Fallout Scenarios

[rose-colored-coolaid]

One of the most important behaviors that smart people and smart organizations participate in is planning for catastrophic scenarios. I know "The Secret" and other name-it-to-claim-it belief systems are prefaced on thinking only about the positive, but in the real world the people who follow such ideologies are saved by those of us who plan for both the good and the bad.

In that light, I wanted to start a thread dedicated to predictions about how the housing bubble will fallout. I believe almost everyone in America recognizes it is a bubble now, so let's start there. We have already seen foreclosure spikes in the most inflated markets and price drops on a national level. So what's next?

I'll start. Keep in mind, I am making no likelihood prediction, only offering scenarios to consider.


Scenario 1) Massive correction - largely contained to housing - that over corrects towards the downside before stabilizing. Prices have inflated by (some say) as much as 100%, so this scenario predicts a collapse of 50%-80% before prices stabilize and again see reasonable gains. Other than builders, lenders, and real estate agents, everyone pretty much keeps their jobs. Such a scenario might take 3-5 years to play out.

Scenario 2) Inflation induces declines which are felt but largely unrecognized. In this case, prices are flat or slump slightly until inflation causes the value of the house to match historical norms. Rent will increase each year until it approaches mortgage prices again somewhere around 2027.

Scenario 3) Priced-out-forever: a massive number of people become homeless, crime rises considerably, and the pseudo-American-Dream of homeownership will never again be recognized by the masses. 65%-70% of people own their home today, but as they die or new residents immigrate, the percent of owners declines forever. This second class of citizen realizes that no legal means exist for them to rise above poverty and homelessness. These vagabonds eventually outnumber the homeowners. Either violence erupts or the massive voter block of POFs (priced out forevers) forces America into being a socialist nation. The time horizon for this is forever.

Scenario 4) The housing slump causes a national or global recession/depression. Millions lose their jobs, and all assets decline in value against the dollar. The decline in asset valuations makes manufactured goods cheaper and the reduction in oil demand pushes out peak oil a few extra years. Asian nations initially suffer when there are no customers for their exports, but the demand is eventually filled by Asian markets which are becoming increasingly self sufficient. Eventually the USA comes out of it's slump to find wages here are more in line with BRIC (Brazil/Russia/India/China). We reestablish the American manufacturing base and sell cheap American goods to China to build our economy back up.

Scenario 5) Housing declines significantly, but not precipitously. Some areas see double digit declines for 2-3 years, but most properties decline less than 40% and more than 15%. Overall demand for housing units decreases as speculation is driven out. This reduces cost of supplies (concrete, wood, paint, etc) to where replacement cost for a typical 3 bedroom 1,700 sq ft house are below $100,000 (excluding land and permits). This creates a vicious downward spiral towards replacement cost, with many people losing their homes and most speculators going into bankruptcy. The government attempts to stop asset deflation, but are unable to while still protecting the overall economy. The next president only has a 4-year term. The fallout causes a general malaise to run through all financial sectors as lending is viewed as more risky. Rates increase, which slows down economic expansion. Leveraged buyouts stop occurring, and anyone investing in Blackstone loses their shirt. The cost of debt hits the stock market brining it down towards 2002 levels again before it enters another long secular bull market around 2017.

[The Tim]

Great subject. Coincidentally, I was just thinking of making a post on this very subject. My question would be something like "what's your worst-case scenario, best-case scenario, and most-likely scenario for Seattle's housing market?"

I will probably do that post this week, and I'll definitely link to this thread. Hopefully we can get some interesting discussion.

[sniglet]

Despite my prevarications I still give about a 70% chance that a major real-estate bust will hit the Puget Sound resulting in nominal price losses of at least 50%, but likely far more (depending on locale).

I just don't see how all those people in our region with exotic mortgages (e.g. 100% finance, 100% interest, negative amortization, etc) are going to pull through if there is any kind of significant slow-down in depreciation. We have geared our market to REQUIRE appreciation or else the whole house of cards will come crashing down. I repeat my belief that comparisons to previous downturns don't apply here since we are in entirely uncharted waters with regards to the number of home-owners without any equity cushion.

If Puget Sound real-estate were to experience zero, or even slightly negative, apprecation for just one year it is a virtual certaintly that a massive wave of foreclosures (from these equity poor home-owners). So far Seattle has been spared the mass defaults seen in other states because the magic of appreciation has bailed out the equity deficient owners. But just see how quickly that can change when the virtuous appreciation/re-finance cycle stops. Then we will have a vicious depreciation/default cycle.

Further, I expect that credit standards are going to continue tightening over the next year as the mortgage securities market continues to bleed. Before this is over I believe we will hit a point where the ONLY loans available are GSE conforming, except for those willing to pay horrendous interest rates. I expect we will start to see a lot more seller financing too.

All this will occur in the context of the first prolonged nation-wide real-estate slump since the great depression. The global economy will undoubetdly be significantly impacted, and nearly every Seattle area employer will institute hiring freezes, and in most cases out-and-out lay-offs. Aircraft orders will be cancelled as global economies struggle, and software sales will slow down dramatically as companies and consumers put off upgrades in an effort to conserve cash.

This is my top-level prediction for the next 4 or 5 years. The only alternative I can see is some major re-flationionary campaign that results in currency destruction. I just can't see some middle course where we muddle our way through.

That said, I am optimistic. I think we will come out of the coming downturn better than ever, with capital being allocated properly once again. We need a good purge every 20 years or so. It's just been far too long since the last cleansing so we have some catching up to do.

[sniglet]

I think Tim's "worst case" scenario (posted on his blog) is a bit optomistic. In the "worst" case I think we are going to see nominal housing prices drop far below 1997 equivalents. The "recession" Tim talks about would more aptly be called a "depression", and have global implications (e.g. China will tank just like most other economies).

Also, I think that the propability of this "worst case" scenario is far greater than 50%. As I've said before on other threads, we are in comopletely uncharted territory here, with the explosion of easy credit and exotic mortgages leaving our market MUCH more fragile than at any time in the past (by an order of magnitude). A large percentage of Seattle area home-owners have no equity cushion to help them weather a downturn. We are vitually guaranteed a massive wave of foreclosures when depreciation stops.