As the yen carry trade unwinds, the DOW vacillates wildly, market volatility continues to rise, and the idea of risk returns to the minds of investors world over, we are left with one, stubborn enigma: The price of houses in the San Francisco Bay Area.
At this point, there is no denying that real estate prices are in a full on correction, nation wide. Anyone with an ounce of honesty now fully recognizes the existence of a bubble. The few who doubted the bubble have now seen their stake in the bet that the subprime loan game would last forever vaporize. All you need to do is Google subprime meltdown for a current counting of the carnage.
The Dominoes are Falling
My longer term readers know that I am no doomster. I've written numerous articles at Patrick.net where I've taken issue with the tendency for many "bubble believers/bubbleheads" to insist that the housing bubble will end in the smoking ruins of Western Capitalism. Even Peter Schiff (Euro Pacific Capital) is far too pessimistic for my taste. I think gold is generally a terrible investment for average retail investors. It's a big suckers game where you and I are the suckers. Schiff reminds me of Edward Yourdin: an otherwise intelligent, perhaps occasionally brilliant, thinker and technician who gets his biggest predictions wrong, or at least grossly mistimed.
No. What we're seeing is just a big, unpleasant correction, not the end of the world as we know it.
As subprime lenders continue to implode and the holders of those mortgages start walking away from their obligations in ever bigger numbers, downward pressure on housing prices will continue to mount.
It's not that the subprime lending segment of US mortgages is overwhelmingly large. In fact, it is but a smallish portion of the overall pool of all US mortgage debt. The problem is twofold:
- Subprime loans have funded an increasingly large portion -- in some areas over half -- of recent bubble-priced home purchases.
- As subprime loans disappear as a borrowing option, so do a large number of recent marginal buyers. Simply, these folks are subprime because they cannot afford to buy houses at bubble-prices with conventional loans.
In an article titled Housing Bubble Economics from August 2006 I detailed how the decline in housing prices would/should progress.
For the most part, this is what we're seeing now occurring in real estate markets across the country, including most of California.
Fortress Silicon Valley
Most, but not all of California. The San Francisco Bay Area, especially Marin, San Francisco, San Mateo and Santa Clara counties (The City and Silicon Valley) continue to defy gravity. While inventories continue build at arguably the fastest rate since the Great Depression, prices remain flat, or even edge higher!
Is the Bay Area an island? Have we found the legendary "permanent new plateau" in home-prices?
What we are seeing occur, I believe, in the Bay Area is a psychology bubble. Probably, a short lived one. But, Web 2.0 is in the air. Google is still hiring. Entrepreneurs are being funded, companies are getting bought, investment bankers are getting bonuses. Everyone feels great! And when people feel good about their jobs they:
- Are willing to pay a very large portion of their incomes to buy a house, because they think their incomes will keep rising at an increasing rate.
- Are not willing to sell homes for a discount, because they think they can ride it out indefinitely.
Where I was mistaken in my original analysis was in considering the power of psychology in the market of both marginal buyers and marginal sellers. What we have really is a complex transition from this graph to the earlier one, in which the shape of the buyer and seller curves both contain multiple discontinuities.
Discontinuities are important to solving the mystery of recent confusion in the Bay Area real estate market. On one hand we can see homes both super expensive and working class reasonable sit for over a year on the market without a bid anywhere near asking price. On the other we see occasional outbreaks of bubble-like bidding wars, with buyers elbowing one another at the open house just to queue up to write up no-contingency offers.
Mathematically, a discontinuity (the vertical part of a supply or demand graph curve) is where the price function is undefined. In other words, anything can happen. I alluded to this in my earlier article. It is playing out much more than I would have expected, though.
Never bet against psychology as the short-term winner in any market function.
Fundamentals Always Win in the End
But in the end, fundamentals always reign supreme. Things simply cannot be what they could never be. In this case, people simply cannot afford houses which they cannot afford.
What is interesting right now in the Bay Area is that both fundamentals and technicals are working to depress housing prices. But yet prices remain stuck. The culprit: behavioral psychology.
I don't need to draw a graph to prove that this cannot last very long, nor will it be pleasant when this mass thinking breaks down and prices come unstuck.
The German word describes this future unwinding quite efficiently: Torschlusspanik. For those who study behavioral finance and economics know well that what market psychology giveth, so too can it taketh away. I would add, "taketh away with beautifully terrible speed and efficiency".
[Parallel discussion I'm hosting on Patrick.net is here.]