The party is largely over for California real estate. Lost in the mix of all the economic news is the grim reality that we still don’t have a budget for the state. We are facing another five weeks delay and days closer to issuing IOUs yet again. Yet this information is still flying underneath the media radar. It is relegated to page nine if you can even find it. The Federal Reserve and government have taken the advice from banks in virtually every policy move; suspend mark to market, inject trillions of dollars into the banking sector, provide loan modification options, purchase mortgage backed securities, and more tax credits and all this combined merely served as a stop-gap for the real estate price adjustment. Why? Home prices in many areas are still too expensive because incomes are weak and employment (especially good paying jobs) are hard to come by. The major budget deficit we face (like many other states) is a reflection of a weak economy.

Not much has changed in 2010 at least for California real estate. In fact, from August to December of 2010 California real estate is going to face much tougher waters ahead. Let us list five important reasons why.

Reason #1 – California budget delayed yet again

We currently face a $19 billion budget deficit which comes out to 22 percent of the current general fund budget. This is a massive amount of money. The buck stops in Sacramento and virtually no one has a clear direction of where we are heading. In fact with an election year our amazing representatives are planning their election campaigns for November instead of dealing with the pressing issue at hand. We can blame the tactics on an election year but the budget has been in the red for over three years now. This crisis did not come on as a shock.

Now why would the budget crisis be an issue on real estate? First, there are only a couple of ways to plug the gap. You either raise revenues through higher taxes or simply having a better economy and collecting more. Clearly the fact that we are in a massive hole tells us that revenues are not coming in. The temptation for elected officials will be to tax even more although California is already massively taxed. In L.A. County many are already paying close to 10 percent in sales taxes! Need we mention city officials making $800,000 for tiny working class areas like Bell?

The other option you have is to cut. And this is an option the Governor is taking:

“(Business Spectator) Schwarzenegger has proposed slashing spending to balance the state’s books, an approach rejected by Democratic lawmakers. Their leaders in the state Senate and Assembly are trying to draft a joint plan likely to include proposals for tax increases to rival the governor’s budget plan.

By ordering furloughs, which he also did last year, Schwarzenegger is bringing pressure on state employee unions allied with Democratic lawmakers on the heels of losing a courtroom battle to cut state employees’ pay to the federal minimum wage to bolster the state’s finances.

Schwarzenegger’s new furlough order was instantly condemned by labor officials as a political ploy.”

I’m surprised that some of the better coverage on the California economy is coming from out of the country. Either way, you can see where the line is being drawn in the sand. Both of the above outcomes are not positive for California housing. More layoffs equates to less people able to afford homes. Higher taxes and people have less to spend on housing. The problem stems from the California economy relying on real estate for both jobs and spending and all this happened in a once in a lifetime bubble. That bubble has now burst yet the state budget structure is still relying on bubble revenue figures.

Reason #2 – Inventory growing

Source: MLS

The amount of inventory in Southern California has been growing steadily. In fact, we can pinpoint the actual growth to roughly March when we started to realize that programs like HAMP were merely smoke and mirrors operations to make the numbers appear better than they actually were. Now we are seeing more and more distressed property hitting the market. Keep in mind that the above chart is based on MLS data and this heavily understates the actual shadow inventory of problematic real estate. Not much has changed the calculus of toxic mortgages:

I’ve annotated the above chart to give a clearer view of where we are. Keep in mind that some banks have reworked option ARM loan products (50% of option ARMs are here in California) yet problems are still extremely high:

Now the above data is fascinating. California is home to half of these loans so it will be worth our time to look at this closely. From March of 2009 to March of 2010 we went from having 714,018 performing option ARMs in the U.S. to 513,000 option ARMs in March of this year. As of today, roughly 34 percent of all option ARMs are not even current. These are toxic waste products. Why the big drop? Many of these ended up as foreclosures but many got pushed into interest only loans that buy a few more months (maybe a year or two) but these will default as well.

So inventory keeps growing because of problems in the system. I’ve kept meticulous data on the MLS for Southern California for close to four years. Let us examine the shift in makeup over the last few years:

September 2007

MLS listings: 166,514

Short sales + foreclosures: 9,711

Distressed inventory as percent of total MLS: 5.53%

September 2008

MLS listings: 133,388

Short sales + foreclosures: 48,951

Distressed inventory as percent of total MLS: 36.44%

September 2009

MLS listings: 69,936

Short sales + foreclosures: 19,702

Distressed inventory as percent of total MLS: 28.33%

August 2010

MLS listings: 83,677

Short sales + foreclosures: 25,562

Distressed inventory as percent of total MLS: 30.54%

So if we look at the above, from September of 2009 to August of 2010 you can see that distressed MLS inventory has jumped. But overall inventory has also increased. The earlier chart shows a steady increase at a time when typically inventory is depleted because of the spring and summer selling season. With tax credits finished and big MBS purchasing programs over, where do we go from here?

Reason #3 – California employment growth anemic

California unemployment still stands at 12.3 percent. What this means, is that the equivalent underemployment rate for the state is closer to 23 percent. If you look above, only three sectors actually experienced any jobs added over a 12 month period. How can overpriced areas in California maintain high prices without having a solid employment base? We know how we did it last time and it was through high leverage products like Alt-A and option ARMs. What do we have in our arsenal this time? Sure you can purchase a home with a 3.5% down payment via FHA insured loan products but you need to have verifiable income. And just because you can buy with government metrics, this doesn’t mean that it is a good reason to do so. The exponential growth in FHA insured loan defaults should explain why low down payments are not a good enough reason to purchase a home.

California employment growth is weak. And as we mentioned, the government is actually looking at slashing payrolls. The last decade had a massive amount of jobs that were built around the housing bubble and real estate consumption. Those are largely gone and won’t be coming back. What industry will step in? For these reasons betting on housing in California for the next few months is a losing bet.

Reason #4 – Government incentives burning out

In the time honored tradition of pandering, the California government pushed an incentive for new and first time home buyers in California. As would be expected, the money was eaten up quickly. This is $200 million that the state clearly does not have to spend (did we mention the $19 billion budget gap). So now, the state has combined the Fed tax credit with the state tax credit and low money down payment FHA insured loans for the maximum effect. The only next step available is to give away homes to anyone that would want one. Clearly this momentum is burning out because there is no such thing as a free lunch (or home in this case).

There are only so many ways you can juice the market without having a healthy economy. At least during the housing bubble, people could get jobs in virtually any industry because credit was flowing like beer at a frat party. Anyone and everyone could get whatever they wanted. It reminded me of the dot come craze and any company with a webpage and dot com after their name would get a few million dollars in seed money. Those days are over. People now have a better understanding of real estate simply because they have been forced to pay attention instead of believing the “real estate always goes up” mantra.

Reason #5 – California buyer psychology

The fact that people have to pay full price on a mortgage is stunning to many. Those teaser rates created a big class of people that believed in the 5 or 7 and move up crowd. You know what I’m talking about here; these people believed that you buy a starter home, stay put for 5 to 7 years, let the magical David Blaine like effects of real estate appreciation work, and then you can sell and move into your McMansion. It was a clear path (at least it seemed that way). So five year option ARMs weren’t such a bad idea in their mind. Who cares that the loan exploded on the first day of year five because some other schmuck would be in the home with a new loan. The home buyer won. The mortgage broker and agent made out like bandits with giant commissions. The state made out like a champ by taxing those commissions. It seemed to be the perfect shell game. Those days are over and now the only game in town is the 30 year fixed mortgage (or the 15 year fixed but that is rare in California).

Given current prices in niche markets like the Westside, many people are simply vying to rent. Or the more realistic reason, they simply don’t qualify for a $600,000 loan on a tiny place in a prime location. There is no guarantee prices will go up. We did a comparative analysis between Japan and the U.S. and Japan had [has] weak prices for over two decades. Don’t take my word for it; listen to the Fed chief of St. Louis:

“(Barron’s) IN WHAT MAY BE PREPARATORY STEP for a major shift in the U.S. monetary policy, St. Louis Federal Reserve Bank President James Bullard warned the U.S. is closer to succumbing to a Japanese-style deflation than any recent time, which he urged be countered with “quantitative easing.”

Quantitative easing, or QE, is economists’ jargon to describe the Fed’s massive purchases of $1.7 trillion in Treasury, agency and mortgage-backed securities, a program that started in March 2009 and ended a year later. The purchases were part of the doubling of the size of the central bank’s balance sheet as the key component of the Fed’s efforts to prevent the meltdown of the financial system in late 2008 and early 2009.”

In other words, there is little reason to believe home prices in California will go up. With so much uncertainty with interest rates, jobs, and the budget why would people buy when we are entering the typically weak fall and winter seasons? Yet I’m sure there are many itching to dump their money into the real estate game; after all, this is California and the gold rush mentality will always be here even after the money is gone.

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