Invaluable financial data for millennials, and anyone else outside of the top 1%
I know I could have used the song’s actual title, “For What It’s Worth,” but that wouldn’t grab your attention as well.
Enjoy this song while I summarize the history of past crashes and look at where we are in the ever accelerating economic cycle.
1. A brief history of banking and economic crashes
There have been a large number of financial bubbles and crashes in our history, that you can read about in more detail here. But here’s a good chart that summarizes our history of recessions and banking crises:
For about a century, without any regulation, we had bank panics on a very regular basis. After the Great Depression, a ton of regulations were passed that created a much more stable economic environment. For about 50 years, the economy enjoyed a period of relative stability, which still included normal business cycles of expansion and contractions. (Here is a history of all the recessions since the Great Depression.)
Over all, the post war period of 1946–1970 was one of unparalleled economic growth for the middle class. People could afford to buy houses, send their kids to college, and save for retirement.
However, those regulations were eased again under Reagan and finally repealed under Clinton, resulting in the following hit parade of financial shit storms:
1980–1991: S & L Crisis
1990: Recession (the result of Reagan’s deficit spending)
1994: Real Estate Crash (California only)
1998: Bail out of Long Term Capital Management (huge warning sign that was ignored by free market thinkers like Alan Greenspan, resulting in the 2009 crash)
2001: Dot.com bubble Stock Market Crash (precipitated by interest rate hikes by the Federal Reserve — thanks, Chairman Greenspan)
2009: Financial Meltdown (and resulting real estate crash)
The point here is that we have seen an increasing number of crashes happening during shorter intervals.
2. A brief history of recent California real estate crashes
While you may think this has no connection with you, think about California as the canary in the mine shaft.
In 1989, California real estate was at an all-time high. A nice family house in the north San Fernando Valley (not the expensive areas near Ventura Blvd, or in the hills below Mulholland Drive) was sold for $325,000.
In 1990, the recession started, and by 1992, the real estate market had dropped dramatically.
In 1994, after the Northridge Earthquake, we saw the absolute bottom of the market, as there was a net state population loss for the first time every. That nice house I mentioned earlier went into foreclosure, then suffered earthquake damage, fell out of escrow four times, and eventually was purchased for $180,000. (The good news is, the massive insurance payouts for all the damaged homes resulted in a much quicker turnaround in the California economy that coincided with the rise of the internet, giving us a few relatively prosperous years during Bill Clinton’s administration.)
In 2003, prices had increased significantly. Almost 50% of California mortgages were interest-only loans. That means people had no stake in their homes. It also meant that these loans would come due in five years, when homeowners would either have to refinance their homes or come up with payment in full. Banks completely ignored underwriting regulations. Loan brokers were told they could issue loans up to 120% LTV, while not verifying employment. Appraisers had to come in at the sale price, no matter how ridiculous the value, or they faced being black listed.
By 2004, prices had almost tripled, and they increased more than 40% over the next two years, as the market hit its peak in 2006. From here, the market stabilized for a year.
In 2007, the housing market crashed. This caused all the over-leveraged banks and insurance companies that were using derivatives backed by toxic real estate assets to eventually crash. For a really entertaining explanation of this tragedy, I highly recommend the movie The Big Short.
3. Where is the real estate market on the spectrum from collapse to unsustainable bubble?
Here are some interesting charts to help explain where we are in the current cycle.
The cost of the median 3-bedroom house in California in September 2007 (the end of the bubble) was $472,000. The median price of that same house was $480,000 in August of 2017.
But we do have to take into account inflation and the current value of a dollar. Here’s a calculator that shows how the value of money has changed over time.
From the perspective of inflation, we are not yet at a similar point in the housing bubble. The median price for California 3-bedroom homes would have to climb to $558,907 to equal the height of the last bubble.
Hopefully, there is still a little time for you to prepare for the next crash. Some “experts” think the market won’t reach its peak for another two years.
Remember that nice little house in the north SF Valley that sold for $325,000 in 1989, then dropped almost 45% in value by 1994? Let’s look at the value in present dollars that house would cost at the height of the 1989 real estate bubble:
Now, check out this screen shot of Zillow’s current value of a house that is almost 1,000 square feet smaller.
Zillow estimates this small house is worth almost $700,000. With $130 down payment, you could have a house that would cost over $2500 per month, not including home owners insurance and real estate taxes, which would add another $600–700 per month. So, we’re looking at about $3,200 per month to own a small home.
It should be noted that the cost of a 2-bedroom apartment in the Valley is around $2,000 per month. And if you wanted to rent a similar house, it would cost somewhere between $2,800 and $3,500 per month.
Investment adviser William Bernstein offers the rule of thumb that you should never pay more than 15 years’ fair rental value for any home. Based on that, a $3500 per month rental house would be worth only $630,000.
One can make the argument that with tax deductions and the money you pay toward the mortgage principle, we’re not at the point of saying definitively that it is better to rent than buy. This is important because if there are no more buyers, the real estate market will drop sharply.
Remember that nice little house in the north SF Valley that sold for $325,000 in 1989, then dropped almost 45% in value by 1994? Let’s look at the value in present dollars that house would have cost at the height of the 1989 real estate bubble:
Now, check out this screen shot of Zillow’s current value of the house:
Based on price per square foot, the house would have sold in the $800,000s at the height of the bubble. Using the current value of 2006 dollars, the house would have to sell for over $1,000,000. So there is some theoretical room for the market to continue to grow.
We have already surpassed the 1989 bubble, so the question is whether we can surpass the 2006 bubble. While no one can predict the future, here are some of the factors that helped the 2006 bubble continue as long as it did:
- The Bush administration was using wars to finance the economy and keep voters happy. By not including the Iraq and Afghan Wars in the budget, the government was just printing money to pay soldiers and defense contractors.
- By not enforcing financial regulations, the government allowed the banks to churn bad loans to increase their profits, but also pay all the people working in real estate related industries.
- The Baby Boomers started to retire. As these people cash in their retirement plans, sell their homes and move to cheaper locations, they have more disposable income in the short term and continue being strong consumers.
- A large part of the population still believed in the American Dream. Even though my generation lived through the 60s, OPEC oil crises, and the failure of trickle down economics, we still believed that we would survive and our children would prosper.
- Government stability. Regardless of how many bad things Bush and Cheney did, the Democrats did not call for impeachments when they took power in Congress in 2006. Nor did they threaten to shut down the government in order to end the war in Iraq, or push for some progressive reform.
Unfortunately, none of those factors exist any more. Obama made the wars part of the budget, so we know exactly what the costs are and how it affects the deficit. Banks have had to pull back and become much stricter with their underwriting rules, making it harder to get loans, even for the people who can afford to buy a house. The early Boomers are now making their way to assisted living, which costs a fortune, or require so much medical care they are now a financial burden to their families, pension plans and the government. We’ve seen the results of the Bush disaster, and the largest demographic group in the country hasn’t seen the American Dream working throughout their adult lives. And finally, we have Agent Orange and his walking Constitutional time bomb. Need we say anything about stability?
Also on the negative side, price-to-income ratios are incredibly out of whack in Los Angeles and Orange County, worse than any other big city in the country. This means people living with parents or roommates well into their 30s and 40s, decreasing home owners and increasing numbers of renter, and a net loss in workers over the last six years.
For the moment, foreign investors are keeping the market going, but that, too, shall pass. Over all, there aren’t a lot of positive factors that would support continued price increases.
4. Other indicators of a rapidly approaching crash
Real estate, the stock market and the economy are connected. When something goes wrong in one sector, it will eventually affect the others.
Consumer beliefs and behavior can increase the likelihood of a crash.
Remember those huge real estate gains between 2003 and 2006? Instead of people living within their means, a large part of the population used their houses as a virtual ATM, buying cars, boats and vacations. Once the market dropped, these people owed more than their homes were worth, and were paying so much more on their additional debt that they couldn’t afford to stay in their homes. This resulted in thousands of short sales and foreclosures.
For the people with interest-only loans, it was the easiest thing in the world to just walk away from their homes, resulting in thousands of foreclosures. Even those that wanted to stay and were capable of making their mortgage payments, had to make a balloon payment at the end of the loan’s five year term. With a dip in value, none of these houses could be refinanced, adding thousands more properties to be foreclosed.
When everybody’s selling… there are no more buyers
There’s a famous story about Joe Kennedy (JFK’s father and an immensely wealthy investor) and his decision to get out of the stock market before the 1929 crash that resulted in the Great Depression:
In the winter of 1928, Joe Kennedy decided to stop to have his shoes shined before he started his day’s work at the office.
When the boy finished, he offered Kennedy a stock tip: “Buy Hindenburg.”
Kennedy soon sold off his stocks, thinking: “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over.”
My observation is about all the get-rich-quick-in-real-estate “with no money down!” courses. Like Trump University. Guess when they started their scam? 2005, with real estate at almost all-time highs, but still in the frenzy of speculation.
After the crash, as the real estate market continued to drop until it hit its low in 2012, these scams disappeared. Guess why they disappeared? Because they were out making tons of money on all the deals that were out there.
Over the last few months, I’ve started to see the reappearance of the get-rich-quick-in-real-estate courses. These are truly the worst kinds of scams as they don’t teach anything you couldn’t learn about real estate on the web. They invite you to a free seminar, and then spend a few hours trying to get you to pay $200 for a three day intensive course. At that course, they try sell you on personalized investor training that costs $25–50K, for which you get nothing but a couple of software apps.
Acts of God, or those who think they are…
Our fragile economy features weak wages, fewer worker benefits and ongoing efforts to deregulate nearly every consumer and public protection in this country. Meanwhile, real estate is near or at its peak and the stock market is at all-time highs. Any one of the following acts could cause another major real estate crash which would drag down the stock market and then the rest of the economy:
- A big earthquake
- A major terrorist attack (but only those perpetrated by non-whites)
- Agent Orange firing off some nukes in response to a nasty tweet
- Constitutional crises
- Civil War
You get the idea. If the experts think things could keep going for another couple of years, they won’t. And when things go bad, they go bad really fast.
The only business I’m betting on at this point are companies like these:
4 Person Elite Survival Kit (72 Hours)
The 4 Person 72-Hour Elite Emergency Preparedness Kit has all items packed securely in our large wheel duffle bag. This…
Next, time, if there’s a demand for it, I’ll write about what people can do to not only prepare for the bad times, but take advantage of them.