Monday, November 15, 2004

San Francisco Bay Area Housing Crash Continues

Patrick Killelea


  1. Interest rates going back up. When rates go from 6% to 7%, that's a 17% increase in the amount of interest a buyer has to pay. House prices must drop proportionately to compensate for that.

    The majority of loans are now adjustable, not fixed. This means a big hit to the finances of most owners every time interest rates go up.

  2. Massive job loss. More than 300,000 jobs are gone from Bay Area in the last 4 years. This is the worst percentage drop in the last 50 years. It's worse than Detroit car problems or Houston's oil bust. People without jobs do not buy houses and owners without jobs may lose the house they are in. Even the threat of losing a job inhibits house purchases. We are still in a serious and prolonged recession.
  3. Salary declines. From we hear that "demand for labor that salaries have in fact returned to 1997 and 1998 levels." Local incomes are nowhere near what they need to be to sustain current house prices.
  4. Population loss. San Francisco continues to lose population at the fastest rate of any city in the US and most of those are professional jobs. The problem is not only the dot-com crash, but also outsourcing technical jobs to India, which continues at a frantic pace as corporations realize they can pay an Indian only 20% of what they must pay a similarly qualified employee in the Bay Area. Fewer people in the Bay Area means less demand for housing.
  5. Stock market crash. The NASDAQ under 2000 is still less than 40% of the 5000 it was at the peak of the recent stock market bubble. The crash in the NASDAQ probably hit the Bay Area harder than anywhere else because of all the stock held by employees of tech companies. That money would have gone into housing, but is now gone.
  6. Extreme use of leverage. Leverage means using debt to amplify gain. Most people forget that losses get amplified as well. If a buyer puts 10% down and the house goes down 10%, he has lost 100% of his money on paper. If he has to sell due to job loss, he's bankrupt in the real world. Even a small price decline will bankrupt buyers with small equity. Buyers foolish enough to buy with no money down are already bankrupt, but still unaware of the fact.
  7. Inflation warp. The rest of the economy shows little inflation, but housing inflation has been very high. This disconnect makes houses more expensive in terms of real work. There is no increasing salary to pay off the ever higher interest, so the only way to do it is more work. Many buyers will have to postpone retirement due to overpaying for their house.
  8. Surge in foreclosures. We are already reaping the consequences of poor lending. Foreclosures are at the highest rate they've been in 40 years, about 1,500 in the second quarter of 2004 in Santa Clara county. There are only about 4,500 sales in the quarter, so about one third of house sales are ending in foreclosure.
  9. Shortage of first-time buyers. Even in Britain, there are the same issues, because the same fundamentals apply. Durlacher, a City stockbroker, said the shortage of first-time buyers was a sign of a speculative bubble it believed would burst, sending prices tumbling by almost a half. "Our analysis suggests the housing market now represents a bubble," it said in a 22-page report on the health of the housing market.

    According to the California Association of Realtors, the percentage of Bay Area buyers who could afford a median-price home in the region plunged from 20 percent in July 2003 to 14 percent in July 2004.

  10. Surplus of speculators. The number of houses bought for pure speculation is increasing. It is now possible to buy a house with 103% financing, the extra 3% to cover closing costs, with no money down. All this is on the unwise assumption that housing will rise ever higher, covering interest payments through appreciation.
  11. Trouble at Fannie Mae and Freddie Mac. They are now being forced to tighten up sloppy lending. This means they are not going to keep buying very low-quality loans from banks, and the total money available for buying houses is falling. On 24 Feb 2004, Alan Greenspan said that Fannie Mae and Freddie Mac could pose a threat to the US financial system, putting pressure on them to increase the quality of the loans they buy.

  12. The best summary explanation, from Business Week: "Today's housing prices are predicated on an impossible combination: the strong growth in income and asset values of a strong economy, plus the ultra-low rates of a weak economy. Either the economy's long-term prospects will get worse or rates will rise. In either scenario, housing will weaken. Caveat emptor."

Who disagrees

that house prices will continue to fall? Businesses making money off of foolish house buyers will continue to deny the bubble exists, or that the correction has already started.
  1. Real-estate brokers take a percentage of the price, so they want buyers to overspend on the house. Realtor(TM) is a commercial term, not a real word.
  2. Mortgage brokers take a percentage of the loan, so they want buyers to overspend on the loan.
  3. Appraisers need mortgage brokers for their business, so they are going to give the appraisals that brokers want to see, not the truth.
  4. Banks get origination fees but no longer hold their mortgages, so they take no risk. They do not care about the potential bankruptcy of borrowers, so they will lend far beyond what buyers can afford. Banks sell most loans to Fannie Mae or Freddie Mac.
  5. Owners do not want to believe they are going to lose huge amounts of money.
  6. Newspapers earn money for advertising and articles by Realtors(TM), so they have a strong motive to publish the unrealistic forecasts by Realtors(TM).
  7. John Karevoll of Dataquick in particular is consistent in claiming there is no housing bubble. This helps sell Dataquick's housing data to those who want evidence that nothing is wrong.

What are their arguments?

  1. "There are great tax advantages to owning."
    FALSE. It is now much cheaper to rent a house in the San Francisco Bay Area than it is to own that same house. This is true even with the deductibility of mortgage interest figured in. It is possible to rent a good house for $1800/month now. That same house would cost $600,000. Assume 6% interest ($3000 per month), $2000 closing costs, and a buyer loses $770 more per month buying than renting. Renting is a loss of course, but buying is a bigger loss.
    Monthly Rent: $1,800.00
    Property Tax: $400.00 ($625 per month at 1.25% tax before deduction)
    Interest: $1,920.00 ($3000 before deduction, $1920 down the drain after taxable income deduction)
    Other Costs: $250.00 (insurance, maintenance, etc)
    Total: $2,570.00
    Buyers still have to come up with the principal payment as well, just to have it wiped out as the value of their house declines. Readers can put in their own numbers at the Nolo rent vs buy calculator.

    Remember that buyers don't deduct interest from income tax; they deduct interest from taxable income. Interest is paid in real pre-tax dollars that buyers suffered to earn. That money is really entirely gone, even if the buyer didn't pay income tax on those dollars before spending them.

    Buyers do not get interest back at tax time. If a buyer gets an income tax refund, that's just because he overpaid his taxes, giving the government an interest-free loan. The rest of us are grateful.

    If our current bubble situation holds, a renter will be able to live in a house for 30 years, then buy that house outright with the saved principle payments, and have an extra $277,200 of savings on top of that! ($770 x 12 x 30).

    Rents are not going to go up because unemployment is still widespread around here, and jobs that went to India, Russia, and China are not coming back. Interest rates are going up already, and that will force housing prices down much more dramatically.

    Another way to look at it: except for the rich, everyone either rents a house, or rents money to buy a house. To rent money is to take out a loan. A mortgage is a money-rental agreement. Owners with a mortgage are effectively renting their house from the bank, but there's an important difference. The bank takes no risk, the same as renters take no risk. It's the owners who bear all the risk of falling house prices.

    Whether one buys now or later, total payments will probably be the same, just higher interest on a lower house price. But for those who buy now, the loss in house value will be their personal loss, and may wipe out every penny they've ever earned, and then some. Remember that leverage works both ways.

    As Warren Buffett and Charles Schwab have both pointed out, houses don't produce anything. They do not increase in intrinsic value. Unless there's a bubble, house prices simply reflect current salaries and interest rates. Consider a 100 year old house. Its value in sheltering you is exactly the same as it was 100 years ago. It did not increase in value at all. It did not spontaneously get bigger, or renovate itself. Quite the opposite - it sucked cash out of its owners for 100 years of maintenance and taxes. Its price went up about as much as salaries went up, and fluctuates with interest rates.

  2. "OK, owning is a loss in monthly cash flow, but appreciation will make up for it."
    FALSE. Appreciation is negative. Prices are going down, which just adds insult to the monthly injury of absurd mortgage payments.
  3. "If you buy, at least you have a house, but if you rent, you end up with nothing."
    FALSE. Renters in this market end up with much more money, while living in the same quality house as an owner. At the end of 30 years under our current conditions, a renter would have enough cash on hand to buy the same house outright, and would have an extra $277,200 of accumulated savings, and would have lived in an equivalent house all that time.

    The principal portion of mortgage payments on the other hand is not gone yet. It is just one's own money, moved from from one pocket to another when it moves from bank account to house equity. That part is disappearing right now as interest rates rise and the market value of every house falls.

  4. "Prices have been driven by supply and demand."
    FALSE. Supply is increasing as building continues, and demand is falling as the population of the Bay Area decreases, and the salaries of those who remain decreases. Prices have been driven by low interest rates and increasingly risky loans. Look around at the construction. Then drive by the Caltrain station and up the Embarcadero and look at all the new empty condos. Drive out toward Pleasanton or Livermore and look at all the plywood sprouting from the hills. Who is going to buy all this extra housing? The unemployed tech workers who haven't yet left the area are in no position to do so. This is even a national problem. According to, housing starts have been rising faster than the number of households since 1995.


    • Is there less land now than there was a few years ago? No, there is the same amount of land. Nobody is making land, but California hasn't fallen into the sea yet either.
    • Are there fewer houses? No, there many more houses on that land, increasing supply.
    • Are there more buyers? No, far fewer because so many people are unemployed and so many have left the area.
  5. "Population increase will fuel housing price increases."
    • The Bay Area is losing population the fastest of any area in the US right now - worse than Buffalo, worse than Detroit. The Bay Area climate is not helping at all.
    • Immigration won't changes this because jobs are emigrating even faster. Rents are falling in part because so many recent immigrants are leaving.
    • There is going to be a huge glut of housing as old baby-boomers sell their houses to use the cash for retirement, putting 20% of all houses on the market for that reason alone.
    • Birth rates are declining in all industrialized countries, with the US birth rate barely replacing the citizens who die.
  6. "As a renter, you have no opportunity to build equity."
    FALSE. Everyone can build equity by starting a business, investing in businesses that actually pay dividends, contributing to a 401K, or by simply saving money in a savings account. In fact, most other investments have a higher real return than housing. The NASDAQ was up 80% in 2003.
  7. "If you rent you are a buyer. You are just buying it for someone else."
    FALSE. Not in the Bay Area. It may be true that rent covers mortgage payments in most of the US, but the Bay Area is just the reverse. No one buys with the intention to rent out in the Bay Area because that's not viable. The owner is subsidizing the renter, a wonderful thing for renters during this crash.
  8. "If you don't own, you'll live in a dump."
    FALSE. It is easy to rent a much better house than can be bought with the same payment right now. Renters live better, not worse. There are downsides to renting, but if given a good place and a good landlord, it is possible to be quite happy renting during the crash.
  9. "If/when the market goes south, you can walk away."
    TRUE, but it's unwise to walk away because that ruins the buyer's credit record and causes bankruptcy. Even for those already bankrupt, a no-money-down purchase takes away from future earnings.
  10. "Buyers are rushing to buy now because..."
    FALSE. It is often heard that buyers are rushing to buy because:
    • interest rates are falling
    • interest rates are done falling
    • interest rates are rising
    If buyers are always rushing in, how much of a rush could it be? All the articles mentioning buyers runing in are quoting Realtors(TM). Consider how much advertising revenue newspapers get from Realtors(TM). The newspapers' customers are the advertisers like Realtors(TM), not the readers. The readers' place in this scheme is simply to believe everything they read and then go out and spend, so that the advertisers can take their money.
  11. "But the house down the street sold for 25% over asking!"
    FALSE. Realtors(TM) love to create the false impression of a hot market by deliberately "underpricing" a house. The Realtor(TM) knows that the seller won't take less than a million, but he puts out ads asking $800,000, just so that naive buyers will bid on it, thinking they might possibly get it for that. Then the Realtor(TM) can say "Look how hot the market is! Look what a good Realtor(TM) I am! My listing sold for 25% over asking!"
  12. "I was lucky that my Realtor(TM) told me to increase my bid by $100,000. Otherwise I would have lost, because my Realtor(TM) knew about a secret bid $90,000 above mine."
    FALSE. This is a way to lose an extra $100,000, which your Realtor(TM) will share in as part of his commission. It's a typical shill move.
  13. "But my neighbor told me the house down the street sold for such a high price."
    FALSE. In the Real Estate column of the Palo Alto Daily News on 2 April 2004: "Beware of the neighborhood grapevine. A combination of wishful thinking and enthusiasm can result in a rumor that a listing sold for an inflated price. The actual sale prices may be quite a bit lower."
  14. "OK, higher interest rates will drive prices down, but there will be lag--you'd have to wait some time."
    FALSE. It's instant and proportional. Once buyers are spending all they have, the only way to balance higher interest is with lower price. Same payment, but more of it goes to interest and less to principal. The loss in house value is the buyer's loss.
  15. "The Bay Area is a special place that will always be expensive."
    TRUE, but it's not getting more special, so it's not going to get more expensive relative to incomes. In fact, it will still be too expensive at half of current prices, which is where things are going.
  16. "There's always someone predicting a Bay Area real estate crash."
    TRUE, yet also irrelevant. Just because there is always someone predicting it doesn't stop it from happening. There are very real crashes every decade or so. Even a broken clock is right twice a day.
  17. "Sure my house fell 30% after 1989, but it's doubled since then."
    TRUE, but it's still a bad investment. Say a house cost $100, fell to $70, then went up to $140. So it's up 40% in 15 years. That's a bad investment - only 2.3% annually for 15 years, at great risk to the principal. A buyer would have done better with cash in a savings account. One may object that the gain is leveraged, but do not forgot that leverage works both ways: if a buyer puts only 10% down and the house goes down 10%, he has lost 100% of his money. If it goes down 20% he has lost 200% of his money.
  18. "But housing was high when interest rates were 21%."
    FALSE. Housing prices were only 3 times median income back then, much less than the 10 times income they rose to in 2000. More importantly, inflation was much higher then, so fixed debt was easier to pay off with increasing salaries. Here is a chart of median house price vs median income in Palo Alto:
    Year  Median House Price    Median Income   Multiple
    1970 33900
    1980 148900 24743 6.0
    1990 457800 55333 8.3
    2000 910000 90377 10.0
  19. "The government will make sure housing prices don't fall."
    FALSE. There have been many local crashes, and the government can't stop them. Every bad neighborhood with formerly nice houses is evidence of what can happen. On a national level, Greenspan's power to move interest down is eliminated when rates are near zero. He will raise them now just to gain more wiggle room to use later. Even if rates were zero, it would still take $33,000 per year in principle payments alone to pay for a million-dollar house over 30 years, and principle payments are not deductible at all.
  20. "Look, housing continued to rise after the dot-com crash, so it will always rise."
    FALSE, consider the turkey in the farmer's barnyard. He thinks the farmer will always come feed him and not ask for anything. Then Thanksgiving comes. Whack. Past performance is no indication of future results.
  21. "Rent can go up, but a 30-year fixed mortgage payment cannot."
    TRUE, but house owners lose anyway, because the value of a house falls as interest rates go up. No one can afford what the buyer paid for it, and taxes will go up, insurance will go up, and maintenance costs go on forever. Renters do not worry about any of those, and rents have been going down on top of that.
  22. "You have to live somewhere."
    TRUE, but it is possible to spend much less for the same kind of house, just by renting during the crash. A renter spends about $1,245 less per month in the example above. He could save hundreds of thousands of dollars, not only by saving every month, but by avoiding the devastating loss of his downpayment. Rents are very far down, and renting gives flexibility in choosing a place and choosing when to leave. The number of places for rent has skyrocketed, so landlords are desperate and very happy to lower the rent. Some residents of the Bay Area have already sold and are happily watching their old house fall in value while they pay relatively low rent for a few years.
  23. "Newspaper articles prove prices are going up."
    FALSE. The numbers in the papers are not complete. Those prices are "estimated" from the county transfer tax and making that tax public record is optional. There are many cheap sales which are never in the paper. There are the bargains that come on the market and get snapped up because they are for sale by owner, or because Realtors(TM) buy them and turn around and sell them for much more, or because the sale takes place through the foreclosure court.
  24. "It's not a house, it's a home."
    FALSE. It's a house. Wherever one lives is a home, be it an apartment, condo, or house. Calling a house a "home" is a manipulation of your emotions for profit.
  25. "If you don't buy NOW, you'll never get another chance."
    FALSE. This rumor goes around in every generation, yet there are always sellers and there are always buyers. Prices are always corrected when they get beyond what buyers can pay. In fact, they're being corrected right now.
  26. "I just want to own my own home."
    TRUE, most people do and that's fine. Buyers will get a chance in a few years when housing costs half as much and they have saved a fortune by renting. Home ownership is great - unless you ruin your life paying for it.

What should you do?

To win this game, buyers have to save up a big downpayment, and not buy anything, not even go look at open houses, until interest rises and prices fall much more. Sellers have to sell now, while they still can.


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