Some of the adjustment back to a normal level of inventory will simply be price adjustments. These losses will be taken by builders, homeowners and investors. The rest will come from all the houses that will NOT be built over the next few years as the slow but steady natural growth in households finally gets demand back in line with supply. This suggests a serious economic headwind over the next several years.

Five years out, things look much better. The excess inventory should be gone and the baby boomer’s kids start getting married and having kids. Until then though….

You live in random Midwestern industrial city. The housing market is terrible. Finally, you find someone who wants to buy your house but they have no money. Zippo. If they could come up with 5%, they could qualify for a loan and buy the house. Hey – why don’t you agree on a price 5% above your asking price, then kick back the 5% to the buyer who can get their loan by using the kickback as a downpayment?

Until Friday, this was totally legal for government guaranteed FHA loans- as long as you used a charity to stand in the middle as the go between. In recent years, up to 50% of ALL FHA loans involved downpayment “assistance.”

The housing and loan bubble was fueled by a lot of sketchy practices, and this one ranks right up there.

As I understand, Downpayment Assistance Programs (DAPs) have existed for a long time. They used to get actual charitable donations and help cash strapped but hardworking people buy houses.

In the late 1990s, a new type of DAP charity came to life. This one was closely linked to the real estate industry and, with the blessing of HUD and municipalities, pursued the seller as the ultimate donor.

The two biggest ones were Nehemiah and Ameridream. Over the last 10 years, Nehemiah has given $900 million in kickbacks, which may have supported $30 billion + worth of home purchases, mostly in low income areas.

Ameridream, founded in 1999, comes close with $400 million and $14 billion of home purchases.

This is big business, albeit one in a 501(3)c wrapper and one with crack lobbyists.

Following the money trail at quasi- charities is always fun. In this case, the loot appears to have been stashed in for-profit marketing affiliates owned by charity officials. A 2006 article tells of some house cleaning that has gone on at several organizations.

While the scandalous parts of this tale are fun, the most outrageous bit is the support these programs are still receiving from cities and elected officials.

Various parts of the Federal government have been concerned about the program from its inception. HUD and FHA don’t like it because the performance of loans with DAP is bad and they know prices are being inflated. The IRS doesn’t like phony charities. The GAO issued a scathing report in 2005.

So why did this program stay in existence for 10 years?

Because cities liked it. It clearly helped move a lot of property and may have even contributed to the boom in certain areas.

It was a quick fix to some long term, seemingly intractable problems.

The problem with short term solutions like artificially supporting the housing market is that they don’t address the underlying problems of decaying cities, the loss of manufacturing jobs and a cycle of poverty. They can even make the problem worse.

Overinflated sales prices are kind of like escalating CEO salaries. Just like the executive talent market, the real estate market is very driven by “comps” – prices that other houses in the area have sold for. And if you keep overinflating overinflated prices, pretty soon you have a bubble.

Nehemiah pioneered the seller-financed DAP in Sacramento, a city which is beginning to face the consequences of a bursting bubble. Many people, even those who can afford their mortgages, are now “upside down” – they owe more to the bank than they can clear on a home sale. Others who want to sell their homes cannot find buyers, even at discounted prices.

What was a virtuous cycle on the way up is now a vicious cycle on the way down.

You would think that officials would have learned their lesson.

Officials throughout the country are begging FHA to change its mind and continue to allow “gifts” from sellers to buyers. Nobody wants the music to end.

But it has.

Note 2: I know there are problems with the images.

Until recently, the US has been quite good about self-regulating its demand for new housing units. The number of houses and apartments that we need corresponds to the number of households in the US, a number that changes as the number of people in different age brackets changes. For instance, when the baby boomers left home and got married, housing demand soared again. When housing demand went up, so did prices and then builders went crazy building until demand was sated and prices came back down (at least on an inflation adjusted basis).

Below is a chart from a famous paper published in the late 1980s that shows how changes in price closely followed changes in housing demand during the preceding 40 years. While the paper’s conclusion that real housing prices would sink through 2010 as the baby bust generation (i.e. me) left home was controversial, the paper was convincing on the relationship between changes in price and demographically determined demand.

from: Greg Mankiw’s website

There are always a certain percentage of houses that are sitting around empty – some because they are second homes hardly ever lived in, some because they have been abandoned, and some because the owner has moved away / died and no one has bought the house yet. The census bureau does its best to keep track of these numbers and the consistency in the percentage of homes that are empty because they are being sold (the “vacancy rate”) is remarkable.

Take your average toddler and their food consumption. There may seem to be no rhyme or reason to individual feeding decisions, but they seem to end up eating just the right number of calories over a week. If you think of hunger being the signal our body gives us to tell us how much to eat, price has been a reliable signal to home builders about demand for houses. And historically, it has worked fairly well.

Original data source: US Census Graph: calculatedrisk.blogspot.com

Well, something happened over the last decade. We had rising prices without a corresponding increase in household driven demand for housing. Odder still, prices continued to rise over the last 2 years while increasing numbers of houses stood empty. This is the equivalent of deciding to eat Thanksgiving dinner every night, for a month. Maybe a year.

There will be fodder for many a Ph.d as to what kicked off this episode in American history. It may have been the stock market boom (the initial jump in prices could have just been Northern California and New York), it may have been some interest in vacation homes, it may have been the re-emergence of builders after their bankruptcies in the late 1980s, who knows. It definitely got major support from a combination of 1% short term interest rates, ARMs and securitization. The ability of speculators to buy up houses with only minuscule deposits may have been what turned excess into a full-fledged bubble. An estimated 25% of homes purchased in 2005 were for investment purposes.

What did the big residential builders do, faced with growing inventories? They kept building more houses. As a matter of fact, housing units are still being built. Yes, some projects are on hold but many others are still moving toward the finish line.

A couple of things are clear.

America will have to go on a housing diet. In combination with high levels of vacancy among rental properties, we are several (3-4) years away from growing our population and households enough to get back down to a normal level of house vacancies even with a drastically reduced run rate of home building. Normal would mean that if you price your house at market, you can expect to sell it in a couple of months.

A slight lowering of interest rates will not do anything. There are just more houses than people at this point. And there are a lot more houses than people who can afford them.

Prices are generally too high. They make no sense versus the cost of new building, they make no sense relative to rents, they make no sense in terms of affordability, they make no sense given inventory levels.

Prices could fall a lot. First there are the people who cannot afford to keep their homes at their current interest rates. Then there are the banks whose inventory of repossessed homes is growing. Countrywide alone already owns $2.5 billion of real estate, much of it in California. Then there are the speculators who cannot afford to pay any mortgage without a renter. Then there is the problem of home builders who NEED to sell or face bankruptcy. Hovnanian Homes just had the “sale of the century” to try and clear out inventory, a requirement to survive through this market cycle.

Real estate markets tend to work a little differently than stock markets. Prices take a while to adjust as many people will decide to just wait to sell their house until they can sell not a loss. The first sign of a troubled market is usually slowing sales. Then you see a buildup in number of homes for sale and homes take longer to sell. If it is really bad, sales continue to slow. The number of homes technically on the market may actually go down as discouraged sellers just decide to wait it out. Then, based on how desperate the homeowners are (home builders and banks tend to be impatient owners), prices may go down.

In this case, prices in some markets may go down a lot. In the worst markets in California it may be 50% plus. As a country, it could be 30% on average.

Then, we have the problem of mortgage equity withdrawal, better known as MEW. MEW is the net amount of money that people borrow against the equity in their homes – think home equity loans, cash out refinances. It is arguable that most of the economic gains of the last 5 years have been due to the spending binge of consumers on home improvements, cars, vacations, and even meals out using money from their homes.

First, imagine what happens to Home Depot and GM as that tap is turned off and the credit cards are eventually maxed out.

Then, imagine the potential losses of people who bought their homes anytime during the boom. Some of these losses will be borne by the lenders, some losses will mean the loss of life savings and some losses, for those who can sit tight over the next 10 years, may just be paper.

Then, imagine the loss of wealth felt by everyone. Despite the huge increase in home values, so little equity was put into new houses and so much money was borrowed against old homes that home equity as a percentage of home value is at record lows. If home prices fall back down to trend prices, and there is absolutely nothing I have heard that makes me think they won’t, a large percentage of American homeowners will be underwater. This undermines confidence, alters retirement calculus and presents a major problem for anyone who needs to move.

Please do remember that real estate is local and this reappraisal of American real estate will not be uniform. The most important variable in real estate is always supply versus jobs. Markets with a lot of empty homes where prices went stratospheric and are not consistent with local incomes will be hit hard. Places like Orange County who meet that criteria and will suffer a lot of job loss because of a downturn in the mortgage market will be disasters. Cities like Austin which did not experience a big boom and who have diversified local economies will be fine. Places like Silicon Valley with very little inventory at the moment will be okay, for the moment.

Looking out on the horizon, the good news is that the baby boomers kids are becoming adults and there will be an increase in households down the road to live in all the extra homes we built. The other good news is that homes may become affordable again for the average young family. There will eventually be some excellent investment opportunities.

If someone just gets a little overweight, they can increase their exercise a little bit or diet for a short period. If someone has become obese and wants to get back in shape, the measures required are more extreme. America, get prepared to count calories.