The Pareto Principle and the Next Wave Down in Real Estate
oftwominds.com
In February 2007 I suggested a 4% mortgage delinquency rate could trigger a decline in the entire housing market. Since that proved prescient, we should revisit the analytic tool behind that call: the Pareto Principle.
There is a whiff of euphoria in the housing market, a heavily touted confidence that "the bottom is in." It's all roaring back--rising sales, multiple bids by anxious buyers, 3.5% down payments, low mortgage rates and the bonus of an $8,000 first-time home buyer credit (a gift from U.S. taxpayers). Housing Lifts Recovery Hopes (Wall Street Journal)
Foreclosure-related sales account for over 30% of all sales nationally, and over 70% in hard-hit markets such as Las Vegas, but like piranhas feasting on a school of weakened fish, nobody in the real estate business mentions the huge losses of capital and equity which created all these "bargains."
All we need for a complete bubble reflation is people avidly gaming the system... oh wait, we have that, too. A recent Time magazine cover story on Las Vegas contained this informative tidbit (courtesy of Michael Goodfellow):
(Realtor) Boemio specializes in short selling, in a particularly Vegas way. Basically, she finds clients who owe more on their house than the house is worth (and that's about 60% of homeowners in Las Vegas) and sells them a new house similar to the one they've been living in at half the price they paid for their old house. Then she tells them to stop paying the mortgage on their old place until the bank becomes so fed up that it's willing to let the owner sell the house at a huge loss rather than dragging everyone through foreclosure. Since that takes about nine months, many of the owners even rent out their old house in the interim, pocketing a profit.
Hmm, isn't this the same recipe of froth, low down payments, cheap, easy mortgage money and scamming which got us in trouble the last time? Only the lenders lose, but then now that Ginnie Mae and FHA have stepped up to replace the disgraced, bankrupt shells of Fannie Mae and Freddie Mac, then it really isn't the lenders taking the risks, it's the U.S. taxpayer (again).
It's the same old mispriced risk and misallocated capital which created and popped the housing bubble in the first place, with the lagniappe insanity of giving people $8,000 of taxpayer funds to prop up home sales to benefit builders, realtors and lenders. (Hats off to their lobbyists--Congress stood on its hind legs and barked on command. "How many years to the next election, Tuffy? Bark! Good dog--only one!")
It's not just new buyers and gamers buying--it's investors plunking down all cash for "bargains," in many cases outbidding each other just like the good old days. 'Cash is king' in market for foreclosed homes (SFGate.com)
All-cash sales are most common where prices are low and bank-owned properties account for the lion's share of listings. In foreclosure-ridden Pittsburg, for instance, 42.7 percent of home sales in the first three weeks of July had no record of a purchase loan, according to county data analyzed by MDA DataQuick. The median price for those transactions was $105,000.
For the same period in San Pablo, 45.1 percent of sales appeared to be cash transactions; their median price was $110,000. In the Bay Area overall, 22.2 percent of sales in the July period looked like cash transactions; their median was $200,000, DataQuick said.
"Houses are less expensive than they've been in over a decade, and there is a Gold Rush mentality out there," said Andrew LePage, an analyst with San Diego's DataQuick. "If you want to be the one who gets the house, in some cases you just have to have cash."
Despite the cheerleading, the gaming and the "Gold Rush mentality" there are a few flies in the ointment. Topping the list: almost one in seven mortgages are distressed--in foreclosure or delinquent:
4.3% of mortgages in foreclosure (marketwatch.com)
The non-seasonally adjusted delinquency rate increased from 8.22 percent in the first quarter of 2009 to 8.86 percent this quarter.
The delinquency rate includes loans that are at least one payment past due but does not include loans somewhere in the process of foreclosure. The percentage of loans in the foreclosure process at the end of the second quarter was 4.30 percent. The combined percentage of loans in foreclosure and at least one payment past due was 13.16 percent on a non-seasonally adjusted basis, the highest ever recorded in the MBA delinquency survey.
Moody's Economy.com estimates that lenders will foreclose on 1.89 million homes in 2009, up from 1.43 million last year.
Then there's these factors:
Souring Prime Loans Compound Mortgage Woes (Wall Street Journal)
Improving Home Sales Belie Market Reality (Wall Street Journal)
Can Vanished Real Estate Wealth Come Back? (Wall Street Journal)
I have applied the Pareto Principle to the housing market over the years, and now that foreclosures have hit the critical 4% mark, it's time to revisit the 4/64 rule and the 80/20 rule. I was introduced to the Pareto Principle by longtime correspondents Harun I. and U.K.C. The Pareto distribution quite effectively predicted that the 4% "vital few" subprime defaults would have an outsized effect on the 64% "trivial many" households with mortgages.
Readers of this blog learned in May 2006 of the likelihood that 5 millions homes would soon be in foreclosure:
How Many Foreclosures Will Hit the Market? (May 1, 2006)
Can 4% of Homeowners Sink the Entire Market? (February 21, 2007)
How 4% of Mortgages Have Brought Down the Entire Market (August 21, 2007)
Will Delinquencies Trigger a New American Revolution? (April 7, 2008)
Feedback Loop of Recession: Housing Bust, Debt and Layoffs (March 10, 2008)
Could 50% of All Homes End Up in Foreclosure? (June 3, 2008)
Why Housing Is Far from Bottoming: Depression, Demographics, Defaults and Dumps (October 8, 2008)
Bingo, foreclosures are on track to exceed 5 million shortly. (1.3 M in 2007, 2.3 M in 2008 and 1.8 M (est.) in 2009.)
Critics might well ask why the The Pareto distribution should apply to the mortgage/housing market. It is a fair question, because the Pareto Principle is not causal--it merely captures the distribution probabilities within groups.
That said, there are a number of fundamental causal drivers which suggest the 4% of homes in foreclosure will have a dramatic, long-term negative influence on the value of 64% of the housing market (the 4/64 rule).
Once the number of distressed mortgages rises from 13% to 20%, then we can anticipate the 80/20 rule will apply: those 20% will wield an outsized influence on the remaining 80% of mortgages. Recall there are about 50 million mortgaged homes in the U.S. and about 25 million owned free and clear. The value of all homes will be pressured as foreclosed and distressed housing is placed on a saturated market.
A key driver of future delinquency is negative equity. Owing more than the value of the home saps homeowners' willingness to "stay the course" and keep sacrificing to pay the mortgage. Regardless of your opinions on the morality of this trend, it is undeniable: |
