Thursday, May 3, 2012

Housing Prices: a rebuttal to Barry Ritholtz, part 3

  - by New Deal democrat

As I said in part 1 of this series, Barry Ritholtz' argument that house prices will decline further rests generally on three arguments:
     (1) housing is not actually affordable by traditional measuresDown payments remain unrealistically high, and buyers cannot qualify for mortgages;
     (2) there is a large overhang of "shadow inventory" most especially including but not limited to foreclosures, which are primed to put renewed downward pressure on prices; and
     (3) potential buyers, especially younger buyers, are fearful of the potential immobility that comes with owning a house vs. renting.

In part 2 I addressed the affordability issue.  In this part let's look at the issue of shadow inventory.

At least as far back as two years ago, based on data showing the mortgage resets and recasts peaking in the 2010-12 time frame, commentators were calling for a foreclosure tsunami to strike imminently.  That prompted me to keep score of Realty Trac's monthly foreclosure report.  It quickly became clear -- even before the robosigning scandal broke -- that no such tsunami was materializing

At the end of 2010, I asked if it was time to start looking for the end of the housing bust?, concluding that
My best guess is that the national low for the Housing Bust is still several years away.

Yet the low real prices and declining inventory in some of the most severely impacted cities argues that we should start to look for a bottom in at least some of those locales within the next 6 to 12 months.
Sure enough, the first of the 20 metro areas tracked by the Case Shiller index bottomed the next June, and by the end of 2011 seven of the metro areas appear to have bottomed.

In mid 2011, based on second derivative improvement in list prices (i.e., less bad declines),  I said that
housing prices have already "faced the brunt of market forces" without support for a full year, as a result of which they have been falling closer and closer to equilibrium, the rate of decline is abating, and actual real time data shows that nominal if not inflation adjusted stability may indeed be reached as soon as early next year.
When this was published in June of last year, one of the very first comments was
What the author fails to consider is the enormous shadow inventory held by the banks which, at some point, will either hit the market or be bulldozed due to vandalism or deterioration from lack of regular maintenance.
A similar scenario has played out month after month since then.  The YoY comparisons in list prices got ever less negative, and finally turned positive at the end of November.  Every month I would point this out.  Every month I would be told that shadow inventory was all set to overwhelm the market.  Well, here we are almost a year later, and as I discussed last week, all of the list prices indexes and all but one of the median/mean sales price indexes appear to have bottomed.  Additionally, one of the repeat sales indexes has bottomed, although the most famous - the Case Shiller index - is still down on a YoY basis.

In other words, month after month for at least two years now, the fabled foreclosure tsunami has failed to appear - including in the months before the robosigning scandal ever appeared - and for months leading up to the federal mortgage finance settlement as well.  The settlement was signed on April 5, so we are running out of excuses for the so-far-iinvisible tsunami.

As to foreclosures, Barry Ritholtz's argument is
For the past year, while the Robosigning giveaway settlement was being negotiated, Banks had voluntarily stopped most of their foreclosure machinery. Those departments have since been revamped (now, mostly legal !) and are starting to process delinquencies and defaults again. Thus, we should expect to see a significant increase in foreclosures as a percentage of total existing sales (in 2011, foreclosures were 24% of EHS).

If there is a silver lining, its that lower prices can bring out buyers....  But bargain hunting and a sustainable turnaround are two different things. There are many good reasons to believe that the 5.5 million foreclosures we have so far brings us only to the 5th inning of this real estate cycle. We are, in my best guess, barely halfway through the full course of foreclosures.
Barry makes a similar argument with regard to other "shadow inventory" and in particular those houses whose owners are "underwater," i.e., owe more in a mortgage than the house is now worth.  He says:
Shadow Inventory includes: Bank owned Real Estate (REOs), distressed homes not yet for sale, including short sales and delinquencies not yet defaulted. Various properties in different stages of Foreclosure are also in the shadow inventory.

This definition still yields a broad range of potential shadow ... inventory from 1.6 million homes (CoreLogic) to 8.2-10.3 million .... But ... I include in my definition of shadow inventory the enormous overhang of underwater homes ....

... That’s between 12 – 18 million houses as potential supply at higher prices.

The key question for the Housing Recovery case: What happens if and when prices begin to rise? .... [It] is reasonable to assume that many of these homes would be put up for sale and become inventory.
(my emphasis)
There are two important points to be made about Barry's argument. 

The first is that here Barry is actually arguing a second derivative, i.e., not the direction of prices, but the amount of increase.  He says that lower prices will bring out more buyers, but he questions if there will be a "sustainable turnaround."  Similarly he believes that more shadow inventory will hit the market "when prices begin to rise."  Thus his argument on its own terms is about the amount of a rise, not that prices will necessarily fall further with more foreclosures and/or underwater owners putting their houses on the market.

Secondly, consider the following two extreme hypothetical scenarios for foreclosures:  (1) all 10 million foreclosures are immediately processed and all come on the market in the same month; vs. (2) foreclosed properties continue to come on the market in dribs and drabs of 100,000 a month for the next 10 years.  The outcome as to prices would be wildly different.  In the first scenario, it is easy to imagine a crash in prices, that would end relatively quickly as the supply of foreclosed properties was sopped up.  In the second, the increase in the number of properties entering the market at any given time would be so small that it would likely make a very small impact on overall price, and almost certainly not change the direction at all, although its slight dampening effect would last for a very long time.

The question becomes, which scenario is closer to the truth?  Assuming the numbers to be correct - which isn't necessarily so - depending on how fast and furious foreclosed properties enter the market, there will either be a renewed downturn in price, or else there will simply be a slight dampening in the direction of prices.  If prices increase, under this scenario, the additional properties on the market due to foreclosures simply lessen the amount of the bounce off the bottom. Calculated Risk made a good presentation of the present state of foreclosures yesterday.

Given the continuing failure of the predicted foreclosure tsunami to appear for over two years now, the most likely outcome in my opinion is closer to the second one.  Foreclosures and other shadow inventory will enter the market, but at a sufficiently subdued pace that it only causes a dampening effect on price movement -- i.e., it affects the second derivative as opposed to the first.  Barry may well be right that this shadow inventory prevents a "sustainable turnaround" as additional shadow inventory enters the market "when prices begin to rise."  But that by its terms means that prices do, in fact, rise in nominal terms.

Next:  psychology and demographics