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When the Walls Come Tumbling Down

Doug Kass

Our house is a very, very, very fine house
With two cats in the yard
Life used to be so hard
Now everything is easy, 'cause of you
I'll light the fire
While you place the flowers in the vase that you bought today.

-- Our House, Crosby, Stills, Nash & Young

At the core of my economic concerns for 2006-08 is the swift and deep deterioration in the U.S. real estate market.

Housing has been -- to paraphrase New York Yankee slugger Reggie Jackson's self-description -- the straw that stirs the drink of the consumer and the economy.

The construction industry has been the most important catalyst for economic growth since 2001. The Federal Reserve took interest rates to unprecedented low levels, and mortgage lenders encouraged activity through creative mortgages, which kept mortgage debt service even lower by requiring small monthly payments.

Indeed, economists at Merrill Lynch (and elsewhere) have pointed out that residential and nonresidential construction activity was responsible for nearly half of GDP and employment growth since 2001.

Equally important, the unprecedented rise in home prices (especially of a coastal nature) buoyed consumer confidence, allowed the consumption binge to be extended (through record refinancing cashouts) and encouraged consumers to stop saving (comfortably relying instead on the appreciation of their homes).

On The Edge, I argued -- prematurely -- that the housing cycle was no different than past cyclical experiences and that the long boom forecast by industry participants (homebuilders and analysts) was fallacious and, in the fullness of time, housing activity and prices were headed for a fall.

The major reasons for my forecast were twofold and differed from the declines of the past (which were influenced by job losses and other negative macroeconomic forces). Affordability (home prices divided by household incomes) had been stretched to levels never before seen, and a new class of buyers (speculators or daytraders of homes) had artificially inspired rising home prices (very similar to daytraders of stocks in the late 1990s).

Over the last nine months, the cyclical peak in housing activity has come and gone. Almost weekly, prior upward guidance by homebuilders has been replaced by the slashing of estimates, lower order rates and eroding backlogs. And the industry's inventory has mushroomed to multiyear highs.

The worst is yet to come for housing; it is moving toward a very hard landing. And with a further decline, will be (important) attendant and adverse ramifications for consumer confidence and aggregate economic growth.

Housing led the economic recovery and will now lead the economy's contraction -- a causal relationship far older than most hedge fund managers' (who have never seen a bear market) half-life of investing.

House in the Hamptons

For five months of the year, I live in the tony town of East Hampton, N.Y. (I purchased the home three years ago.) I live in a nice 50-year-old home on a little more than an acre, which sits about five blocks from Georgica Beach.

When I left East Hampton for southern Florida (my winter residence) last October (which, coincidentally, was the statistical peak in housing), there were no homes for sale on my block (which consists of about 12 homes). However, upon returning to Long Island in late May 2006, four of the existing 12 houses had been demolished and replaced with new homes for sale (I would estimate, on average, each home was about 7,000 square feet).

All four homes have been for sale since May (by speculators/developers) with no bids. Moreover, three other existing homes on my block have been put on the market this summer. No bids there either.

Real estage agents across the country routinely have Sunday open houses, and East Hampton is no exception. Those open houses on my street have come and gone; there has been no traffic.

East Hampton is symptomatic of many other coastal real estate markets. The hard landing in housing is upon us and, as usual, the cycle will be more extreme than expected -- just as the climb was unexpectedly high.

During the halcyon times last spring, I participated in a CNBC town hall special titled "The Real Estate Boom," in which Dr. Robert Shiller of Yale University and I debated with optimistic industry participants and housing economists about the slope of the cycle. We were in the distinct minority. Many industry insiders still see a soft landing in housing. They were, and are, wrong.

As I mentioned previously, the statistical peak in housing (measured by new-home sales) was October 2005, only nine months ago (and with a unit drop in new-home sales since the peak of less than 20%). By contrast, the average postwar cyclical downturn for housing has been between 26 to 52 months, and in units, has averaged a 51% drop.

As I wrote earlier, the worst is yet to come for housing and, with it, the multiplier effect on the domestic economy will be felt widely.