When Forecasts Go Bad

Many people don't know that economics is really a social science; sure, there's a lot of math and stats involved, but they're only barometers to explain the behavior of people and markets. That's why the book Freakonomics was such a huge hit -- it helped explain the hidden meanings behind economic case studies (such as crack dealers living with their mothers) that at first glance didn't make sense.

The fact that economics is a social science is also why forecasts can go bad -- sometimes very, very bad. Writing earlier this month in Slate, author Daniel Gross (one of my favorite writers & commentators) argues that certain forecasts are inherently suspect:

...within the fraternity of financial and fiscal forecasters, the seers at the National Association of Realtors—longtime chief economist David Lereah and his successor Lawrence Yun—may be uniquely ill-equipped to deliver sobering forecasts. They work for a trade group whose mission is to buck up the spirits of real-estate brokers. And real-estate brokers—who live to sell, promote, and market—are constitutionally disinclined to hear anything but good news.

That's also why you might see similarly (relatively speaking) rosy forecasts from other trade group sources such as NAHB, although since their magazine, Builder, is licensed to be published by another company, Hanley Wood, the magazine can remain more objective. That's also why you might expect the CBIA to release bad news on a Friday afternoon in order to minimize coverage by the state's newspapers (sort of like when the White House declassifies documents on a holiday weekend).

These trade groups are in a tough spot: they don't want to anger those members they represent, and yet they want to be viewed as objective and appropriate news sources to the media, although Gross argues that NAR took it to the extreme:

Indeed, as I noted last summer, Lereah's penchant for putting out positive spin on dismal housing numbers inspired a blog and led critics to dub him the Baghdad Bob of real estate. Lereah has moved on. But Yun has picked up where he left off.

In addition to claiming that the sun is shining brilliantly even as rain pours down from the heavens in a mighty stream, Lereah and Yun have also hazarded optimistic, educated guesses about the future.

I think these guesses have really hurt the NAR's credibility as well as those of all real estate agents, many of whom are much more responsible with their clients when it comes to hazarding guesses about the future. Markets go up, markets go down, and there's always risk involved. Period.

So what about other economic forecasters? Why do they get it wrong? Several reasons according to Gross:

There are some institutional reasons for this: Many economists are associated with corporations, Wall Street firms, and trade groups, where it doesn't pay to be bearish. Others fall into the trap of extrapolating existing trends into the future. But given the complexity of the contemporary world, the huge range of variables, the unrelenting flow of data, and the fallibility of humans, it's likely impossible to forecast consistently with any accuracy. And it's especially difficult to project economic activity when the economy reaches inflection points—times when the economy is about to go from expansion to contraction, or vice versa.

Certainly relying on past patterns alone could allow a forecaster to ignore an inflection point. Writing in the New York Times, author Peter Bernstein offers a recipe for botching future predictions:

From the end of 2002 to the early months of 2007, prosperity seemed firmly rooted and even touched by some kind of magic. The Fed appeared to have inflation under control, productivity was high, no squalls were hitting the stock market, the dollar’s decline was orderly, home prices generally rose steadily, and the unemployment rate fell in many months. Even better, investors could buy all those interesting new forms of financial paper invented by the engineers, offering high yields at what the rating agencies assured investors was low risk.

But the magic was not in concrete; it never is. The conviction that risks were low led investors to take greater risk without requiring higher expected returns. By late 2006, the Fed was wrestling with inflationary pressures from oil and food, productivity had lost its momentum, housing prices had been declining since summer, and the mortgage markets were starting to crack.

Nevertheless, like me in 1958, investors refused to see the ground shifting beneath them, even though the environment was no longer what they knew and thought they understood. Like me, they were walking into a trap where the responses were not what they had anticipated. Like me, they were headed toward big surprises for which they had no preparation.

The Science of Guesstonomics

Remember a year ago when many economists were predicting flat or very weak growth in the housing market? This was well before the mortgage issue arose, so most were looking just at inventory and sales numbers.

So why should anyone believe their forecasts for 2008? I'd argue that it depends on the performance of their previous predictions, and CNNMoney's Chris Isidore provides a summary. Some highlights:

Greenspan & Bernanke:

Former Federal Reserve Chairman Alan Greenspan and his successor Ben Bernanke, after reviewing home sales and mortgage rates in fall 2006, were hopeful that the market had bottomed out.

"It may be too soon to say that it's over. It may not be too soon to say that the worst is over," said Greenspan in an October 2006 speech in Richmond, according to press reports.

In a November 2006 speech, Bernanke said he saw some "encouraging" signs in recent housing reports.

Many commentators think that Greenspan ignored the ultimate consequences of a housing bubble with increasingly lower short-term interest rates and that Bernanke has not seemed concerned enough about the market's meltdown.

Lawrence Yun, NAR (thank God they got rid of former Chief Economist David Lereah, who in February 2006 published Why the Real Estate Boom Will Not Bust—And How You Can Profit from It.). Thanks to him, numbers from all trade groups are now suspect:

The National Association of Realtors made a forecast a year ago that was far more optimistic than those by Wyss and many other economists. The Realtors expected only a 1 percent drop in the pace of existing home sales, and a 1 percent gain in median prices. Instead, 2007 will likely end with a 12.5 percent plunge in the pace of sales, and nearly a 2 percent drop in prices, the first such decline on record.

The group's current forecast for 2008 calls for a 0.5 percent increase in the pace of sales, and a 0.3 percent rebound in prices. But Lawrence Yun, chief economist for the trade group, said that making forecasts is even tougher this year than it was a year ago.

Yun forecasts essentially flat prices in 2008. Yet, he also believes there's at least a one in four chance that prices will fall more than they did this year, and about the same chance that prices could rebound by 3 percent or more.

"I would not be surprised if home sales improves in 2008," he said. "At the same time I can also foresee a circumstance where buyers continue to pull back, the inventory sitting on the market continues to build and it causes prices to go down further."

I think Mr. Yun is flailing a bit, but he's right that economic forecasts are always tricky. Of course I also remember when CAR's Leslie Appleton-Young said she needed more time to come up with an appropriate term when the market peaked and started trending downward, thus suggesting she was caught unawares.

Robert Shiller (co-founder of the Case-Shiller index):

Robert Shiller, a Yale economist who had argued for years that a bubble was forming in real estate prices, points out that one group was on target about where prices would go - investors in a real estate futures market that he helped set up on the Chicago Mercantile Exchange.

Starting in May 2006, the CME set up futures contracts for 10 metropolitan real estate markets, allowing investors to bet whether prices would go up or down and by how much.

By the end of 2006 those futures were pointing to real estate price declines between 5 percent and 7 percent in those markets, Shiller said. That ended up in line with the 6.7 percent annual decline in the October reading of S&P/Case-Shiller home price index, which was the largest drop recorded in that 20-year-old price measure.

"I'm not normally an advocate of market efficiency, but there's something to be said when you're putting money on the line with your prediction, rather than just talking," he said.

Those futures today are far more bearish about future housing prices than most current economists - foreseeing an additional 4 percent to 14 percent drop in prices over the next year.

Although the Case-Shiller index doesn't track all cities, its strength is its focus on matching sales of the same properties. Plus Dr. Shiller has a good point when he says, "there's something to be said when you're putting money on the line with your prediction, rather than just talking."

New home sales down nationally but up in the West

From the notoriously revised Commerce Department statistics, new home sales fell to a 12-year low in November but were up by 4% in the West. According to the USA Today story:

The sales pace for November was much weaker than economists were expecting. They were predicting sales to drop around 1.8%, to a pace of 715,000.

I take two things from this article: (1) Economics always offer guesstimates and so never really know for sure (such is the nature of predictions, although they do offer solace to some people which keeps psychics in business); and (2) Expect revisions next month from the Commerce Department since the survey less than 5% of permit reporting places nationally.

Higher Gas Prices Bad News for Commuters

If you read the comments to various housing blogs, you'll notice many predictions of across-the-board price declines of 30% or more, but I don't think it's that simple.

According to an LA Times story, Californians should expect gas price approaching $4.00 per gallon in 2008 (Happy New Year!):

"If anyone expects gas to be less than a new record, they are not thinking," said Fadel Gheit, senior energy analyst for Oppenheimer & Co. "There is no question it will be much higher than last year."

Americans will start 2008 paying about 65 cents more a gallon than they did in January 2007, according to the forecasts, and by April could see self-serve regular selling for $3.50 to $3.75 a gallon.

In California -- where gas this year has fetched as much as 50 cents more than the national average -- $4 a gallon "will no longer be considered a rogue number," said Tom Kloza, chief oil analyst for the Oil Price Information Service. "It will list for that much in a lot of places."

So what does that mean for far-flung areas with poor public transit options and requiring a long (and increasingly expensive) commute? Probably larger price declines than in areas which are within walking distance of various MTA lines or require shorter commutes. For example, I'd expect sellers to offer greater discounts in Palmdale than in North Hollywood, but only time will tell.

Perhaps next time politicians try to float a sales tax increase to fund public transit options in certain counties in which they've been voted down, voters will take it more seriously.

Loan defaults moving onto Option ARMS

The next wave of potential loan defaults is expected to involve Option ARM loans made to borrowers with good credit according to the LA Times. Why were these loans so popular? Simple math and greed:

Before standards were tightened, several mortgage brokers and former and current Countrywide employees said, it was easy to sell option ARMs to borrowers by focusing on the low minimum payment.

As the housing market boomed, borrowers figured they could always sell the home at a higher price if they got in trouble -- and brokers pocketed big rebates for selling option ARMs, said John Diamond, a Chino broker with 39 years in the business.

Although a broker might earn $4,500 for selling a $300,000 fixed-rate loan, Diamond said, the commission could total $12,000 on an option ARM of the same size.

"These loans drove the whole industry from late 1999 through late 2006," Diamond said. "It was just about the only thing any broker wanted to sell."

I remember those days well: if you were bold enough to demand a traditional 30-year fixed rate loan, you had to be prepared to steadfastly stand behind your decision, which wasn't easy when others were bragging about their low teaser rates and payments. Suddenly anyone who could fog a mirror was becoming a loan broker, including cab drivers and personal trainers (and I'm not making this up). It was really little more than "Take the Money and Run" (no offense to Woody Allen, of course).

I just wonder where the media was when these loans were taking off: if newspapers and TV stations were regularly doing stories on the different types of loan options -- and the consequences -- would it have mattered?

Some good news: the world economy has never been healthier!

While some Americans have been failing Home Economics 101 and splurging on things they didn't need or could appropriately afford, from this Newsweek story the rest of the world has been behaving... (drum roll, please)...quite responsibly! While it's too soon to know if a newly adult world will help bail the U.S. out of its housing-induced hangover, it's still good news that once we recover the world's economies will mostly be on better footing:

For the past four years, the world has grown at a 5.2 percent annual rate—a full 2 percentage points higher than in the '80s and '90s—thanks in large part to booming emerging markets. While the United States and many parts of Europe are lagging, most of the rest of the planet is soaring. Consider that between 1980 and 2000, the number of countries growing at 5 percent or more hovered around 50. In 2006, 104 nations grew at that rate...

Even as Western consumers have fudged on retirement savings in favor of flat-screen TVs, and Western governments have skimped on education and infrastructure, emerging nations have been paying back debt, taming inflation, strengthening their institutions, diversifying their economies and generally behaving like responsible global citizens. The result has been a huge range of benefits: fewer hungry children in Tanzania, increased political stability in Brazil and a more balanced global financial system, in which nations previously labeled unstable debtors are now extending credit to richer countries...

Emerging nations are no longer just extracting resources and supplying cheap labor, but growing their own massive middle classes, breeding world-beating companies and becoming players on the global financial stage. Such developments—the prospect of China suddenly being a major source of investment capital, cash-rich Latin American countries banding together to lend to one another, Russia emerging as the top luxury-car market—have defied the predictions of the world's collective economic wisdom.

Bueno trabajo!

Reverse Mortgages to the Rescue

Since the Bush Plan to Save Housing won't assist any borrowers who can't make their existing mortgage payments, the reverse mortgage has arisen as a potential savior for older buyers looking to pay off a toxic loan while receiving steady monthly payments from their built-up equity. Writing in the Wall Street Journal:

Reverse mortgages used to be a way for homeowners to get extra cash during retirement. Now they're also being used for a more-pressing purpose: helping people who are struggling to meet payments on high-interest-rate loans to keep their homes.

The strategy, which is relatively novel but gaining popularity among legal-aid attorneys and housing advocates around the country, calls for persuading lenders to take the cash generated by a reverse mortgage in lieu of foreclosing on older homeowners...

Other public-service attorneys around the country are turning to reverse mortgages as a way to negotiate lower payoffs for subprime loans made to older clients. In Chicago, for example, "we advise a lot of clients that a reverse mortgage is appropriate when it's the only way to keep them in their home," says Michelle A. Weinberg, a supervisory attorney at the Legal Assistance Foundation of Metropolitan Chicago. "The same people have been refinanced over and over again to very little benefit for themselves, with high fees."

It won't bail out everyone, but it could help older borrowers who claim they were misled by lenders who didn't divulge the details of loan resets down the road.

Lot Write-Downs to Continue?

On the heels of Hovnanian's $638 million loss for fiscal year 2007, Bloomberg's Jonathan Weil thinks (in an opinion piece) that the large gaps remaining between builders' stock prices and book values (or assets minus debts) implies future impairments to come:

Eight of the nine U.S. homebuilders with market values of at least $1 billion now trade for less than their book values. Some like Pulte already have taken large writedowns on everything from real estate and joint ventures to goodwill. Yet their plunging stock prices indicate bigger charges to earnings may be needed.

Under the accounting rules, companies mainly use internal estimates of future cash flows to test whether assets such as real estate may be impaired. If the values aren't supportable, companies must write down the assets to their so-called fair values, though these may be only loose guesses.

Pulte is one of five companies in the Standard & Poor's 500 Homebuilding Index; the others are Centex Corp., D.R. Horton Inc., KB Home, and Lennar Corp. While the five companies have a combined book value of $22.7 billion, the stock market says they're worth just $15.2 billion. Put another way, the market is signaling that their net asset values are inflated by more than $7 billion, mostly because of frothy inventory values.

Oddly, Wall Street analysts covering the stocks appear to be rejecting the market's hints. Pulte, for instance, is expected to post a $153.2 million fourth-quarter net loss, according to a Bloomberg survey of seven analysts. That suggests no one is counting on major writedowns. The loss would be much larger if Pulte were to mark its assets in line with what its stock price implies...

NAHB's Cloudy Crystal Ball

The National Association of Home Builders (NAHB) has recently come out with their year-end forecast, and I'm a bit disappointed because it's mostly more of the same rehashed news we've all been reading for at least a couple of months. A clear crystal ball it is not:

Placing the blame for the housing recession squarely at the feet of the mortgage market meltdown, NAHB CEO Jerry Howard and chief economist David Seiders warned of another bleak year for housing in 2008, during the NAHB's year-end Housing Forecast call on Thursday.

Exacerbating the situation is the slowdown in the overall United States economy, as housing and mortgage problems have spilled over and tightened credit conditions economy-wide.

Over the past couple of years, I've found NAHB's forecasts to be a little behind the eight ball on their housing forecasts, and it seems a bit convenient to lay the blame on the housing recession "squarely at the feet of the mortgage market meltdown," as if no one at Mr. Seiders and Co. had any clue that home prices were far outpacing incomes in many markets and that there was a serious risk of overbuilding when measured against most reasonable demand forecasts. And, because association groups such as NAHB and NAR likely historically felt compelled to appease their members with continuously optimistic forecasts, housing bears such as Chris Thornberg (formerly of UCLA, now of Beacon Economics) and Mark Zandi (Economy.com) have been able to drive their trucks through the resulting breach and make big names for themselves because they're being proven right.

I tried discussing this and other subjects when I met Mr. Seiders at a reception during the last Builder 100 conference in Carlsbad, but found his professorial demeanor tough to penetrate. Perhaps I should have raised my hand?

Lot Prices Coming Down: This is Good News

Since the largest cost for builders in California is the land upon which they build, making homes affordable has been challenging when landowners refuse to cut their prices in the face of a slower market. Simply put, the market for new homes will not improve markedly until prices are more in line with household incomes and buyers can qualify for mortgages in the traditional way (i.e., 10-20% down, a couple months of reserves, etc.).

That's why it's actually good news that lot prices in hard-hit areas such as the Antelope Valley and the Inland Empire have finally fallen to levels last seen two or even five years ago. According to a story by Builder's John Caulfield, a report (i.e., clever press release) produced by the land broker The Hoffman Company, finished lot land values are down by up to 52% when comparing the fourth quarters of 2005 and 2007.

Why the change? Not surprisingly, fewer buyers. According to the story:

Norm Scheel, a principal with Hoffman, tells Builder ONLINE that the majority of the pullback in land prices occurred this year, which he attributes primarily to a "lack of need" among home builders that are themselves selling land and walking away from options.

"Home builders seem to be doing two things," says Scheel, "preserving capital and burning inventory."

So where is the carnage the worst? Areas such as Lancaster and Palmdale, where lot values in certain areas have plunged by over 38% (and which will eventually mean more affordable new homes). In the Inland Empire counties of San Bernardino and Riverside, the hardest-hit areas include French Valley (-52%), Highland (-49%) and East Lake Elsinore (-47%).

These areas do have something important in common: they were all areas that buyers were willing to drive to in order to find something affordable. Now, with home prices falling in those communities closer to various employment centers (such as the Santa Clarita and San Fernando valleys or the western and southern Inland Empire), the only ways that land prices in more outlying areas can compete is on price.

This is also exactly what happened with land prices in the early- to mid-1990s that eventually led to the housing recovery of the late 1990s and early 2000s.

It's really just part of the correction process, painful as it may be for landowners (and especially for those who borrowed heavily to buy land).

"Prestine" Oceanfront Condos in Mazatlan!

Sometimes I can't help myself: even when I'm on vacation (in this case Mazatlan, Cabo San Lucas and Puerto Vallarta with my extended family), I'm always interested in local real estate, how it's marketed, who the buyers are and how it all compares to how we do things here in the U.S.

One thing I noticed: when signs are translated into English, the spelling (and often the use of apostrophes) tends to suffer (i.e., No Worry's Bar and Restaurant in Cabo). I always wonder why builders would spend tens of millions of dollars on a project and then fail to pay someone to spell check a sign (especially a billboard near a popular beach!).

But perhaps I'm quibbling: for prices sometimes far less than in the U.S., American buyers have long flocked to the Mexican Riviera (although prices in Cabo San Lucas are now at U.S. levels).

When Mexico became too crowded and pricey for the value-oriented second home buyer, they popularized Costa Rica, and now 70,000 ex-patriots call that country home (at least part of the time). Now they're starting to look elsewhere in Central America, chiefly Panama, Honduras, Guatemala and Belize.

During my recent trip, I read a book on buying second homes in Central America that I'll be reviewing for the Los Angeles Times, which I hope will be one of many to follow in the future. Assuming they like what I turn in, it should run sometime in January in the real estate section or "West" magazine.

I learned a lot from this book and will be giving it a positive review, but what struck me the most was this: with governments not just in Central America but around the globe improving their economies and stabilizing their governments, no longer will areas such as Palm Springs or Florida be the only game in town for U.S. retirees. If the U.S. hopes to compete for the next generation of second and/or vacation home shoppers, builders will have to work hard to stay on top of their game.

And of course that means never mis-spelling "pristine."

At sea, no blogging this week

I thought that perhaps I'd be able to post at least some blog posts this week, but I'm on a cruise ship off the coast of Mexico and the wireless reception really ain't up to snuff. I return on Saturday, after which I'll catch up on the week's news and post on Sunday.

The "Mild" Fed

Writing in Business Week, writer Peter Coy suggests that the Fed's lowering of rates and creating the Term Auction Facility will certainly help, but more will be needed:

What's becoming clear is that market frenzies take their own course, and there's no easy remedy. The core problem remains: Many banks loaded up on iffy assets such as subprime loans that are continuing to lose value as the U.S. housing market keeps sinking. They're reluctant to make new loans because they don't trust their borrowers, and they want to husband their cash in case they have to make further writedowns. The Fed's Dec. 12 plan, while it should ease stress in the system, "does not fix in any shape or form the source of the problem," says Lena Komileva, Group G7 economist for Tullett Prebon, an interbank broker.

And yet today's report of higher-than-expected inflation could also mean that the Fed can't cut interest rates as much as it would like, prompting a delicate balancing act between (a) aiding the housing market; and (b) fighting inflation.

Green homes in the area of home theaters

Back in 2000, I met with Rich Lambros of the Building Industry Association of Southern California to discuss starting a council (or other such group) to focus on technology in the building industry (we ended up with the Technology Task Force). Part of that was certainly green building, but the group struggled to gain notice because most builders didn't want to hear about it: after years of muddling through the 1990s, the market was finally looking up and they didn't want to threaten their production schedules with anything too new.

For the next rebound, however, it'll likely be new technologies and green building that will help revive the building industry, so it's good to see so many magazine titles focusing on green building techniques and the large number of solar energy companies at the BIS Show.

And yet despite the best efforts to replace energy-hogging incandescent lightbulbs with florescent or even LED alternatives and to push Energy-Star compliant appliances whenever possible, it seems the insatiable appetite for larger, more impressive home theater systems may completely negate those gains.

Writing in the Wall Street Journal, Rebecca Smith warns that prices for the largest TV sets are dropping so fast that what can appear like a bargain today can quickly be eaten up by future power bills:

"What scares us is the prices for plasma sets are dropping so fast that people are saying, why get a 42-inch plasma set when you can get a 60-inch or 64-inch one," says Tom Reddoch, director of energy efficiency for the nonprofit Electric Power Research Institute's laboratory in Knoxville, Tenn., an independent organization that advises the utility sector. "They have no idea how much electricity these things consume."

Doug Johnson, senior director of technology policy for the Consumer Electronics Association, says the industry is working to improve disclosure and energy efficiency. He says comparing television energy use to refrigerator energy use is "hackneyed," adding, "when was the last time the family gathered around the refrigerator to be entertained."

But consumers making an effort to go greener at home -- and who also want to ditch their bulky old TV set -- can be in a bit of a bind. The energy savings gleaned from swapping out incandescent light bulbs for energy-efficient compact fluorescent lights, for example, can easily be canceled out by the pileup in entertainment gear.

Currently, 11% to 13% of the average American household's electricity bill stems from consumer electronics. But that is projected to rise to 18% by 2015, according to the EPA, part of the Department of Energy.

So maybe as builders promote their own green building initiatives it'd also be useful to model more energy-efficient home theater systems (like using LCDs instead of plasmas), because all it takes is some 16-year-old know-it-all to suggest that marketing "green" may be little more than a simple gimmick.

California new home sales down by 46%

Hot off the press:

The monthly report issued by CBIA and Hanley Wood Market Intelligence (my alma mater) for October concludes that we're still off by nearly half from the same period of 2006 (it takes HWMI about a month to compile its data and then up to another couple of weeks to write/edit/approve and post the press release):

The monthly CBIA/Hanley Wood Market Intelligence (HWMI) New Home Sales and Pricing Report showed that new home sales in October were 46 percent below October 2006, similar to the year-over-year decline seen in September. During the month, 3,292 homes and condominiums were sold in the subdivisions tracked by Costa Mesa-based HWMI, compared to 6,047 in October 2006. Sales of single family homes dropped by 37 percent, while sales of townhomes and “plexes” – duplexes, triplexes, etc. – were down 41 percent and sales of condominiums were down 71 percent.

Compared with the same period last year, the median base price of homes sold dropped by 9.7 percent.

Non-seasonally adjusted total new-home sales were 3 percent lower than levels seen in September, although it is not unusual for October to show a slower pace of sales activity than September. Median base sales prices statewide were just under 1 percent higher than in September.

There were, however, a couple of relative bright spots including Fresno (-10.7%), Santa Rosa/Petaluma (-3.4%) and Visalia/Porterville (-14.7%).

Want to see how your area is doing? Click here.