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Banks Bleeding Value And Hiding Desperation as US Housing Slump Continues

Stock-Markets / Credit Crisis 2008 Mar 24, 2008 - 08:42 AM GMT

By: Ronald_R_Cooke


Best Financial Markets Analysis ArticleThe decline in fixed asset values continues. Homes. Shopping Centers. Commercial and industrial properties. Land. And the decline is not done. Not by a long shot.

Residential Housing
Let's look at the decline in residential housing valuations.

According to National Association of Realtors data, average American home prices have declined by ~ 13% from their high in June 2007 to January 2008. Unit sales were down ~ 23% during this seven month period. Although unit sales are expected to increase this spring, property valuations are still under downward pressure.

Geography plays a big role in real estate valuations. Prices are either stable or increasing in many specific geographic markets. In bubble markets like California , however, current asking prices are out of sync with reality. Higher quality home sellers are asking – on average – for $270 - $340 per square foot. Lower quality and obsolescent properties have listing prices of $214 to $268 per square foot. The larger the lot (particularly for homes with acreage), the higher the asking price. On the other hand, actual sale prices are declining. According to the California Association of Realtors, the median price for a single family California home declined by 21.9 percent from January 2007 to January 2008. A review of foreclosure data shows that average Bank repossession sales are in the $178 to $260 per square foot range.

If we run the numbers, it is highly likely the final sales price of higher quality properties will come down another 15 – 20% from current asking prices. Lower quality and obsolescent property values will decline by another 8 – 12%. In this scenario, the net loss from the highest real estate valuation in 2006/2007 to the actual sales price in 2008/2009 for higher quality properties could exceed 35%. Lower quality and obsolescent home values loses could exceed 20%. In some California communities, over 30% of the “For Sale” listings are in foreclosure. It is highly likely Bank repossessions will frequently be sold at a discount to the original loan value.

The point about the sub-prime mess that everyone seems to be missing is this: a high percentage of mortgages in these “bubble” markets (including refinance and second loan deals) now exceed, or will soon exceed, the sales value of the underlying asset. That's all mortgages. Prime or sub-prime. Furthermore, purchase home values will tend to decrease until there is some reasonable equilibrium between rental and purchase home values. Or to put it another way: why would I pay $268 per square foot for a purchase property when I can rent an equivalent house for $195 per square foot? ( For lower quality properties, and assuming a 7% gross ROI, this means the owner occupant who pays $1.81 per square foot per month can reduce cash outlays to $1.14 per square foot per month by renting an equivalent unit).

This is actually happening. As banks continue to unload Real Estate Owned (REO) properties (where the bank has foreclosed and taken possession of the property), and property owners find it is better to rent, rather than sell, their vacated property, the number of rental units will increase. For a buyer with cash, it's a good investment so long as rental income exceeds property ownership costs.

Does that mean our banking system will continue to suffer a decline in the value of its fixed asset portfolio?


If consumers – on average – are strapped for cash to pay current expenses, they will max out their credit card debt (thus further increasing the risk of loan defaults), and cut back on discretionary purchases. Since they are unable to borrow against the value of their home, many consumers have no way to sustain their prior lifestyle. Let's face it. For them, monthly income will be less than monthly expenses. There are only two ways out: bankruptcy and/or create a new downscale lifestyle. For some, that means spending less on shelter. The monthly cost of owning a home must be competitive with the monthly cost of renting a home.

In California the median down payment for property purchases in 2005, 2006 and early 2007 was less than 17%. Most of these loans are under water. With no equity left, buyers are now able to treat monthly home mortgage and tax costs as rent. Under pressure to cut their cost of living, and with the need to re-allocate monthly income from housing to food and fuel, consumers will be forced to consider less expensive shelter. This is both a direct and an indirect result of high oil and natural gas prices, increasing world demand for more and higher quality food, the inflationary impact of America 's ethanol program, and the shortfall of current agricultural production.

In effect, Banks have become property managers. They “rent” to the buyer. If the value of the house goes up, the buyer can cash out the additional equity by refinancing the mortgage or taking out a second loan. If the value of the property does not change or declines, the buyer may chose to walk away from the loan.


Under existing accounting rules, Banks can cook the books by claiming income long before actual cash comes in the door. Option loan income includes interest which has not been paid, but merely added to the balance of the loan. Earnings from mortgage backed securities can be booked as income long before they are earned. Banks have considerable flexibility when it comes to identifying the status of bad debt. Add these items up, and a bank may face asset losses that exceed reserve capital.

It would appear to be imprudent to claim this will be a short and mild recession. Conventional economics looks at dead data and assumes the numbers look good for a quick recovery. Cultural economists, like me, look at what is happening to consumer lifestyles. And that picture is not good. Higher food and fuel costs do force a reallocation of consumer financial resources. They will have to spend less on other non-discretionary purchases – like housing. They will have less free cash to spend for discretionary purchases. A return to more conservative financing rules, and relatively weak real estate values, have effectively eliminated the use of home equity financing as a sort of savings account that can be tapped at will for more cash.

No. The collapse of our financial markets is not over. The value of debt financed assets (fixed asset deflation) will continue to deteriorate until intrinsic value roughly equals the underlying debt. Look for further declines in the value of:

•  residential real estate (single family homes in one to four unit structures),

•  commercial real estate (shopping centers, apartment buildings, office buildings, industrial properties, and land),

•  mortgage backed securities and collateralized debt obligations (CDOs), and

•  leveraged debt (including derivatives).

What determines intrinsic value?

•  For hard asset properties, two parameters. How much the buyer or renter can afford to pay per month, and the availability of lower cost alternative properties.

•  For leveraged debt: there must be an identified asset with a stream of income sufficient to cover monthly debt payments. If one can not determine the underlying asset upon which the income stream is based, then the paper is worthless. And that – is one of the problems with CDOs.

I'll stick with my prior estimate: loan losses from all financial instruments will exceed $700 B

With the full support of Congress, (including Senators Clinton, Obama and McCain) the Fed is giving copious quantities of cash to the big investment banks that got us into this mess. No one is being held accountable. These banks will spend the cash. But when its gone, the mortgage default problem will still be there. We are committed to printing an unlimited amount of money to keep a small number of insider institutions solvent.

This would appear to be a high risk and very inflationary strategy.

But. I could be wrong. You decide.

Ronald R. Cooke
The Cultural Economist
Author:  Detensive Nation

Cultural economics is the study of how we interact with economic events and conditions. Culture, in this sense, includes our political systems, religious beliefs, psychology, history, customs, arts, sciences, and education. The term "Economics" refers to the extent and process of how we employ capital, labor and materials. If human existence is dynamic, then economics – as a science – must be able to characterize the interaction of culture and economics in contemporaneous terms.

Ronald R Cooke Archive

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26 Mar 08, 12:59
You could be right

I'm not an economist, but I "get" what you are saying. I live in Los Angeles, and the prices of the homes for sale that I've been paying attention to haven't been dropping all that much. That, and everyone I know (ok, 1 person) who was actually willing to purchase a house right now had such a difficult time getting a loan, that her deal fell through. Frankly, this is the first time in my life I've been glad to be a renter, but now rent prices are skyrocketing and I am wondering how we're going to make it. Even with rent control, if the local gov says that the property value is up, they can raise our rent 5% or more than the typical 3%. There is some serious disconnect between reality, the government, what people (like myself) earn for a living, and the costs involved with living.

27 Mar 08, 12:06
Housing Market View from Michigan

I live in michigan and we have been on the bleeding edge of the housing crash. Our values never were over inflated and in the past two years still have dropped 30%. Unlike California we are a recourse state. So if the bank forecloses they can sue the homeowner for the difference in the sales price and the mortgage. That's not the case in California and people can walk away from their mortgages. California values are going to drop WAY more than 30%.

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