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Back when the housing market topped in July 2005, mortgage debt’s critical role in the burgeoning new real estate saga was identified by The Elliott Wave Financial Forecast  (see Additional References below). One key element of the latest Times story is its discussion of debt, and its discovery of what a burden many of the mortage "innovations" of recent years will be in an environment of falling prices. It notes, for instance, that home equity withdrawals have been so big that the average household in Boston now has slightly less equity than it did in 2000, according to Economy.com. One lead player EWFF identified was the nothing-down loan. Says the New York Times’ David Leonhardt, “Then there are the people who bought their homes in the last couple of years and made almost no down payment. Many of them may now be underwater, owing more on their mortgages than their houses are worth. Most worrisome, growing numbers of these families are falling behind on their mortgage payments, and they won’t be able to bail themselves out by refinancing or selling their homes. ‘We’re now going to combine a high amount of debt with falling home values,’ said Mark Zandi, chief economist of Economy.com.”

The danger has taken longer than we thought possible to dawn. Given the size of the peak, however, it probably shouldn’t surprise us. “In the initial stages of a depression, sellers remain under an illusion about what their property is really worth,” Conquer the Crash noted. The strength of the illusion simply expresses the strength of the unfolding decline. It must be a big one because it managed to hold homeowners in a trance-like state of conviction for a full eighteen months after the peak in the housing market. And this quote from the Times article shows what a tentative brush with recognition it is: “You could have been excused for thinking that the real estate market was crashing.” Obviously, the there’s a long way to go.

The only place to find a true depiction of the real estate market’s predicament, remains Conquer the Crash. For a quick overview, check out the entry from the September 2005 issue of EWFF (see Additional References below), which covered the importance of the “public’s affection for real estate and the debt needed to acquire it.” The November issue of EWFF updated the situation by noting that while buyers illusions “about what property is really worth” have started to dissolve, “a more cautious approach on the part of lenders” remains a  missing ingredient. With the full scope of the decline under wraps, lenders have until very recently been able to maintain loan performance “by taking loans that begin to be troubled and doing whatever they have to refinance borrowers in the midst of foreclosure proceedings.” Now that the New York Times is using words like “crash,” however, shoring up the trouble spots will become much harder. Perhaps the most important aspect of this story is that it is definitely getting attention. It is listed as the second most popular on the Times “most e-mailed” list. These stories and entries from Socio Times over the last 16 months show the progression from Mr. Bubble in August  2005 to a nagging concern early this year  to an impending bust in August 2006. It’s taken its time, but now that the word is spreading, real estate problems should fan out in all directions.

September 2005, EWFF
THE ECONOMY & DEFLATION
Back in March 2000, EWFF noted that the “fate of the world” hinged on the manic rise in 50 U.S. stocks, many of which were unprofitable. Five years and one recession later, the global economy is hanging by a similarly thin thread. The difference now is that the weight of the world is being held up by the public’s affection for real estate and the debt needed to acquire it. According to Irwin Stelzer of The Weekly Standard, data compiled by the Bureau of Labor Statistics “shows that housing and related industries now account for 4.8 million jobs, some 60% more than the once-mighty auto industry.” While the U.S. auto industry lost 60,000 jobs in the past 4 years, the housing industry created almost 600,000 jobs in construction and financial services. Newspapers are a good example of how whole industries are clinging to real estate’s coat tails. As anticipated in past issues, the newspaper industry is slowly falling prey to the Internet and gathering deflationary forces, but its saving grace is a flood of real estate ads that have poured in over the last year. The Wall Street Journal reports that real estate ad revenue increases of 16% to 45% are “masking what has been a years-long decline in classified-ad revenue at newspapers.”

But the home-buying binge comes at a steep cost to U.S. households. The household surplus/deficit chart from Paul Kasriel of Northern Trust Co. shows the financial impact to homeowners. From the 1950s to 1999, one year before the start of the bear market, households maintained a surplus, whereby disposable personal income exceeded total expenditures on consumer goods and services and residential investment. At the height of the great financial mania, the balance of payments shifted, and households rapidly slipped into arrears. People’s willingness to borrow and spend on goods, services and homes bailed the economy out, but it leaves the primary driver of the U.S. economy with virtually no financial flexibility. What possessed owners and home buyers to spend themselves into a $400 billion deficit? Only the psychology of a Grand Supercycle trend change can account for it. Nothing else can explain the twisted mindset on display in recent real estate stories in the L.A. Times: “mortgages used to be something people strove to pay off. Now they’ve become income tools.” “What was once considered undesirable — taking on large debt — is now seen as smart. And what used to be smart — becoming debt-free — is described as imprudent.” Says the chief economist of the National Association of Realtors and author of Are You Missing the Real Estate Boom?, “Paying off a mortgage [is] very unsophisticated.” The chief executive of an Internet-based mortgage company echoes this sentiment: “If you own your own home free and clear, people will often refer to you as a fool.” Many of these people undoubtedly said the same thing about anyone who advised against piling into Internet stocks in 1999.

Banks seems to be blind to the danger of overpriced collateral as they continue to stuff their balance sheets with mortgages assets. The chart above shows how the ratio of mortgage debt to total credit outstanding has nearly tripled in the last 20 years. Banks are doing everything in their power to keep this line rising. In addition to the no-interest loans mentioned in recent issues, “payment option” loans in which borrowers can pay less than their monthly interest are growing fast. These loans are also known as “negative amortization” loans because underpayments increase the amount that the borrower owes. At Countrywide Financial, the largest mortgage lender in the U.S., the principal value of negative amortization loans rose almost 100 times, from a value of $33 million at the end of 2004 to $2.9 billion on June 30. (Thanks to Grant’s Interest Rate Observer for this figure.) In another unprecedented leap of lending faith, CNN reports that the banking industry is “opening its doors to a controversial new market: illegal immigrants. Despite heated political debate in Washington over illegal immigration in the United States, an increasing number of banks are seeing an untapped resource for growing their revenue stream. ‘Once you’re in the country, and you haven’t done anything wrong, the chances of being deported are very slim. Banks are banking on that.” Talk about a collision course with bear market forces. Even as U.S. governors declare border emergencies and immigration emerges as a focal point in the 2006 Congressional election, banks are looking at illegals as potentially limitless source of borrowing.

Why The End Is Near
The July issue showed Time magazine’s “Home Sweet Home” cover story over a completed five-wave advance in the NAREIT index and labeled it “Housing’s Home Stretch.” There are many reasons to believe that a bear market in real estate has, in fact, just begun, including the latest reading on that chart of bank mortgage holdings. At 61%, bank mortgage holdings touched a Fibonacci point of likely reversal. Another factor is the action in the EWI Sub-Prime Lenders Index, which the March issue of EWFF identified as the “front edge” of the great financial bubble. After completing five waves up at three degrees of trend in January (see chart on page 2 of the March issue), the index declined in five waves, sputtered higher in a countertrend bounce and reversed in what should be a powerful decline to much lower levels. The homebuilders have also joined in with a five-wave decline of their own. The decline’s break of the exponential curve formed by its near vertical rise (shown on the chart) is a powerful sign that a long, hard fall is starting.

Homebuilding company insiders apparently contributed to the fall as their sales at several key firms are running at their highest levels since 1985. Richard Bernstein of Merrill Lynch notes that the one-sided selling levels are similar to insider sales of technology stocks on the approach to their March 2000 peak. New home sales are still strong, but as the August issue of The Elliott Wave Theorist noted, the decline is now underway in several foreign markets and a tell-tale inventory build-up, which Conquer the Crash cited as the first sign of the big collapse, has started. Reports of rising inventories are surfacing from California to Massachusetts. In Sacramento, inventories rose to a 7-year high in July then shot up another 26% in August. Nationally, prices for condominiums fell for a second straight month, while the number of condos on the market rose sharply. In the once-torrid South Florida market, “the word ‘correction’ is being increasingly whispered” and agents report a “subtle change” in the tone of business over the last six months. More houses fail to sell and more listings expire—“something that would have been unheard of a year ago”—and asking prices are falling. “The market is turning,” says a Palm Beach realtor. Houses purchased by speculators in hopes of a quick flip are “killing the market in certain areas.”

Then there’s the uh-oh effect, which, as our collage shows, continues to mount within the real estate sector. Noting that reversals from “the biggest tops of all” are accompanied by ignored warnings of imminent reversal, the January EWFF stated that a flurry of concern about a housing bubble is similar to concern in 2000 about high prices for NASDAQ stocks, which EWFF used to successfully anticipate the NASDAQ’s peak in March of that year. Contrarians continue to contend that the housing boom cannot end because many pundits are worried, but the majority and its conviction are what matters. At this point, there is one key difference between concerns about the NASDAQ in 2000 and real estate worries: the effect is much stronger this time. “Talk of the current prospects for ‘the bubble’ has become an evening-news staple and is fueling endless cocktail party conversations and Internet blogger musings.” The National Association of Realtors’ web site even posted an unusual “wait-to-buy” advisory. The message was quickly removed because it was being “viewed incorrectly as a pronouncement that the bubble was popping.”
 
Worry Yes, Action No
Trepidation is rising, but few are acting on it. In fact, the more plentiful the “warnings” depicted above become, the more common are statements that say that a real estate decline is not going to happen and, if it does, it won’t be that bad. “Is the Great Housing Run coming to an end?” asks the Chicago Tribune. “Many Chicagoans apparently think not.” Most cautionary notes continue to be quickly followed by words that prices will stall or flatten or correct, but not actually fall. Some are convinced that the bubble cannot burst now because the worry surrounding the market is too pronounced. We agree with Alan Greenspan, who touched off the latest flurry of anxiety by simply noting that “history has not dealt kindly” with overextended markets in the past, an understatement for markets that became as extended as housing is now. When manifestations of the rise last longer and express themselves more intensely than ever before, it doesn’t mean that history no longer applies and should not be heeded. It means that while history may take longer to assert itself, when it finally does, it is likely to do so intensely. The reason the collective shudder is strong this time is that, in addition to marking the end of the line for the housing boom, the next decline will snuff out an even larger financial euphoria that dates back to the first half of the 1990s. One of our favorite “uh-ohs” is from the Cleveland economist who envisions an “orderly adjustment, or, more ominously, ‘an orderly crash.’” Anything but an all-out crash. The most bearish forecast that we have seen is for a 40% decline over the course of a generation. Conquer the Crash forecasts a decline that could exceed 90% in only a few years.

The Bell Tolls For Debt, Too
As Conquer the Crash pointed out, the real estate boom is joined at the hip to the credit bubble, so a heightening social discomfort with credit fits right into our scenario. In addition to Greenspan’s “veiled warning” about the “need to deal in greater detail with balance sheet considerations,” the mortgage Bankers Association just issued an advisory about mortgages that require much higher payments later on. “The rising popularity of interest-only and payment-only loans are being attacked because they expose borrowers to ‘potentially substantial payment shocks,’” says The Wall Street Journal. Many say that high and rising debt levels have been around forever, but within the last two weeks, papers all over the country are suddenly enamored with stories about how dangerous high debt levels are. More than 153 different publications picked up on an Associated Press offering issued under the banner “Debt Load Makes Americans Vulnerable.” Even more amazingly, the coverage offered a relatively balanced point-counterpoint discussion of the potential for a scenario “in which the bills come due and Americans can’t pay, with devastating consequences for the entire economy.” The story ends by drawing a parallel to the Great Depression, when a bubble burst and “a panic in the market caused the crash of stocks, real estate and commodities that had been bought by speculators with borrowed money.”

One day later the Associated Press produced another story with the exact same theme: “Experts Warn Debt May Threaten Economy.” The second was even more popular, appearing in at least 212 different outlets. It cited, “a chorus of economists, government officials and elected leaders both conservative and liberal warning that America’s nonstop borrowing has put the nation on the road to fiscal disaster.” Here’s a condensed version: “Our profligate ways…seem like a recipe for a national economic nightmare. …If we don’t start making tough decisions soon. …The dangers are clear as day. … We’re stealing our children’s future and our grandchildren’s future….It’s going to require the American people and the country’s leaders to clean financial house. …The worse debt becomes, the more vulnerable America is to shocks. …Pressure are building in America’s homes to straighten out our finances or get ready for a real mess. …We have to get our act together.” This is the shift in “orientation from expansion to conservation” predicted in Conquer the Crash. It’s happening now because it is time for a new sophistication in which debtors and potential debtors “become more conservative” and “borrow less or not at all.” Lenders are still behind the curve. But once they see the writing on the wall, the lending rug will get pulled out from under the economy in a hurry.

July 2005, EWFF
The leverage upon which “the dream” is built is way beyond the record high margin levels in stocks in 2000. “I’ve been playing with the bank’s money,” says the cover girl on the May issue of Money Magazine. Forget the 30-year mortgage; 40-year home loans are now “mainstream” and 60-year, no-interest terms are offered in hot markets like San Francisco. This time there is no mistaking who the Enrons of the bust phase will be. They will be the firms now pedaling adjustable-rate, no-interest/nothing-down and assorted other types of “sub-prime” mortgages. According to the ISI Group, homeowner equity was 56.3% in March, a slight uptick from the lowest level on record. A strong undercurrent of envy is another tie to the dot-com era. “Desperation is driving people,” says the director of Harvard’s Joint Center for Housing Studies. “People are not looking at what they are going to have to pay over the long term. They are asking what is the lowest possible payment I have to make over the next 12-months so I can get in.” Says a California disc jockey, “I saw my friends and colleagues getting rich. I wanted to get rich too.”