San Francisco Bay Area Housing Crash Continues

San Francisco Bay Area Housing Crash Continues
PMI mortgage insurance now refuses to insure more than $350,000 of risk in speculative markets like San Jose/San Francisco.

New house sales plummet 9.2% in January nationwide, while median prices fall 13%.

Speculators now account for 25% of all purchases, and an additional 13% are vacation houses, making market very likely to go into free-fall when they all sell.

This winter's sales volume in Santa Clara County is only 44% of what it was last summer, the worst ratio in at least 10 years. Prices are already down every month for Nov, Dec, Jan, and Feb.

(You can also go directly to Housing Crash Blog and reference link collection.)
Why?

1. Interest rates going back up. When rates go from 5% to 7%, that's a 40% increase in the amount of interest a buyer has to pay. House prices must drop proportionately to compensate.

The majority of loans are now adjustable, not fixed. This means a big hit to the finances of many owners every time interest rates go up, and this will only get worse as more adjustable rate mortgages (ARMs) get adjusted upward.

From CBS.MarketWatch.com on 13 Jan 2005: "There is a double whammy inherent in these ARMs," said Frank Nothaft, chief economist for Freddie Mac. "At the end of fixed-rate period you face a hike in interest rates and you have to start paying principal. There is more default risk in these interest-only ARMs than in a fully amortizing product."

2. Massive job loss. More than 300,000 jobs are gone from Bay Area in the last 4 years. This is the worst percentage drop in the last 60 years. It's worse than Detroit car problems or Houston's oil bust. People without jobs do not buy houses and owners without jobs may lose the house they are in. Even the threat of losing a job inhibits house purchases. We are still in a serious and prolonged recession.

3. Salary declines. From http://www.mccallstaffing.com/need/needsal.html we hear that "demand for labor that salaries have in fact returned to 1997 and 1998 levels." Local incomes are nowhere near what they need to be to sustain current house prices.

4. Stock option expensing. The Financial Accounting Standards Board issued final guidelines that will force companies to deduct billions of dollars of employee stock options from profits starting in mid-2005. This will greatly reduce the amount of money that local technology employees will get, and that in turn will depress housing prices even more.

5. Population loss. San Francisco continues to lose population at the fastest rate of any city in the US and most of those are professional jobs. The problem is not only the dot-com crash, but also outsourcing technical jobs to India, which continues at a frantic pace as corporations realize they can pay an Indian only 20% of what they must pay a similarly qualified employee in the Bay Area. Fewer people in the Bay Area means less demand for housing.

6. Stock market crash. The NASDAQ at about 2000 is still only 40% of the 5000 it was at the peak of the recent stock market bubble. The crash in the NASDAQ probably hit the Bay Area harder than anywhere else because of all the stock held by employees of tech companies. That money would have gone into housing, but is now gone.

7. Extreme use of leverage. Leverage means using debt to amplify gain. Most people forget that losses get amplified as well. If a buyer puts 10% down and the house goes down 10%, he has lost 100% of his money on paper. If he has to sell due to job loss, he's bankrupt in the real world. Even a small price decline will bankrupt buyers with small equity. Buyers foolish enough to buy with no money down are already bankrupt, but still unaware of the fact.

8. Inflation warp. The rest of the economy shows little inflation, but housing inflation has been very high. This disconnect makes houses more expensive in terms of real work. There is no increasing salary to pay off the ever higher interest, so the only way to do it is more work. Many buyers will have to postpone retirement due to overpaying for their house.

9. Surge in foreclosures. We are already reaping the consequences of poor lending. Foreclosures are at the highest rate they've been in 40 years, about 1,500 per quarter in Santa Clara county. There are only about 4,500 sales in the quarter, so on average, about one third of house sales are ending in foreclosure.

10. Shortage of first-time buyers. According to the California Association of Realtors, the percentage of Bay Area buyers who could afford a median-price home in the region plunged from 20 percent in July 2003 to 14 percent in July 2004.

11. Lightbulbs going on in many brains in the Bay Area: "Hey, I can just go to New Mexico or Oregon, buy a gorgeous house outright, and comfortably retire on the rest of the price difference. My neighbors just did it, so I'll have friends there too."

12. Surplus of speculators. The number of houses bought for pure speculation is increasing. It is now possible to buy a house with 103% financing, the extra 3% to cover closing costs, with no money down. All this is on the unwise assumption that housing will rise ever higher, covering interest payments through appreciation. Even the National Association of Home Builders admits that "Investor-driven price appreciation looms over some housing markets."

13. Trouble at Fannie Mae and Freddie Mac. They are now being forced to tighten up sloppy lending. This means they are not going to keep buying very low-quality loans from banks, and the total money available for buying houses is falling. Fannie Mae recently announced a $9 billion loss and its mortgage portfolio shrank at an annualized 16.8 percent rate in January 2005, on top of a 10.1 percent decline in December 2004.

14. The best summary explanation, from Business Week: "Today's housing prices are predicated on an impossible combination: the strong growth in income and asset values of a strong economy, plus the ultra-low rates of a weak economy. Either the economy's long-term prospects will get worse or rates will rise. In either scenario, housing will weaken. Caveat emptor."

Who disagrees
that house prices will continue to fall? Real estate related businesses don't make money if buyers do not buy. These businesses have a large financial interest in misleading the public about house prices.

1. Real-estate brokers take a percentage of the price, so they want buyers to overspend on the house. Realtor(TM) is a commercial term, not a real word.
2. Mortgage brokers take a percentage of the loan, so they want buyers to take out the biggest loan possible.
3. Appraisers need mortgage brokers for their business, so they are going to give the appraisals that brokers want to see, not the truth.
4. Banks get origination fees but have been selling their mortgages, so they take no risk. They do not care about the potential bankruptcy of borrowers, so they will lend far beyond what buyers can afford. Banks sell most loans to Fannie Mae or Freddie Mac, but that is going to end as Fannie Mae shrinks.
5. Newspapers earn money from advertising placed by Realtors(TM), so papers have a strong motive to publish the Realtors'(TM) unrealistic forecasts.
6. Owners themselves do not want to believe they are going to lose huge amounts of money.

What are their arguments?

1. "There are great tax advantages to owning."
FALSE. It is now much cheaper to rent a house in the San Francisco Bay Area than it is to own that same house. This is true even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $1800/month. That same house would cost $600,000. Assume 6% interest ($3000 per month), $2000 closing costs, and a buyer loses $770 more per month buying than renting. Renting is a loss of course, but buying is a bigger loss.

Renting:
Monthly Rent: $1,800.00
Buying:
Property Tax: $400.00 ($625 per month at 1.25% before deduction, $400 lost after deduction)
Interest: $1,920.00 ($3000 per month at 6% before deduction, $1920 lost after deduction)
Other Costs: $250.00 (insurance, maintenance, etc)
Total: $2,570.00

Buyers still have to come up with the principal payment as well, just to watch it wiped out as the value of their house declines.

Remember that buyers don't deduct interest from income tax; they deduct interest from taxable income. Interest is paid in real pre-tax dollars that buyers suffered to earn. That money is really entirely gone, even if the buyer didn't pay income tax on those dollars before spending them.

Buyers do not get interest back at tax time. If a buyer gets an income tax refund, that's just because he overpaid his taxes, giving the government an interest-free loan. The rest of us are grateful.

Under current conditions, a renter would be able to live in a house for 30 years, then buy that house outright with the saved principle payments, and have an extra $277,200 of savings on top of that: ($770 x 12 x 30). The renter comes out way ahead of the owner, and this doesn't even count the huge losses the owner will suffer as housing falls year after year for the next decade or more, just as in Japan.

Another way to look at it is that except for the rich, everyone either rents a house or rents money to buy a house. To rent money is to take out a loan. A mortgage is a money-rental agreement. Owners with a mortgage seem to be renting their house from the bank, but there's an important difference. The bank takes no risk, the same as real renters take no risk. It's the owners who bear all the risk of falling house prices, and all the costs of repairs.

2. "OK, owning is a loss in monthly cash flow, but appreciation will make up for it."
FALSE. Appreciation is negative. Prices are going down, which just adds insult to the monthly injury of crushing mortgage payments.

3. "House prices don't fall to zero like stocks prices, so it's safer to invest in real estate."
FALSE. House prices do not fall to zero, but even a fall of only 10% completely wipes out everyone who has only 10% equity in their house. This means that house price crashes are actually worse than stock crashes. Most people have most of their money in their house, and that money is highly leveraged.

4. "If you buy, at least you have a house, but if you rent, you end up with nothing."
FALSE. Renters in this market end up with much more money, while living in the same quality house as an owner. At the end of 30 years under our current conditions, a renter who saved and invested would have enough principle on hand to buy the same house outright and would have an extra $277,200 of accumulated interest savings, and would have lived in an equivalent house all that time. Owners frequently end up with nothing because they lose the house to foreclosure.

5. "Prices have been driven by supply and demand."
FALSE. Supply is increasing rapidly as building continues, and demand is falling as the population of the Bay Area decreases and the salaries of those who remain decreases. Prices have been driven by low interest rates and increasingly risky loans. The dramatic drop in rents and widespread rental vacancies prove that demand for housing is actually much lower now than a few years ago.

The http://www.census.gov site has data for Santa Clara County for the years 2000-2003 which shows that the number of housing units went up at the same time that the population decreased:

year units people
2000 580868 / 1686474 = 0.344 housing units per person
2001 587013 / 1692299 = 0.346
2002 592494 / 1677426 = 0.353
2003 596526 / 1678421 = 0.355

So housing supply in Santa Clara County increased 3% per person during those years. In a sane market, prices should fall 3% to compensate for the extra housing.

At a national level, there is a similar story in the years 2000 to 2005:

2000 115.9M / 281M = 0.412 housing units per person
2005 124.6M / 295M = 0.422

At a national level, there is 2.4% more housing per person now than in 2000. So national prices should have fallen as well.

6. "Nobody is making land."
TRUE, but they are making houses at a record rate, which is increasing supply dramatically at a time when new houses are not needed. We have the highest rental vacancy rates since the 1950's.

7. "There's an under-supply of housing. That's why prices will rise."
FALSE. There is a large oversupply of housing. To repeat: builders are making houses at a record rate, which is increasing supply dramatically at a time when new houses are not needed. We have the highest rental vacancy rates since the 1950's.

8. "Population increase will fuel housing price increases."
FALSE. The Bay Area is losing population the fastest of any area in the US right now - worse than Buffalo, worse than Detroit. Immigration won't change this because jobs are emigrating even faster. Rents are falling in part because so many recent immigrants are leaving, with some going back to China because opportunities are so much better there. There is going to be a huge glut of housing as old baby-boomers sell their houses to use the cash for retirement, putting 20% of houses onto the market for that reason alone. An additional 25% of houses are owned by speculators, who will soon sell because they are losing money. Birth rates are declining in all industrialized countries, with the US birth rate barely replacing the citizens who die.

9. "As a renter, you have no opportunity to build equity."
FALSE. It is owners who are losing equity, and losing it in a leveraged way as all their principle payments get wiped out. Renters can build equity by starting a business, investing in businesses that actually pay dividends, contributing to a 401K, or by simply saving money in a savings account.

10. "If you rent you are a buyer. You are just buying it for someone else."
FALSE. It may be true that rent covers mortgage payments in other places, but not in the Bay Area. No one buys with the intention to rent out in the Bay Area any longer because that's not viable. The owner is subsidizing the renter, a wonderful thing for renters during this crash.

11. "If you don't own, you'll live in a dump in a bad neighborhood."
FALSE. It is easy to rent a much better house than can be bought with the same payment right now. Renters live better, not worse. All the best neighborhoods have rental vacancies. There are downsides to renting, but since there are thousands of vacant rentals, you can take your pick and be quite happy renting during the crash.

12. "If and when the market goes south, you can walk away."
FALSE. Owners can try to default and walk, but the lenders and the law are not going to let them get away. Lenders will make sure the buyer's credit record is ruined, will take a chunk out of every paycheck, and may even press criminal charges. Bush has convinced the senate to pass new bankruptcy legislation that corners mortgage holders, making them virtual slaves to the banks with no way out.

13. "The house down the street sold for 25% over asking, and that proves the market is still hot."
FALSE. Realtors(TM) try to create the false impression of a hot market by deliberately "underpricing" a house. Say a seller's agent knows that house will probably go for $500,000. He places ads asking $400,000 instead. The goal is to first of all prevent buyers from knowing what a realistic price is, and secondly to get buyers to blindly bid against each other. There are four players in this game and three of them are on one side: the seller, the seller's agent, and the buyer's agent. Yes, the buyer's own agent works against the buyer, because there is no commission if there is no sale. There's a saying in Las Vegas: "There's a patsy in every game, and if you don't know who the patsy is, you're it."

14. "I was lucky that my Realtor(TM) told me to increase my bid by $100,000. Otherwise I would have lost, because my Realtor(TM) knew about a secret bid $90,000 above mine."
FALSE. Your agent gets paid nothing if you don't buy the house, and he gets more if you waste more money by bidding too high. Those are two big motives to invent false bids.

15. "The MLS proves things are great."
FALSE. All sorts of funny things happen in the MLS. For example, if a house just doesn't sell, Realtors(TM) can remove its record in the MLS so that you cannot see that it failed to sell. Then the house comes back on the market at a lower price, and unsuspecting buyers think it's on the market for the first time. Their Realtor(TM) can "prove" it's a new listing by showing the MLS listing: "See, here's the listing date, just came on the market. Better hurry and buy it, this one is hot."

There is nobody checking that the MLS shows true selling prices. The MLS prices are often just wrong. Realtors(TM) do not want buyers to see how much the buyer is being overcharged, so you can see the motive to fudge previous selling prices.

16. "The Bay Area is a special place that will always be expensive."
TRUE, but it was just as special ten years ago, so that does not account for the current bubble. Even at half of current prices, it will still be expensive.

17. "There's always someone predicting a Bay Area real estate crash."
TRUE, yet irrelevant. Just because there is always someone predicting it doesn't stop it from happening. There are very real crashes every decade or so. Even a broken clock is right twice a day.

18. "But housing was high when interest rates were 21%."
FALSE. Inflation was much higher then, so fixed debt was easier to pay off with increasing salaries. Now we don't have increasing salaries, just a housing bubble. House prices and salaries have become disconnected.

Interestingly, house price increases almost exactly mirror the increase in mortgage debt. According to the Washington Times: "Consumers have doubled their mortgage debt from $3.5 trillion to $7 trillion since 1996, borrowing and spending profusely on the assumption home prices will keep rising." So the increase in house prices is not backed by real assets and can easily reverse.

19. "My dad made money on his house, and it will work for me too."
FALSE. Your dad bought his house when houses were cheap compared to salaries, maybe 3 or 4 times annual salaries. Go ask him. Things are different now. Here is a chart of median house price vs median income in Palo Alto:

Year Median House Price Median Income Multiple
1980 148900 24743 6.0
1990 457800 55333 8.3
2000 910000 90377 10.0

Palo Alto has lost about 15% since 2000, but that is not nearly enough to bring prices and incomes back into relative alignment. Most bankers use a multiple of 3 as a "safe" price to income ratio.

20. "The government will make sure housing prices don't fall, because all the powerful people in the government have houses and want to keep values up."
FALSE. There have been many local crashes, and the government can't stop them. Nor would they even want to; the current Republican administration would probably be quite happy to see blue states like California, New York, and Massachusetts crash and burn.

21. "Look, housing continued to rise after the dot-com crash, so it will always rise."
FALSE, consider the turkey in the farmer's barnyard. He thinks the farmer will always come feed him and not ask for anything. Then Thanksgiving comes. Whack. Past performance is no indication of future results.

22. "Rent can go up, but a 30-year fixed mortgage payment cannot."
TRUE, but irrelevant. House owners lose even with a fixed mortgage, because the price of a house falls as interest rates go up. Most people want to sell within 7 years of moving in, and many more have to sell because of illness or divorce. No one can afford what the owner paid for it, so the owner has to take a large loss. Renting it out will not come close to covering the mortgage. Rents have fallen 23% in the last 4 years.

23. "You have to live somewhere."
TRUE, but that doesn't mean you should waste your life savings on a poor investment. You can live in the same kind of house by renting during the crash. A renter could save hundreds of thousands of dollars, not only by paying less every month, but by avoiding the devastating loss of his downpayment.

24. "Newspaper articles prove prices are going up."
FALSE. The numbers in the papers are not complete and have murky origins. Those prices are "estimated" from the county transfer tax and making that tax public record is optional. A buyer who does not want you to see how little he paid has only to ask to put the transfer tax on the back of the deed and it will not show up on computer searches of the deed, which show only the front. Others voluntarily pay more tax than they have to, in order to inflate the apparent price to fool the next buyer. At a tax rate of about $1 per thousand of sale price, as in San Mateo county, you have to pay only $100 extra tax to make your purchase price look $100,000 higher. Another common occurrence is for the buyer to get a large cash payment back from the seller. So the house price looks high in the paper, but in reality the buyer got a huge rebate.

25. "It's not a house, it's a home."
FALSE. It's a house. Wherever one lives is a home, be it apartment, condo, or house. Calling a house a "home" is a manipulation of your emotions for profit.

26. "If you don't buy now, you'll never get another chance."
FALSE. This argument was also popular more than a century ago in 1889 in Los Angeles, just before a huge crash. There are always sellers and there are always buyers. Prices are always corrected when they get beyond what buyers can pay. In fact, they're being corrected right now.

27. "The limited land in the Bay Area means prices will always go up."
FALSE. Japan has a very severe land shortage, but that hasn't stopped prices from falling for 14 years straight. If we really had a housing shortage, rents would be going up, but they're going down instead.

28. "It would take another 911 terrorist attack or a major earthquake that wipes out this area in order for the price to fall by 50%."
FALSE. Even with a 50% decline in prices to $300,000 or so, the median price in the Bay Area will still be roughly double the median price in most of America, and the median Bay Area household income of about $70,000 will still not be sufficient to buy a house. So a 50% decline is well justified by the fundamentals.

29. "Housing is an excellent hedge against inflation, so you should buy now anyway."
FALSE. Interest rates go up with inflation, and higher interest will be the last straw for ARM mortgages in the Bay Area. Their defaults and foreclosures will drive down the cost of housing for everyone else around here. Remember that more than 50% of Bay Area mortgages are adjustable now. There is little chance that salaries of ARM owners can keep up with inflation because of two billion people in India and China who would be happy to do their jobs for much less money.

30. "Houses always increase in value in the long run."
FALSE. True house values are constant. Warren Buffett and Charles Schwab have both pointed out that houses don't produce anything. They do not increase in intrinsic value. Unless there's a bubble, house prices simply reflect current salaries and interest rates. Consider a 100 year old house. Its value in sheltering you is exactly the same as it was 100 years ago. It did not increase in value at all. It did not spontaneously get bigger, or renovate itself. Quite the opposite - it drained cash from its owners for 100 years of maintenance and taxes. Its price went up about as much as salaries went up.

31. "Maybe we should just accept that we missed out on a great opportunity to get into the real estate in the past N years."
FALSE. Did we all miss out on a great opportunity to get into the stock of Internet companies with no business model? The question is what is likely to happen in the next few years according to fundamental economics.

32. "I just want to own my own home."
TRUE, most people do and that's fine. Buyers will get a chance next year when housing costs half as much and they have saved a fortune by renting. Home ownership is great - unless you ruin your life paying for it.

What should you do?

To win this game, buyers have to save up a big downpayment, and not buy anything until prices fall much more. Then buyers should come in with a huge cash position when sellers are desperate. Sellers have to sell now, while they still can.

Comments? Mail p [at] patrick.net. Please send me good links about the housing bubble and I'll include them here. I prefer links that do not require any registration. If you'd like to donate to support this page, please use this button: