You know things are going well for the economy when Bernard Madoff is fighting in prison over the stock market. Maybe the argument revolved around dollar cost averaging into this easy money rally. Here in California, specifically in Southern California there seems to be a lot of energy getting behind the housing bottom parade. Prices have stabilized to a certain degree. Yet is this really a bottom? It think it is important to frame the argument in relation to employment, incomes, and demographic trends. Simply saying we are at a bottom is like saying home prices will always go up just because. Hopefully people will learn from this bubble that housing prices can be inflated with interesting loans like Alt-A and option ARMs.

Speaking of option ARMs:

“(Housing Wire) Several of our investors have questioned the current loss severity in light of negative amortization and home price decline,” researchers wrote in the report. “Our analysis suggests that option ARM loss severity will likely range between 60% and 70% provided home prices have stabilized.”

As we have highlighted before most Alt-A and option ARM products sit in California. Los Angeles County has the largest number of Alt-A loans of any county in the United States. Wells Fargo has a large option ARM portfolio brought on board through their acquisition of Wachovia but many of these are of the Pay Option ARM variety that have 10 year life spans. Even with that, many of these loans are imploding already:

Source: Housing Wire

On a positive note, the Governator signed new mortgage legislation that includes, the destruction of option ARMs:

“(LA Times) Late Sunday night, the governor signed AB 260 by Assemblyman Ted Lieu (D-Torrance). The measure, which takes effect Jan. 1, tightens restrictions on mortgage brokers so they cannot steer borrowers to riskier, higher-interest loans when they qualify for less-expensive ones.

The new law also bans so-called negative-amortization loans, which offer the option of monthly payments so low that the loan amounts can actually grow over time.

The law also limits prepayment penalties to no more than 2% of the loan balance and allows state regulators to enforce federal lending laws.”

Option ARMs never had any business of existing so this is positive news. Yet the option ARMs that will cause problems are already out there recasting from 2010 to 2012 and no one is originating option ARMs anymore since the government is the lender of first and only resort.

When we talk about a housing bottom we really need to look at history to gain some perspective. It wasn’t always the case that California had a higher median home price than that of the nation. Yet slowly over time California started disconnecting from the nationwide median price. I thought the best way to highlight this divergence is to plot data from 1968 comparing nationwide and California median home prices:

Now this is a fascinating comparison. Nationally, prices moved up steadily until the late 1990s when they seemed to disconnect from the trend. California however had a few surges. We see one occurring in the mid-1970s when prices started diverging from nationwide prices. Then, we see another surge in the 1980s when we had another real estate bubble. Finally, we hit a trough around 1995 and take off like a lunar expedition and the bubble of the century is born.

Prices have crashed as they do when bubbles burst. But are prices at a bottom? In the last peak in the 1980s California home prices cost about twice that of the nationwide median price. At the height of the current bubble, it almost reached 3 times the nationwide median price. Take for example the trough in 1996:

1996

California Median Price: $177,270

Nationwide Median Price: $122,600

At this juncture, a California home cost roughly 44 percent more than a median price home throughout the country. Let us run the numbers as they stand today:

2009

California Median Price: $285,480

Nationwide Median Price: $174,000

A California home will cost you 64 percent more than the nationwide median price home. Keep in mind that this bubble of course is unprecedented in nature but the argument that somehow prices are historically cheap doesn’t even line up with the 1980s bubble trough. Clearly this bubble that has wiped out over $12 trillion in household wealth is much larger. Plus, we have yet to see the Alt-A and option ARMs hit the market and this will bring prices lower in mid to upper tier markets – in fact, this is where the action is going to take place in the next few years. Even if we go back to the trough ratios of 1996, we still need a 10 percent drop in prices. How significant is that? Well if you are using a FHA backed loan that will easily wipe out your saved down payment and some.

It is also important to understand that we are entering the slow selling season for real estate. Let us examine Southern California data:

Now this chart is worth exploring. Fall and winter are historically slow selling months. Spring and summer without fail bring out the buyers. Boom or bust these are typically good times for home sellers. As you can see from the above chart, without exception since 2000 the low season selling point is reached in January or February. Keep in mind the recent boom in Southern California was largely due to investors, first time home buyers lured by the $8,000 tax credit, low interest rates, and people looking at the first chart where prices have crashed and assuming it is now a good time to buy.

But what if the tax credit is removed as it should be? What will happen? You can rest assured that this coupled with the seasonal trends will only push sales lower and most likely prices. What you need to factor in as well is that foreclosures don’t care about seasons. They are going to happen no matter what because they are dependent on the real economy. We can run extend and pretend loan modifications but without employment growth, it is merely a paper façade. So for those just rushing to buy right now they are entering a market with so much artificial stimulus right before the following:

(a) Tax credit removal (it will happen at some point)

(b) Slower selling season

(c) Alt-A and option ARMs coming online in full force 2010 to 2012

(d) Banks holding off inventory and moving like snails with foreclosures

These are a few items that artificially boost the market and it has only stabilized prices, it has not created a boom. The reason prices will continue to have pressure on the downside is California employment is weak. 12.2 percent official unemployment with a under utilization rate of 23 percent:

Without job creation housing prices will continue to face pressure to the downside. If you want to see some added job pressure just look at this data:

Source: OC Register

So prices are still too high reflecting the actual economy. You need to remember that California wages boomed in the 1990s because of the technology bubble and unemployment was relatively low and heading lower so home price increases made sense. Incomes went up, unemployment went down, and housing prices went up. Yet now we are to believe that incomes going down, unemployment going up, is somehow the reason for prices to move up? I don’t buy it.

I think most of us would agree that housing at the very minimum has to reflect the incomes of households in their community or potential buyers. Otherwise, your home will sit on the market. As a property owner I know this well. I can “want” $2,000 a month in rent but if the market is only paying $1,500 then guess what? I can sit back and have the place sit vacant for months losing monthly cash flow or I can work with the market rate. The difference with the current housing market is the government is trying to inject artificial stimulus by giving tax credits, artificially lowering rates, and trying to back stop the entire banking industry just so people can go and buy homes. But until the job situation recovers, there won’t be any sustained recovery. That is why this belief that a jobless recovery is no problem misses the entire point that people purchase homes when they feel secure in their jobs and have wages that will allow them to buy a home within their price range.

Let us look at the actual MLS data:

It is interesting since the peak in fall of 2007, the inventory number has steadily decreased. But this brings into question the big X-factor of the shadow inventory. Keep in mind this is MLS public data. The real factor is how many homes are in the shadows for Southern California. Here’s some interesting data from the Amherst Mortgage Insight study:

Source: Amherst Mortgage Insight

Now this is fascinating data. We need to also include the Inland Empire above and you have some of the top 5 areas with shadow inventory. In fact, that MLS number trend heading lower is dwarfed by the growth in shadow inventory. Factor in the shadow inventory for L.A. and San Diego and the shadow inventory is nearly twice as big as the actual MLS listed properties. We’ve never been in a spot like this so to assume things will play out nicely is ignoring the facts.

There is a false sense of security in the current market. If you are looking to buy, be cautious. The market is really artificially stimulated and the only outcome so far is stabilization (or at least on the surface). Remove this, and you can guess what will happen next year.

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