Feedback Loops

The Housing Market - Wall Street
"Two-Step"

The dynamic now playing out between the housing market and Wall Street reminds me of one of those classic, Muhammad Ali-Joe Frazier title fights.

For those too young to remember, the fights were the ultimate, knock-down, drag-out affairs. By the late rounds, the two combatants, barely able to stand (let alone defend themselves), simply took turns pummelling each other with what little energy they had left.

Substitute "the credit markets" and "residential housing," and you have a pretty good idea of what's been happening to real estate in many markets nationally.

As discussed in my July 8 post ("Vicious Cycle"), falling home prices drive down the value of mortgages -- plus all the various side bets on mortgages. That impairs credit-creation via Wall Street and the banking system, which makes mortgages harder to get and more expensive . . . which further crimps demand for real estate, driving prices down some more. Rinse and repeat.

Call that the "macro" vicious cycle.

The "micro" vicious cycle operates wholly within the housing market.

Here's how it goes: Real estate drops, which drives nervous Buyer and Sellers to the sidelines -- Buyers because they don't want to catch the proverbial "falling knife," Sellers because they don't want to accept another price cut (or can't, if they're "upside down" on their mortgage and can't bring a check to closing). That causes real estate to drop some more, which causes more people decide to wait, which causes another go 'round.

For many people, uncertainty is worse than unmitigated -- but definite -- bad news. At least you know what to do with bad news. But what do you do with uncertainty? Wait for it to lift, usually.

Recovery Scenario

That dynamic explains why so many commentators and people in the industry are so laser-focused on calling the bottom (never mind that "a watched pot never boils").

Calling the bottom is crucial, because that's when the various negative feedback loops operating in so many markets begin to weaken, and, eventually, reverse.

So what do you look for? Interestingly, not what everyone seems to be focused on: changes in inventory levels; the level of pending and closed sales (and trends therein); and, of course, prices. My guess is that those are actually all lagging indicators -- they merely serve to confirm that the market has already bottomed (employment levels play the same role in the life cycle of recessions).

Rather, the first sign of a bottom -- the twig indicating dry land to Noah -- is likely to manifest as a (subjective) firming of the market, first picked up on by -- you guessed it -- the most plugged-in realtors.

A nice house in Linden Hills, with great character and a surprising amount of space, is priced aggressively at $399k -- and gets it right away. An architect-designed contemporary in Fern Hill, with over 3,000 FSF, hits the market priced conservatively at $650k -- and quickly gets that, too.*

Six or eight more deals like these around town, in quick succession, and suddenly a soggy real estate market has better tone. That fires up commission-hungry realtors to do more deals, which lures more would-be buyers and sellers back into the market, which firms up the market even more.

Animal spirits, indeed.

Sexy . . . Prices

At the low end of the market, the pace also picks up, if only because the banks are finally getting religion about clearing their balance sheets, and have dropped the prices of their foreclosed homes accordingly.

Not every house can look sexy, but every house can sport a sexy price. Eventually, even a distressed home in a tough(er) part of town is cheap enough to allow someone to make a profit -- if only the builder buying the property for the land if/when the condition of the home slips too far. In many neighborhoods, in many communities . . . that point has already arrived.

Only after these positive loops gain some traction -- and the old, negative ones start to fade -- do the statistics everyone's watching turn positive.

*Actual sales the week of July 14-18.