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For the last 18 or so months, I’ve been telling you why an epic real estate crash is almost guaranteed AND on the near horizon. I now think that it’s very likely that it could happen this year, possibly shortly after Labor Day. Here’s why…
Most people buy a house based on the down payment that they can afford and the monthly payment they can afford.
As an example, if someone has $1,000 a month to spend on the principal and interest portion of a mortgage, they can get roughly $222,000 of house at 3.5% interest.
Right now, 30 year mortgages are being advertised at 3.5% or less. Meanwhile, real inflation, according to the St. Louis Fed, the American Institute for Economic Research and ShadowStats.com is in the 8-8.5% range. To explain why this is a problem, we need to look at banks quickly.
Some businesses are easy to understand. A hardware store buys a wrench for $1, sells it for $3, and if they sell it in a short enough period of time, and cover all of their expenses, they make 30-60 cents apiece. Do that enough times with enough items, and they stay in business.
The bank version of a wrench is cash. They buy dollars from customers in the form of CDs at a low interest rate, and they sell those dollars to other customers in the form of loans, like mortgages with a higher interest rate. So, a bank might offer 2% interest on CDs, turnaround and loan it out at 5%, and if the borrower pays on time, the bank makes 3% before expenses. Historically, the spread has been about 2.7%, but it tends to get smaller as rates go lower and get bigger as rates go higher. There’s a whole extra layer of complexity when you include fractional reserve banking, but it’s not necessary to talk about that right now.
With proper underwriting, this is a fairly stable system. Banks compete for CD money and usually have to pay customers close to the rate of inflation, or even a little more.
In recent years, this system has been turned upside down. Instead of borrowing money from customers in the form of CDs, banks are increasingly borrowing money from foreign nations and the Federal Reserve at incredibly low rates that have driven CD rates and mortgage rates down to unrealistic and unsustainable rates. In simplified terms, we’re both creating money out of thin air and borrowing money from China and other countries at rates that are lower than the rate of inflation, and that cheap, plentiful money is propping up the real estate market.
At some point, China, other Treasury buyers, and CD buyers are going to demand a return on their money that is at or above the rate of inflation in the US. So, let’s see what would happen if banks started offering CDs at 8%, or slightly below our current 8.5% inflation rate, and they loaned it out at 10%.
That $1,000 payment that currently buys a $222,000 house at 3.5% only buys $114,000 worth of house at 10% interest. This is HUGE. That’s a 48% drop in value, and in my mind it’s not a matter of if it happens, it’s how soon and how quickly it happens once it starts. In addition to propping up OUR banking system, the Fed is currently pumping hundreds of billions of (fiat) dollars into foreign banks to try to prop them up and keep the global financial collapse from hitting us.
To add to the problem, banks are still estimated to be holding a “shadow inventory” of 2 MILLION houses that they aren’t putting on the market and have an untold number of additional houses in default that they aren’t foreclosing on.
Because if banks would actively foreclose on houses in default and sell all of the houses they have in their REO inventory, it would look bad on their books for their next FDIC stress test. As it is, if they don’t foreclose and don’t try to sell their foreclosed houses, they can claim that their market value is much higher than it actually is. If you’ve ever heard people like Billionaire Kyle Bass from Hayman Capital talking about “mark to market”, this is one of the applications. It’s the process of re-stating corporate balance sheets with the actual market value of their assets, rather than their inflated value. Mark to market is both necessary for long term stability AND it would be a crushing blow to the stock market and banking system.
Houses have historically gone up in value due to inflation and rising wages, more demand than supply, low interest rates, and poor underwriting. In most parts of the country, low interest rates is the only one of those factors that’s still having a positive effect on housing. Inflation without rising wages doesn’t necessarily help housing. More restrictive underwriting and higher down payment requirements have squeezed many buyers out of the market and made supply higher than demand. All in all, we’re starting to pay the piper for the artificial increases in real estate prices since 2001.
Many people don’t realize that the crash we’re about to experience right now actually started with the shutdown of the sub-prime market in 2001. Ironically, the 9/11 attacks are what “saved” us from having a crash in late 2001/early 2002. In response to the 9/11 attacks, Bush encouraged a policy of low mortgage rates, lax underwriting, and the benefits of home ownership. These policies went counter to market forces and have simply amplified and postponed the eventual crash that we’ll experience.
The situation is similar to a wind loaded cornice. If you’re not familiar, it’s a situation where you’ve got a mountain ridge that gets a lot of snowfall and has a prevailing wind. Over the course of a winter, big overhangs of ice and snow form.
Many years ago, I did both back country guiding and ski patrol and wind loaded cornices are a BIG danger in the back country. From the top, it may look like you’re safely standing on a ridge, but in reality you’re standing 10 feet out from the ridge with nothing but a snow cornice below you.
The crazy thing about cornices is that they look and feel stable…until they’re not, and then you’re hosed.
Cornices are one of the things that avalanche crews focus on breaking free to keep skiers safe at resorts. Blowing cornices loose and letting them fall is the only way to create a safe, stable mountain for skiers. As long as there are cornices above or below skiers, it’s only a matter of time until the cornice(s) break free and take people out.
The parallels to our current situation are extensive. Our current economy is built WAY out on a fragile cornice and the only ways to stabilize things are to prop up the cornice or for it to fall and for us to ride out the resulting avalanche.
I see this playing out in one of two ways. Either prices will suddenly and catastrophically drop due to an event, or China and other Treasury buyers will pressure the Fed to start raising rates gradually but consistently over the next several years.
3 other factors:
1. The Fed says they’re keeping rates low through 2014, but they also have to keep the IMF, OPEC, credit reporting agencies, and Treasury buyers happy, so there’s no telling what will happen.
2. Japan has been in “dead man walking” mode for most of the last 22 years and there are new signs showing that they’re about to fall. They’re the 3rd largest economy in the world, they’re printing and injecting their economy with more money than we are (comparatively) and it’s having no effect.
3. Believe it or not, a lot of the major market traders take the summer off. (Wouldn’t that be nice?) As a result, there’s a good chance that the Fed will wait until these guys are back from vacation (Labor Day) to make major announcements.
Enough of the doom and gloom…what can you do to put yourself in a good position if this happens?
The first thing is to not worry about it happening. You have control over the decisions you make, but there isn’t anything that you can do as an individual to keep food inflation, higher interest rates, or market crashes from happening.
If you have a home that you intend on staying in long term, enjoy it and don’t worry about the value.
If you just bought a home at “historically low” interest rates and don’t plan on staying there long term, you may want to reevaluate your plans with a trusted and competent financial adviser. As a former stock broker, I’d suggest finding someone who understands and enjoys macro and micro economics and real estate. This isn’t a conversation to have with someone who only understands insurance or only understands stocks. Forward this article to them, have them look at it, and get their thoughts. HOPEFULLY, I’m all wet and there’s no basis at all for my concerns. This is a case where I’d absolutely love to be wrong and to get hundreds of emails telling me how wrong my analysis is.
If you are looking to buy a home in the near future, get to know the major players in the real estate investor community in your local area and try to buy a house that’s significantly under market value. There are incredible deals (25%-50% below retail) across the country right now that will give you some cushion if interest rates shoot up and prices drop.
If you’re currently living in an urban area and looking to buy a piece of rural land that you could use as a retreat location and grow food on, don’t waste any time but don’t make any rash decisions. Specifically, don’t pay too much for a bad piece of property. Also, look in non-conventional places to find properties for sale. As an example, if EVERYONE in your area looks in the MLS, Craigslist, and the newspaper to find properties, then make sure you’re also looking in the Thrifty Nickel and on Ebay.
Also keep in mind that the increase in farm prices, the drop in inventory, and increase in demand make it more likely that if a disaster happens in the near future that you’ll need to survive right where you currently live. Remember, the workable plan that you have in place will ALWAYS beat the perfect plan that you haven’t taken action on. Keep making daily forward progress in improving the survivability of your current living situation. And if you haven’t checked out the www.SurviveInPlace.com Urban Survival Course lately, I encourage you to head over to www.SurviveInPlace.com and check it out.
Two other resources I want to encourage you to consider the following:
1. Gold, silver, and other precious metals. Specifically, Tom Cloud from Cloud Hard Assets. I did an interview with him a few weeks ago that you can read here:
2. The Elevation Group. This is a VERY alternative investing newsletter run by a couple of good friends of mine. What they have done is team up with some of the very best financial advisers in the country (including “Rich Dad, Poor Dad” author, Robert Kiyosaki’s advisors) to be able to share many of the “black box” investing secrets of the ultra rich that allow them to make money regardless of what happens with the markets.
How good of friends are they? I’ve actually stayed at both Robert and Mike’s houses within the last 2 weeks and helped Mike get one of his newborn goats his first colostrum from his mother and start sucking. They’re good guys and The Elevation Group is definitely worth checking out.
What are your thoughts on my analysis of the real estate market? I’d actually love to have it shot full of holes. How about other factors in the market that you’re seeing? Share your thoughts by commenting below:.