Whither stocks when real estate crashes?


Thinks s/he gets paid by the post
Dec 6, 2003
I've been watching real estate in my old home town of Orange County, CA. It's one of the biggest bubble markets in the country, with the affordability index at about 11%. I believe the bubble recently started to pop there (sales down, prices down, inventory up), and I expect it to get pretty ugly and for other regions to follow.

So, what will it mean for stocks if real estate craters?

When the last real estate bubble popped in 1990, we entered a 2-year recession. In Japan, real estate took down the entire economy, and it took them almost 15 years to recover.
C'mon, Wab, it's never that simple.

From Hawaii I would've said that the Japanese economy crashed because every bank in their country was lending to the keiretsu on the world's easiest margins, making good on their customer's dumbest investments, buying every derivative that Wall Street could cram down their throats, and hiding the whole thing under a web of interlocking partnerships & SPEs that made Enron look like a pack of Boy Scouts.

And we were also struggling through DESERTs SHIELD & STORM, which pretty well crushed the Japanese oil & travel industries, to say nothing of the American versions. And when the Japanese buying stopped (both retail & real estate), then Hawaii found out how leveraged our expectations really were.

But instead of coming clean, the Japanese financial industry continued to cover up-- drying up all liquidity and driving the economy straight into deflation. The govt also dried up liquidity in hopes of keeping a strong yen. Frankly they're lucky they didn't end up in America's 1930 Smoot-Hawley territory all over again.

Hey, this time it's really really no-kidding different. Sure, oil is tight for OPERATION IRAQI FREEDOM. And travel is tight from oil & terrorism.

But the financial industry has learned how to lay off default risk by selling the derivatives of that risk to insurance companies, institutions, pension funds, & retail investors. And every mortgage-holding bank or credit union has laid off their debt as collateralized mortgage operations, bought again by... you get it. Just look at Fannie & Freddie's latest contortions.

I think the nationwide real-estate runup has been pretty reasonable when today's record-low interest rates make mortgage payments about the same % of take-home pay as 1989. There still are (will always be) the pockets of excess that you've pointed to but the low rates and the Treasury's three shifts at the printing plant will keep things from crashing.

Hawaii's 21st century real estate boom began not with the Japanese but from Silicon Valley. A portion of those investors smart enough to flee tech sank their profits into Hawaiian land & trophy homes. Maybe as real estate falls off, people will liquidate their equity and buy QQQs?

FWIW things are slowing down here too. Statewide June/July price & volume records weren't broken last month or this month. (Maui & Kauai were another story like Orange County.) But schools are back in session and the seasonal slowdown may be upon us all. We'll know more in another six months!

I think that Florida real estate-- what's left of it-- will go through a crash & rebound as frustrated retirees flee for Arizona (no rain?) this December while optimistic value investors slowly flow in to buy them out next summer.

And I'd sure hate to be an insurance company holding its float in a large basket of illiquid derivatives right now. Warren Buffett's probably looking at the large-cat & re-insurance competition right now and licking his chops.

I bet that Florida Power & Light stock is approaching deep-value territory this weekend... so it should be pretty immune to potential future downward pressure?
Indeed at least part of the underlying assumption is that there is a real estate bubble. From what I can read and tell, the coastal business centers have risen steeply but there is still a huge section of middle American where things are just plodding along. Here in Denver, we've seen maybe 2-3% a year increase for the last few years. The only housing sector that seems weak are the upper priced McMansions.

I think there are global areas where people have just adjusted to high priced housing, with no bursting. London might be one example I can think of.
No disrespect to Denver, but I'd guess that the coastal cities that do have a bubble probably represent something like 30% of the US population. That's a pretty big chunk of the economy, and the first effect of lower real estate prices is generally a reduction in consumer spending due to people feeling less "rich."

Couple that with the rest of the current economic trends, and things could get interesting.

If we start seeing defaults, I think Nords is right that banks have offloaded a lot of the risk. Assuming most mortgages are bundled and sold on the secondary market as CMOs, and those securities are backed by the Federal government, that means that ultimately the risk has been offloaded onto tax-payers. Which is the same place it would have ended up if we were bailing out banks, so the "risk management" ends up as mere indirection.
I live in North county San Diego and houses and condo cconstruction is still very very strong. But many people are buying houses they can't afford....Zero to little down interest only ARMs. New condos are going for $400-$600K + and new houses are going for $600-$800K +.

I personally see a train wreck ahead in San Diego if long term interest rates rise sharply.....ARM payments go up....SD housing prices start to fall....many people $50-100K+ underwater with rising ARM payments....what will all these home buyers do who have little or no net worth?.....maybe pay for awhile then probably drop off the keys and walk away.

If this happens, it won't be good news for the stock market. Consumers will feel less rich. I agree with TH that 2005-2006 could be (very) ugly for the stock market. I read an interesting article by a well known ecconomist who said 2005 looks like a black hole....with virtually all assets being over valued...I believe he lives in Washington state?.....I will post if I can find.

I know I'm being cautious as the end of 2004 draws near. I feel this could be a very bad time to be heavily leveraged with SD housing or equity margin....I don't like equity margin at anytime actually.

What will I do if all this happens....probably lower my withdrawls to say $600-$700 per month and ride the storm out....surf everyday the waves are good, study Spanish with Latina girls, and eat fresh in Costa Rica and Panama.

Non of this could happen....we'll all know in a few years. If it does happen... I'll probably just spend less. What would everyone else do?

Buy REITS that own apartment buildings in the bubble areas...

All of those mortgage defaulters have to go somewhere.. :p
Re. "What will I do if this happens?" Surfing, studying Spanish with Latin girls, and eating fresh in Costa Rica
and Panama sounds pretty good regardless of what the
DJIA is doing, or any other financial info for that matter.

John Galt
Weird - big article in New Orleans paper about well heeled developers coming into Ivan hit areas hoping to buy real estate from people who don't want to rebuild. A monster expensive condo building boom is expected. Large 'hurricane proof' buildings (condos?) did ok and the developers say the land is 'not quite as outrageous in price' as other coastal areas. ? Go figure?

Blue water Gulf and white sands - although a lot of it needs to be put back on the beach where it belongs.
John Galt,
I agree that surfing, studying Spanish with latina girls, and eating fresh fish in Central America and South America sounds pretty good.

If the grim forecasts that TH and I are forecasting happen within the next two years, I'll continue to do the above but just have a few less Imperial and Panama beers each week :D

So, what will it mean for stocks if real estate craters?

If real estate gets discredited as an investment, some of the money in real estate may wind up in the stock market. Money transferred from commercial paper, cds, and bonds to real estate after loaning money became discredited in the wake of the high inflation 70s.
If real estate gets discredited as an investment, some of the money in real estate may wind up in the stock market.
A lot of money went into real estate as a result of the recent bear market in stocks (including a bunch of mine).   But it's much harder to move money from hard real estate to stocks than vice versa.   And that assumes that people can escape with some equity after leveraging themselves up the wazoo via low down-payments and HELOCs.

If real estate does crash, and people become averse to investing in real estate, that might be a great time to buy.   As somebody with too much cash, I'm hopeful  :)
But it's much harder to move money from hard real estate to stocks than vice versa.

Yes it is, suggesting that this would be a slower process. People would be inclined to buy enough house to live in, and not more as an investment. New money would gradually funnel into alternate investments. Many local governments would respond by further restricting the building on new homes in an effort to support prices. This will tend to make potential price drops uneven accross the country.
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