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Housing Bubble:
A Rude Awakening White Paper Special

By Eric J Fry, Executive Editor

Housing Bubble: What the Numbers Tell Us

Recent existing home sales data confirm the fact that the housing boom-boom is going bust-bust. Sales of existing homes fell 11.2% from a year earlier, while the absolute number of homes for sale jumped to a new record. Based on the current rate of sales, a 7.3-month supply of homes awaits buyers, the most in 13 years. Net-net, the housing market does not appear to be heading for the "soft landing" that Ben Bernanke says he expects, but rather, the crash landing that many of us fear.

By now, everyone knows the housing boom has busted. Even the National Association of Realtors admits as much. Just last summer, David Lereah, the NAR's Chief Economist delivered a sobering presentation to the NAR Leadership Summit in Chicago entitled, "Reality Check," in which he flatly declared, "The housing boom ended in August 2005."

To illustrate his point, Lereah provided the nearby table, detailing the magnitude of the year-over-year sales declines in the nation's hottest property markets.

The only issues worth pondering, therefore, are how low prices might fall and/or how long the bust might last. Without trying to be too specific, we'd guess that prices will fall a lot and/or that the bust will last a long time…But that's just a wild guess.

The key to these mysteries probably lies somewhere within the Golden State, the epicenter of housing unaffordability.

Housing Bubble: Los Angeles Case Study

Imagine a country of 10 million citizens. Imagine it is one of the wealthiest countries in the world. And yet, it is a country where only 14% of the population can afford to buy the median-priced home.

The reader requires no imagination…This "country" is Los Angeles County, the least affordable metropolis in the nation, according to the NAHB/Wells Fargo Housing Opportunity Index. Only 1.9% of the new and existing homes sold between January and March of this year were affordable to L.A. County residents earning the median income.

How did California housing become so ridiculously expensive?

One word: Credit.

Housing Bubble: Fueled by Credit

Without easy credit, and lots of it, California real estate could never have achieved its epic valuations. Credit not only enabled first-time buyers to "stretch" a bit, it also enabled and emboldened speculative buyers, speculative builders, second-home buyers, second-home builders and every other variant of housing market participant/speculator.

But because financing became so exotic, and speculative participation in the market became so great, the simultaneous unwinding of both will be as pleasant as hanging out with your in-laws during a root canal.

The unwinding is already beginning. The NAR's Lereah offers a succinct explanation and post-mortem:

? Mortgage rates rose almost one point
? Affordability conditions deteriorated
? Speculative investors pulled out
? Homebuyer confidence plunged
? Resort buyers went to sidelines
? Trade-up buyers to sidelines
? First-time buyers priced out of market

As a result, Lereah explains:

? Sellers' market transitioning to buyers' market
? Home sales plummet, prices lag, inventories rise
? Cooling markets left with high percentage of exotic loans
? Builders offering non-price incentives
? Days-on-market lengthening
? Residential construction activity slows
? Home prices beginning to soften

We all know what happens NEXT. But we just don't know how bad it will be. Please allow us to offer a prediction:

? Home sales continue plummeting
? Prices begin to plummet
? Exotic loans begin to squeeze over-leveraged homeowners
? Prices plummet some more
? A new bull market in housing does not begin until 2020…or maybe a little sooner.

Since the California boom relied heavily upon exotic financing to plug the gap between affordability and purchase prices, the gap between affordability and purchase prices widened to extreme proportions.

Every valuation gap that relies on credit, rather than cash and income, is likely to narrow eventually…especially when the burden of existing credit is on the rise. And that's exactly what's happening in California.

Almost 40% of the state's homeowners - compared to 29% nationally - pay at least one third of their income for housing, according to the Public Policy Institute of California. Even worse, one fifth of all recent home-buyers pay more than HALF of their income for housing.

Furthermore, California home-buyers have increasingly financed their purchases with unconventional loans, such as adjustable rate, negative amortization and interest-only mortgages, rather than traditional fixed mortgages. Just under a third of mortgages initiated or refinanced in California this year have interest-only components, compared with 1.4 percent in 2000, according to LoanPerformance. This tactic may have seemed quite savvy when rates were low, but it seems much less savvy now.

Highly leveraged, adjustable-rate home-buying has become so prevalent in the Golden State that the California Association of Realtors (CAR) recently changed its "affordability" methodology. The Housing Affordability Index (HAI), when the CAR launched it in 1984, assumed a 20% down payment and a fixed-rate mortgage. But that's "old school" now. The new and improved affordability index assumes a 10% down payment and an adjustable-rate mortgage.

Despite the new methodology, A Californian must still earn almost $100,000 per year to "afford" the state's $482,000 median-priced home. And Despite the new methodology, the ability of first-time home-buyers to purchase the median-priced home stands at an all-time low.

Very few readers would be shocked to learn that California homes are beyond the means of most California residents. But what you may be shocked to learn, is that California homes are also beyond the means of the folks who actually own the homes.

If wanna-be home-buyers cannot afford to buy homes, and EXISTING homeowners could not afford to re-purchase the very roofs over their heads, who will be buying houses? Or to re-phrase the question, how much lower must prices fall to restore some semblance of affordability?

A lot lower, we predict.

Click here to see just how much lower and to learn about how the whole nation seems to be catching the "Denver Flu"

Housing Bubble: Profiteering in the Chaos

"We conclude that a decline in house prices is underway," Grant's Interest Rate Observer recently remarked. "If the house market, like the stock market, were mean-reverting, the sell-off could carry a far way. A return to the post-1968 trend line would imply a drop of 22%. Which, of course, for these real estate-centric United States, would imply disaster.

"We do not predict disaster," Grant continues, "but we do expect a pullback severe enough to inhibit the leveraged American consumer and to stunt the growth of the U.S. economy…"

Your California editor does not predict disaster either, but he does not rule it out. Nor does he rule out the possibility that mortgage-lending stocks might fall a lot lower…before they move higher once again.

Real estate transactions - and related economic activities - have become a disproportionably large contributor to the overall U.S. economy. Therefore, we would miss them greatly if they took a sabbatical.

"Between 1997 and 2004," Grant relates, "the value of these residential transactions amounted to 16.4% of GDP, almost double the median reading from 1968 through 2005." This monumental real estate boom fostered "echo-booms" in all housing-related industries. Since the end of 2001, according to Northern Trust economist, Paul Kasriel, housing-related industries have produced a whopping 43% of the nation's total net private sector employment growth.

Obviously, therefore, any slackening of real estate activity could convert the nation's largest job-creator into a job-destroyer.

"In the months ahead," says Kasriel, "Econ 101 predicts that the prices of existing dwellings will continue to soften. This will serve to reduce the excess supply as some not-so-serious sellers take their homes off the market and as those sellers who have to sell acquiesce to the reality of lower prices. The knock-on effects of all this will be subdued consumer discretionary spending as those 'home ATMs' are not refilling as rapidly as before. Another factor that will curtail consumer discretionary spending is slower income growth in housing-related industries as employment and sales commissions moderate further."

Membership within the California Association of Realtors, for example, might slip a bit, once home-selling becomes more tedious - and less remunerative - than raking rock gardens.

"We know that the behavior of the residential real estate sector tends to lead the behavior of the overall economy," Kasriel conntinues. "That's why folks at the Conference Board stuck housing building permits into the index of Leading Economic Indicators rather than the coincident or lagging indices. Might it be in this cycle that the behavior of the residential real estate sector is even more important than other cycles?"

"Yes," is the implied and worrisome answer.

Housing Bubble: Real Estate Casualties

The casualties of a real estate-induced recession would be many and varied. So varied, in fact, that we could not begin to anticipate them all. But we could certainly anticipate that those closest to the front lines - namely, builders and lenders - would suffer first and most. We would expect both sectors to continue sliding lower…especially if a "second wave" of selling sweeps through the housing market.

A terrific report by two analysts at JMP Securities makes the case that the housing "recovery" is no better than a faint hope.

"Based on our field work," write analysts Alex Barron and James F. Wilson, "we do not believe the worst news [on housing] is out yet. We continue to see that the level of discounting to sell homes is rising sharply, in particular to move cancelled and unsold spec homes. And yet, despite the high level of discounting, buyers are still reluctant to buy."

The bearish duo issued their grim prognosis early last month - well before the Census Bureau announced a stunning 9.7% drop in new home prices during September. New home prices had never fallen this sharply in one year since December 1970, when prices tumbled 11.2%.

"A little over a year ago, buyers couldn't wait to sign contracts to purchase homes," a Wall Street Journal headline recently observed. "Now, many can't wait to get out of them…New-home builders are taking a big hit from record numbers of contract cancellations, or 'kickouts.' Fort Worth, Texas-based D.R. Horton Inc., the nation's biggest developer, says its cancellation rate is currently 40%, compared with 29% a year ago. Meritage Homes Corp., in Scottsdale, Ariz., is reporting a 37% kickout rate, compared with 21% a year ago. And Standard Pacific Corp. says that 50% of its contracts fell through in the third quarter of this year, compared with 18% for the same period last year."

But these troubling facts have not dissuaded Alan Greenspan and other economic cheerleaders from predicting a recovery in the housing market.

"The worst is behind us as far as a market correction," declares David Lereah, NAR's Chief economist. "This is likely the trough for sales. When consumers recognize that home sales are stabilizing, we'll see the buyers who've been on the sidelines get back into the market, and sales will be at more normal levels…"

Analysts Barron and Wilson disagree. The prognosis for the housing market remains very poor, they contend, and it remains particularly grim for the builders of new homes.

"The housing market is landing harder than most people realize," they warn. "As we study the number of listings versus homes sold across various price ranges, what we find is major disconnect between the prices where the majority of the listings are and the prices where the majority of the sales are transacting. For example, in Phoenix, Arizona, 63% of the sales and 46% of the listings in July were for prices under $300,000, resulting in a 4-6.5 months' supply of homes in this price range. However, for prices over $300,000, which is where most builders had been building last year, the months' supply is 9.5-14 months."

From the perspective of publicly traded homebuilders, therefore, the housing market may be even worse that it appears to be on the surface. And clearly, signs of a bottom remain elusive.

"We continue to look for signs that a recovery is imminent," Toll Bros. CEO, Robert Toll, remarked last week, "but can't say that one is in sight."

Donald Tomnitz, CEO of D.R. Horton, the nation's largest homebuilder by revenues, agrees with his counterpart at Toll Bros. Just yesterday, Tomnitz remarked, "As we look forward to 2007 we will have a more challenging year."

And yet, despite these cautious remarks from the leaders of the homebuilding industry, investors are throwing caution to the wind. Homebuilding stocks bounced nearly 6% yesterday - punctuating a rally that has lifted the sector more than 20% since mid-July. But analysts Barron and Wilson would advise against bottom-fishing among the homebuilding stocks.

"Historically, we see that speculative excesses generally take longer than one year to work themselves off. So far, the housing stocks seem to be closely tracking the Nasdaq decline after it peaked in March 2000. Thirteen months after the peak, the Nasdaq was down 60%. This was followed by a brief rebound that lasted three months and took the index up 17% from its lows. Subsequent to this brief rally the Nasdaq fell another 30% over the next three months to a lower low. The Nasdaq eventually bottomed out three years from the peak in March 2003, 75% below its all-time high. The homebuilding index peaked in July 2005 and then fell 50% 12 months later. [But, over the last three months, the index is up 21%]. We believe the housing stocks are likely to re-test their lows in the coming months and perhaps go below them before we see the ultimate bottom."

Our advice: Wait for rays of sunshine to appear before heralding the dawn.

Housing Bubble: In The Beginning

There comes a time in every man's life when he seeks to become the lord of his own castle…rather than the tenant of another lord's castle. There comes a time when he wants to break free of the tyranny of landlords and rent checks…to own his own home.

Let's ignore the fact that he is merely transferring his indentured servitude from a landlord to a mortgage lender, he FEELS that he "owns his own home."

So what happens when the security of this lifetime investment is threatened? What happens when the housing bubble hisses and finally bursts, when his castle comes under siege? With his back against the wall, Mr. Homeowner must face some hard facts.

The Anatomy Of A Housing Bubble:

These are difficult illustrations to digest. Indeed, many homeowners will not survive the oncoming crisis…but there are a few ways he can protect himself.

Learn how the full impact of the housing bubble will effect your biggest investment with this special Strategic Investment housing report

Housing Bubble: The Case-Shiller Index:

"We've had the biggest housing boom in the history of this country," explains Yale professor, Robert Shiller. "That can't go on forever…I'm thinking that this boom is so much bigger, that we will see a substantial fall that will affect the country overall…We're not [automatically] bound for an enormous decline, but I think it's likely."

Shiller aired his skeptical remarks during an interview with Bloomberg News recently. The housing boom has been so large and all-encompassing, Shiller argued, that the coming bust also promises to be large and all- encompassing.

Helpfully, Shiller does not warn of impending disaster without also providing a partial refuge. The Yale professor helped to create indexes that track home values in ten major metropolitan centers. These new indexes, dubbed the Case-Shiller Indexes, underlie a new batch of futures contracts that debuted three months ago on the Chicago Mercantile Exchange (CME).

The new contracts reflect home prices in most of the nation's hottest property markets, namely: Boston, Chicago, Denver, Las Vegas, Los Angeles, Miami, New York Commuter Index, San Diego, San Francisco and Washington D.C.

"Why did you create these futures contracts?" the Bloomberg interviewer asked Shiller.

"They're designed to allow people to adjust their exposure to a risky market," he replied. "The total value of real estate owned by households in the United States is $20 trillion. Bigger than the stock market. Not everyone needs to hedge. But a lot of people should be adjusting that risk exposure."

Housing Bubble: An Unprotected Liaison

Remarkably, very few homeowners are availing themselves of these new hedging instruments. Only $71 million worth of housing futures are currently changing hands. "That's peanuts by Wall Street standards," Shiller admits.

Furthermore, $71 million would not amount to even a single peanut in relation to the $20 trillion of household real estate equity. In other words, our nation of leveraged homeowners remains completely unhedged against the prospect of falling home prices - a prospect that seems increasingly likely if we are to trust the newly minted Case-Shiller futures contracts.

"In all 10 [futures contracts]," Shiller reports, "we have what's called backwardation. That means that the futures price is below the price that it is today. All of the markets are predicting price declines. And these price declines range from 4% to 5 1/2% by May of 2007…That's not me talking; that's the market."

To help frame his bearish expectations for the housing market, Shiller refutes the myth that residential real estate has been a great long-term investment. "It has not been a great investment," he says flatly.

Between 1890 and 2004, Shiller's book, "Irrational Exuberance" explains, U.S. residential real estate increased by only 66%, in real terms - that's only 0.4% per year. By comparison, U.S. home prices soared by 52% between 1997 and 2005 - or by 6.2% a year. Since home prices have soared so far above their long-term trendline, he reasons, a reversion toward the mean would not be surprising.

"Many contend that a sustained pullback in house prices is unthinkable," remarks James Grant, editor of Grant's Interest Rate Observer. "But the unthinkable - or, at least, the highly atypical - has already happened. In 2001- 2005, prices levitated.

"Shiller agrees."

So why did it happen?" The Bloomberg News interviewer wanted to know.

Shiller, an economist by trade, cited no economic rationale for the boom. Rather, he provided an explanation rooted in the curiosities of human behavior.

"One of the mysteries of human society is how we interact with each other," he said. "We are an empathic species. When you have emotions, I see it in your face and I feel the same emotions. That means we kind of move as herds. And so when other people are getting excited and they are talking about the real estate market, it gets me excited too. You can't stay above it. If you are human, you get drawn in. But then when the emotions start changing, you get drawn into that too. And the emotion does seem to be changing. It looks like we're at the beginning of a change in psychology."

Clearly, emotions are changing. The feel-good era of thehousing market is visibly yielding to the feel-less-good era.

Housing Bubble: The Endgame

Earlier this year, one of the world's greatest living economists made three very shocking

predictions. Now they are coming to fruition. Homeowners around the country are slowly coming to grips with the fact that the value of their biggest investment is eroding…and the dollars they used to buy it are becoming weaker and weaker all the while. You can continue to look the other way and hope for the soft landing that Bernanke is hoping for, or you can get real and protect yourself.