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The housing bubble hangover, part 2

July 3, 2010

A booming ‘shadow inventory’ in the housing market is almost certain to bring another wave of falling prices and another round of Federal Reserve stimulus.

By Bill Fleckenstein

MSN Money

Economic and financial problems are now garnering more attention as the “Goldilocks” viewpoint that prevailed earlier this year has disappeared — which isn’t surprising, as that view was only a mirage anyway.

Thus it looks to me like we may be just a data point or two away from seeing the Federal Reserve launch a second round of stimulus, which is sometimes cloaked in the obfuscatory term “quantitative easing” — or, as I’ve referred to it lately, “Q.E. II.”

If I may mix nautical and aeronautical metaphors, our illustrious Federal Reserve chairman, Ben Bernanke, may already be getting long aviation-fuel futures for his next helicopter mission. I say that because of a Bloomberg TV interview June 23 by former Richmond Fed chief Al Broaddus, who is considered by many to be a tight-money “hawk.” (Watch the video here.)

Among other things, Broaddus said that he had expected the language in the Fed’s June 23 communiqué to be “markedly more pessimistic, less optimistic than the corresponding statement after the April meeting.” Of course, it wasn’t markedly different; it was just somewhat weaker. Perhaps the Fed is trying to avoid spooking folks. Broaddus also noted that weakness in the housing market “increases the probability” the Fed will be happy to let Q.E. II set sail.
Much of the blame for upcoming weakness can be laid at the feet of housing, although there are going to be additional culprits. As folks know, government incentives have mostly run out (though the time to close on a home and get a tax break was extended), and supply is building and liable to swamp demand. That should lead to lower prices, which will likely also impact psychology.

Scared of its own shadow

Recently mortgage banker Mark Hanson nicely laid out a handful of reasons for housing’s excess supply, or “shadow inventory.” Readers may recall from the real-estate bubble days that I used to refer to Mark as “Mr. Mortgage,” before he revealed his identity. He understands the housing and mortgage markets better than anyone else I know, so I thought I would share some of the causes for pent-up supply mentioned in his recent report:

  • The 8 million loans in some stage of delinquency.
  • Short sales, which are surging and are now government-endorsed through the Treasury Department’s Home Affordable Foreclosure Alternatives Program, and may be the ultimate form of shadow inventory due to the fact the borrower does not have to be delinquent and the property never has to be listed on the Multiple Listing Service. With almost 30% of the 57 million homeowners who have mortgages owing 95% or more on their property, the pool of more than 15 million homes that are short-sale eligible is a mega-threat.
  • Modification re-defaults, which, according to Standard & Poor’s, will occur at a 70% rate. Based on the national loan modification surge that began in earnest only in the third quarter of 2009, and the ultimate bubble we are experiencing now, we are seeing just the positive effects of modifications and not the negative re-default effects. But the leading edge of the re-default wave is upon us now, and before long it will produce a new and substantial channel of mortgage loan defaults and foreclosures that few are modeling at this time.
  • An improvement in sentiment and price stability in some regions that has encouraged homeowners to sell after holding off for three years as the market crashed. In fact, as sales surged last month, thanks to the taxpayers’ gift (the homebuyer credit), inventories rose sharply, catching even National Association of Realtors economist Larry Yun off guard. He commented on it after last month’s existing-home-sales report. This is the first evidence of pent-up supply having a negative impact on housing fundamentals.

I agree with Hanson that the effects of all this are only just beginning to be felt, but it seems to me that the second leg of falling home prices is probably under way. That, plus high unemployment, ought to force the Fed to swing into action.

We could be stuck here awhile

As for the stock market, I have shared my expectations for a somewhat “rangy” environment, in which the market neither crashes nor makes significant progress to the upside (versus the 2010 highs), supported on the one hand by money printing and stimulus but hampered on the other by immense fundamental problems. Thus far, the range on the Standard & Poor’s 500 Index ($INX) has been roughly 10% or so — i.e., from 1,020-ish on the downside, to 1,130 or so on the upside. I expect those “bookends” will probably widen over time, most likely on the downside, and I would not be at all surprised to look back in a few years to find out that the S&P traded between 850 and 1,150.

To me, the probability seems high that we could experience an extended period where the market averages essentially go nowhere (they’ve done that for a decade already), much as we saw in this country from 1966 to 1982. For reference, during that entire period, the Dow Jones Industrial Average ($INDU) traded in essentially a 300-point range, with around 1,000 on the high end and about 700 on the low.
In the past two weeks, the market has traded at both ends of the recent range, but prospectively, if a large, long-term trading range develops, I wouldn’t expect both the upper and lower bounds to be touched every other week.

About Bill Fleckenstein: Bill Fleckenstein is president of Fleckenstein Capital, a money management firm based in Seattle. He writes a daily Market Rap column for his website,, as well as the popular column Contrarian Chronicles for MSN Money.

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