California, the epicenter of the housing bubble is facing difficult times. It is becoming rather apparent that this housing bubble has the risk of causing a worldwide recession. It is hard to imagine until you look at the facts how this bubble got out of hand so quickly. The foreclosure problem is now hitting squarely on the state. Last month for Southern California over 30 percent of homes sold were distressed properties. This rate is only increasing and will put future pressure on prices on the downside since first, we still have record inventory and it is harder to get a home loan. The latter part, getting a home loan is harder and for the right reasons. Folks simply do not have the incomes to support the prices in many areas. The only way they can purchase homes in these areas is with liar loans or sub-prime products but those are now largely absent and rightfully so. We are left with the reality that prices were fueled by egregious lending practices and lack of income.

We can look at it another way. It wouldn’t be such a problem if in the last 10 years incomes had doubled as well. In California, per capita income went up 56 percent while the median home price in Los Angeles went up twice as fast. So how can it be that prices became so disconnected? In this article we are going to examine multiple facets of the housing market both in California and nationally and demonstrate that areas like California, are in fact in a double bubble much larger than the average US market.

Los Angeles Median versus U.S. Home Median Price

Contrary to popular belief, buying a new US home and the median home price in California weren’t so much apart in 2000. Of course the new home of 2000 was probably a lot larger and nicer than the Los Angeles median priced home but the above chart gives us a good reference to begin with. First, let us look at the start date of 2000 compared to the peak January prices of 2007:

2000

Los Angeles Median: $192,000

US New Home Median: $163,500

*Difference of 17 percent

2007

Los Angeles Median: $520,000

US New Home Median: $254,400

*Difference of 104 percent

What happened during these seven years that sent Los Angeles home prices twice over the national new home median price? If in fact, the nation itself is facing a historic bubble which if we are to look at the above chart, is correcting quickly how historic is the California bubble? It is in fact unprecedented and there is really no model telling us how low prices can go since we never had a model showing us that prices could run up so quickly. This for the most part was fueled by lax lending, financially irresponsible loan products, a Federal Reserve that was asleep at the wheel, and an economy that was addicted to easy credit. No one really is without blame but some have a much larger share of the responsibility. Both the national market and the California market are now facing steep corrections. Southern California at the height of the bubble in 2005 was underwriting adjustable rate mortgages for 70 percent of all home purchases.

Even now with rates still at historical lows and Fannie Mae, Freddie Mac, and the FHA trying all they can to juice the market, have no products that make up for the gap that the NINJA products once took up. Unless government backed institutions are able to come up with methods of not checking income and greasing the wheels, the bubble burst still has years to correct especially in double bubble areas like California.

New Homes Sold

We have never witnessed a national housing bubble. It is the case that areas like Florida in the 1920s, Southern California in the early 1990s, and other cities like Boston have seen past bubbles but on a regional level. The subdivision assembly line of building new homes has been developed to a science. In no time in history were we able to build so many houses so quickly. The only problem with this was that it was fueled at the expense of future expected growth and credit. One thing to be said about credit and buying a home. Mortgages in their 30 year flavor came about in the first half of the 1900s. Previously, mortgages had a term of 15 years and at times, even 10 years. This changed as the product evolved and the 30 year mortgage has been status quo for the majority of the 1900s. The extension to 30 years made sense since many people, it was assumed, would be living in their homes long after their mortgage is paid off.

The logic of the utility of a mortgage evolved in the 1990s but morphed into another creature in the 2000s. The mortgage product was viewed as a temporary bridge until you were able to sell your home, at a large profit of course, and were able to buy a much larger home in the parroted five to seven years. The home, as you can see from the new home sales above, was now a pit stop until you were able to buy a newer and bigger home. This psychology burned strongly and created the additional demand for new homes. No longer was a home valued for its stability but was seen as a commodity with only future appreciation and zero risk involved. The market created the consumer psychology which we are currently battling with. The consumer for the most part is still expecting easy access to credit because that is how they were conditioned for a decade.

Per Capita Income

Let us look at the per capita income for California. During this mega bubble decade, per capita income for Californians went up by 56 percent. However, the median home price went up by over 100+ percent statewide. Take a look at the above chart to see how per capita income has grown. It may seem drastic but then examine that in conjunction with the first chart looking at Los Angeles County. Growth in home prices stripped any gains in personal income. Normally, we would see similar growth spurts if income went up as well. This has occurred in the past during inflationary times. Yet, we had a major disconnect here. So how can it be that incomes grew at a much slower pace yet people were able to support higher prices? That is where the bridge of toxic loan products comes in:

Debt has exploded in the last decade. Although it has slowly started to decrease simply because of a credit crunch, we are still in uncharted territory. The amazing thing is banks would still be loaning out these banana republic loan products if it weren’t for the house of cards simply collapsing on its own weight. That is why these bailouts and now there is talk of giving the Federal Reserve, a key culprit in this bubble, much more responsibility over Wall Street. How is that even an option? First, we have Greenspan slashing rates fueling the bubble and also encouraging people to take adjustable rate mortgages. Then, we have Ben Bernanke missing the mortgage debacle by saying in the first half of 2007 that sub-prime was contained and there was nothing to worry about. Now, the panic has set in and he is doing a déjà Greenspan by slashing rates and showing him up, but bailing out an investment bank. What makes anyone think that Bear Stearns is the only investment bank with problems? Does this mean that we’ll be bailing out every other investment firm with problems? After all, if you dig into their balance sheets they all have toxic products linked to mortgages with the only difference being how much each one carries.

Homeownership and Vacancy Rates

As expected, the homeownership rate is declining nationwide but also in California. With historically low affordability and stagnant wages, we can expect the homeownership rate to continue to decline. In fact, in areas such as Los Angeles County where the majority of people rent, we can expect prices to decline even further because there is a ready market to absorb folks that decide either voluntarily or involuntarily to leave their homes. In addition, from the graph above you can see that homeownership rates spiked from 1997 to 2006 in conjunction with the advent of toxic mortgage products. This is another good leading indicator of a future bottom. We can expect to hit 56 percent once again and then, we can start discussing if we are truly at any housing bottom. And in a further sign of market distress, the vacancy rate in the state is increasing:

Well this is also being caused by the state of the dismal and looming short falls in the California state budget. Keep in mind that many of the proposed job layoffs have not made their way onto the market. This will only further drop the homeownership rate and also keep vacancy rates spiking.

Trade Balance

You may have noticed that many pundits have now been laying off the talk that a lower dollar will help us with exports. Take a look at the above chart and you’ll see that a lower dollar is actually doing very little in helping this situation. Now why is that? For one, Americans are hyper-consumers. Nowhere on this planet is there a people that spend so much money, usually on credit, and have a resiliency to keep on spending. Many other nations including Japan have a higher per capita income and also, a strong savings rate. Our savings rate is negative. So a lower dollar is a double whammy since imports go up in price relative to the dollar and exporters abroad see Americans consuming less hurting their bottom line.

Having a low dollar policy is pennywise and pound foolish. Most Americans get paid in dollars and consume very little domestic products. The market for our exports is nowhere as strong as the market here is for imports. To think this was going to be a remedy for our economy was somewhat baffling. I was looking at the hottest growth sector and it is healthcare. With an aging population, which of course isn’t out there producing and a younger population caring for them, which sectors are going to be producing these so called shadow exports? The market abroad is nowhere strong enough for it to avoid a recession.

Future Steps

We are going to face drastic changes in the next decade. The concept of credit is going to radically shift and we are going to need to prioritize as a nation. It is amazing how many people I talk to that simply cannot imagine coming up with 20 percent down for a home. Or many don’t grasp the idea that if you want to purchase a luxury item, maybe you should save up and pay for it in cash. My guess is that as credit becomes more scarce, people will have to determine what is a need and a want. Priorities are going to realign and maybe this double bubble pop will be a positive thing for the nation in the long term. After all, how is becoming consumerist hamsters really positive for our nation? Wouldn’t it be better if we were prudent, industrious, and financially savvy? It is hard to stomach when I hear the government tell us, “go out and spend those rebates” since this is such a wrong course of action. Hopefully people are now seeing through this and gearing up for tighter times and being positive that we don’t repeat these same mistakes again.

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