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Thursday, December 30, 2010

Schiff- Home prices are still too high

An Opinion piece by Peter Schiff in the Wall Street Journal today. The ironic thing is that Mr. Schiff is a notorious 'inflation' hawk. I've always disagreed with in certain respects, but this article indicates that he would probably be categorized in the skewflation camp.

Nevertheless, as pessimistic as it may seem, Mr. Schiff makes a lot of points that are awfully hard to dispute.

AP- Most economists concede that a lasting general recovery is unlikely without a recovery in the housing market. A marked increase in defaults and foreclosures from today's already elevated levels could produce losses that overwhelm banks and trigger another, deeper financial crisis. Study after study has shown that defaults go up when falling prices put mortgage holders "underwater." As a result, the trajectory of home prices has tremendous economic significance.

Earlier this year market observers breathed easier when national prices stabilized. But the "robo-signing"-induced slowdown in the foreclosure market, the recent upward spike in home mortgage rates, and third quarter 2010 declines in the Standard & Poor's Case–Shiller home-price index—including very bad October numbers reported this week—have sparked concerns that a "double dip" in home prices is probable. A longer-term view of home price trends should sharply magnify this fear.

Even those economists worried about renewed price dips would be unlikely to believe that the vicious contractions of 2007 and 2008 (where prices fell about 30% nationally in just two years) could return. But they underestimate how distorted the market had become and how little it has since normalized.

By all accounts, the home price boom that began in January 1998, when the previous 1989 peak was finally surpassed, and topped out in June 2006 was extraordinary. The 173% gain in the Case-Shiller 10-City Index (the only monthly data metric that predates the year 2000) in those nine years averaged an eye-popping 19.2% per year. As we know now, those gains had very little to do with market fundamentals, and everything to do with distortionary government policies that mandated loans to marginal borrowers, and set off a national mania for real-estate wealth and a torrent of temporarily easy credit.

If we assume the bubble was artificial, we can instead imagine that home prices should have followed a more traditional path during that time. In stock-market terms, prices should have followed a trend line. When you do these extrapolations (see lower line in the nearby chart), a sobering picture emerges. In his book "Irrational Exuberance," Yale economist Robert Shiller (co-creator of the Case-Shiller indices along with economists Karl Case and Allan Weiss), determined that in the 100 years between 1900 and 2000, home prices in the U.S. increased an average 3.35% per year, just a tad above the average rate of inflation. This period includes the Great Depression when home prices sank significantly, but it also includes the frothy postwar years of the 1950s and '60s, as well as the strong market of the early-to-mid 1980s, and the surge in the late '90s.

In January 1998 the 10-City Index was at 82.7. If home prices had followed the 3.35% annual 100 year trend line, then the index would have arrived at 126.7 in October 2010. This week, Case-Shiller announced that figure to be 159.0. This would suggest that the index would need to decline an additional 20.3% from current levels just to get back to the trend line.

How has the market found the strength to stop its descent? No one is making the case that fundamentals have improved. Instead, there is widespread agreement that government intervention stopped the free fall. The home buyer's tax credit, record low interest rates, government mortgage-assistance programs, and the increased presence of Fannie Mae, Freddie Mac and the Federal Housing Administration in the mortgage-buying business have, for now, put something of a floor under house prices. Without these artificial props, prices would have likely continued to fall.

Weitz - this is the story no one talks about. The measures taken to 'prop up' the market were unsustainable. Now, the tax credit has run it's course, and interest rates are creeping back up from historic lows. I still maintain that a second leg down in prices is imminent. The extent of the drop is hard to predict, but I would be very surprised if it did not exceed the 5% drop that many 'experts' are predicting.

Where would prices go if these props were removed? Given the current conditions in the real-estate market, with bloated inventories, 9.8% unemployment, a dysfunctional mortgage industry and shattered illusions of real-estate riches, does it makes sense that prices should simply fall back to the trend line? I would argue that they should overshoot on the downside.

With a bleak economic prospect stretching far out into the future, I feel that a 10% dip below the 100-year trend line is a reasonable expectation within the next five years, particularly if mortgage rates rise to more typical levels of 6%. That would put the index at 114.02, or prices 28.3% below where we are now. Even a 5% dip would put us at 120.36, or 24.32% below current prices. If rates stay low, price dips may be less severe, but inflation will be higher.

Weitz - if Mr. Schiff is correct, our "recovery" will most certainly be short lived and things will likely get worse before they get better...a scary proposition indeed.

From my perspective, homes are still overvalued not just because of these long-term price trends, but from a sober analysis of the current economy. The country is overly indebted, savings-depleted and underemployed. Without government guarantees no private lenders would be active in the mortgage market, and without ridiculously low interest rates from the Federal Reserve any available credit would cost home buyers much more. These are not conditions that inspire confidence for a recovery in prices.

In trying to maintain artificial prices, government policies are keeping new buyers from entering the market, exposing taxpayers to untold trillions in liabilities and delaying a real recovery. We should recognize this reality and not pin our hopes on a return to price normalcy that never was that normal to begin with.

Mr. Schiff is president of Euro Pacific Capital and author of "How an Economy Grows and Why it Crashes" (Wiley, 2010).


  1. I dont know how much control the fed has over the rate anymore.

    LOL, I cannot imagine what would happen if the props were removed. Interesting strategy from the Gov, ‘keep the props up till hopefully the economy recovers enough to where the market aligns to the props’; the primary beneficiaries being the banks who are double dipping.
    I’m sure foreclosure losses in the banks are being insured on the back end as well.