July 28, 2007

Second Quarter Housing All-Stars Recap: Subprime closes shop, Prime Loans Gone Wild, and the Future of Housing.

When Darth Vadar lured unsuspecting folks to the dark side, he was actually referring to the sinister and destructive nature of lax credit. For some reason, the business world and the mainstream media believed that this economy built on recycling credit was going to last forever. Even listening to the numerous housing shows, you would think that housing would always be the number one greatest investment on the face of the planet. Even today, as I was heading over to an appointment, I was listening to a prominent radio show on FM regarding real estate and the host is still in wonderland. One of the female co-host actually told a caller this:

“Right now is the perfect time to buy. Because even if real estate goes down, in 3 to 5 years you will have massive equity.”

I almost punched my stereo by this financially retarded advice. For one, the caller had no down payment. And another point, if real estate is going down and he comes in with little money, how is he going to have “massive equity” in the home? This was a case and point of so called real estate experts purporting short-term thinking and failing to look at the macro scope of this credit bubble. And then, I was watching a local television station this week discuss the record foreclosures here in California and they told the audience this nugget of wisdom:

“If you are having a hard time making your payment and have equity, refinance your house and get some money out. This will keep you afloat for a while longer. If this doesn’t do it, go ahead and cash advance on your credit cards to keep your mortgage payments.”

Am I really hearing and seeing this? Did I eat some kind of imported food tainted with hallucinogenic mushrooms? This “advice” is wrong on so many levels. For one, tapping out equity to keep a payment you clearly cannot afford is financial suicide. What you need to do is evaluate whether you need to sell your home or not. And tapping into credit cards as a short-term carryover loan to pay your mortgage is flat out stupid. You think these folks are going to pay the bank before they purchase food and keep their utilities on? The inflated sense of self for some of these experts makes you think that we are seeing miniature Napoleons running around.

In this article we will examine three major converging factors that bursted the housing bubble. First, we will examine the end of subprime lending. Second, we will look at the cancerous spread of horrible loans into the prime sector. Finally, as noted by last week's tremendous drop in the stock market we will examine what will happen now that the bubble has fully burst and is spilling green toxic sewage credit all over the country.

Subprime Is Out to Lunch. Forever.

We witnessed weakness in the markets with many subprime lenders closing shop. We are now out over 100+ major players in the subprime market due to horrible loans and collapsing on their own weight. As the subprime market collapsed earlier this year, the market kept on chugging along because of the belief that this damage was contained to one sector. Clearly as the quarter progressed this was not the case. And how could it be any different? The housing market stalled and folks couldn’t play the musical chair game of refinancing. This was noted in the massive drop in mortgage equity withdrawals. Like a WWE wrestler, the market needed to tap out.

In addition, we realized that Wall Street had enough of subprime loans. Principally because hedge funds realized that the underlying assets may be a tiny bit overpriced. Oh really? I’m reminded of the story of some of the large hedge funds homes being inhabited by raccoons and roaming free range hogs. I wonder if the hogs went 2/28 on the property? The problem stemmed from long distant investors buying up properties sight unseen on inflated appraisals. Now that the market is scrutinizing what the collateral was, it does not like what it sees.

Later in the quarter, we have the end of the 2/28 teaser mortgages. A mainstay of the industry during boom times. No longer are folks able to squeeze into over priced places on these ridiculous loans. In Southern California we had a peak originating month in August of 2005. Perfect timing for next month where many loans will reset and folks are no longer able to refinance into additional loans. The problem is also happening where appraisers are now seeing homes drop in price. No longer will most banks give you a HELOC simply because you have a pulse and a home in an over inflated metro area. As in the last article, foreclosures are booming to the next level. Not only that, as highlighted in detail, people making $130,000 a year are also having problems covering their monthly nut.

It is clear that subprime is now down and out. But prime was protected right? Well this leads us into the end of Q2 and the infection of the prime sector.

Prime USDA Mortgages

Countrywide announced that it has faced one of its worst quarters. Not only that, the CEO Mozilo stated that he didn’t see housing coming back until 2009. Talk about a vote of confidence. We also saw the problems at Bear Sterns with prime loans going bad in the so-called Alt-A tranches. That is, financially risky loans given out to credit worthy customers. But again, simply because you have a 750 FICO doesn’t mean you can make the payments on a $600,000 mortgage unless you have income to back up your score. The issue with the last few years is income didn’t even matter. As I discussed many months ago, a study conducted by the LA Times found that stated income borrowers over stated their income 60 percent of the time. Out of these, 50 percent overstated their income by 50 percent. This in conjunction with mortgage resets is showing who has been swimming in Huntington Beach without any trousers now that the tide is going out.

So the market got extremely spooked. That is why last week we saw almost a 5% retrenchment of the overall stock market. And not only here in the US did markets suffer, but markets in Europe as well since they decided to jump into the worldwide credit orgy. Alt-A is going to face some serious pain. At the peak in California, 73 percent of all originated loans were adjustable. Now that rates are resetting in the face of housing depreciation home owners are facing something they didn’t expect. Being stuck. Stuck like a stick in the mud. Yet you hear housing pundits sound off asinine quotes like the two mainstream folks above, and you wonder why this bubble is bursting? Somehow they feel that everyone is living in their world of perpetual credit expansion. Many of the prime banks, hedge funds, and Wall Street drank this Kool Aid for many years. But the party is now finished. Eventually the music stops and the piper needs to be paid. Last week the overall stock market, which keep in mind supposedly tracks the health of the overall US market, went down with a three hit combination. And this is in the face of good GDP numbers! But the numbers are a farce because many are realizing that the sustained growth was predicated on us buying consumption goods on credit therefore inflating the health of the economy. Doubt me? Go to Target, Wal-Mart, Trader Joes, Ralphs, or the mall and count how many folks actually pay in cash or check.

So Now what that Housing is Done?

If you don’t want to take my word for it, you can listen to Mozilo who is head honcho of the mortgage giant Countrywide. He doesn’t see this “ship” turning around until 2009. I get a kick out of housing pundits stating things like this from the same housing radio show:

“Okay. Enough of the housing bubble. The correction is over. This is a perfect time to find a good deal. You will have equity in your home. Housing always goes up. We may see a small correction but once it goes up, it will go up fast like the last few years!”

Correction? We’ve been in a decade long boom and they think two quarters is a correction? We are in for multiple years of housing being a horrible overall investment. This assumption that housing goes up massively in good times and only retracts baby steps in bad times is fundamentally wrong and is clouded by their own judgment. To quote Upton Sinclair, “It is difficult to get a man to understand something when his job depends on not understanding it.” Clearly they are seeing what they want to see because the implication would imply challenging times for them should the market go down. You can’t blame them for this faulty analysis. However, they are fundamentally wrong and demonstrate their lack of macroeconomic policy each time they open their mouths.

On Friday we were left with a taste of things to come. An announcement that Fannie Mae and Freddie Mac may face losses of $4.7 billion in the subprime market. These government sponsored entities are the white elephants in the room in our over mortgaged 3/2 stucco home. As we were too busy looking at subprime imploding and Alt-A tranches getting hammered, most mainstream folks failed to examine the cancerous growth of this credit bubble. Now it is reaching the absolute nucleus of the US housing market. These two behemoths should they face a problem have the potential of bringing down the entire market significantly. Last week we dropped almost 5 percent across all major markets because of Countrywide and a fear of credit being shut off. Just wait if issues at the two GSEs are as bad as many think.

The housing and credit bubble lasted too long. There is tremendous excess that needs to be washed out. The market is in for a long and prolonged downturn. What you need to look out for is snake oil salesmen trying to tell you that we’ve already had our correction and it is time to buy. It is comical to think that many months ago the former NAR chief David Lereah had called the bottom, multiple times. Maybe we have a differing view on what constitutes a bottom.

Do you think Fannie Mae and Freddie Mac are the next to show cracks due to this housing market?

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catherine said...

You are right, it hasn't even started yet.this ain't no subprime problem, IT IS A YOU CAN'T SELL YOUR HOUSE FOR TWO YEAR PROBLEM.......everyone is looking to the types of loans and analyzing all that crap, you financed your home at 90-100% and now it is going to fall 50% in value, you do the math........people are walking away, Alt-A is next and "A" is right behind it........the subprime went first cause it was the weakest, "A" loans in Countrywide and Wells Fargo are about 40% option arms, tied to LIBOR, ouch, you ain't seen nothing yet and after the "A" people use their credit cards to stay afloat a year, they will send their homes back too..........this isn't going to get better for at least 4 years.........this is going to make the Enron and Worldcom crash look like baby time..........the big boys have been quiet about this because they are taking their billions out of the market and by Christmas the number of closed mortgage companies will top 200.......quite a few builders will be on that pile too...........it is over and 5 banks will win out and people will get hosed good, fannie mae and freddie will tak a trillion dollar hit, 5% raise in taxes for that right at the same time the baby boomers are collecting their first social security check....ouch.......

covered said...

"To quote Upton Sinclair, “It is difficult to get a man to understand something when his job depends on not understanding it.” Clearly they are seeing what they want to see because the implication would imply challenging times for them should the market go down. You can’t blame them for this faulty analysis. However, they are fundamentally wrong and demonstrate their lack of macroeconomic policy each time they open their mouths.

Once again, Dr.HB nails it and it bears repeating. Now that the horse has left the barn, what we have left to deal with is herd mentality...or bubble psychology. After what can only be described as The Great American Psycho-Drama of the past seven years the chickens are at long last coming home to roost (Ok, enough with the barnyard metaphors, but they really do seem apropos.)

Don't get me wrong. Bubbles are great. I had a tremendous windfall from this one. Ironically, or luckily for me, it came on the heels of the dot.com bubble I got lucky enough to cash out of before that bubble came crashing down.

The problem is that people are gullible and greedy enough to actually believe the hype. "It's a new paradigm." "It's different this time." "Real estate always goes up." It's called human nature and it will never change. Ever. The ones who get hurt do not know how to sell!

Perhaps the thing about this housing bubble/ credit orgy that is and will be the toughest is the emotional investment aspect of it. "The American Dream" of homeownership has been programmed into most of our heads as "the" goal since we were children. People become emotionally invested in the idea of owning a nice home as a place to raise their families, send their kids to school and entertain their friends. Nice idea. In theory. Left out of the equation is the fact that one has to be able to afford it to realize "the dream."

Now that the idealogical dream has been corrupted by easy credit, reckless lending, "pride" of ownership (debtorship) and insatiable something-for-nothing greed, FBs are staring like a deer in the headlights (oops, another animal metaphor) at literal financial ruin. It's not too late to sell for some (much harder, but still not too late), but they won't. They are left only with "hope," not a viable investment strategy.

There are two sides to living on planet leverage. There's the Casey Serin, Tony Robbins, David Lerach, "Watch TV--Get Rich" types and there are market participants (somehow the word "investor" just doesn't seem to fit here) who know when they see "multiple offers," "seller will entertain offers between $800,000 to $950,000" and the always grand "Real Homes of Genius(tm)" the bell is ringing loudly and it's time for the swallows to return to Capistrano. Damn, there I go again.

Vera said...

Freddie and Fannie have been on my radar for a while - it's no surprise. What really gets me is how easy it was for everyone involved to game and/or scam for SO LONG. I thought it would go down sooner - some of my friends say I am too "gleeful" about the mess. Frankly, I was fed up with the fact that even being in the top 10% of earners, I couldn't afford a 1000-sq-ft bungalow. It made no sense to me. I guess I could have gotten a toxic loan - I have good credit so I could have overstated my income - but who wants to suffocate in monthly debt?

Let's just hope some folks get a clue after this fiasco and set some rules to stop it from happening in the future. A lot of people suffered because of this bubble - including HONEST appraisers and others who didn't drink the koolaid or compromise their ethics.

Unfortunately, it's more likely it will happen again. Maybe in another form - but we seem to recycle our economic mistakes one way or another.

formul8 said...

"cash advance your credit cards to stay afloat"????????????

How about "if you can't afford the house and have equity- SELL IT."

Hiphopapotamus said...

the credit bubble is bursting but that's not preventing lenders from beating a dead horse, to keep with the animal metaphors. i was out of town this week and when i returned and checked my mail i found no fewer than 9 (!) pre-approvals for credit cards plus an offer for a heloc on an investment home i own from - guess who? - countrywide! the brochure said i could use the money to consolidate credit card debt (perfect, i just got 9 new cards!), make some home improvements (wink to home depot and lowes) or just go buy a car. it's win-win-win! too bad i already decided to sell this overpriced asset and i close escrow this week. think of all the money i won't be able to owe forever!

covered said...

@Dr. HB
Here's a link to award winning journalist Peter Eavis' detailed expose of Fannie Mae. Although a couple of years old, it pretty much spells out everything about the corporate structure there:

Peter Eavis Digs Into Fannie Mae

The North Coast said...

I have been wondering how long the unraveling was going to take to hit the "prime" sector. While everyone has been yelling "subprime!subprime', I have been thinking of all the people I have met who used IO loans to buy and can barely make the payments even so.

These loans were given only to people with good credit, and you had to wonder what would happen to the buyer's fine FICO score when the loan reset and she couldn't come up with the $30K balloon payment (or $200K,or $300K) for the balloon payment for all that deferred interest. These people really didn't grasp that all they were doing was deferring the hit, not escaping from it.

There is a lot of this out there. Looks to me like half the newer and more expensive houses and condos were purchased with this homicidal loan type.

Dr Housing Bubble said...

I just finished watching the WSJ and the topic dejour was housing. However, it doesn’t seem like many folks are concerned. If anything, they were saying now is a good time to buy because inventory is high even after admitting housing will be slow until 2009. I’m not sure how unbiased these people are but the data is contrary to what they are seeing. Hence the battle between bulls and bears.


It will progressively get worse with little jumps here and there. False rallys will pop up and give the sense of recovery. Take a look at the short-sale count that I update weekly on this site. Inventory is going up and so is the percentage of short-sales.


You mention the American Dream and many in the business world fail to realize how powerful psychology played into this bubble. People were willing to spend 60 to 80 percent of their net income on housing simply to own. I know many mainstream outlets don’t want to highlight figures like this but looking at our negative savings rate, clearly folks are spending more than they earn. To keep up folks have to access credit and so they have for the past decade at levels that we’ve never seen.

Thanks for the link. A book you should read is by John Talbott, The Coming Crash in the Housing Market. I read the book four years ago and a lot of what was said back then, is occurring now. I remember talking with family members in 2003 about the housing bubble and they simply laughed. And they had a reason to do so since housing went up another 3 years; although even in 2003 fundamentals were out of whack. Now we are in another dimension.


I read a book a few years ago highlighting the CDO risk and how Fannie and Freddie are one step away from bringing the economy into a recession. This felt like a lifetime ago since housing kept on chugging along and folks kept on piling up the debt like a kid at buffet.

Now the question arises, who will bail out the market? I cringe each time I hear this bail out talk. Companies need to fail that irresponsibly lent credit to everyone. And I do have sympathy for folks going into foreclosure since I know many. But they share in the blame as well. Yet those that are financially prudent should not be penalized for someone’s inability to manage their household finances.


Somehow selling is never an option. You hear “buy a home”, “refinance a home”, or “get equity out of your home to remodel” but never sell a home from housing pundits. Well, they do recommend you sell a home if you are moving to a larger place.


Animal metaphors are great. I’m sure Orwell is getting some sales on Amazon because of this. There is a site where you can opt out of credit card offers. It is here Opt Out Pre Screen. I’ve notice a slight decline but even my neighbor’s dog got a credit line of $5,000; so I’m not sure how good this really is.

@the north coast,

Absolutely. Folks had to keep up with the Joneses and the only way this was possible was with risky loans. Even people making good money had a hard time resisting the pressure to buy a larger home or tap into their home ATM machine. Clearly, they had no intention on having a mortgage burning party in their future.

JimAtLaw said...

What's really amazing here is how very wrong the host's advice was - if the caller is on a 1st with no activity vitiating the single form of action rule (e.g., HELOC), they can walk away with just a foreclosure if I understand correctly. But, if you try to move that debt to credit cards and fail, not only are you turning deductible interest non-deductible, the collection agents that take bad debt from the credit card cos. will be coming after you indefinitely with wage garnishment, seizure and other nastiness. Oy.

R said...


I clicked the link to "The Coming Housing Crash." The author predicted in 2003 that housing would crash. If he were correct, housing must drop far below 2003 prices.

If home prices merely return to 2003 prices, then while the market would've made a serious correction, the author was way off. A homeowner is better off buying a home in 2003 so that he begins to earn equity rather than paying rent.

So are you predicting that the market will correct way BELOW 2003 prices? That sounds like a 60-70% drop from the peak in 2005.

Finally, a friend mentioned that the NYC area, in particular, Brooklyn, is experiencing housing APPRECIATION still. Many people buy redeveloped brownstone 900 square feet condos for $300-400k. 3 to 6 months later, they're worth $400-500k. I thought he was duping me into something but a quick google search found some credibility to it. Any thoughts?

Nick said...

Question for you Dr. HB... what listed companies do you feel have yet to be hit in terms of their stock price?

Nick said...

Dr. HB,
A quick follow up... Given his uncanny accuracy, what do you make of HS Dent's (www.hsdent.com) prediction of a soaring DOW at 20,000 by 2009?

An interesting thought is that if the dollar has lost 30%, to a foreign investor, that would mean that they are buying U.S. Stocks at a 30% discount. Or another way to look at it is that the DOW, valued at 13K, is really from a foreign investing standpoint, hovering at around 9,100K.

I can think of no other driver that would cause the market to go so high so fast... what are your thoughts?

I'm relatively young (24), and have been investing since I was 16. Which is to say my knowledge, at best, is incomplete. But I'm curious how the DOW could rise with a collapsing housing market...

Tyrone said...

Fascinating story about some folks in Ventura that feel they should receive $800K+ for a home they purchased on 2003 for $410K. Now they're willing to "settle" for closed bid starting at $594K. Awwwwww... only 10% per year.

Seller tries a best-offer strategy

Sandy said...

I do think Freddie Mac and Fannie Mae are going to be the next ones to spiral downwards. *sigh* None of this is a surprise to anyone with an ounce of common sense (which apparently isn't so common!). The lending practices were insane, and it's about time things began to swing back to a normal level. I guess the party's over, and everyone can go home now! Oh, whoops, there is no home anymore! :(

Dr Housing Bubble said...


You bring up an important issue. Many people that seem to be real estate experts really had very little understanding of finance and overall economics. You bring up the legal implications but these folks are not lawyers. Lots of money will be lost because people followed the advice of so-called experts.


Even in the book written in 2003, the definition of a crash was a 15 to 20 percent decline nationally. In terms of percentages, I’m not sure how useful this really is. I think a better way to predict future prices is to factor the following:

1. Potential Appreciation/Depreciation
2. Tax Benefits
3. Local Rental Market
4. Property Location
5. Income and Prestige of Area

This should give you a better view of ascertaining a realistic price for a home. Given that appreciation is going to stall or go negative, this would be an argument for lower prices. Tax benefits will add a premium to prices. The local rental market will play a big force. Since people were buying homes expecting 10, 15, or even 20 percent jumps that is why many jumped into the bubble. It was common for someone to buy a $300,000 home only to sell it next year for $400,000. After taxes, commission, and everything associated with selling a home that is a nice sum of money. Not sure what other investment vehicle would give you that much return and leverage in a short period of time (especially going zero down or 5 percent down). But this is now finished. This was a solid argument for buying a home regardless of fundamentals, “buy today and sell next year for a 20 percent profit.” Many just assumed this was going to last forever.

New York is a different market altogether. Yet people still get financed from decentralized banks and MBS holders. So I do see prices getting hit there as well. Percentage decreases all depend on the area you are looking at.


Do you mean peak highs or lows? Just take a look at the builders and housing indexes. You can find company financials online and review their income sheets. It is a great source of education

In terms of a higher DOW and declining dollar this is very probable. The issue at hand is whether or not the Fed is going to protect the dollar from falling any further. The housing bust in my view, will force public opinion to examine economic policy, something we haven’t done for this entire decade. People need to wake up from their credit coma and understand that we are merely playing into a global Ponzi game that is coming to an end.

If you’ve kept your money in cash, you’ve lost money over the last decade. Even keeping up with inflation we have fallen behind many currencies. But jumping into the Euro in my view is simply running from one burning house to another. This is a global issue and needs to be addressed by multiple nations.

It is good that you are prudent as an investor. It will serve you well in the long run. I would examine companies and investment vehicles on a case by case basis. Keep in mind there are many states in this country that are still fairly priced in real estate. You won’t be making 20 percent yearly gains but it is a good addition to a diversified portfolio.


Interesting piece. And they are in a hard place because they have a home closing in another state soon. Either way, they keep referring back to last year or peak prices as if that market still exists. These folks are delusional. You know what they say about the worth of a piece of a property? It is worth whatever someone is willing to pay. At least that was the battle cry for the last decade.

Inventory is rising and short-sales are growing. There are much better deals than negotiating with someone like this. Either they respect the prices being offered or their home doesn’t sell. This is common in any healthy market. The only problem is we’ve been living in a toxic mortgage bubble and those mortgages are systematically getting eliminated from the market. Run the numbers on this place on a conventional mortgage and you’ll see that interest may not be as high as they think.


Fannie and Freddie will be the last to show cracks. We still need to hit full stride with the Alt-A sector which will occur over the next 2 quarters. This is a long and slow process. And summer peak selling season is nearing an end with record inventory.

Bob said...

I wonder when all this stuff will begin to enter the consciousness of buyers and sellers on LA's westside (loosely meaning west of say...rossmore/vine)

Sales may have slowed, but people are *still* paying insane prices in this part of town. Condos in Hollywood and DT are still humming along, Foreclosures are few, and in "nice" areas, teardowns still sell for around a million and up.. What's gonna stop this madness here?

FWIW, I think it will end, but if you don't read beyond the headlines, there's nothing to suggest to people that this is anything other than I minor blip in the market.

I'm a potential buyer, top 5% salary, no debt, and cash for a DP. I could "afford" to buy, but +/- a million bucks for a crappy 3/2 on a tiny lot is beyond insane. I'd have thought this part of town would be feeling some pain right now. But, at least outwardly, all is well. The smugness here is maddening. :-(

WhistleMan said...

Fannie and Freddie are the source of cash - they can't have serious trouble unless they deploy the cash, but my inside info shows they have not been deploying cash and thus the low liquidity for guys like Countrywide, Indymac, and American Home. Freddie and Fannie will make a ton of money once the opportunity comes to buy otherwise OK asset at flea market prices. (They did the same thing in 1998 meltdown, making $2B in the process).

The real game (caution: you are about to get insider information) is WaMu. This company in Q1 and Q2 this year, to be concise, tweaked the accounting book to meet earnings and at the same time hope the problems in mortgage market reversed. The problem is, the mortgage market got much much worse since end of Q2. One month into Q3 we are talking about Alt-A loans performing as bad as subprime loans as you all have now heard.

The total earnings they managed to add to income is at least 4 cents and 5 cents respectively by manipulating the books. The guy who worked the book was promoted for the idea of shifting credit card reserves to "shelter" the mortgage losses while they hold the loans in the balance sheet.

They must be in a dillemma right now, since

a) reversing the Q1 and Q2 manipulation plus the upcoming huge loss in Q3 will result in missing estimate by 20 cents and will get their stock to mid 20s by Oct.

b) However, keep doing the same thing again in Q3 may either raise SEC alarm, get a question from people about where they sell their loans for such high $, or simply lead to a significant probability of restatement (read: $5-10 WaMu stock by Dec or in Q4 sometimes.)

They have to choose big pain now or AHM-level pain later.

I absolutely can't divulge anymore including the name of the WaMu accounting guy etc, but in the mortgage accounting land this is no secret cuz I am not even working for WaMu but I have heard this over and over since April.

Watching from the Sidelines said...

Bob - Sales seem to be humming along in Burbank as well. Condos/townhouses are selling for $600k plus, many $650-$700k. On top of the PITI there is also the HOA payments. These are running $275-$300 per month. And in the area I live in (renting my little 2bd, 1bth first floor of a 2-story duplex) none of these new constructions have pools, spas, yards, garages, etc. They do have underground, assigned parking, but not actual separate garages.

Who can buy these things? Yet they seem to be selling. In fact the building next door just had the notice to tear down posted yesterday so it will be going bye-bye very soon.

I too earn in the top 10%, have almost no debt, contribute heavily to retirement and have money for a down payment. I cannot afford a house in the neighborhood I want to live in. The prices have not come down. I've seen houses on the market in the neighborhood for months, some since last fall at least. I've seen them listed, removed and relisted, but they don't really drop the prices - maybe $10-$15k, but on a house that is $600k plus that is nothing really.

And then it seems like some idiot will actually pay someone the frickin bubblicious asking price they want. The sale of that one damn house will keep all the other idiots holding out for their fantasy asking price. It's ridiculous and frustrating.