Tuesday, October 27, 2015

Million Dollar Shack: Why Real Estate Prices Will Collapse In Southern California

The following video is a treasure because it provides real life look into the housing bubble brewing in Southern California through the eyes of a "normal" middle class family in that area. They have been priced out of the housing market and, like many families living in the area, they are watching prices runaway to the upside while they try and save for a down payment.

The video shows tour buses filled with wealthy Chinese investors looking to deploy excess cash in American real estate. Most do not remember, but this exact same process occurred in the late 1980's when Japanese investors flooded the American real estate market with their excess capital. Their economy experienced a tremendous asset boom during the 1980's and money was flooding into America driving real estate prices higher. There was a fear at the time the Japanese were going to purchase "everything" in America and essentially take over the country.

The Japanese asset bubbles burst in the early 1990's and the buyers of American real estate quickly became sellers which helped create the savings and loan crisis that struck American banks in 1991. Once hot properties were bundled and sold to investors at a fraction of their late 1980's prices (both residential and commercial).

The echo bubble today is following the exact same process. China has experienced a real estate price surge over the last 10 years due to a government sponsored debt fueled mania. To help put the magnitude of their debt growth into perspective think about this: The entire U.S. banking system is $15 trillion in size. China has increased the size of their banking system debt from $10 trillion in 2007 to over $25 trillion today. That means they have added a debt mountain equal to the size of the entire U.S. banking system in just 8 years to an economy that is almost 40% smaller than the United States in terms of GDP. Almost all of this money has found its way into the Chinese real estate markets causing prices to explode higher. Excess capital from wealthy developers and real estate investors has poured onto American shores. While areas like New York and Miami have felt a surge in Chinese real estate investment, Southern California has been the focal point.

When China finally reaches its Minsky moment in terms of debt growth and the marginal buyer becomes the marginal seller this process will reverse, just as it did with Japanese investors in the early 1990's. If the technology bubble in Southern California were to burst at the same time China begins to deleverage you will see SoCal real estate prices plummet the way Las Vegas prices did during 2008-2009. Why? It will become a market of real buyers that must qualify for a mortgage. To help explain why prices will collapse in this environment please see the following excellent walk-through from Realty Trac on the impact from mortgage rates rising:

Why Real Estate Markets Could Quickly Stall

Perhaps my favorite part of the video below is the rock star Realtor who is confident prices will "double again" from their current levels over the next six years;

"The amazing part, I don't think it's going to end. I think fundamental supply and strong demand is going to drive this market forever."




The Grand Finale For Worldwide Asset Bubbles: Pre-Emptive Central Bank Action

One of the most thought provoking pieces I've read this year is Artemis Capital's October Newsletter titled "Volatility & The Allegory Of The Prisoner's Dilemma" (see below for the full newsletter). There are numerous subjects within the letter that are well worth expanding on, but I'd like to focus on one in particular here today.

Alan Greenspan took over as chairman of the Federal Reserve on August 11, 1987. Just two months after he was sworn in the U.S. stock market experienced the largest one day drop in history; a 22% decline. Greenspan immediately took action to calm the markets through interest rate cuts and liquidity. That momentous fall began the period the period now known as the "Central Bank Put." If the markets were to ever get into trouble, central banks would immediately react to the stem the crisis and "help" the markets resume their climb higher.

We saw this in 1987, 1994, 1998, 2001 - 2004 and 2007 - 2012. Each "put" became larger in scale and duration to help quell any concerns and push investors back into the pool of risk assets. The markets became accustomed to the put, but they were still aware a crisis needed to occur first, before central banks would take action. 

This all changed in the summer of 2012 when Mario Draghi unleashed his "whatever it takes" speech. The European Central Bank stood ready to print money to purchase an unlimited amount of government bonds to ensure yields remained at manageable levels.

Why was that speech key? Because it marked the end of the central bank put era and ushered in a new even more incredible chapter in central bank history. In today's financial world central banks do not wait for a crisis or market decline to occur before they take action; they now follow a policy of "pre-emptive" central banking. 

From Artemis:

"To differentiate, pre-emptive central banking refers to monetary policy action in anticipation of future financial stress to avert a market crash before it starts, even if markets appear healthy and volatility is low."

Just weeks after Draghi's speech in 2012 the Federal Reserve launched QE3. At that time there was little to no stress in the financial system, the economy was gaining jobs monthly, interest rates were resting at all time historical lows and the stock market had already doubled off the 2009 bottom.

In essence, Bernanke felt something could be coming so he decided to act before it even arrived. The following year in 2013 the Bank of Japan provided an encore with their own gargantuan QE program, which they then enlarged in 2014 (it's still running every month!). When the Bank of Japan launched their program to purchase government bonds, interest rates were already resting close to 0%.

The European Central Bank joined the party over the last year with a QE program which still runs today while interest rates across Europe are negative on government bonds years into the future.

Earlier this week they announced plans to enlarge the size of the current QE program and bring interest rates on deposits further into negative territory. Why? They have tasted the QE drug and love the way it feels. They want to pour more liquor into the punch bowl to make sure investors have no desire to leave the party.

More widely watched here in the United States was the Fed's decision to keep interest rates at 0% because the stock market had fallen about 5% off its all time record bubble highs in August.

The central bank put taught investors that if they were ever caught in a downdraft they would be quickly brought whole and could expect new highs in short order. Any dip was to be immediately bought in every market; stocks, bonds and real estate. The put policy was enough to create the environment entering 2008 that almost destroyed the entire financial system.

What we have today with the pre-emptive policy is far, far more troubling. Central banks are leveraging up their easing programs before the markets even have a chance to correct. Any fear by investors in risk assets that markets could even decline in the short term has now been erased. This, of course, is seeping into every asset class; stocks, bonds, residential real estate, commercial real estate, art, venture capital, private capital.....EVERYTHING.

The psychology behind this self-reinforcing paradigm is both fascinating and disturbing. It is the market's collective belief that central banks have the power to elevate and permanently push markets higher that is actually pushing markets higher. The danger exists because the narrative behind this paradigm is actually false. Central banks have no actual ability to push markets higher (as seen during their continuous easing during 2007 to 2009 while markets were collapsing). It is only a false belief in a power that does not actually exist that keeps a bid under risk assets.

At some point asset values reach an absurdity that is so far removed from reality that some market participants began to look around and become concerned. This moment can be delayed for far longer than rational participants can imagine, but it always arrives. It occurred for technology stocks in March of 2000 when a few investors looked at their portfolio of 300x P/E tech stocks and decided to take some profits. It will occur at some point as well for those investors holding negative yielding bonds for insolvent countries like Spain and Italy. The stories we will tell in the future looking back at the absurdity of the world we live in today will make people buying Pets.com in 2000 and purchasing 17 homes to flip in the Las Vegas desert in 2006 seem tame in comparison.

Unfortunately, the underlying losses are now baked into the cake. The U.S. stock market is now many deviations away from historical fair value based on real life fundamentals of the companies they represent. If interest rates for U.S. bonds were to rise only 300 basis points back up to around the 5% level (still well below historical levels) it would create losses across the board of at least 20% on portfolios (rising bond yields mean the principal value of the underlying bonds decline).

Those are only the losses you can instantly quantify. The secondary impact would be felt in asset classes around the world. Mortgage rates rising would essentially shut down both residential and commercial real estate activity. The junk bond market, perhaps the largest risk in today's bubble universe, would implode. The derivatives market, or the the insurance put in place to cover losses in the bond market, would reveal itself again the way it did in the fall of 2008. Who is the AIG out there that provided the insurance for the $5 trillion in fracking junk bonds (remember the entire subprime real estate market was only $1 trillion in size)? My guess is they are not going to have the cash to cover the losses.

How much longer can this go on? I have no idea. All I know is the further we go down this rabbit hole into the realm of the absurd, the greater the losses will be when the risk off mentality returns.

You can read the complete newsletter from Artemis below: