The Real Cost of a Picket White Fence: 3 Housing Factors to Think About; Prices set at the margin, income discrepancies, and bubble euphoria.

After drinking water out of the bailout fire hydrant, I think most people are scrambling to get an idea of what is happening. An issue placed on the back burner by many politicians is suddenly garnering massive media playtime. Amazingly, Americans in a large percentage are against any bailout talks or consideration. The nationwide MSNBC and a local station KTLA ran unscientific polls asking the questions, “do you support a government bailout for the mortgage industry?” The answer was a resounding NO. In fact, from a brief review of these polls 95 percent of Americans are against any form of corporate welfare. They realize that deep down this is only a ploy for the government to subsidize maverick hedge funds, Wall Street circus acts, renegade brokers, and Vegas inspired buyer gambling. They want you to believe that they are doing it for the person on the street. How are they going to help out expensive counties such as Los Angeles where the median home price is $547,000? And what about those that have been foreclosed or are being foreclosed on? Don't they deserve a retroactive bailout? Come to think of it, why don't they give me money I invested in tech stocks back in 1999 that was wiped out since these companies had P/E ratios higher than Barry Bonds' batting average. Or the money I lost in Vegas two months ago on blackjack (I suspect that the dealer was a former hedge fund manager since he asked if I wanted margin and wanted to flip a home in Henderson). A decade of conspicuous housing consumption has left the nation hanging on a thread looking for more bubbles to fuel their credit addiction. What other highflying act will allow American consumers, a large part of the economy, to continue their spending marathon? We’ve already seen that mortgage equity withdrawals had a lot to do with bolstering the economy over the past years. Unfortunately you can’t tap into your home equity line of credit if you are swimming underwater Jacque Cousteau style. See, like any Ponzi Scheme, those that get in early do well on the backs of those that come in late. And like any good Ponzi Scheme those coming in at the end are left holding the manure filled bag of worthless mortgage backed securities; it turns out a 600 square foot Real Home of Genius isn’t really worth $500,000.

Then we have the fear mongering by the politicians and the media. The new line that I’m hearing dished out is “well you wouldn’t want your entire neighborhood full of foreclosures eh?” Instead of drop kicking my monitor Jackie Chan style at this completely stupid and moronic assertion, I will show you that at any given time, only a very small percentage of all housing units are up for sale. So why all the brouhaha? Because housing prices are set at the margin; meaning, homes are priced by the units that are currently sitting on the market. And the fact of the matter is we’ve been operating on a one-trick pony economy where housing has kept us out of any recession and has provided the fuel to keep this SUV of spending going forward. But now that housing is depreciating we are realizing that yes, this economy is based on housing. Otherwise, who really cares that housing prices are trending downward? If we are such a diverse economy this one tiny sector shouldn’t mean so much; but it does because of the massive credit bubble we are living in.

So today we will examine 3 new factors that you should keep in the back of your mind since I have a feeling this housing mess won’t go away anytime soon. First, home prices are set at the margin so we will examine the actual numbers. Since politicians and the media like churning information and creating a fear cycle we will carefully look at housing supply in relation to units being sold. And again, anyone following this housing bubble isn’t surprised. In fact, it was predicted here a very long time ago. You may be saying, “but I feel safe because daddy Bernanke is here to save the day, he saw this coming.” Let us take a trip down memory lane:

"At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained," Ben Bernanke Quote to Congress' Joint Economic Committee. March 2007

“Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited,” Bernanke said in May 2007.

“In particular, the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.” –August 31 Ben Bernanke

Wrong, wrong, and now you get it. Even the last statement is misleading because how did we go from “fundamental factors” being okay in May to “weakness in housing” in August? So given that the Fed Chairman didn’t see this coming even as early as May of this year, do you have confidence that these other yahoo politicians have the right policy decision in mind? We can discuss other policy mistakes regarding the current administration but that would require much more than this housing blog.

The second factor we will look at is income discrepancies. Current home prices are not in line with current family incomes. Unless you think making $14,000 and buying a $720,000 home is perfectly fine and makes economic sense. Finally we will examine the current market panic. Bubbles burst in typical fashion (see Manias, Panics, and Crashes) and this credit bubble will pop in the same way. We can pull the Band-Aid off fast or continue the absurd policies and allow for more guerilla mortgage products to enter the market.

Prices set at the margins

At any given point in time there is only a small fraction of homes on the market for sale. Drive down any street of the 88 cities in Los Angeles and you will see homes for sale, but not many. Unless you are driving in some home builder subdivision in Arizona or a condo high-rise in Florida, the majority of this country isn’t selling each and every single home on the block. But the media now has this fear mongering idea that if the market corrects, every person is going to be bumming cigarettes under the San Gabriel River. So instead of their verbal attacks on the public let us take a look at the actual numbers for Southern California:

*Data Source: Census.gov

There are approximately 6,000,000 housing units in Southern California. Keep in mind this includes apartments, rentals, and owner occupied homes. Now how many homes are for sale as of today in SoCal? How about 139,689 or to make it more tangible, only 2.33 percent of all available housing units in the area. Doesn’t seem like the entire neighborhood is going to hell in a hand basket as the media would like us to believe. And keep in mind that we are seeing record foreclosures and inventory here in Southern California and as of today, we are still only seeing 2.33 percent of all available units on the market for sale. See, not everyone bought into this housing bubble. Some people decided to rent. As I’ve pointed out the majority of households in Los Angeles County rent. Some people decided that they would rather save their money and wait the market out. Some are simply going to rent because they unfortunately cannot afford a home. This idea that everyone should own their home is dangerous and has also led us into this mortgage market debacle. If you are unable to buy a home without a shady zero down mortgage maybe you should wait until you can buy a home with more conventional financing. Others, bought before this entire bubble game started. So they are still sitting pretty on equity and have no plans of selling. There are also approximately 20 percent of people in Los Angeles that own their homes outright; many of these people are retired or nearing retirement and have no vision of flipping their homes. So the battle comes down to those that want to buy and those that want to sell right now. It looks like more and more people are wanting to sell and less and less people want to buy (or at least buy at current market prices). And why would you buy right now with prices decreasing each and every day? In addition, the prospect of you flipping and turning a profit now is as likely as finding Michael Vick at a PETA fundraiser as an honorary member.

Show me the Income!

Again the media likes to believe that everyone is earning $300,000 so a $547,000 median home price isn’t so far fetched. I’ve discussed this affluent façade in a previous article but let us take a quick look at income statistics for this country:

Household income (overall percent of US households over):

Income Percent of Households over:

$65,000 34.72%

$80,000 25.6%

$91,705 20.0%

$100,000 17.8%

$118,200 10%

$166,200 5%

$200,000 2.67%

$250,000 1.5%

$1,600,000 0.12%

So what does this tell us? In order for a family to comfortably afford a median priced home in Los Angeles County they would need to make $200,000. As you can see from the above data, only 2.67% of all households make this much. And I doubt any family making $200,000 will want to buy a Real Home of Genius as they would probably prefer to rent in a better neighborhood and invest the massive difference they are saving from buying a home. Are there tax benefits to owning? Of course. Many housing pundits want to use some voodoo economics to make you think spending $1 so you can get two quarters back is smart math. If you really need a tax break buy a rental property in a non-bubble city; you’ll get cash-flow, the benefit of owning real estate, and the feeling of owning a home if that is something that you desperately need. With all this talk, isn’t it fascinating that the media doesn’t state the obvious? That homes are massively overpriced! Incomes cannot support current prices without using mythical fantasy world exotic mortgages that seem to be a thing of yesteryear. 2/28 mortgages, option ARMS, negative amortization, stated (liar) income loans, and all variations of these dubious mortgages will come under the congressional microscope in months to come, just watch.

Smoking the Housing Bubble Peace Pipe

We’ve been living in a housing obsessed society. In fact, I’ll be happy in a few years where you will be able to go to a party and not have to listen to some wannabe Trump talk about his recent flip in the Valley and how he pocketed $50,000. The hardest part listening to this hogwash is knowing that they are part of this speculation bust that we are now seeing; deep down anyone that has a basic idea of finance and economics knew that this couldn’t go on forever. And here it stops in Q3 of 2007. In fact, I haven’t heard much of this talk in the last year. Yet in this housing bubble decade we have seen the media eat up the housing game and carry the party line. Take a look at some of the shows that have made the air in recent years:

Property Ladder

Discovery Home's "Flip That House"

A&E's "Flip This House,"

HGTV's "Bought and Sold,"

Bravo's "Flipping Out"

TLC's "Real Estate Pros."

The Apprentice

And the list goes on. Everyone suddenly had housing religion. But the good thing about bubbles is after the pop, slowly the talk dissipates. Remember the technology bubble? For years this was all the talk and anything with a dot com was worth putting your entire retirement funds into. How much talk have we had about these once high flying companies after 2001? Not much. I think by 2009 we’ll be more concerned about cleaning up the mess of 2 back-to-back bubbles, that is if we don’t see another bubble after this one. And yes, housing is very different from stocks. But what do you think funded this game? Mortgage backed securities. Where did these MBS trade? Hopefully you realize that not everything is linear but following the interconnectedness of this credit bubble you can understand why we are truly in an epic once in a lifetime housing bubble.

Do you think politicians and the media are handling this housing bubble burst correctly?

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3 Reasons Why This Credit Bubble is worse than 1929. Precursors to a Recession: Complicit Fed, Population Involved, and Greater Dependence on Credit

The market seems to have taken well to the liquidity injection by the Federal Reserve. Since the past two weeks of subprime debacles and stock market woes, the market is slowly gaining a foothold. Investors don’t seem to care that each day a few lending companies are collapsing and firing thousands of people. Growing foreclosure numbers, housing prices depreciating, and consumer spending cut backs don’t seem to matter. The sentiment is we will be back to good times in a matter of weeks. Just to give you some idea of how quickly the market is turning take a look at the number of foreclosure filings in California:

This is no small increase. We are up nearly 300 percent in one year. And since the data available does not have the current month of resets (which for California will be the largest) you can easily predict where the next data point will land. So why is the market rallying? There are multiple parallels to the false jump in stock market prices that occurred during March of 1929. At this time, we actually had a Fed that was concerned regarding the booming market. In fact, let us take a look at sentiment at the time:

“The tug-of-war between Washington and Wall Street reached its peak in late March of 1929. The Federal Reserve took steps to limit how much banks could lend for buying stocks. Interest rates doubled, which should have discouraged borrowing, “But people who dreamed of 100 percent profit in a week were not deterred by an interest rate of 20 percent a year,” President Hoover recalled. “When the public becomes mad with greed and is rubbing the Aladdin’s lamp of sudden fortune, no little matter of interest rates is effective.” Borrowing continued. “

This quote from a very brief booked called Six Days in October by Karen Blumenthal, which ironically is for “children over the age of 12” seems like it may provide some insight into the current credit crunch. Many books cover the Great Depression with opposing views and reasons for the decline. But this event happened sufficiently long ago that we can look at it and take lessons from it from an objective stand point. During the last few days in office, Calvin Coolidge was quoted as saying stocks were “cheap at current prices.” Keep in mind that all this speculation ramped up in the last three years of the decade specifically 1927, 1928, and 1929. Sort of like 2004, 2005, and 2006 with the subprime fiasco. Again, the rhetoric during these times was of continued prosperity with little consideration of the massive debt being used to support the current market.

As we hear about certain companies stepping in and the Fed offering support, we are reminded of the big players during the Great Depression that stepped in such as National City offering $25 million to brokers in March preventing a decline at the time. So the market had 7 more months of breathing room. The underlying fact still existed at the time as it does in 2007 that the underlying assets such as U.S. Steel, RCA, Westinghouse, and other companies were incredibly overpriced for what they were selling for. Fundamentals were living in Wonderland. Instead of stocks being over valued we now face massively overpriced houses in 2007. Before I punch my fist through the monitor, yes I do realize that stocks and housing are very different pieces of investments. How many times have we heard, “you can’t live in a stock” as if we were going to run off to the San Gabriel River and fabricate a makeshift home out of Google stock under the freeway overpass. Yet there is comparisons that we can make. Many people speculate through their homes. Need we point out the cadre of players: Flippers, Mortgage Brokers, Agents, Hedge Funds, Banks, Builders, Stock Investors, and pretty much everyone in this country. A stark contrast from 1929; it is estimated that out of 121 million people, just 1.5 million to 3 million of them owned stock during the latter years of the 1920s. How many Americans own their home in 2007? How about 70 percent. How many are living in an overpriced and inflated asset? Probably everyone in most metropolitan areas.

The issue occurs with the credit leverage of what has been going on. Let us highlight a brief example. Say Bill and Susie public decided to buy a starter home in Southern California for $400,000 in 2004. Bill and Susie figured that they would flip this house in 1 or 2 years so it didn’t make sense to take on a 30 year mortgage. They talk with their mortgage broker Jane, and she offers them a 2/28 mortgage with zero down. Bill and Susie seemed shocked that they can control a $400,000 piece of real estate for nothing. They purchase their home, live a comfortable life, and after 2 fantastic seasons of American Idol decide to sell their property. Amazingly, Joe and Cindy public want to buy this same home for $600,000 in 2006. After speaking with Jane the broker, Joe and Cindy plan on flipping the home in 1 or 2 years so they decide on going with a 2/28 mortgage as well. Bill and Susie leave with a nice chunk of change after selling fees and since this is sunny California, they will not pay any capital gains taxes because they lived in the home for two years. Sweet deal. Now Joe and Cindy are licking their chops and “know” they’ll be able to sell the home in 2 years for $1 million at the current rate of appreciation. However, they start hearing rumblings of a crashing market. They get an appraiser to their home in summer of 2007 and find out their home is only worth $550,000. They realize that they will not be able to make the payment once it resets since it will amortize over 28 years with a higher rate and will jump a whopping 75 percent. So who made money here?

Bill and Susie: Approximately $200,000 profit. Return on Investment? Over 100 percent since they didn’t put down one penny.

Joe and Cindy: They are down over $50,000. Return on Investment? Nothing and in fact, they will owe a lot more money than if they had rented.

Broker Jane: Nice kick backs on each loan.

Agents: Nice cuts from each sale (and purchase) of the home.

Wall Street: Amazing returns in Real Estate and Mortgage Backed Securities.

Government: Great returns on higher assessed property taxes and sales receipts.

Consumer Outlets: Amazing sales with mortgage equity withdrawals and the wealth effect making every American spending happy.

So it seems we only have one loser when the game of musical chairs is over. And that is the current owner of the property. However, if what we are hearing from Fed and other central banks is true, this market has a little bit more steam in it because so many players are involved in making money from continually perpetuating this bubble. Forget fundamentals and true asset values. Who cares when everyone is making money. This is why from a policy perspective, this credit bubble is much more widespread than the time just before October of 1929.

Complicit Fed

The Fed has already cut the discount rate and has done a few symbolic injections of liquidity into the market. Yet they are still cautious. As I was watching Senator Dodd talk about the bail out, he constantly mentioned that he was “pleased” that the Fed is willing to use any tools necessary to help this market. However, he wasn’t "pleased" that the Treasury wasn’t so Pollyanna and didn’t want to lift certain caps for government secured mortgages. As we’ve talked about, the Fed in the year leading up to the Great Depression radically increased rates to put a stop on the market. In this case, we actually have a Fed that is willing to continue this market speculation. We also have symbolic buys from certain large banks stepping in trying to assure the market that everything will be okay. Seems familiar. Yet looking at the raw numbers and looking at the fundamentals, no one is talking about a housing bubble. Am I the only one wanting to drop kick the morning newscaster like Chuck Norris when they say, “the problem with this market is the subprime debacle.” At this moment I pull out my megaphone, turn it on high and scream, “IT IS THE RIDICULOUS HOUSING PRICES YOU MORON” while dogs and birds scurry off my property. Everyone suddenly wants to blame the mortgage company and lenders as the soul reason for this entire mess. Since 2000, we’ve had countless players [see above] that made out like bandits in this market. Why would they want to see a different market?

The Fed is an independent agency. At least that is what they would like us to believe. Senator Dodd kept emphasizing this while giving the public an implicit wink that the Fed will do whatever the politicians tell it to do. Can it be that someone wants to buoy this market up at least until the election is over in November of 2008? Sadly, I’m not sure what could be done. Thankfully the Treasury at the moment seems to be standing its ground. I wouldn’t be surprised if in a month or so we turn on the television and see printing presses hand delivered to each lending institution. This may seem far fetched but just a few months ago, you literally had an ATM machine attached to your home (if you owned it) and could create money out of thin air simply by writing a check to yourself. $50,000 made out to me. Yes!

Population Involved

The parallels are very different this time as well. A large part of the country is involved in this bubble. Consumer sales will be hit when the market turns south. If your business depends on people buying discretionary products from you, the oncoming recession will hurt you. Anyone that worked for a subprime outfit is definitely at risk (if not gone already). Construction and building is on the decline. After all, why would you buy a depreciating asset at least in the short-term? Financial institutions are having trouble. Borrowing has gotten more expensive. 70 percent of the U.S. population owns their home. When I say own, I mean that that many are on the deed or title as owner. Some estimates point out that 30+ percent of Americans own their home straight out. But for those that don’t, equity as a percentage of the value of the home has been on the decline. This is a sobering fact considering that in no time in our country's recorded history have housing prices risen so drastically. Can it be that many folks turned on the spigots and let the equity drain out of their homes? Maybe.

Even those in the public sector will be hurt since local governments and municipalities depend largely on sales and property tax receipts. The State Controller of California in August reported a projected short-fall of $787 million in total tax receipts; a big adjustment considering the projections were only issued in May of this year. These are things that haven’t hit the mainstream media but will in the near future.

Great Dependence on Credit

Think this country doesn’t have much mortgage debt outstanding? Take a look at this chart I put together showing the increase of debt over the last 15 years:

We’ve nearly tripled the mortgage debt in 15 years. Again this is as much a credit bubble as it is a housing bubble. At the peak of this mayhem, in August of 2005 over 70+ percent of all loans in California were adjustable rate mortgages. Of course this includes negative amortization, option ARMs, 2/28, interest only, and every other exotic mortgage product floating out in the market. Our dependence on credit is amazing. This partially comes from the fact that we as a nation have a negative savings rate. I imagine it is hard to spend something you do not have but many credit card companies during this massive boom were more than willing to lend you the credit. Where does this end? I think we are already seeing the end. I know we are in a bubble like no other when I get credit offers and refinancing offers from companies that no longer are in operation! Maybe they should contact their direct mailers and let them know that they are no longer offering 0 percent for 12 months or 5 percent Home Equity lines.

The parallels to the Great Depression are many. I’ve highlighted two letters one from a lawyer dealing with the fallout and another from a banker giving his opinion on the market. Yet it doesn’t seem like we are willing to learn from the past. In fact, it appears that from every branch of government we are more than willing to keep this thing going. Don’t you find it ironic that big banks can go to Fed and get a discount while you can’t? How does this liquidity help Joe and Cindy who are upside down by tens of thousands of dollars? I guess in the end, someone needs to carry out the garbage.

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Personal Story by a Lawyer from a Previous Asset Bubble. Can we Learn from the Past and How will the Housing Decline Impact You?

When you think of the credit bubble, what comes to mind? Overpriced Homes? The subprime implosion? Massive credit? Or are you simply indifferent to it? The housing and credit bubble will have a long lasting impact on an entire generation of people living through it. When we see that a certain company has self-destructed or foreclosures are skyrocketing, what does this mean on a personal level for society? In the case study of a couple making $130,000 a year and going into foreclosure, we see that this bubble will impact the rich and the poor including the farmer making $14,000 a year and buying a $720,000 home. These stories drive the point home and make the credit bubble discernable to people from all sectors of society. It is easy for most people that understand housing to assume everyone can read a 30 year mortgage statement or has substantial knowledge regarding investing in the stock market. However, we have examined that the majority of the population is not affluent or what we consider to be really rich.

Very rarely do I come across a personal account that encompasses the entire scope of what a bursting bubble can do to an economy and the people living in it. Bubbles, as examined from the past, have a very similar pattern in the stages they progress. Mass euphoria leads to a case of mass resentment and depression both economically and personally for many families. I came across a letter written from a lawyer from Mason City, Iowa in the Corn Belt recounting the impact of the Great Depression on his town. It is a poignant and somewhat eerie story to read considering the date of writing is 1933. The similarities of what happens in the past raises many questions that I hope to discuss at length and how it will influence our future as a nation. These are things that as a society we will face. Foreclosures, larger numbers of families facing economic problems, and the repercussions of another bubble bursting. Since I found this letter in a very old file, I have decided to type up the large part of the letter since it is a necessary read for anyone trying to diagnosis potential issues we will face. Of course, times are different. We are not in the late 1920s or early 1930s, but human nature, bubble psychology, and the essence of being a person are timeless. Below are paragraphs of the entire letter:

“The boom period of the last years of the World War and the extremely inflationary period of 1919 and 1920 were like the Mississippi Bubble and the Tulip Craze in Holland in their effect upon the general public. Farm prices shot sky high almost over night. The town barber and the small-town merchant bought and sold options until every town square was a real estate exchange. Bankers and lawyers, doctors and ministers left their offices and clients and drove pell mell over the country to procure options and contracts upon this farm and that, paying a few hundred dollars down and expecting to sell the rights before the following March brought settlement day. Not to be in the game marked one as an old fogy, while paper profits were pyramided and Cadillac cars and pleasure trips to the cities took the place of Fords and Sunday afternoon picnics. Everyone then maintained that there was only a little land as fertile as the fields of Iowa, Illinois, and Minnesota, and everyone sought to get his part before it was all gone. Like gold, it was limited in extent and of great potential value. Prices skyrocketed from $100 to $250 and $400 per acre without regard to the producing power of the land.”

Real estate speculation is not a new subject. As noted by the lawyer, people from all segments of the economy were playing the real estate speculation game. If you didn’t play the game, you were considered old school and lacked the intelligence to be financially savvy. Bringing this to the current market, we can see how someone driving a Mercedes may hold a view of someone driving a Honda Civic. Clearly, the person driving the Civic isn’t playing the real estate game or has an understanding of how to manage their finances. Sadly, a large percentage of those in the Civic will perceive the person driving the Mercedes as wealthier even though they have an $800 a month lease and in fact may have a net worth in the negative territory. So many people decided to jump into the game and this is noted by the large increase of employment related to the housing complex in the past decade. The letter continues:

“During this period insurance companies were bidding against one another for the privilege of making loans on Iowa farms at $90 or $100 or $150 per acre. Prices of products were soaring. Everyone was on the highroad not only to comfort, but to wealth and luxury. Second, third, and fourth mortgages were considered just as good as government bonds. Money was easy, and every bank was ready and anxious to loan money to any Tom, Dick, or Harry on the possibility that he would make enough in these trades to repay the loans almost before the day was over. Every country bank and every county-seat town was a replica in miniature of brisk day on the board of trade.”

Many housing pundits would like you to believe that modern real estate products are somehow superior to past products. Either way, you are securing a note onto an asset and the basic concepts still apply. As you can read from the letter, second, third, and even forth mortgages were common in the 1920s. The perception, just like in better housing days, that housing was an absolute secure investment was something held very near to the heart during the lead up to the Great Depression. We also notice that lending institutions were just as eager then as they are today to loan money out to anyone with a pulse. How quickly did the tide turn after the Crash of 1929? It did not happen overnight:

“The drastic deflation of Iowa loans under the orders from the Federal Reserve Board, upon which Smith Wildman Brookhart, depression Senator from Iowa, poured forth his venom, definitely marked the downward turn in the mythical prosperity of boom days. Despite our hopes for the better, conditions have grown steadily worse.”

“During the year after the great debacle of 1929 the flood of foreclosure actions did not reach any great peak, but in the years 1931 and 1932 the tidal wave was upon us. Insurance companies and large investors had not as yet realized (and in some instances do not yet realize) that, with the low price of farm commodities and the gradual exhaustion of savings and reserves, the formerly safe and sane investments in farm mortgages could not be worked out, taxes and interest could not be paid, and liquidation could not be made. With an utter disregard of the possibilities of payment or refinancing, the large loan companies plunged ahead to make the Iowa farmer pay his loans in full or turn over the real estate to the mortgage holder. Deficiency judgments and the resultant receivership were the clubs they used to make the honest but indigent farm owners yield immediate possession of the farms.”

So we realize after the “great debacle” that foreclosures did not peak until 1931 or 1932. So it took 2 to 3 years for the pent up excess credit to hit the market. With our 24/7 media coverage and online to the nanosecond updates, most people think the bubble burst or later recovery will happen tomorrow. Unfortunately, it will occur over a long and drawn out period while people silently scream. The denial of the current credit bubble is extremely similar. By looking at the numbers conservatively, we see that we are going to have much of the same in 2008 and 2009. Not only will it be the same, but we are eliminating the “safety” feel of real estate and compounding it with growing foreclosures and declining prices. We recently had a first national housing median price decline since - guess when - The Great Depression. And it is not uncommon for people to start taking sides at this point. Some want to call bottom and those financially conservative realize we have a long way down before we hit bottom. The letter also highlights the sucking dry of savings and reserves of many families. Well, we already know that we have a negative savings rate so I’m not sure how long a family could stay afloat without using credit cards or blowing through their retirement funds (if they have any). How did this impact society’s view on real estate?:

“Men who had sunk every dollar they possessed in the purchase, upkeep, and improvement of their home places were turned out with small amounts of personal property as their only assets. Landowners who regarded farm land as the ultimate in safety, after using their outside resources in vain attempts to hold their lands, saw these assets go under the sheriff’s hammer on the courthouse steps.”

We have this mentality in the current market place. The majority of folks that invest heavily into renovating their homes are looking to flip the property for a larger profit. Not everyone, but with shows like Flip This House you begin to realize that home is a temporary pit stop for many in our society. And then we have the generational psychology shift that housing isn’t a safe investment in every circumstance. Foreclosures started going through the roof shortly after the psychological shift:

“During the two-year period of 1931-32, in this formerly prosperous Iowa county, twelve and a half per cent of farms went under the hammer, and almost twenty-five per cent of the mortgaged farm real estate was foreclosed. And the conditions in my home county have been substantially duplicated in every one of the ninety-nine counties of Iowa and in those of the surrounding states.”

Growing foreclosures start to hit multiple counties in Iowa during the tidal wave period of 1931-32. Currently we are facing incredibly large foreclosure jumps in California, Colorado, Arizona, Florida, and Michigan to name a few states. This is something that has only started. It has moved from the center of wealth in the 20s of the farm and industrial cities, to the urban metro centers of the 2000s. Like the previous bust, it took about 3 years for the general market to realize there were major issues. When times change they change quickly:

”We lawyers of the Corn Belt have had to develop a new type of practice, for in pre-war days foreclosure litigation amounted to but a small part of the general practice. In these years of the depression almost one-third of the cases filed have to do with the situation. Our courts are clogged with such matters.”

“Gone, too, is that pride of ownership which made possible the development of stock and dairy farms with their herds of fat cattle and hogs, their Jersey cows, their well-kept groves and buildings which beautified and developed the countryside. The former owners were willing to use a large part of receipts from a farm’s income to increase its value and appearance but the present absentee owner regards it only as a source of possible dividends.”

“From a lawyer’s point of view, one of the most serious effects of the economics crisis lies in the rapid and permanent disintegration of established estates throughout the Corn Belt. Families of moderate means as well as those of considerable fortunes who have been clients of my particular office for three to four generations in many instances have lost their savings, their investments, and their homes; while their business, which for many years has been a continuous source of income, has become merely an additional responsibility as we strive to protect them from foreclosures, judicial receivership, deficiency judgments, and probably bankruptcy.”

“The old maxim of three generations between shirt sleeves and shirt sleeves is finding a new meaning out here in the Corn Belt, when return to very limited means in a formerly prosperous population is the result not of high living and spending, but of high taxes, high dollars, and radically reduced income from the sale of basic products.”

A few things to note. The impact on a societal level is time and productivity will shift into protecting faltering estates. Folks will try to save their homes, try to avoid bankruptcy, and we will have collectors focusing on bringing accounts current (if they can). This is time spent from other economically productive activities. However, it is an unavoidable evil of any bubble to wash out the excess liquidity. The letter also discusses the loss of homeownership pride. I’ve thought about this many times here in Southern California. Most of the time, I hear folks saying, “do you know I have $300,000 in equity and if I upgrade the bathroom, it’ll be worth an additional $25,000?” I ask them if they are upgrading for their family but normally it is to sell it off to the next highest bidder. We are starting to see dents in this mentality. Why invest so much in your home if appreciation is stagnant or declining? If you really wanted to be a proud homeowner, you would do these things simply for improving your home. Many did upgrade via mortgage equity withdrawals and second mortgages. However, when the market bottoms out you realize that many did it as a ploy to inflate the value of their home for a future time to market and not for the betterment of their families' well being. Either way, folks can do whatever they want with their home and money but clearly, homeownership pride for many in Southern California and other large metro areas is based on how much equity you have amassed. The lawyer recounts a sad story of a client:

“George Warner, aged seventy-four, who had for years operated one hundred and sixty acres in the northeast corner of the county and in the early boom days had purchased an additional quarter section, is typical of hundreds in the Corn Belt. He had retired and with his wife was living comfortably in his square white house in town a few blocks from my home. Sober, industrious, pillars of the church and active in good works, he and his wife may well be considered typical retired farmers. Their three boys wanted to get started in business after they were graduated from high school, and George, to finance their endeavors, put a mortgage, reasonable in amount, on his two places. Last fall a son out of a job brought his family and came home to live with the old people. The tenants on the farms could not pay their rent, and George could not pay interest and taxes. George’s land was sold at tax sale and a foreclosure action was brought against the farms by the insurance company which held the mortgage. I did the best I could for him in the settlement, but to escape a deficiency judgment he surrendered the places beginning in March 1^st of this year, and a few days ago I saw a mortgage recorded on his home in town. As he told me of it, the next day, tears came to his eyes and his lips trembled and he and I both thought of the years he had spent in building up the estate and making those acres bear fruit abundantly. Like another Job, he murmured “The Lord gave and the Lord hath taken away”; but I wondered if it was proper to place the responsibility for the breakdown of a faulty human economic system on the shoulders of the Lord.”

“When my friend George passes over the Jordan and I have to turn over to his wife the little that is left in accordance with the terms of his will drawn in more prosperous days, I presume I shall send his widow a receipted bill for services rendered during many years, and gaze again on the wreckage of a ruined estate.”

“I have represented bankrupt farmers and holders of claims for rent, notes, and mortgages against such farmers in dozens of bankruptcy hearings and court actions, and the most discouraging, disheartening experiences of my legal life have occurred when men of middle age, with families, go out of the bankruptcy court with furniture, team of horses and wagon, and a little stock as all that is left from twenty-five years of work, to try once more – not to build an estate – for that is usually impossible – but to provide clothing and food and shelter for the wife and children. And the powers that be seem to demand that these not only accept this situation but shall like it.”

Powerful writing isn’t it? Hard to believe and even conceptualize a time when prudence and financial discipline were esteemed. This is the sad account of many folks being demoralized and unable to recuperate a substantial nest egg to retire. Their main concern shifted to providing the basic necessities for their family. Keep in mind that the majority of Americans store their wealth in home equity. Many people that grew up during the depression seem frugal and downright strict with their budgets and lifestyles. It left a visual scar on their psyche. How could it not? We look at our current culture and hear prominent financial gurus telling people to walk away from their home if they have no equity. Just leave. Don’t try to fight to keep it. Default and declare bankruptcy if necessary. My main question is who will pay the eventual bill? If you say the government then that means you will be paying back for the mass irresponsibility of financial institutions, imprudent government policy, and the mass greed of many. Unfortunately, this bubble will affect everyone in some form since all of us need shelter and this credit bubble was built on the over appraisal of a shingled laden roof over your head.

What do you think of the lawyer’s letter in relation to our current economic situation?

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The History of the Los Angeles County Housing Bubble (2000 – 2007). Proudly a County of a Renting Majority.

Take a long and hard look at the chart above. Sometimes a picture is worth a thousand words or in this case, worth half a million. Many would be housing buyers have felt the angst of never being able to afford a home in Southern California. Anyone sitting on the sidelines for the past seven years has seen the largest historical run-up in housing and probably felt helpless at each consecutive jump in prices. “Housing has gone up 20 percent year over year,” became a monthly media sound bite embedded into the psyche of any California resident. We start out with a median price of $200,000 seven years ago and currently see median home prices of $520,000 in Los Angeles County. This double-digit year over year appreciation started in February of 2001 and didn’t end until April of 2006. That means housing never dropped below 10 percent yearly gains, (sometimes reaching gains of 26.6 percent) for 5 years and 2 months.

Even as we are facing massive meltdowns in the subprime and now prime mortgage arenas, why in the 30 mile zone world is LA housing still going up? Welcome to the world of shady statistics, exotic mortgages, and good old fashion greed.

Lies, Damned Lies, and Statistics

Los Angeles housing has always been relatively expensive in comparison to the rest of the nation. Let me define the word always. When I say always, I mean from 1970 and beyond. Similar to real estate agents saying real estate always goes up. Yet something happened in the last decade that sent housing prices in the Southland into the Al Gore stratosphere. I remember reading a book by Robert Allen called Nothing Down and thought to myself as I read it many years ago, “this sounds fantastic but this is relegated to the late night infomercial circuit with tanned gurus in Hawaiian shirts pimping real estate seminars at 2AM.” Go figure that a few years later, nothing down went mainstream. Not only was nothing down mainstream it became a staple of the housing bubble.

Lending standards took a major dose of laxatives and let out a major wave of dirty mortgages. Hence, the name “toxic” loans we now hear. At least that makes sense because these mortgage products were full of you know what. In addition, all the stats used by mortgage lenders incorporated skewed statistics and made up incomes. If you think stated income is ridiculous then you have not lived in Los Angeles. Stated income was the future baby! Why does the bank need to know how much I make? Why are they nosy and trying to dig into my business? When I say I make $500,000 I really mean it even though I have no idea where my W2s are. I’m not even sure if I work but we’ll let Wall Street worry about that. It was an implicit agreement of you sign here, and we’ll put you into this over inflated home. If people on the streets were conjuring up their incomes, what about the companies providing these people the mortgages? Well now, we are taking a deeper look at what really went on and opening the Christmas gift from hell. It turns out that Nothing Down doesn’t bode well in the mortgage game. Why is that? People will generally fight like riled up hyenas if they have skin in the game. If you had to put 20 percent down on a piece of real estate you will do all you can before having the house foreclosed. However, with zero down most folks are more than happy to walk away from their massive mortgage obligations. Heck, the lending institutions are doing this right now in their 11^th hour. We all know that every large metro area is declining and facing massive jumps in foreclosures.

Wacky Median is Still Going Up

No negative housing information seems to make a dent on the resilient LA median price index. The prices keep going up. Again, the devil is in the details. Sales volume has dropped off a cliff and has been in free fall mode for over a year. Yet a home that doesn’t sell cannot be factored into the overall sales data. Therefore, what we see is homes in prime areas such as Beverly Hills, Brentwood, Santa Monica, and Palos Verdes skew prices even higher because these places are still selling. Lower priced homes aren’t selling therefore they are not included in the overall sample size. And the sales sample size is shrinking as we speak.

Then we have homeowners addicted to five years of double-digit gains unable to reconcile that they can no longer sell their home for peak prices. They feel entitled to peak prices because they say so. Can it be that housing prices were inflated by exotic mortgages and general greed? Why else would people be so eager to jump into a home that they could rent for half the price? The new paradigm of housing included double-digit appreciation until the end of time. Well the end of the time arrived in summer 2007.

Why Did Los Angeles Go Up and Other Areas Did not?

This may come as a shock to you but we have sun here in Southern California. Actually, we own the exclusive rights to it. Therefore, prospective buyers had to pay a sunshine tax to live here. Florida has sun too hence their run-up in real estate. This may seem simplistic but most metro areas in the US are now overpriced. Some are overpriced by 10 percent and some are overpriced by 50 percent. LA wasn’t the only place with a mad run-up in prices.

We also have a very mobile population. The majority of folks spend a good portion of their day on the 5, 10, 210, 405, or any other freeway you can think of. A very small portion of people see housing as a long-term investment here. The general culture does not think of buying a home, raising a family, and retiring all in one place. In fact, we have a culture where you play the Russian matryoshka doll game; you know where each little doll is nestled in a larger doll? Well people purchase homes here to trade up. Each consecutive purchase brings you a larger home with an equally larger mortgage. Each added member to the family is reason to purchase a larger car on a new lease. This is how many families operate in the Southland.

Yet the squeeze is being put on the middle-class of the state. Rising gas prices, car costs, healthcare, food, utilities, and housing all cut into the operating budget of the family. Like the couple earning $130,000 and lost their home to foreclosure, many families are realizing they are suffocating on servicing their debt. The grim fact may hit many families like a ton of bricks that they were using credit to stay afloat. Now that credit is becoming more expensive to obtain, they are realizing the true nature of their spending habits. Many families are also feeling the pinch of a declining dollar. I’m not sure if John and Susie Public are too concerned about a falling dollar or inflation. You just hear them ramble about, “damn, prices are always going up!” I’m hoping that people start asking the next question and look into the reason prices are going up. And many folks are realizing that their paycheck isn’t keeping up with the cost of living. Slowly the public is being taxed via inflation and a falling dollar. The only person running for president that I’ve heard mention anything about these economic issues is Ron Paul.

Los Angeles is a different beast. We have 88 cities in the county. We have 10,000,000+ people living in a relatively small area. There are 3,339,763 housing units. The median income for a household in the county is $42,189, and the median income for a family is $46,452. In addition, the homeownership rate is 47.9 percent. So in fact, Los Angeles County has a renting majority population. But if you want to own, we have some wonderful Real Homes of Genius eager for a new owner.

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Housing Minsky Moment: 3 Factors. Prime Contagion, Record Foreclosures, and Publicity.

This week witnessed the final nail in the housing bubble coffin. We have reached what seems to be the Minsky moment for the housing market. Named after the US economist Hyman Minsky, the idea holds that over long periods of economic stability leverage tends to grow in predictable stages. This economic stability leads to a fertile environment sprouting trunks of easy credit access with little perceived risk. However, as the growth continues there seems to be a movement from moderate lending, risky lending, and finally outright irresponsible Ponzi like lending. With 100+ subprime lenders imploding on their own convoluted mortgages, the housing market is like a fish out of water gasping for life and clearly in the last stage of the lending cycle. The first event occurred on Tuesday when the gargantuan mortgage lender, Countrywide Financial announced dismal second quarter results. They announced that second quarter profits shrank by a third due to growing delinquencies and get this, creditworthy borrowers defaulting. The talk early in the year about subprime being contained turns out to be an absolute ruse. Now we have prime mortgage borrowers swept up in the housing slump. Yet the bigger news came from Countrywide’s CEO Mozilo, saying that he does not see housing recovering until 2009. Imagine that.

Then we have the inability of the mainstream news media to inform us regarding critical issues. Instead, we have the morning news plastered with Lohan up to her usual debauchery and athletes gone wild. As a matter of fact, while California set a new record in the foreclosure department, the mainstream media felt this only warranted a footnote at the end of the newscast. We don’t hear much about Iraq anymore. And what of the collapsing dollar? I think I hear Nero Fiddling while something burns.

In this article we’ll examine three critical factors that propelled housing into its public Minsky moment; prime contagion, record number of foreclosures, and negative publicity.

Prime Contagion

Mozilo likened the housing market to a gigantic ship needing to turn in the ocean. It will take time was his underlying point. I like to think of the housing market more like a NASA mortgage rocket with no turning back. Have you ever tried turning back a rocket-propelled vessel? His statement seems to offer some hope that housing will return even though he unloaded millions in his company stock. Maybe he forgot to mention that the ship he was referencing was the Titanic. Either way, housing is passed the shaky ground stage. I’ve shown countless examples in our Real Homes of Genius series that clearly highlights an outrageous bubble housing psychology. We also discussed a few months back the subprime implosion as credit suddenly tightened and subprime lenders started dropping like moths heading toward the light. In fact, I felt this was the watershed event and would set the tone for the summer.

Yet glorious housing bull pundits at this time championed the amazing summer rebound and the silo mentality of containing the subprime debacle. Ignoring rising inventory, $1 trillion in mortgage resets, and a stagnant market they decided to jump on the housing Pollyanna bandwagon. After all, this summer was housing's last shot to demonstrate continued bubble resilience. Unfortunately, this summer is only the beginning of a very difficult downturn in the housing market and most likely the overall economy. The market has ballooned beyond any economic model of sustainability. I discussed the pseudo $5 trillion in wealth created by this housing bubble and all credit linked to it. How much of this wealth will disappear is yet to be seen.

Yet now we are realizing that prime loans are also taking a hit. No longer is this implosion contained to one segment of the housing market. For a large part, we have this entitlement mentality of folks thinking their homes are worth more than what they truly are. Say you bought in 1997 for $200,000. Now your home is worth $600,000. This is a very typical scenario in California. You’d feel $400,000 richer simply by living in your home. And many folks had this wealth effect. In fact, they converted their homes into ATM machines and used mortgage equity withdrawals to prop the economy. Unfortunately, many folks are now realizing that some appraisals may be bubblicious in their estimates. Say this given home drops to $400,000 in a few years. Nothing is lost, in fact they are “up” $200,000 but the psychology and perceived loss does make people feel poorer. When people feel poorer, they spend less. In our economy based on 70 percent consumption, that equals a recession. Clearly, this is where we are heading. We have scheduled mortgage adjustments set for 2008 and 2009 to the tune of approximately $2 trillion:

This housing market followed no economic rules and like the Minsky moments of past, greed and irresponsible credit will once again collapse another bubble. Chalk it up to history repeating itself. Which leads us to the historical moment set in California.

Record Foreclosures

Southern California has reached a record number of foreclosures. That is correct, we are swimming in uncharted territory. Notice of defaults are quickly approaching record territory as well. To be exact we are off by 102 homes, which by the time this article is posted, we will surpass. So we can say that we have record numbers of Notice of Defaults and foreclosures. Take a look at the chart below and see if you can spot the trend in California:

The interesting tidbit of this information is NODs are turning over and going into foreclosure. If anything, you can consider the NODs as a canary in the mine; and if we are to read the data correctly we are in for some massive foreclosures. As stated by DataQuick:

“Most of the loans that went into default last quarter were originated between July 2005 and August 2006. The median age was 16 months. Loan originations peaked in August 2005. The use of adjustable-rate mortgages for primary purchase home loans peaked at 77.8% in May 2005 and has since fallen.”

Now if you examine the rate reset chart in conjunction with the foreclosure data, there really isn’t anything stopping this train. Over 75 percent of loans originated in August 2005 were adjustable-rate mortgages. Given the hot product was 2/28 teaser suicide loans, what special date are we approaching? That is right, August 2007 where a massive batch of these loans will be resetting in a declining market with higher rates. So even if these folks want to refinance, they will be hit by higher rates and a larger payment.

Amazingly, these loans are also fairly new. With a median age of 16 months. Clearly the problem here is people jumping into homes they cannot afford by horrible mortgage products. In addition, the rate of default on second mortgages is also skyrocketing. This would seem obvious since missing the payment on the primary loan implies you are not paying your second. But guess what? In the midst of all this there is good news. The median price for a home keeps on going up! We won’t go into exposing the inaccuracy of using a tiny sample size of higher priced homes skewing overall market stats. We want to leave you with one piece of good housing news for the day.

Negative Publicity

This may turn out to be the only good news left for housing. The media is fickle and suffers from long-term memory loss. Even a year ago, we were reading about stories of people making thousands in real estate transactions. People were racing over like NASCAR drivers ready to become brokers and agents as reflected by the number of licenses issued by the Department of Real Estate here in California. Now, you are more likely to find negative housing information permeating the media machine. And don’t you find this odd in a state where housing is still flirting with a median price of $600,000? If the media dug deeper into this implication and did constructive journalism, it would be clear that we are in a full fledged housing bubble bursting. Why are they afraid to come out and simply admit what the data is suggesting? That housing is in for a major correction and housing prices grew on the back of irresponsible lending and greed. The key ingredients from any historical bubble are present again.

The issue is the real estate industry employs countless people, pays high amounts of money for advertising, and has many politicians bought. So of course they carry clout. But this will only get you so far. You can only fool the market for so long. It is becoming apparent that this system will collapse on its own weight. In a way we haven’t felt the ramifications of what is to come. We are only getting a sneak peak of the real housing bear market. I was looking at old LA Times articles and the positive rhetoric from housing peak to negative bubble chicken little print took about 3 to 4 years. So given this past reference, you can expect a bottom somewhere in 2009 or 2010. Employment numbers still do not accurately reflect the coming job losses we will face. Our economy was based on this bubble via credit, mortgage equity withdrawals, trading houses up like baseball cards, and a cultural neurosis on all things housing.

When do you think we will reach a housing bottom?

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The Foreclosure Story: What does the Process Look Like?

We all know that foreclosures are on the rise throughout the nation. Most people realize that a foreclosure means that you will lose your home. But how does this process look like? In reality, the foreclosure process is a drawn out and lengthy ordeal. It is a gut wrenching and personal nightmare for most folks. So this article is a story about a couple. A couple who is the poster representation of the housing boom and now bust. In this article, we will examine their profession, income, and monthly budget. Amazingly, folks are very upfront when they are making lots of money but go into clandestine mode when they are having financial difficulties. Below is the couple’s profile:

Joe and Mary

Ages: 29 and 28

Professions: Joe - Senior Account Executive (lender), Mary - Real Estate Agent

Location: Orange County

Yearly Income Combined: $130,000 Gross

Net Monthly Income (After Taxes): $8,200

Automobiles: Mercedes E350 Sedan ($599/33 month Lease), GL 450 Suv Purchase ($56,000)

Monthly Auto Fuel Cost (Filling up Once Per Week): $350

Home Purchase: Costa Mesa 4/2 Home, Bought Late 2004 for $675,000

Credit Card Debt: $25,000

Monthly Food Budget (Including Dining Out): $700

So this should give you a nice snapshot of the couple. Since they were sophisticated investors in the know, they decided to jump into the home with a 2/28 loan, interest only with no money down. After all, someone making $130,000 a year can clearly sustain pretty much anything right? And as we all know, no money down was no longer simply a thing of late night infomercials but a mainstream way of buying a home. Here is the monthly budget below with the teaser rate loan (they had it for 2.75%):

2004 Budget

House Payment (PITI – at 2.75% interest only/2 years): $2,249

Auto Cost (monthly payment/lease/loan/fuel): $1,749

Dining: $700

Credit Card Payment: $500

Total: $5,198

Monthly Net: $8,200

Disposable income: $3,002

Keep in mind we are not factoring in medical insurance, cell phone cost, utility bills, retirement accounts, and many other items. These are things that I am aware regarding their budget since I was privy to the information. Well, more like them showing off to me, but I made mental notes on these items as I would with a past client showing me their monthly budget. So even with that said, $3,002 a month in disposable income is a pretty nice chunk of change to pay the remaining monthly items. But again, this was a teaser 2/28 loan. Unfortunately, they didn’t factor in one of them losing their job, a rate reset, and a slumping housing market. Let us take a look at the late 2006 monthly budget:

2006 Budget

House Payment (PITI – amortized fully over 28 years/full rate of 6.25%): $4,962

Auto Cost (monthly payment/lease/loan/fuel): $1,749

Dining: $700

Credit Card Payment: $500

Total: $7,911

Monthly Net: $8,200

Disposable income: $289

Suddenly the jump in the rate creates a crunch on the household income. Keep in mind the above still doesn’t factor in other monthly cost. In addition, this was in late 2006 before, Joe lost his Senior Account job because the company went under. They were already feeling the pinch since the housing industry was already showing signs of weakness and their income being variable with commissions, was also taking a hit. Joe jumped to another mortgage outfit but they were only able to give him $30,000 a year base plus any commissions. Of course with the tightening of the housing market business is not going so well since both of their careers are tied directly to the housing industry. Their combined income is no longer $130,000 a year but approximately $80,000 a year. So let us run the numbers again with the new household income:

2007 Budget

House Payment (PITI – amortized fully over 28 years/full rate of 6.25%): $4,962

Auto Cost (monthly payment/lease/loan/fuel): $1,749

Dining: $700

Credit Card Payment: $500

Total: $7,911

Monthly Net: $5,804

Disposable income: $-2,107

Now we are running massive monthly budget deficits. It may come to a shock to many people that a household earning $130,000 a year actually may have financial difficulties. But looking above, you can see how easy and quickly someone can go into financial ruin. Statistically, this couple was in the top 10 percent of household incomes in the country. Yet they spent way beyond their means. California living is very expensive. You’ll also notice that being in the industry they are in, they felt that they needed symbols of affluence to keep up with the Joneses. So now that you can see that not only folks that make $14,000 a year purchasing $720,000 go into mortgage trouble, even those that are considered the most affluent also have financial problems. The next phase of this case study is the foreclosure process.

How Does Foreclosure Really Look Like?

Foreclosure has been a somewhat unheard of novel thing in California for the past decade. Any homeowner in trouble was able to put their home up for sale and it would sell quickly before the entire process ran its course. The market was so hot that it covered financial irresponsibility by letting folks off the hook. This all ended last year. Suddenly, the market is declining yet rates are still resetting. Folks are realizing that they are unable to make the payments, sell for their asking price, and losing their homes. So how did Joe and Mary lose their home? This is the next stage of the foreclosure story and a sad one.

The psychology of running massive monthly deficits is a hard one. For one, you are probably wondering about the incredibly high car cost. This is Southern California and having a new model is somewhat common practice. The worst depreciating item you can own is a vehicle. Regardless, they purchased one of the two Mercedes and after a year or so, if they decided to sell they would be selling at a loss. So after Joe lost his job, they decided to put their home up for sale knowing they would be unable to make the payments. At first, they thought that they would be able to make a nice profit on the home. This was not the case. This is how the following months looked like:

Month 1-6 – (Pre-Foreclosure)

Joe and Mary miss one payment. They have their home listed at $790,000 on the MLS. No bites. The bank sends a late notice to their home. Since they’ve been in the industry, they have seen homes sell even before landing on the MLS. They are certain that they will sell the home.

Total Monthly Payment Behind: $4,962

Late Payment: $40

Total to Cure Account: $5,002

Another month goes by and no offers. They lower the price to $775,000 to generate some interest. Nothing. They start getting a bit anxious. They get another payment from the bank but this time, they will need to make two payments. At this point, they make a conscious decision not to pay the mortgage and put in a clause for a future buyer to cure the account when they buy:

Total Monthly Payment behind: $9924

Late Payment: $40 x 2

Total to Cure Account: $10,004

At this point the bank tries to make contact with Joe and Mary. If they couldn’t pay $5,002 how are they going to pay double that? A third month comes along and they lower the home price to $750,000. Still the market is dry and silent. At this point the couple receives letters from the bank and attorney. They now start receiving formal letters:

Total Monthly Payment behind: $14,886

Late Payment: $40 x 3

Legal Fees: $75

Total to Cure Account: $15,081

Forth month comes along:

Total Monthly Payment behind: $19,848

Late Payment: $40 x 4

Legal Fees: $75 x 2

Total to Cure Account: $20,158

Fifth Month:

Total Monthly Payment behind: $24,810

Late Payment: $40 x 5

Legal Fees: $75 x 3

Total to Cure Account: $25,160

The bank issues a demand for full payment including full balance, back interest, plus late charges, and legal fees all at once. The legal notices start. Joe and Mary now have their home listed at $715,000. Still no bites. They did have some people come by but the deals didn’t materialize. Now they need $25,160 to cure the account but the bank has legally informed them that they will accept no payments except a full balance payment on their original $675,000 note. Keep in mind the bank is no place for negotiations. Can you imagine calling up your local Mercedes dealer and saying, “Hello Mercedes? Yeah, I’m not going to be able to afford the $600 this month but would you be willing to take $300 plus a free Dodger ticket?” The bank now sends a certified letter of notice of intent to foreclose. Joe and Mary realize they will not sell their home. The notice and waiting period begins. They stay in the place two more months. Now it will cost $35,000+ to bring the account current plus a full payment on the balance. Of course this will never happen given the circumstances of their finances. No payments are arranged and the house is sold at auction and of course, the bank reclaims the home as REO since they are on the sheets for $675,000.

The home is now officially REO and get this, they have it listed for $750,000! The bank is delusional. Joe and Mary now have a foreclosure on their credit record and rent a much smaller home. They managed to break the lease on the Mercedes but are on the hook for the purchased SUV. You’ll notice how things spiral out of control when you spend more than you earn. I can only imagine households with $60,000 getting into this mess. If anything, it will accelerate ten times faster. They are considering bankruptcy but the new laws are now more stringent in terms of letting people completely off the hook, especially a couple that makes nearly twice the median US income.

Hopefully this article gives you an inside look at the story of foreclosure and how it can happen to anyone. I've seen many blogs talk about foreclosures and the numbers but haven't seen a post detailing the entire process and how it impacts a home owner's bottom line. Not only that, but you should get an understanding that we are in a bubble so large, that missing one payment puts you in arrears for $10,000, or the down payment of a modest home in many states of the US. If this is what happening at stage one of the bubble, what do you see happening in the latter stages?

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