HISSSsssssssssssss
Leaks in The Real
Estate Bubble!
Ralph Kettell
Archives
January 8, 2004
Happy New Year to All !
I just arrived back from a
two-week trip to Spain with my family and am suffering from substantial
jet lag, but the sight I saw this morning on my computer screen
prompted me to bang out this short missive.
I looked at the section on
my stock tracking screen which shows the major averages indices,
bond rates, etc. and they all appeared normal (at least as normal
as can be expected when the markets are being propelled higher
by unbridled investor enthusiasm and extremely stimulative monetary
policy). I scrolled down through some of the stocks I watch for
indications of where the economy is headed (although I certainly
would not buy any of them at this time), and most of them appeared
to be having a flat to moderate up day. Then it jumped out at
me. The three homebuilder stocks which I track, DHI (D.R. Horton),
LEN (Lennar), and PHM (Pulte Homes) were in the midst of a phenomenal
early morning plunge.
At 10:30AM, DHI is down $3.40
to $37.90 an 8.2% drop, LEN is down $4.65 to $88.62 a 5.0% drop,
and PHM is down $2.90 to $41.81 a 6.5% drop. They were all lower
a few minutes ago when I first noticed the drop. DHI, down the
most of this group, had just announced that 4th quarter earnings
were up 20% from the same period the previous year. One would
expect the stock to go up after that kind of news, right?
Well perhaps it a case of the
market expecting a 22% increase and only got 20%? Or maybe the
market knows something the rest of us don't.
Why is this so important? Who
cares if a few homebuilding stocks are off a bit?
First of all from a fundamental
standpoint, the real estate market is the most important market
in the USA and has been for the past 2 years. Investors, after
having been burned by the stock bear market which began in 2000,
have been pouring money into real estate at an incredible pace.
They have bought new, bigger better homes at hugely inflated
prices. They have put money into investment property. However,
most importantly, even those of us who haven't moved to keep
up with the Jones' have almost to a person refinanced their homes.
Much of the money that was refinanced ended up as new liquidity
in the economy. It has literally been the grease that has kept
our economy out of a depression, at least so far. If it were
not for the artificially low interest rates and reduced lending
standards, Alan Greenspan might be out of a job by now. Al just
loves bubbles, whether they are from his daily bubble bath, or
the bigger more unruly ones he helps create in the US economy.
The current real estate bubble
and its impending aftermath will be remembered for years to come.
The damage it will reek on the already unsteady (or worse) US
economy will be tragic for many unfortunate US homeowners. However,
its effects will not be felt by homeowners only. No, the effects
will be felt by everyone. When the air whooshes out of the real
estate bubble, everyone will catch a financial cold or flu or
pneumonia from its chilling effect.
First, the homebuilding stocks
will drop like a rock as their bottom lines go from very rosy
to horribly scary. At this point in the cycle, builders are over
optimistic (as is most everyone). When builders get more optimistic,
caution gets thrown to the wind and greed can and usually does
kick in. While the greed component is not essential to the scenario
I am detailing, it does make for a more spectacular crash. The
combination of optimism coupled with greed gets the builders
to do more of what has made them so much money in the past few
months. They build more houses and many of them are done on spec.
Why not! In the 3-5 months it takes them to build the houses,
they all (always) go up in value. This translates into greater
profits for the builders.
This may not seem like a big
deal, but let me assure you it is huge and can be like a drug
to an unsuspecting homebuilder. Lets say for example that on
a typical $250,000 house the builder makes $20,000 profit. All
the rest is cost of land, interest, materials, labor, sub-contactors,
and finally real estate commissions. If the house price goes
up 5% during the time the house is under construction, then the
builders profit goes up approximately $12,500 or 62.5%. In the
heady times of the past year or so, 5% increases are quite uncommon,
rather 10%, 15% or more are far more the norm. Therefore the
more courageous or perhaps more foolish builders have been making
obscene profits on their spec houses. This cycle prompts some
of the less courageous, more risk averse builders to try the
same thing that their now wealthier friends have been doing.
It also prompts the ones that having been making a killing to
increase the amount of spec building they are doing.
This will all lead to a tragic
end for many of these home builders. When the economy reverses,
it does not take a very large decrease in home prices to completely
wipe out a builders profit. In fact from the earlier example,
a drop of $20,000 or 8% will completely wipe out all profit for
the builder. At that time the smart guy will sell quickly and
get out of a bad situation. Unfortunately for many of them, human
nature kicks in. Greed prevents them from selling, because they
want to make money, which is understandable. What ultimately
happens is that many of them never sell and the banks end up
with a supply of real estate in various states of completion
that they never really wanted, and the builders declare bankruptcy.
Now the banks have a stock
of homes to sell. What happens next? Well the banks are much
quicker to act than the builders. They sell the houses as quickly
as possible, because they do not like to be in the real estate
business. Banks much prefer banking. Often the banks will contract
with another builder to quickly finish the homes so that they
are more saleable. In the process of selling the houses quickly,
the banks drop the prices to the fire-sale range. This has a
very deleterious affect on the prices of other homes for sale,
new and used. This is the start of a vicious cycle, because as
the home prices drop, other builders are squeezed as are homeowners
who are forced to sell do to loss of their jobs, transfers, etc..
The banks end up with more real estate and the cycle goes on
till it has run its course and home prices are much lower than
they had been in the hey days. The net result is that the banks
lose money, the builders go bankrupt, and the homeowners who
have to sell take a bath.
How do I know this is going
to happen?
I witnessed it first hand in
Houston. In the mid 80's Houston real estate fell off a cliff.
It was precipitated by a horrendous drop in the price of oil.
At that time, Houston was still in a building binge, subdivisions
were being developed at a phenomenal rate and houses were going
up everywhere. All of a sudden there was no more demand, but
a great deal of supply. Prices plummeted! Banks became temporary
real estate companies. From 1986 to 1988, banks sold far more
real estate than home builders. The number of home listed on
the Houston MLS exceeded a one year supply. Ouch! The home values
dropped by 60 to 80% in many sections of Houston.
I went to Houston in late 1987
and throughout 1988 and bought many foreclosed single family
houses. I figured if you could buy real estate at 20-40% of replacement
cost, you couldn't go wrong if you had the staying power to hold
on until the local economy recovered. I was right although it
took longer than I had originally thought. I have sold most of
those houses between 2000 and 2003. There will be an opportunity
to do the same thing in many places throughout the US, but not
until prices drop more than in half from where they are currently.
Keep your powder dry in gold and gold stocks waiting for the
right time to re-invest in real estate.
As you can see from today's
market action, the homebuilding stocks are starting to crack.
Once the cracks widen and the sound turns from and HissSSsss
into a WHoooosssshhH, watch out below. The flu will spread quickly
from the homebuilders to the banks and mortgage companies and
especially to our old friends FANNIE (FNM) and FREDDIE (FRE).
Most important, however, is that the economy will have lost its
last source of liquidity and the consumer will have lost their
last crutch. All equities will fall and they will fall quite
hard.
We are heading down the same
path as Japan in the early 90's. After the Japanese stock market
crashed in 1990, the economy stayed OK for a couple of years.
The real estate values held their own and consumer spending was
reasonably firm. Then, however, the real estate started to crumble
also and since then the Japanese consumers have holed up and
saved rather than spent. Let me repeat that, the consumer spending
stayed firm after the stock market collapse and did not fold
up until the real estate crashed.
In the US, a large percentage
of the population has been investing (playing) in the stock market
for the past few years. However, a far greater percentage of
the population owns homes. When home prices drop and those poor
folks have negative equity, they will stop spending and the market
will grind to a halt. In the stock market, the most you can lose
is what you have invested (in most cases). In the futures/commodities
market, you usually don't lose more than you invest unless you
answer a margin call, because the broker will sell out the position
quickly to protect himself. With a home, however, there is no
such protection. With the current lending practices, many people
start out in a negative equity position. This doesn't bother
them as all their friends did the same thing and now they have
20 to 30% equity due to price increases. When the prices drop,
it's a whole new ballgame. How many of these folks are going
to continue to make mortgage payments of $1000 a month when they
can rent the same house for $600 a month down the street. If
they had put down $10,000 deposit they might not be so eager
to walk away and destroy their credit. Most of them, however,
put up little or no money, so when the house prices drop and
the rents drop and they are in a negative equity situation, they
will walk. Guaranteed!
The end of this process will
be significantly lower consumer spending and a resulting deep
recession. I would say depression, but the government won't call
it a depression until 10 or more years after it has ended. The
stock market will go lower than anyone can fathom, and there
will be a whole generation (currently aged 25-50) which never
invests in the stock market again.
As a final humorous (or perhaps
sad) aside, I want to tell you what many people in Houston (who
still had jobs) did when home prices collapsed. They would have
a house valued at say $60k, which had cost them $110k and on
which they had a $100k mortgage. They would go out and buy a
foreclosed house for $100k which was twice the size of their
existing house. They told the lender they were in the process
of selling their existing home, so the lender would gleefully
approve them for the new loan. Their home payments would be about
the same as on the first house. Then they would go out and buy
a new car and anything else they needed to buy on credit. Finally,
they would contact their lender on the first home and tell them
that they were quit claiming the house over to them. Rather than
fight it, the existing lender would take back the house and post
the foreclosure to the credit report of the homeowner. The homeowners
weren't bothered about the foreclosure, because they had their
immediate needs covered, house, car, etc. The lenders wouldn't
bother taking the owners to court, because they were inundated
with foreclosures, and it was far cheaper for them to simply
take the property back peaceably. Human ingenuity and/or conniving
is incredible!
January 8. 2004
Ralph W Kettell, II
Archives
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 Disclosure:
The
author is not an investment advisor and this article should not
be construed as a recommendation to invest in the discussed securities.
The author is merely presenting some possible scenarios and what
the potential risks and rewards associated with an investment
in these securities could be. The author has not been paid to
write this article, either in cash or securities.
Disclaimer:
The
author's objective in writing this article is to make potential
investors aware of the possible rewards of investing in this
stock and/or warrants and to elicit interest on their part in
this stock to the point where they are encouraged to conduct
their own further diligent research. Neither the information,
nor the opinions expressed should be construed as a solicitation
to buy or sell this stock. Investors are recommended to obtain
the advice of a qualified investment advisor before entering
into any transactions in the stock.
_______________
321gold
Inc
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