Some will point to smaller countries that suffered rampant inflation after their central banks printed money but we have more in common with Japan, what was the 2^nd largest economy in the world.  In this article we will try to carefully look at research on the Japanese boom and bust and also take a look where we stand in our current financial crisis.

Source:  The Economist

The first definite comparison we can make is with the rampant rise in home values.  Japanese real estate values saw a massive ten year boom during the Heisei boom.  The chart above clearly shows the trajectory of land values.  Yet research shows that a large part of this was concentrated on a few urban cities.  In this regard, the U.S. had a much larger and more pervasive boom impacting multiple cities across the nation like Miami, Las Vegas, New York, Los Angeles, San Francisco, Phoenix, and many other locations.  If we separate Tokyo out we see that overall Japan did have a bubble but it doesn’t seem as large or as widespread:

Source:  Debt Deflation

The above is an interesting chart because it reflects a concentrated urban bubble.  We had many suburbs popping up with home builders trying to create demand where there was nothing more than a bubble to chase.  Many of these areas including the Inland Empire in California have large homes selling for half off (or more) with very little demand chasing after the homes.  It is an interesting case study as to why values go up so quickly but miscalculations by the Federal Reserve and misguided policies led to the biggest and most widespread housing bubble here in the United States.

A 2003 paper by the Bank for International Settlements (BIS) focused on the Japanese housing bubble and concluded the following:

“What should be noted regarding Japan’s experience is that the enthusiasm of market participants, together with the inconsistent projection of fundamentals, contributed to a large degree to maintaining temporarily high asset prices at that time. Such enthusiasm is often called euphoria, excessively optimistic but unfounded expectations for the long-term economic performance, lasting for several years before dissipating.”

“It was thus excessive optimism rather than consistent projection of fundamentals that mainly supported temporarily high asset prices.”

There is little to debate that what fueled housing prices in the U.S. was also ignited by euphoria for real estate that was largely disconnected from fundamentals.  Let us construct a chart similar to the above with Tokyo and Japan but in this case, we will look at the Los Angeles MSA and the 10 city composite from the Case Shiller data:

Although it would appear that Tokyo had a much quicker and faster rise in prices, an area like Los Angeles saw a very similar trend.  Yet what separates the two bubbles is that the U.S. as an entire nation also saw a massive rise in prices over a short period of time.  Looking back, we see that the peak for U.S. housing values was reached in 2006 with the Los Angeles MSA also reaching a peak in this year.  The chart above shows the clear decade long boom in housing values.  What we find over this decade period is that home values in the U.S. increased by a factor of 3 while home values in L.A. increased by a stunning factor of 4.  In other words, the U.S. housing bubble was equally as large in magnitude as that faced by Japan but much more widespread.

The BIS paper also makes the comparison that Japan faced nearly two decades of bubbles, one started in the stock market followed by the real estate bubble:

“First, at the time of the Iwato boom, when Japan’s economy entered the so-called “high economic growth period”, asset prices increased rapidly, reflecting an improvement in fundamentals due to technological innovations. The real economic growth rate exceeded 10% per annum, driven mainly by investment demand due to technological innovations that replaced the post World War II reconstruction demand. On the price front, consumer prices rose while wholesale prices remained generally stable, thus leading to the so-called “productivity difference inflation”.

“Kakuei Tanaka, who became Prime Minister in 1972, effected extremely aggressive public investment based on his belief (remodelling the Japanese archipelago) that it was necessary to resolve overpopulation and depopulation problems by constructing a nationwide shinkansen railway network, which led to an overheated economy.”

This economy is largely seen by the charts below:

We have a very similar parallel here with our NASDAQ boom of the 1990s followed by the real estate boom reflected on the previous chart looking at Case Shiller home values.  If we look at the NASDAQ, we realize that even after the recent boom in stock values prices are nowhere near their peak:

On a nominal level the NASDAQ is still off by 55 percent from the peak reached a decade ago.  Often we hear about the lost decade comparison.  In stock values, we are already there.  In terms of real estate values, we are quickly approaching that point.  So we have more similarities in our booms and busts with Japan than many would like to admit.  The 1990s saw a rise also in productivity brought on by technological innovation but this also paved the wave for an economy largely decentralized on a global level.  This hit hard in the manufacturing core of our country.  Someone made the argument to me at the height of the real estate boom that “you can’t outsource real estate” which is true but that is a double edged sword as we are seeing.  The Nikkei peaked on December 29, 1989 closing at 38,915.87.  Today it stands at 9,431, a drop of over 75 percent.  Massive bubbles can have long lasting impacts on the economy.

Missing asset bubbles and targeting inflation

Another important comparison made in the paper is that of perceived stable inflation and how central banks can miss asset bubbles while they are happening.  It is the mistaking of a bubble for real economic growth:

“Third, in the Heisei boom, asset prices increased dramatically under long-lasting economic growth and stable inflation. Okina et al (2001) define the “bubble period” as the period from 1987 to 1990, from the viewpoint of the coexistence of three factors indicative of a bubble economy, that is, a marked increase in asset prices, an expansion in monetary aggregates and credit, and an overheating economy. The phenomena particular to this period were stable CPI inflation in parallel with the expansion of asset prices and a long adjustment period after the peaking of asset prices.”

“The decline in asset prices was initially regarded as the bursting of the asset price bubble, and an amplifying factor of the business cycle. Although the importance of cyclical aspects cannot be denied, further declines in asset prices after the mid-1990s seem to reflect the downward shift in the trend growth rate beyond the boom-bust cycle of the asset price bubble.”

This is an important key point.  The Federal Reserve publicly stated that during the bubble (it wasn’t labeled as such) that inflation overall remained tame and therefore keeping interest rates low was viewed as a prudent policy.  If the economy is growing and is stable, then the central bank should keep liquidity flowing into the system to keep building up legitimate businesses.  Yet separating real growth with an asset bubble can be tricky especially when the policies taken are part of the reason for the asset inflation.  Japan viewed there measures as stable.  We did this in a similar fashion but part of it was that our metrics to measure inflation largely missed the housing bubble.  The CPI measures “owners equivalent of rent” which completely ignored the rise in home values.  This measure is the biggest in the CPI so the data was skewed.  Also, innovation in mortgage products with teaser payments altered the true monthly payment and understated it.  The government for most of this time also only focused on OFHEO (now FHFA) which only looked at home loans secured by Fannie Mae and Freddie Mac and ignored the vast majority of subprime Alt-A, and option ARMs that fueled the last stage of the housing bubble.  In fact, year over year changes in the inflation measure from 1980 to 2000 seemed to be as stable as they come:

During this time we saw the massive NASDAQ bubble and also, the subsequent real estate bubble.  Inflation data largely ignored most of it because the measure was flawed when it came to measuring bubbles.  Japan had similar problems and taking policy decisions on this data has given their economy two lost decades and their economy is still suffering.  Then why follow that same path?

Japan gives us a working sample as to what can happen with asset deflation, a stock bubble popping, allowing banks to remain propped up by government funding, and massive government spending:

*Japan asset, stock and CPI measures

Some seem to think that Japan just sat back and did nothing during this time.  There is nothing further from the truth.  Japan was the first major economy to go down the path of quantitative easing.  Japan also injected enormous amounts of money into their economy to stimulate growth.  Yet the above chart is rather clear in the outcome.  Some point to unemployment in Japan remaining low.  This is more a sleight of hand with economic data.  Although the official rate is low, nearly 1 out of 3 Japanese workers are considered part-time employed.  That is, no security of long-term employment.  We have seen a massive rise in the number of Americans that now work in a part-time fashion.  No benefits, lower wages, and job security that is no longer an option in the longer term.  It is easy to see why asset prices in Japan have remained depressed for so long.  Prices in the U.S. are showing no sign of inflationary pressures because there is little mechanism to force wages up with such a giant over supply of labor in the market.  This is possibly one of the major points missed by those who predict inflation or hyper-inflation in the future.  Central banks can print but they can’t force wages up especially in a global market where cheap wages are the status quo.  To the contrary, banks are following the zombie like behavior of Japan banks by hoarding funds:

Now that we’ve had three full years after the bubble popped, we can see what banks have done to “fix” the problem:

-Hoard money to fix balance sheet imbalances

-Suspend mark to market (Japan banks zombie like tool of preference)

-Ignore major commercial real estate problems

-Drag out the real estate problems (we have done the same with banks delaying the foreclosure process, stopped lending their own capital in place of government loans, and banks have turned inward with government bailout funds).

The above chart shows that banks are still sitting on an enormous amount of excess reserves.  Now that due diligence is back (to a certain degree) who are banks going to lend to?  4 out of 10 workers in the U.S. are employed by the low paying service sector.  Close to 15 million are officially unemployed and unless we go back to the easy lending mortgage days, they won’t be getting any bank money soon.  We have another 9 million workers that are employed part-time for economic reasons (similar to the large employment base of Japan).  You think this group is going to get a loan for a home anytime soon?  Banks have turned their profits inward while the real economy is largely in stagnation.  Yet if Japan is any indicator, these profits will start to go down:

While it is easy to make money right now since a large part of the competition has failed while a select few have been given government backing and funding, as time goes on this profitability goes away.  And the real economy in Japan has languished all this time.  The BIS paper in 2003 gives a wonderful synopsis of what led to the Japanese boom and bust economy:

“The intensified bullish expectations were certainly grounded in several interconnected factors. The factors below are often pointed out as being behind the emergence and expansion of the bubble:

• aggressive behaviour of financial institutions

• progress of financial deregulation

• inadequate risk management on the part of financial institutions

• introduction of the Capital Accord

• protracted monetary easing

• taxation and regulations biased towards accelerating the rise in land prices

• overconfidence and euphoria

• overconcentration of economic functions in Tokyo, and Tokyo becoming an international financial centre

Focusing on monetary factors, it is important to note the widespread market expectations that the then low interest rates would continue for an extended period, in spite of clear signs of economic expansion. The movement of implied forward rates from 1987 to 1989 (Figure 5) shows that the yield curve flattened while the official discount rate was maintained at a low level.”

You might as well put this label on the U.S.  Aggressive behavior of financial institutions?  Doesn’t get more aggressive than giving a loan to someone with no job and no income.  Progress of financial deregulation?  What about repealing Glass-Steagall in 1999, protection we had put in place back from the Great Depression.  Inadequate risk management?  We need only look at AIG, Lehman Brothers, Bear Stearns, Fannie Mae and Freddie Mac, and many others.  Protracted monetary easing?  Does a zero percent interest rate and buying up of mortgage backed securities count?  Taxation and regulations biased toward rising prices?  How about giving new home buyers a tax credit when they were going to buy anyway?  Over confidence and euphoria?  Just go to YouTube and watch some of the real estate commercials from the peak days of the housing bubble.

We have a lot that is similar to Japan and their boom and bust economy.  If their path is any indication of our own, we have a long road ahead and getting home prices back up is probably going to be the least of our concerns.

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We first should look at the history of housing from a historical perspective because many old paradigms of housing have fallen.  Let us first look at nationwide data from 1910 and 1920:

Source:  Census Archives

I decided to dig up some old Census data to show how dramatically housing has shifted over the years.  Many in the housing industry assume that real estate has always been the way it currently is but forgetting about history can lead many into challenging situations.  In 1910 and 1920 the majority of Americans rented their home.  Of the 20 million dwellings in 1920 only 4 million were mortgaged.  Today, the majority of American households own a home.  The homeownership rate has fallen since the crisis started.  California is not immune to this trend:

The nationwide homeownership rate stands at 67.3 percent down from the peak of 69.4 percent back in 2004.  In less than a century the housing market completely transformed.  We went from a country dominated by renters to one dominated by homeowners:

So how did we go from a large number of renters to a majority of homeowners?  Much of the jump came because of government financing in the housing market:

Source:  Hoover Institution

In the middle of the Great Depression the National Housing Act of 1934 was passed to bring on more affordable mortgages and also created the Federal Housing Administration (FHA) and the Federal Savings and Loans Corporation.  The central reason for this was to stem the issues deep in the foreclosure crisis of that time.  The FHA and the FSLIC created the network to allow steadier access to mortgages in the market.  Some factors that came about from this was the push for suburban sprawl and also less focus on improving inner city housing.

There have always been promoters of real estate.  Even in the depths of the recession people were championing real estate in California:

I found this piece from a 1933 California newspaper.  The cries of available supply, lower taxes, and benefits to the real estate industry were already loud and clear back in the 1930s.  You would think that the Great Depression would at least dampen the spirits of housing promoters but that didn’t seem to stop many.  If a Great Depression didn’t stop the promotion maybe a World War?  Not even that could stop the hype:

The above comes from a 1942 newspaper spot.  One thing is certain when it comes to California real estate.  There is always a boom going on, it just depends who you ask.  Timing is such an important factor in purchasing real estate.  Many who bought in California from 2004 to 2007 took the brunt of this current housing bust.  But the usage of highly toxic mortgages has created a long lasting legacy of problems that we are still working through.  The problems are still embedded in the market and many mortgages sit in a financial state of suspension.  This will continue at least throughout 2010.

Let us look at California housing prices going back to 1940:

Source:  Census

Home prices have gone up steadily since the 1940s.  Some decades saw much higher price growth.  The biggest jump came between 1970 and 1980 when home prices went from $23,100 to $84,500 increasing by a factor of 3.65.  This decade has seen the slowest growth since the 1940s.  In 2000 the median California home price came in at $211,500 and today the median home price is $247,000 (an increase of 16 percent while the state’s inflation rate is closer to 30 percent over this timeframe).  So California real estate has now witnessed a lost decade adjusting for inflation.  The likelihood of seeing  a nominal lost decade in prices cannot be ruled out.  Some areas in California like the Inland Empire are already seeing this happen.

Yet what has really happened in California was the transformation of housing into a speculative commodity.  This can be seen by how much income is eaten up by home prices:

It is tempting to look at the above chart and say that home prices are overall cheaper than they were in the 1980s if we factor in the median home price and household incomes.  However home prices are still too expensive and if we look carefully above household incomes never really caught up after the massive inflation of the 1970s.  Access to debt covered up much of this lost purchasing power.  The current median home price in the state is also deceptive because of the massive amount of foreclosure re-sales in the last two years.  Most of these have come from lower priced markets while mid to higher priced areas remain in bubbles.  The above chart highlights the overall sales in lower priced markets and still comes out showing a very expensive market in California.

Much of the rise in home prices this past decade came because of maximum leverage mortgages that didn’t even take into account incomes that were falling further and further behind.  Many of these mortgages didn’t even look at income.  The above chart pulls points at each decade so we miss the 2007 peak in home prices.  If we include that point the chart would look like this:

When you look at the peak price data, it shows how historical this bubble was.  In places like Los Angeles and the Bay Area many homes that are still selling for peak prices were built back during the last home building craze in the prime counties.  Take a look at this 1942 ad:

Much of this massive construction took place decades ago in some of California’s biggest and oldest cities:

Massive population centers are nothing new for the state.  And a growing population will increase housing demand but not how most think:

Source:  Legislative Analyst Office

California is still lacking in affordable housing.  The days of cheap fuel will make it harder for other Inland Empires to sprout up from the ashes.  People forget that California has an enormous amount of land that is similar to Arizona and Nevada.  The Central Valley has plenty of room.  Why don’t they build this out?  For one, access to employment but also the cost of energy to keep these new cities up simply does not make economic sense.  It is unlikely that we will see $1 gas again so fuel is going to impact the suburban sprawl dream that started back in the 1930s.  New housing has to be smarter and more compact near city hubs.  Look at places like Tokyo for example.  We always hear the real estate building crowd that we need more friendly permits but then they go out and build sprawl just like they did back nearly 100 years ago.  Is this really good for our longer term prosperity?  Also, it might have reached its natural end.  People can’t afford to commute from these outer regions.

There is no arguing that the population will grow in California over the next decades.  Yet to assume that this will mean another real estate boom is incorrect.  Look at China for example.  They are now contending with mini bubbles in real estate and they have massive population centers throughout the country.  The big issue in the coming decade is going to be smart and affordable housing.  Ironically many of the current government programs are making housing unaffordable by propping up failed banks.  It also keeps the current structure in place since so much money is involved.  Yet that doesn’t mean it is smart policy going forward.

So what will we see in the next decade?  It is very likely that the homeownership rate will dwindle lower in California.  As more and more people are classified as “part-time” workers with no employment security, a large part of our population will need the mobility of renting or simply won’t have the income to purchase a home.  When people purchase a home, it requires a level of security in their employment.  If a large part of the population doesn’t have that, many will opt to rent, some by choice but many others because of economic reasons.  City hubs will probably see bigger growth as people move closer to employment opportunities.  This isn’t the 1920s when 1 out of 4 people were farmers.  It will definitely be an interesting decade when it comes to California housing.

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Factor #1– Negative Equity

The first thing to grasp is the biggest line item for Americans on their net worth chart is housing.  Or more importantly, home equity:

Even with the massive stock market rally, home prices are still lingering near their trough.  Employment hasn’t picked up as well so unless you depend on seeing your banking stocks going up for your livelihood this rally is simply a reflection of how disconnected Wall Street is from the actual real economy.  The above chart should tell you where things are in terms of housing.  With most conservative estimates, 25 percent of current mortgage holders are underwater.  That is, they owe more on their home than it is worth.  As we know, housing is the number one line item for homeowners so with this kind of figure most Americans are still viewing a gaping hole in their balance sheet.  In states like California with Alt-A and option ARM issues, the underwater level is closer to 35 percent.   Much of this has kept the foreclosure rate elevated.

Negative equity is the number one reason in predicting foreclosures.  Now this is a rather obvious statement because if you did have equity and had problems on your balance sheet all you would do is sell your home.  Without this option, you can let your home go into foreclosure or try to have your lender to agree to a short sale.  And you have to think about what would fix this problem.  The only solution is hyper-inflating home prices to bubble levels.  That doesn’t seem likely so negative equity is going to be with us for years to come because home prices reached absurd levels in this bubble.  Even with a big run up in prices, it is highly unlikely we will reach peak levels.

Factor #2– Income to Housing Price Ratios

Home prices are still in bubbles in many California counties like Los Angeles and Orange County.  Prices are completely disconnected from local area incomes.  I remember early in the bubble that the argument revolved around the monthly payment and completely ignored actual household fundamentals.  The mortgage industry thrived on this because it removed impediments from making mortgages with high kickbacks to anyone with a pulse.  Most of the mortgage brokers who say they were doing a good job “helping people” are only justifying their cause in this bubble and trying to assuage their conscience.  Show us a mortgage broker that did well during this bubble pushing low rate 30 year fixed rate mortgages with solid documentation.  The high income broker crowd relied on crap mortgages like option ARMs and other junk to get their nice little commission checks.

Yet now with the government being the lender of first and only resort, people have to actually look at incomes even at a cursory level.  And as you can see from the chart above, prices are still very high in bubble places like California in relation to income.  Plus, the chart data I gathered only goes back to 1980.  The bubble in California started back in the 1970s:

Even if we apply a ratio between California home prices and nationwide prices current levels are still too high even after this correction.  In other words, the bubble is still here.

Factor #3– Shadow Inventory

Source:  Wall Street Journal

“The John Burns study estimates that five million houses and condominiums on which mortgages are now delinquent will go through foreclosure or related procedures that put them on the market over the next few years. That would represent the bulk of the estimated 7.7 million households behind on their mortgage payments.

This “shadow inventory” of homes expected to hit the market is enough to last about 10 months, based on the average sales rate over the past decade, the Irvine, Calif., firm says.

The problem is largely concentrated in Arizona, California, Florida and Nevada. The shadow inventory is equivalent to 27 months of sales in Orlando, 24 months in Miami and 18 months in Las Vegas, the study estimates.”

It would appear that the shadow inventory that we’ve been reporting on for over a year has now gone mainstream.  I’m not surprised that it took this long to go into the mainstream media just like I’m not surprised the BLS had to revise their unemployment figures by 1.2 million.  Yet the reality is there is a tremendous amount of shadow inventory throughout the United States.  California is plagued with shadow inventory.   This is not a sign of a healthy housing market.  This is more “pretending things are okay” type of thinking.  The real estate industry thinks that this is some kind of panacea and we all need to start using The Secret to will our way to higher home prices.  Yet all this will do is create an environment similar to Japan where the banking industry is going to suck the life blood out of the real economy for decades to come.  Is this really what we want?

What if this inventory was released?  Prices would drop and come in line with more historical measures but more importantly, will finally flush out this giant financial sector that has grown too big.  Will many banks fail?  Absolutely as they should.  Yet the media is reflecting their bias to Wall Street because as we know, millions of Americans are still without work.  Shadow inventory is basically banks inability to move properties in a timely fashion.  They are now speculating that prices will go higher on the taxpayer’s bill.  Wall Street has failed the American public.  We are back stopping the system with $13 trillion in bailouts and back stops and this is the end result?  The only big winner right now is the stock market and big banks.  Everyone else is still battling the Great Recession out.

Factor #4– Weak Equity

Source:  The Big Picture

Home equity used to be a source of pride for many Americans.  In fact, many Americans enjoyed mortgage burning parties.  Now, those parties have been replaced by home equity lines of credit and sucking every ounce of home equity out as a perpetual ATM for consumption spending and trips to Las Vegas.  The chart above is a deeply troubling chart.  The amount of equity has fallen to historical lows.  The minor jump is a reflection of absurd amounts of government bailouts in the housing industry.  Yet equity in housing is still pathetically low.  At the same time, home prices are still in bubbles in many areas.  So what gives?  When you are required to have such a small down payment, you lose this built in equity component of the market.  The above chart reflects years of 20 percent down payments and that has slowly faded away.  Today, with FHA insured loans the only equity you are going to get is based on housing inflation or additional bubbles.  Building equity takes time and many people are now in this ladder mentality buying world where your first home is always a “starter” as if you need a starter home.

The weak amount of equity is surpassed by the enormous amounts of mortgage debt outstanding.  This debt spiral is getting bigger and bigger and we see our government leading the way.  Does anyone really see us ever paying off our various kinds of debts?  We’ll never pay it off!  I remember on a peer to peer lending site Propser, where you became the lender to various sorts of borrowers including subprime borrowers and the initial rates seemed fantastic.  The rates seemed too good to be true.  15 to 25 percent returns.  I put a bit of money into play and things were looking fairly good initially like things did with subprime.  A chicken in every pot!  But when the defaults started rolling in, that 25 percent yield quickly became 20, 15, 10, and finally I was lucky to break even on the portfolio of loans.  Welcome to the new debt world.  Somewhere along the line the idea of paying a 30 year mortgage off became lost in this bubble.  It was all about servicing the debt opposed to paying it off.  Now we are entering a new world and many mortgages like Alt-A and option ARMs are highly toxic and will never be paid off.  Even servicing the loan has collapsed.

Factor #5– Demographics

Source:  Bio Spa

Baby boomers to a large extent drove this housing bubble.  Many had purchased in the 1990s so were able to ride the mega bubble or trade up in housing.  Many also sucked the equity out of their homes to fill every nook and cranny with new stainless steel fridges and flat screen televisions.  As the housing bubble ramped up they saw their housing porn shows telling them to purchase granite countertops because no home is complete without putting shiny rocks in your kitchen.  But as the bubble of a decade recedes, people are left with artifacts of consumption and no real wealth.  It isn’t like a cow that you can live off but these items are sitting there reflecting years of consumption.  Massive gas sucking SUVs sit parked in the driveway ready to suck your wallet dry at the next trip to the gas station.  The above chart highlights many trends over the years with the big baby boom wave:

Source:  Rich Price

But as more Americans wait to have families and more baby boomers start using up healthcare resources, the priorities will change.  Many young couples are waiting longer to start families so the need for enormous McMansions is waning.  Many suburbs relied on cheap fuel and it is hard to imagine oil going back down to $20 a barrel.  So demographically things are changing.  Plus, as many baby boomers downgrade, you will see a steady stream of housing hitting the market for new families.  We have an excessive amount of housing inventory.  This will keep pressure on housing prices for the foreseeable future.

There is this argument made about immigrants plugging the gap.  This is not true.  A large part of the immigrant contingent cannot afford the high priced housing.  Show me data on immigrants buying up all this excess property.  I’ve seen a few examples of rich immigrants buying prime property in a desirable location but show me a steady group of these people buying homes in more middle class areas.  So the trend is clear.  Baby boomers are also going to start pulling on Medicare and Social Security in the upcoming decade putting additional strains on the system.  In other words, more money is going to go away from housing.  There was an article I read recently about many college grads moving back home because they have no job.  Forget about buying, these recent grads can’t even afford a rental.  So the vacancy rate in rentals and housing units is at record levels.  We have years of inventory to work through thanks to this historic bubble.

The decade ahead does not look good for housing.  Beside the above factors, what if mortgage rates go up?  It is only a matter of time given the policies of the U.S. Treasury and Federal Reserve.  And are we going to see tax credits forever?  Is the Fed going to buy more mortgage backed securities?  We are reaching a tipping point of another crisis because so much focus has veered away from the real economy and has obsessed on housing and finance as a panacea for our economic ills.  Welcome to your second lost decade and thanks to Japan, we have failed to learn what history has taught us only years ago.

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Manias of this magnitude do not happen often.  We have examples in history like Tulip Mania in Holland during the 1600s, the South Sea Bubble, and more recently the technology bubble.  Yet in many previous bubbles the events were largely localized to a group, city, or country at best.  This massive housing bubble went global reaching cities like London, New York, Sydney, Tokyo, Barcelona, and Los Angeles.  The amount of money involved is also historical.

But to predict the future of housing values is now largely thrown into a game of speculation.  And this is a new twist.  It was largely assumed that housing for nearly a century tracked inflation.  Yet during the past decade, because of the mania people started concocting wild stories as to why real estate was appreciating in the double-digits year after year.  The “New Normal” was constant double-digit returns.  An astute reader sent me over the California Association of Realtors’ prediction for 2010.  He also managed to pick up a few of their previous predictions.  I have compiled some of the data on the chart below for easy reference:

The green row is the actual price drop for each year.  The blue row is the CAR forecast for each year.  What the above should tell you is that one massively bad year can wipe out years of steady gains.  In 2006 the CAR forecasted a 10 percent increase and the market went up by 6.5 percent.  Not bad but understated the actual gain.  This is when the median California home was selling for $556,000.  The next year it predicted a price drop of 2 percent but the market nudged out a 0.7 percent gain reaching its annualized peak of $560,000.  Then the market imploded.  The CAR’s forecast for 2008 was a drop of 4 percent when in reality the market lost 38 percent.  This is how off this one year prediction was:

CAR Forecast

$560,000 x 0.04 = A drop of $22,400

Actual Price Drop

$560,000 – $346,400 = $213,600

That is a massive miscalculation.  This is like saying tomorrow is going to be a sunny day but in reality having a category 5 hurricane hitting.  You can have 10 years of sunny days but one massive hurricane will wipe all of those days out.  You would think that people would be more cautious the following year with their predictions.  Let us see how it did the following year:

CAR Forecast

$346,400 x 0.06 = A drop of $20,784

Actual Price Drop

$346,400 – $271,000 = $75,400

That is a sizeable difference in my book.  Given that the median U.S. household income is $50,000 making this kind of prediction error is rather large.  Of course the 2008 forecast was off by nearly $200,000.

Now why is the above important to analyze?  Price is hard to predict because markets are largely unpredictable.  But there is one thing that is certain in bubbles when they pop.  Prices collapse.  California has many wildcard factors like shadow inventory, option ARMs, and failed moratoriums hitting the market in 2010.  What impact will this have on price?  Price predictions in a bubble are nonsense because they follow no logic or economic fundamentals.  Prices will go as high as the speculation and gambling gene will allow people to go.

So what else do we know?  Look at the chart above one more time.  Look at the 30 year fixed rate mortgage.  It was extremely stable even during the peak years.  That is because in California much of the price inflation came from Alt-A and option ARM products.  These items are now gone for the most part and option ARMs are now banned.  FHA insured loans are now taking over the market because of the low 3.5 percent down payment but there seems to be a cap being hit at roughly $300,000.  Why?  Because incomes simply cannot support any higher prices.  Take a look at the 30 year fixed mortgage history:

Now the above chart shows another Black Swan event hitting with mortgage rates touching a 17.5 percent high in 1981.  Did people see this coming in 1977, 78, or 79?  Probably not if they were being honest with you.  Right now people are assuming mortgage rates will stay artificially low just because they have been low for a decade.  But right now the only reason rates are this low is because the Federal Reserve has bought up over $1 trillion in mortgage backed securities.  Can the Fed keep this up?  It can only keep this game going as long as foreigners keep buying up our debt but the U.S. dollar’s wild swings show a major event is bound to happen.  When?  Who really knows but this path is unsupportable.

And now, the high end market is facing major pain.  Take a look at mortgages that are $1 million or above:

12 percent of mortgages with a balance of $1 million or more are now 90 days late.  Last year, this number was 4.7 percent.  If we look at mortgages with a balance of $250,000 or less we find that 6.3 percent are in distress.  Now this is a stunning piece of data.  You would logically think that those with higher mortgages would have lower distress rates simply because they have higher incomes.  But the math at least with monthly cash flows is simple.  Spend less than you earn.  If you bring in $25,000 a month and spend $30,000 you will have problems.  Now if you bought a $2 million home that is now worth $1.25 million, will you continue to pay?  Many of the California option ARMs and Alt-A loans are connected to these high priced properties.

And as you would probably figure out on your own, a loss on a million dollar loan takes a bigger hit than a $100,000 loan:

“(Bloomberg) Luxury home prices probably will drop another 5 percent before reaching a bottom in September 2010, according to Sam Khater, senior economist at First American.

Those declines may lead to losses on jumbo mortgages that dwarf the “haircut,” or discount to full value, that banks take on short sales or foreclosures of moderately priced homes, said Rodriguez, the agent with JM Group in Miami.

“When the bank takes a loss on a $3 million property it’s a lot bigger than the loss on a home with a $150,000 mortgage,” Rodriquez said.”

This market is completely stalled.  Even with FHA insured loans going up to $729,750 that is not enough for some of these million dollar toxic loans.  And why should it even go higher?  The median price nationally is $173,100.  The only reason to increase anything is to allow the upper crust to have another exit hatch (as if they need another one after the massive banking bailouts).

And the economy of California is still in shambles.  The current employment situation is deeply troubling:

This is really where I find it hard to see any major price jumps for California housing.  How can we predict housing gains when unemployment is still near its peak?  Also, we have a $21 billion budget deficit starring at us squarely in the eyes.  What that means is higher taxes or more cuts.  Either way, this will be a drag on the economy.

The fact of the matter is housing prices in California are still too high relative to the actual economy.  Those spiking million dollar loan delinquencies basically means we are moving onto the next phase of this bursting housing bubble.  The mid tier will also take a hit.  But to try to put an actual price is more for entertainment value.  As you can see from previous forecasts use them at your own peril.  The California housing market is as volatile as a chemistry set and 2010 is sure to bring us things that we simply have no way of forecasting.

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I did some sleuthing and pulled up some fascinating articles in older newspapers showing how the typical mortgage rate went from 7.25 percent in the early 1970s to a record 17.5 percent in 1981.  In less than a decade rates went up 100+ percent.  It is hard for people to imagine this but let us walk through what happened with the benefit of hindsight.  Let us chart out the average 30 year fixed mortgage, Fed funds rate, and CPI rate of change:

During the start of the 1970s the 30 year fixed mortgage rate started at 7.25 percent.  By the late 1970s the rate was already over 10 percent and by 1981 it reached a peak at approximately 17.5 percent.  The 30 year fixed rate didn’t go under 10 percent again for another five years until 1986.  The Federal Reserve with the help of Paul Volcker brought inflation under control by raising the Fed funds rate over 17.5 percent.  Unlike the current U.S. Treasury and Federal Reserve, we had someone at the head of the ship concerned with the viability of the dollar and put mortgages on the back burner.  This current Fed and Treasury is concerned more with appeasing the crony bankers on Wall Street.

But let us walk through the above chronologically with snippets from papers:

The Milwaukee Journal – Jul 6, 1973

Competing with other forms of deposit vehicles, banks and savings and loans were allowed to raise interest rates to attract money.  As you might remember Americans were actually saving some money at this time so banks did have to compete for major deposits instead of getting massive bailouts from the government.  So banks started increasing their deposit rates.  At the time mortgage rates were around 7.75 percent on 30 year fixed loans.  Some didn’t think rates could go up much higher during this time but then again as we are now finding out forecasting is not a strong skill of the financial sector.

Sarasota Herald-Tribune – Feb 16, 1975

You have to remember that in the early 1970s the U.S. went off the gold standard.  What followed was rampant inflation.  The U.S. basically decided to give itself a 30 year deficit spending party that is now finally coming to an end.  The above is a fascinating advertisement from 1975.  Rates are now moving on up.  By 1975 the 30 year fixed mortgage is now up to 9 percent but home prices are going up.  This was the decade of stagflation but incomes were also going up so there was a form of balance at least.  The ad is interesting because it talks about buying today assuming home prices will go up no matter what.  So what if rates go lower?  This ad was for a product that locked in your rate should rates go down.  Today, we have nowhere to go but up.  You can’t go any lower than the zero bound.

Our current predicament is a troubling one.  The CPI for the entire decade looking at owner’s equivalent of rent completely missed the entire housing bubble.  The biggest item in a household balance sheet and the entire CPI missed it.  So when we look at our first chart, inflation might seem subdued during the 2000s but it was running rampant in housing prices.  The U.S. Treasury and Federal Reserve knew this so housing prices going up was of no worry; in fact this was their desired goal.

But as the 1970s went further into inflation madness, things started getting out of hand.

Eugene Register-Guard – Oct 11, 1979

Now the above piece is fascinating.  When was the last time you saw the National Association of Home Builders attack the Federal Reserve?  The Fed at this time had its eyes set on controlling inflation and commodity speculation.  This was the goal.  In our current crisis it seems that getting people to buy homes no matter what is the ultimate goal.  People forget that during these times many sellers were allowing borrowers to assume their mortgages at their old lower rates.  This was common practice.  Today many loans have a clause that force new buyers to get a new loan to pay off an old one.  Welcome to the new world of finance.

By 1979 mortgage rates were reaching 14 percent.  Home building was already taking a hit.  Inflation was running rampant.  The Fed was jacking up the Fed funds rate fast and aggressively.  Yet today, the fear of inflation is largely absent.  Or is it?  For the entire decade the CPI missed the biggest housing inflation ever recorded.  So where are we really?  If our best measure is not looking at the entire picture then something is amiss.  That is why I have argued that the BLS with the CPI and employment numbers doesn’t really reflect reality.

By 1981 mortgage rates hit their peak.

St. Petersburg Times – May 7, 1981

Mortgage rates hit a massive peak topping in at 17.5 percent.  Can you imagine a 17.5 percent interest rate today?  Can you imagine getting 17 percent in your savings account?  It is hard to even imagine such a time but that was 1981.  Today you are lucky to get 0.5 percent on your savings account even though the U.S. dollar is getting slammed into oblivion by the Federal Reserve.

By 1981 the Fed was winning the battle against inflation but housing was taking it on the chin.  Apparently saving our economy was more important than saving Wall Street and the housing industry.  Today, the Fed is more concerned about the banks and the housing industry than the actual real economy.  Remember those previous articles from the 1970s?  Did anyone see these rates coming?  Absolutely not.  And this is an important case study in behavioral economics.  Today does not equal tomorrow.  So those thinking interest rates can stay this low forever are out to lunch.  Higher rates will crush prices further.

But by 1982 with the Fed controlling inflation mortgage rates also came lower.

N.Y. Times, October 24, 1982

“(NY Times) Prices will not rise soon, Mr. Downs said, because ”there is a tremendous supply of houses on the market – for the next six months or a year, I think prices will remain relatively flat.” Mr. Downs and others believe that lower interest rates will lead to less seller financing.

One commonly held theory among housing and real-estate specialists is that interest rates must get back down to 12 percent before most families will be able to afford to buy a home.

But even though rates on mortgages guaranteed by the government may be at 12.5 percent, different lenders have different forces to respond to and it could take time before many of them drop their rates that low. Many savings and loan associations cannot afford to offer such low rates because they are paying high rates to depositors; some types of savings accounts are paying 16.55 percent interest and will be for the next 18 months.”

12 percent to make homes affordable?  Hah!  12 percent today would rock the entire market to its foundation.  Yet the Fed did manage to control inflation and mortgage rates went lower and lower until they went under 10 percent in 1986.  But this was a decade of high mortgage rates.  To think what we are going through right now is normal is wrong.  The average 30 year mortgage rate over 40 years is 9 percent.  Do you think we can handle a 9 percent rate?

Some will argue that rates are low because they reflect low inflation risk and the Fed can print freely.  Yet the risk is appearing in the declining U.S. dollar.  The mainstream media seems to ignore this but something else similar happened in the 1970s.  Gold soared:

Source:  BBC

In the 1970s gold went from $35 an ounce in 1970 to nearly $850 in 1980.  This was a reflection of the U.S. coming off the gold standard but also rampant inflation.  So if we had little to no inflation this decade, why is gold now up over $1,100?  Because the U.S. dollar is tanking, that is why.  And why wouldn’t it be?  The U.S. Treasury and Federal Reserve, unlike Paul Volcker, only care about Wall Street and the banks since they are governed by crony politics.  They are more worried about people buying homes with no jobs than getting people to have jobs with good wages so they can buy homes.  It really is backwards.  That is why anytime the U.S. dollar makes a strong move up gold gets slammed but also the stock market.

I’m no gold bug but I do follow the markets.  In the 1970s gold shot up because of the U.S. going off the dollar standard and rampant inflation.  Today, gold is rising more because the U.S. dollar is being crushed by the enormous amounts of debt.  The fact that we are bailing out banks with trillions is simply inexcusable with no actual reform on the table.

So what can we gather from the above?  Over the next few years things are going to happen that many of us cannot predict.  The unemployment rate is still up at 10 percent and if we add in the underemployment rate, we are up to 17 percent.  The government is blowing through money that would be normal if we were entering a world war.  With banks offering 0 percent on savings accounts Americans are nearly forced to gamble in the stock market if they want any sort of return.  Social Security has already stated they will offer no cost of living adjustments for the next two years.  All the while the U.S. dollar is doing this:

A few things are certain:

-Mortgage rates can only go up.  We are at the lower bound.  It is a matter of when they go up.

-We will never ever pay off our debt.  Anyone who believes otherwise does not understand arithmetic.  We are spending more than what we are bringing in?  Paying it off?  Hah!  To the contrary, we are spending even more.  I doubt Keynes envisioned fiscal stimulus in the form of trillions to a select group of crony bankers.

-U.S. households are being crushed by enormous amounts of debt.  The Fed hopes to generate massive inflation so we can pay off current debts with cheaper dollars.  In their mind, big deal to have a $500,000 mortgage if the median income is $200,000.  Clearly they are not following the employment market.

As we look at the 1970s and 1980s we can learn many things.  First, massive inflation is no party and this is what the Fed is trying to induce.  Second, many financial “experts” have no clue where things will be heading.  Yet spending more than you earn never ends well.  The signs are all there.  We just need to be open to history and listen to what it is telling us.

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