobs causing recession; the estimated effects of never-before-seen public policy reactions determine when and where prices eventually trough.
Some details on timing and where we are now:
Rates & Shocks
We are 16 months into Stage I. A sooner-than-expected rise in mortgage rates – or other adverse shocks – will domino the decline into Stage II unintentionally. Because financial markets rely heavily on Federal Open Market Committee (FOMC) communication and the fed funds rate is near zero, “forward guidance” shifts have as much impact as yesteryear’s rate increases. To that end, two recent policy communications raise immense concern that Stage II of the home price decline could be incited soon: the first public speech of Loretta Mester and a recent letter from the ranks of the Federal Reserve Bank of San Francisco.
September 5, 2014: Loretta Mester, President and CEO of the Federal Reserve Bank of Cleveland, in her first public address since becoming a FOMC voting member welcomed and expects increased volatility following future Fed guidance and rate changes. Mrs. Mester, the FOMC’s newest communication sub-committee appointee, described volatility as a “necessary part of price discovery.” Her personal view is that forward guidance should be tied to actual progress, anticipated progress and the speed at which progress is being achieved (volatility); progress toward full employment and 2% inflation has occurred faster than she and the Fed expected. While stock market volatility has hovered near all-time lows during the Fed’s most recent communication expansion, home price volatility is at extremely elevated levels.
September 8, 2014: A letter from Jens Christensen, a senior economist at the Federal Reserve Bank of San Francisco, highlighted a concerning expectation gap between investors and the Federal Reserve regarding future interest rates. In the letter titled Assessing Expectations of Monetary Policy, the author showed that public investors are expecting a more rate-accommodative policy than the Federal Reserve and these investors are more confident than the Fed in this stance.
As public policy makers debate seminal decisions on “forward guidance” and unconventional monetary stimulus we note that each 1% increase in mortgage rates drops home values by 4%. At a 2% fed funds rate, where Fed officials and investors expect to be by the end of 2016, today’s over-valuation of 12% grows to 20%. Respectfully, the United States can not afford another housing driven recession.
With home price volatility at an all time high, the escalation from Stage II to Stage III is difficult to predict today. At Stage III, the virtuous cycle of housing, a unique mix of causal financial and social relationships, breaks. At these points in history unique governmental intervention provided the only spark that reignites demand. Price discovery is volatile around each new catalyst of information, and the trough will emerge as consumer and investor confidence rebuilds at lower prices. I believe confidence rebuilds at 15% lower valuations without premptive positive shocks.
Unless, of course, the momentum ignition mentality, made so prevalent in capital markets thanks to HFTs in recent years, takes over and the 15% threshold to “rebuild confidence” and BTFD is really 30%, or 40% or more…
Taking a step back, here is the analysis that Pollard uses to base his opinion that housing is due for a 15% crash within three years:
House prices are 12% overvalued today. They have already started to decline. Today’s misvaluation matches the excess of 2006-07, just before the Great Recession. Since World War II home prices have been tightly correlated to income and mortgage rates (R2 = 96%). Investors/cash purchasers, which make up 50% of home sales, have driven real estate volatility to unrivaled levels in trackable history. As public policy makers debate seminal decisions on “forward guidance” and unconventional monetary stimulus we note that each 1% increase in rates drops home valuations by another 4%; at a 2% fed funds rate, where fed ocials and investors expect to be by the end of 2016, the overvaluation equals 20%. Respectfully, the United States can not aord another housing driven recession. The facts and correlations – the tenets of probabilities – suggest it is more likely than not that home prices fall 15% in the next three years.
Drilling down into Pollard’s “three stages:”
The home price decline will occur in three distinct stages: I. Hot to Cool, II. Demand to Supply and III. Deflation & Response.
Stage I, “Hot to Cool”, has been underway for 16 months, ignited by a Summer 2013 interest rate spike while prices were rising double digit percentages. Another rate shock, driven by unexpectedly hawkish Fed language, would likely stoke the decline from Stage I to Stage II.
Homebuilder absorption rates precede a home price decline
Homebuilder absorption rates have been a unique leading predictor of new and existing home prices. Changes in gross absorption rates – the number of homes sold per community for the largest homebuilders – have historically led home prices by four quarters. Gross absorption rates have been declining for four quarters in a row.
Home price growth slows with outright drops in some places
As of June 2014 prices are already falling outright in 7 of the 10 largest markets. In standardly quoted stats home prices are up 8% over last year, but with the most recent sequential price drops price will be down 1% yoy if prices simply stay the same until next year. Downward pressure is more likely to continue than not given the 12% overvaluation and home price autocorrelation.
Investor demand slows
The number of homes flipped in the US has declined 50% in the last four quarters alongside slowing home price growth. In fact for the first time since the Great Recession home flippers lost money, before taking re-hab costs into account, in some of the largest real estate markets in the country, namely Las Vegas, New York and San Francisco. Generally, investor demand is only a complement to larger trends in home-buying, however, with all-cash sales being roughly half of total closed sales their impact has been magnified.
Negative homebuilder absorption rates, in conjunction with slowing average selling prices are the clearest signs of a weakening housing environment in Stage I. Economists and management teams acknowledge these early weaknesses but remain positive until a “trend” emerges because the data is volatile. When the “trend” properly surfaces we are already in Stage II
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In Stage II investors stop buying and immediately start selling. This activity increases inventory and home prices fall year-over-year. Recent buyers are remorseful. Negotiating buyers begin waiting to see if better prices are ahead until prices slide and cause Stage III to begin.
Because home price values drop 4% for every interest rate point increase, there are not many shocks as powerful as unexpected interest rate lifts. In a concerning letter from economists at the Federal Reserve Bank of San Francisco, Jen Christensen shows that investors are more optimistic than the Federal Reserve Board of Governors about the path of interest rates. Over the last 25 years home sales have never increased when mortgage rates rise by more than 50 basis points in a month. In 2 out every 3 such cases volumes declined by 3-4% that same month. Interest rate shocks this deep into Stage I have the highest probability of forcing Stage II.
Small shocks have outsized impact with high investor demand and high valuations. Investors are naturally unemotional about assets, focused squarely on cash returns. An investor buyer of 100 homes (demand) can quickly become a seller of 100 homes (supply) without having to solve for speed-limiting consumer issues like finding another place to live, switching school districts or missing neighbors.
If investors reduce their demand by 50% and put half of last year’s purchases on the market, which is not unreasonable when home prices fall, total months of supply jump to 7.5 months from a healthy 5-6 months today. Similarly if 15% of aggregate demand converts to supply a comparable increase in the months supply can occur. 5 of the last 7 US recessions were led by a weakening housing market, with greater than 8 months of supply.
The velocity of Stage II is extremely difficult to predict. Home prices (if you think about them like living things) mock what they see. “If Billy across the street goes up $50,000 then Bobby down the block wants to go up $50,000.” In statistics-speak home prices are autocorrelated in the short term partially because the US appraisal system forces Billy and Bobby to stay close. The transition from Stage II to Stage III is set up to happen quicker than ever because Billy and Bobby (individual home prices) go up and down two times faster than normal.
A material financial imbalance is aggravated when home prices decline. Homes make up 24%, or $23 trillion, of consumers’ total assets. An uneven 69% of consumers’ liabilities are the mortgages tied to those same homes. This tilted financial position means a 5% reduction in home prices equates to a 8.6% decline in consumer net worth. At 15% home price deflation consumers‘ real estate net worth drops 26% or $3.4 trillion.
$3.4 trillion of wealth destruction impacts homeowners financially and future buyers psychologically. Unfortunately the Millenials early-adulthood real estate appetite was handicapped by the Great Recession. With a 45% underemployment rate for recent college graduates, elevated student debt and increased home price volatility the willingness/ability to own will likely shrink among the country’s next major wave of consumership.
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The drivers of housing are structurally recursive. The shift from a good market to a bad market occurs quickly, exaggerated by the circular currents of confidence from consumers, investors and lenders in unison. When unnatural levels of demand or supply impact the market prices are pushed in lockstep.
Unnatural demand from investors has created a mismatch relative to long term drivers – income and rates. Arguably, the upward price movement driven by investor demand has helped to restore the confidence of consumers and lenders in housing as an asset class, however, this shifts quickly. Home prices are already declining and the probability of a more severe decline becomes too high to ignore if new negative shocks force Stage II and Stage III of home price declines.
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With all that said, what are Pollard’s suggestions and/or recommendations to offset what will surely be the catalyst for the next recession? He has three:
Public policy suggestions:
Formulate and preemptively communicate a forward-looking monetary policy that balances the risk of raising interest rates from a very low base six years into an economic cycle. If the impact of “forward guidance” changes cause housing weakness and a reduction in corporate profits how will monetary policy spur a weakening economy? Does language simply reverse? Because we are near the end of monetary easing with rates near 0%, will new monetary stimulus be more likely? Could rates be lifted while the stimulus is being increased? Are shadow rates worth considering? An early address of the new cyclical policy toolkit will ease investor volatility when economic slowdowns eventually occur.
Create a skilled trade externship program for the laborers that lose jobs because of lower housing investments. This will lower the multiplier effect of a housing downturn by directly supporting the things that the laborers drive in booms and crash in busts. Simultaneously use this program to train younger Americans in specialized trades while boosting the infrastructure in the country.
Forcefully rebalance number of homes to the number of households. Reduce new builds: Have federal and state regulators reclaim building permit powers from municipalities and localities and limit building to some reasonable percentage of expected household growth. Demolition: Shrink the number homes that can force prices down, particularly those that are already vacant, unsafe and expensive to rehabilitate. Increase migration to the country with a preference toward household headship.
Of course, none of these will be taken seriously until it is too late. And furthermore, one can wonder if it will even be too late: after all some can say that all Pollard is trying to do is pitch his latest company, now that he has left the sell and buy-side: what better way to do that than with a loud call for a housing crash by a former member of the status quo establishment and a letter to Obama.
None of that, however, diminishes the validity of Pollard’s observations and forecasts, and if anything, he is likely optimistic as to the severity of the coming housing crash. Then again, if and when housing has finally tumbled, it will mean that the Fed’s loss of control of its micromanagement experiment in central-planning is now official. Which will also mean that that far greater repository of household wealth, financial assets, which is where nearly $70 trillion of US assets are parked, will be on its way to a long-overdue “fair value”, ex-Fed repricing.
When that happens, whether a 15% or 51% drop in US housing, will be the least of anyone’s concerns.