The Room 3/31/08

Dear Reader,

I am writing to you in the pre-dawn from a soft chair in a Starbucks in Scottsdale, a vast improvement over the small desk in the cluttered toy room that I usually write you from on Fridays. 16 inches from my left hand is a "vente" (in the Starbucks' nomenclature, that means super sized) Americano (four shots of espresso with a dash of water to hold them all together) that I will be consulting with throughout this correspondence. I do so in an attempt to sterilize the effects of a glass of wine or two too many following the close of what I felt was another excellent Crisis & Opportunity Summit.

For those of you unfamiliar with the concept of sterilization, at least as the word is used in the discussion of modern economics, a topic that occasionally slips into these paragraphs, I will elaborate. Sterilization refers to the notion that a central bank can, upon spotting a storm cloud gathering on the horizon, unleash a flood of loose money - the amount is almost irrelevant, as long as it is enough, in their studied opinion, to re-juice the economy and keep the consumers consuming. Then, once the danger is passed, the same central bankers simply cut the supply of money, thereby "sterilizing" the prior injection of cash before the ill and otherwise inevitable effect of price inflation kicks in.

It all seems so logical, this fundamental underpinning of fiat economics. Sense a threat - unleash money. Threat passed - tighten up.

Yet, as you may have noticed, it apparently doesn't work. At least if you use the value of the dollar as the metrics of success, the staunch defense of which is supposed to be job #1 of the Fed. If you are looking for further proof of that contention, your contemplations need extend only far enough to notice that the greenback has lost some 80% of its purchasing power since its link to gold was broken in 1971. There is another side effect of the flawed foundation of the fiat system, at least as it is pursued in the U.S., namely that American consumers, encouraged by the loose money to make a hefty dose of spending a part of their daily activities, are now up to their nostrils in debt and many are underwater.

Over the last day and a half here at the Summit we have heard much about these and other consequences of the government's failed jiggering of the economy and, in particular, the depth and breath of the current crisis. Regrettably, I don't have time to go into great detail in this week's edition, as attempting to do so would result in my missing the plane back home.

To move things right along, I'm going to take the short cut of inviting others to join me on the page. Starting with John, a subscriber who earns his daily soup by serving as a professional real estate appraiser in Northern California. John kindly agreed to candidly answer a series of questions we sent him in our attempt to get a clearer picture of what's going on behind the scenes and under the hood in the all important real estate market.

Real Estate, the Insider's Perspective

Before we get to John's interview, I'd like to share some observations on just one of the many great presentations held at this Summit, that delivered by Andy Miller, one of the most substantial real estate investors in these 50 states (for Andy, a typical day's labor might involve the buying or selling a hundred million dollars worth of real estate or loans connected with same). Andy accepted our invitation to Scottsdale to share his perspective on the outlook for real estate going forward. While Andy used far more sophisticated language than I, I will summarize his outlook as thus:


To be more specific, his view on real estate - and remember, Andy is as "inside" as inside gets - is that we are nowhere near the bottom and that some segments, commercial and condos especially, are going to fall off a cliff.

While there is little in the way of specific actions you can take to invest for a short-term profit from this unfolding situation - mainly because the stocks of almost all the publicly-traded real estate firms have already been crushed - Andy does believe that as this crash occurs it will create the opportunity of a lifetime. If nothing else, in six months or a year down the road you should be able to pick up that dream condo on your favorite beach for an off-key song. As to when the market might bottom, Andy's take is that it all depends on the actions of the government. If it stands aside and lets the market take its righteous toll on the overextended mortgagees and those who hold those mortgages, then the worst of the damage could be over in a couple of years (at least that was my sense of the timing Andy suggested). However, if the government, as it is prone to do, rolls up its sleeves and sets about fixing the many dislocations in the real estate market, then, like the Japanese before us, the real estate fiasco and attendant damage could stretch out for a decade or more. Hot tip: watch the politicians carefully (always good advice, in my opinion, especially if you find yourself in a tightly packed elevator with one).

Another of Andy's many insightful comments was that you should not trust appraisals. That's because, as the bubble inflated, loan officers, looking to make as many loans as possible, and the bigger the better, naturally gravitated toward the most liberal appraisers. By contrast, the more cautious appraisers soon found themselves in an un-enviable position portrayed so convincingly by the MayTag Repairman: sitting at an uncluttered desk, staring forlornly at the silent phone.

As is human nature, a great many, if not most, of the appraisers swallowed their ethics, put away the textbooks they studied when learning their trade, and as a basis of their appraisals began to use the amount of money they felt would evoke a smile on the thin lips of the loan officers.

The task of over-inflating the values became increasingly easier as the "comparables" available to appraisers began to reflect the new reality. To wit, if the shack down the street actually sold for $650,000, then who could dispute that the lovely fixer-up, lacking only in a little TLC (read: "new plumbing") was worth $1,000,000?

Which brings us, finally, to our guest interview with John, a residential real estate appraiser in California. As he described himself in the correspondence leading up to our interview... "I've been appraising in California for 18 years, and deal with the gamut of lenders, borrowers and developers, and see every story, scheme, and scenario possible. I have lots of anecdotal stories and evidence, as well as research and conclusions, from the extremely overbuilt new tracts, where builders are still building—because they're committed—and competing against first generation foreclosures in their earlier phases, and losing money on every sale, to small projects dead in the water or upside down, to the very rural, to the very upscale still paying cash."

With that introduction, here is our interview...

1. Have you ever seen things in the real estate market this bad?

In terms of the all-around uncertainty and worry being felt by borrowers, lenders, buyers and sellers, nothing this bad.

I was in southern California in the mid-1990s downcycle. Things had gotten overheated there especially, but the decline was much more orderly, over maybe 3-5 years, than this one has been in just two or so. In retrospect it was a fairly normal and not surprising correction. People and borrowers got hurt and became wary, but there wasn't the pervasive worry about the bottom falling out. And it wasn't as widespread. That is, while most everyone lost value in their homes in the mid-1990's downturn, fewer people were as directly impacted or in such a critical situation. There wasn't nearly the breadth and depth of indebtedness then. Today there is a much higher percentage of borrowers with a much higher level of debt because, in this run up, so many people continually ran up debt and sucked out their equity.

The frenzy of borrowing and lending up until a year or so ago was far greater than that which led to the escalating prices, and subsequent correction, in the early to mid-1990s. I see instance after instance of someone with say a $300,000 loan taking out a second mortgage or an equity line for $50,000 a year later, followed by an all new mortgage that consolidates the previous two plus tacks on another $50,000. So now they've got a $400,000 loan. Ten months later they get another $60,000. And, in 2004 through 2006 especially, there was a lot of 100% financing, usually a first and a second mortgage, often with the same lender.

The downtrend is not as steady as the mid-90s. It goes in real fits and starts. In cases of some very overbuilt communities I've seen the bar lowered by $30,000 in a single month in a $300,000 to $400,000 neighborhood. It's usually caused by sellers -- often banks -- unloading after a period of waiting or stagnating sales. All of a sudden what was thought of as a competitive asking price is now overpriced by $30,000 or more.

[Ed Note: Andy Miller said the best time to buy properties, when the time is right, of course, is at the end of quarters when the institutional holders dump properties in an attempt to clean up their books.]

2. Are appraisers under any pressure to give rosy valuations?

Not as much at this time, because the lenders are more deeply affected and truly reigning in. Mortgage brokers, who don't fund their own loans, will still try to put some pressure on, but the lenders—the ones actually putting out the money—are saying "tell us what's really happening in the market." They want to know because they've got lots of exposure and want to know the real story. In fact, where before, in the 1990s downturn, FNMA and most lenders encouraged appraisers to call the market "stable" versus "declining" even if everyone knew they weren't stable, this time around they expect to see the declining box checked, unless you make a very convincing case that values are in fact stable (not too common here in California). So, at this point lenders are really tightening. So even the magic cure of lowering interest rates won't help much when lenders are increasingly risk averse.

3. When a property doesn't sell in two or three times the normal time span, why doesn't the seller face facts and slash the price?

I've seen some slashing, and some sellers chasing the price down, but always a step behind. What they'd settle for now, but can't quite get, they could've gotten last year when they were asking $60,000 more. Reductions are more frequent and often sizeable. It used to be that you'd see a token $5,000 reduction, more just to get your listing visible again. Now large reductions are common. This is especially true in the high-end and custom spec homes. Every contractor and contractor's brother was building a spec home, getting bolder in how big and fancy they'd build them. After all if you can make $60,000 on a 2,000 square foot $400,000-value home, why not build a 4,000 square foot home with all the bells and'll cost more and take a little longer but the market's just going up anyway. I watched one 6500 sq ft very high quality spec home go from a $2.5M asking price a few months prior to completion in 2005, slowly down to $1.9M, then $1.6M and so on, eventually to $1,200,000. In the end it sold for around $1,150,000. The guy must have lost money because I'm sure that quality cost him close to $200/sf just to build, not to mention the land (probably $200,000+) and the enormous holding costs for 2-3 years.

The other sellers are, of course, banks, whose motivations vary greatly. I've seen a few put money and effort into a home and try to hold out for reasonably close to market value, but most often they want to get them off their books as quickly as possible. Sometimes they're competitive and sometimes they blow them out. I had one agent who handles REOs (Real Estate Owned) for several lenders tell me sometimes they'll get word to get two sold in the next two weeks. He said that a decision was made, for example, to clear 100 properties nationally off their books in the next 30 days, so that meant orders were going to Region A to unload 12, Region B to unload 15, etc.

He said it was sometimes the case of regulators requiring them to reduce their REO units. In one case, the agent reduced a small home on 5 acres with a 3600 sq ft barn with additional 2BR apartment from $569,000 to $400,000, overnight. It was contracted in three days, and closed a few weeks later for $392,000. Someone had paid $710,000 for it in 2005 with 90% or maybe 100% financing. In another case a lender was asking $325,000 and accepted a cash offer of $175,000. The house was dumpy but sound and livable, and reportedly not a major fixer. It was just not worth $325,000 and the bank was tired of looking at it, and took the offer. Until then nothing in a 3BR/2BA in that neighborhood went below $275,000 or $250,000. Of course these are exceptional cases, but the downward pressure is very real, and very intense still. There are many properties for sale, and buyers are wary, or waiting. Some sellers, those fortunate enough not to have to sell, pull out of the market. Those that have to sell usually have to reduce their expectations.

4. Are there sellers who have been in denial for months about what their property is worth but who are about to come out of denial and make a big cut in the price? Are there many of them?

See #3 above. Again, there are always those that must sell. And, there's another category that falls in between the regular homeowner and the bank. It's the owner/borrower who's in trouble and must sell, or lose the house. This is the "short sale" situation, where the borrower owes more than the property is worth, and is engaging the bank in the selling process to have them accept less than the outstanding loan balance. The bank is involved in negotiations and must approve the final sales price. They're fairly agreeable, because the alternative is going through the entire default process, sinking more time and money into it, and likely losing more. And here we're just speaking about the first mortgage (trust deed in California) holder. Often a second mortgage holder will lose their entire loan amount; after all why would they step in and pay off a first mortgage that alone is more than the value of the collateral?

5. How is the market for buildable lots? More depressed than for houses? How much more difficult has it become to get financing for a buildable lot?

The market for lots has completely dried up. In this area (semi-rural northern California) land was on fire for several years, as contractors bought up nice lots and not so nice lots to build homes on. For a while everything turned to gold. People were selling land held in the family for a long time (just like silverware in the late 70s!). Developers, many inexperienced, were getting in to subdivide land to make 4 parcels, 12 parcels, or whatever zoning allowed. But it is a long and expensive process.

The craze and demand peaked probably in 2005-2006, and I still see some of these projects just coming to market. People have spent two years, and more money than they expected, to get their golden little subdivision, all finalized and ready to go to market...and the market is not there. The demand is so low for unimproved land now, but I haven't yet seen the capitulation I expect. I've seen small and medium sized subdivision projects, which are completely upside down. A friend of mine owns a commercial appraisal firm and specializes in large subdivisions. He's been the bearer of bad news too. In the frenzy, national builders were buying farm land in the middle of nowhere, some two plus hours from metro areas, to create new subdivisions and planned communities. Many of the tracts and phases that never got built now have a residual value of less than zero! That is, taking the estimated value of a proposed completed house (times 20 or 200 or 2,000 depending on how big your plans were!) and backing out the cost to build the house and all your infrastructure, bond obligations, etc., the land is worth less than zero. Of course, it is worth something, but only to speculators willing to sit on it for a long time. There's a reason it was farm land in the middle of nowhere to begin with. Some can't even go back to farming because of zoning and general plan changes and new houses now adjacent. [A whole other topic is farmers selling water rights to new developments and municipalities, resulting in what is an increasing amount of fallow land that's apparently not farmable now. Lots of unintended consequences, and unfolding opportunities?] It's going to be very interesting to watch the market unfold.

6. Based on what you are observing, how much further do you think prices are going down?

My answer would have to be anywhere from "some" more, say 15-20%, should well grounded optimism magically set in before year-end, to a lot more, possibly 30-40%, should news and conditions (and perceptions) worsen and snowball, or there be some unexpected large macro event that shakes things up on top of the underlying situation.

This, of course, is the unknown and unexpected, but these things happen. It could be a natural disaster, a military showdown, somebody doing something big and stupid in the Middle East, political correctness of "Olympic" proportions (what if the Tibet situation goes south, Richard Gere and fans get half the world to boycott China this summer and cause them to lose face in an epic way, and they decide in turn to boycott our dollar...), or simply some confluence of events, in the US or elsewhere, that ratchets up fears and concerns here.

In other words, if the stars line up, and lots of things go well, or appear to go well, throughout 2008, things may stabilize with maybe only a 15% haircut, from here, in general real estate values in the US. To predict less than this just calls for too much precision with all the variables and uncertainty, unless you really believe the downturn is about over, which I don't see. Under current conditions 5-10% can potentially whiz by in a month or a quarter, and is really just noise, between commissions, negotiating skills, fear and uncertainty, and the varied motivations of both buyers and sellers.

On the other hand, if things continue along with the same pressures as I see now, we'll likely see drops of 15% to 20%. If conditions fail to improve in the next 6-18 months, or are exacerbated in some way, then I think we could see larger drops in value, and a more prolonged decline.

Of course, there are many markets and sub-markets throughout the country, and some are more volatile and some more insulated than others. There will be some exceptions and some extremes. In general, though, I believe we're in for some more decline.

7. How long do you think it will be before we see prices come back to the levels they were before the crash? Are we talking months, years or decades at this point? We know this is pure conjecture, but what is your gut feeling based on many year's experience?

That's a long way to go back up, especially since we're still going down at this point. I'd have to estimate as much as a generation, at least for the areas that are being most impacted. It got so overheated with lenders, buyers and borrowers making mutually terrible decisions. Everyone is going to be wary for a long time, especially because this became such a speculation-driven run up.

Besides lots of average homeowners forgetting common sense (and forgetting that even attractive loans still require repayment) and assuming (speculating) that values would keep going up, there sprang up a whole class of everyday people that became speculators, and actually went out and bought second and third homes to turn over. These were people who otherwise don't do real estate deals, because the market doesn't normally afford that kind of opportunity. There was a huge disconnect from what typically drives a real estate market. Most people probably won't go near real estate speculation again, will be careful in their future borrowing, and will be wary of buying more houses than they need and can afford. So, until they're no longer the primary buyers and owners of real estate, and their kids and grandkids stop taking their advice, we probably won't again have conditions that will lead to a rapid increase in values.

Of course, natural growth and demand do cause values to rise, but it could take 10-20 years of typical appreciation (1-3% per year in traditionally less volatile areas, to maybe 3-6% in more active markets like California, the East Coast and Florida) to cover the ground of 4-8 years of frenzy. And that will be after the current downturn stabilizes, meaning oversupplies are absorbed, foreclosure and defaults have run their course, indebtedness is at normal levels, and healthy market conditions are back in place. That in itself will probably be another year or two at best. It doesn't seem likely that the down cycle will last only 2-3 years, considering the last one lasted 3-6 years when the underlying problems were not as bad. To summarize, to get back to where we were at the peak, at least in the areas hit the hardest, we'll need the time it takes to stabilize, at least a year or two, and then, depending on where things do stabilize, likely a decade or two of healthy and typical appreciation.

David again... my sincere appreciation to John for taking the time to work with us on this interview. Correlating his remarks with those of Andy Miller, and taking into account the sheer magnitude and importance of the real estate markets to the U.S. economy, I think the picture painted is fairly bleak.

That said, per Andy, when this wildfire eventually runs its course, it will create the opportunity of a lifetime for investors who have avoided the worst of the losses and have their capital intact.

As an aside, if you are, like John, an insider in a business with experiences that you think other subscribers would like to hear about, drop me a line at

Democracy Versus Republic

As you may have noticed, I am no big fan of the idea of democracy because, in time, democracy inevitably devolves into a fight - with votes - at the public trough. Today, over 51% of the populace of the U.S. are net recipients of money from the U.S. government (read: their fellow citizens).

But if not democracy, what? In my view, it is a republic... a form of government whereby the government is limited to specific functions and no more, and where rights are inviolate and not subject to tampering by whichever gang of powerseekers have captured the flag.

On this topic, one of the participants at the Summit wandered over to me to share the following illustration of the difference between the two forms of government:

In a democracy, two wolves and a sheep get together to decide who they are going to eat for lunch.

In a republic, eating the sheep would be outlawed.

Universal Health Care Anyone?

At this point, given the high cost of health care, the high levels of indebtness which makes those costs unbearable to so many Americans, and because changing the system is as easy as voting in the Democrats, it is my opinion that universal healthcare is a sure thing for the U.S.

Given my time constraints, a more detailed discussion of the wisdom of adopting this large-scale giveaway will have to wait. But I would like to share a couple of anecdotes that will give you a hint as to my general views on the topic.

The first came out of a newspaper I picked up on a recent trip to Canada. The first paragraph, about patients in Ontario, pulls back the peel on the rest of the story, and reads as follows:

"More than 400 Canadians in the full throes of a heart attack or other cardiac emergency have been sent to the United States because no hospital can provide the lifesaving care they require here."

In the same newspaper (the Globe & Mail if I recollect correctly), I also noticed large ads paid for by the Canadian government, couched in a pleading language, for doctors. Given the sheer volume of red tape and effective income restrictions doctors in that country are saddled with, it is no wonder so many of their best and brightest now practice their professions here in the U.S., and there are shortages up north.

My second anecdote comes from a fun service I subscribe to called "This is True" ( Here it is...

"PLEASE HOLD: More than 43,000 patients had to wait outside in ambulances for at least an hour last year before they could be seen in Britain's National Health Service emergency rooms. Standards require that patients must been seen within four hours when they arrive at an emergency room, so when busy, patients must wait outside so the clock doesn't start ticking."

Who knows, maybe the government in the U.S. will learn its lessons from the various universal health care systems being employed around the world, and won't let politics or demands from constituents drive the creation of a system that destroys the few remaining positive aspects of the U.S. medical system... or beggars the country any more than it already is... but that is a long-shot hope at best.

Inflation? What Inflation?

Last week I shared the story of my mother's childhood residence, in Mont Clair, New Jersey, purchased in 1929 for $45,000, and sold below that price almost 20 years later.

My friend of long standing, Ian McAvity, the editor of Deliberations, an excellent service for those of you who lean toward technical analysis, dropped me an email with the following message.


You might be amused that estimates the value of 10 Sutherland Road, Mont Clair, NJ at $1.24 million currently.


So, $45,000 to $1.24 million in about 63 years. But it is worse than that, because the former family homestead was, according to my mother, subdivided into a number of lots, so the actual current value of the property is likely closer to twice that value.

I said to my wife the other day, following an expensive meal, that I need to recalibrate how I think about money. Simply, $20 is no longer the $20 I remember from my youth, but is actually more like $2.00, or even $1.00.

Thus, a dinner bill of $200 for a family of four at a decent restaurant should not evoke a reaction such as "$200! This is ridiculous! How does anyone manage to survive these days, let alone save any money!".

Rather, recalibrating my sense of value to the brave new world whose air we now breathe, my reaction should, going forward, be nothing more than, "Nice dinner, and look, it was only $20."

A self-delusion, or the new reality? You decide.

Bearish Questions

Ed Steer, the hardworking contributing editor to our Daily Resource Plus, sent along an article from Reuters on the Bear Stearns buyout, which I thought you would find of interest. I certainly did. Here's an excerpt...

NEW YORK -- Stunned Bear Stearns shareholders who saw investments virtually wiped out overnight when a takeover deal with JPMorgan Chase was unveiled are demanding to know how it was put together in the first place.

For instance, they -- and Washington lawmakers -- want answers on how the deal was arranged, and gained government approval and financing, all in a few hours, and seemingly without alternative bidders being canvassed.

They also have a host of questions about the role of the Federal Reserve and the Treasury Department in engineering the emergency deal.

So far some crucial details remain murky.

"Under the circumstances, shareholders should be entitled to know just about everything," said James Melican, chairman of shareholder advisory firm Proxy Governance Inc., which is expected to make a recommendation to investors on whether the deal should be approved.

"There needs to be full disclosure of exactly what happened over the weekend," he said. Investors have "an absolute right to know whether there is any other alternative mechanism that could either keep Bear Stearns in business or at least have them get a more appropriate price for their shares."

Billions of dollars in shareholder value have been wiped away in the last week. Based on current market prices, the takeover is valued at $2.41 a share, a shockingly low offer compared with Bear's $159 stock price last April.

Another highly unusual aspect of the deal is the way JPMorgan Chase & Co. has been allowed into the Bear Stearns Cos. Inc. to provide "management oversight of its operations."

If shareholders were to reject the JPMorgan offer, JPMorgan still would have been in a position to understand everything about Bear's trading strategies, staff quality and assets.

JPMorgan even has an option to buy the Bear Stearns' building if the deal collapses.

Congress also wants answers, particularly on the involvement of the Federal Reserve in pushing the deal, which came as Bear Stearns faced a sudden cash crunch and possible collapse. In an unusual move, the Fed agreed to lend $30 billion to fund illiquid Bear Stearns assets to help seal the takeover.

Among the unanswered questions are:

-- Were other parties asked to bid on Bear Stearns, or did the government solely approach JPMorgan about the takeover?

-- Were any overseas banks or private equity firms asked to consider a bid, or did the buyer have to be a large U.S. bank?

-- How did the Federal Reserve arrive at the $30 billion figure and did it discuss with Bear whether it was preferable to arrive at a quick sale or explore a bankruptcy filing?

-- How could due diligence be done and the deal approved in the space of a few frantic hours on Sunday?

-- And how can a party taking over another be allowed to run the target before the deal has gone through?

With so many unknowns, the Senate Finance Committee is reviewing the sale and particularly what implications it may have for taxpayers. On Thursday afternoon the committee's top Republican, Iowa Sen. Chuck Grassley, said he wanted details of the Fed's financial support of the deal, as well as how Bear insiders were being treated under the buyout.

In the House of Representatives, the chairman of the House Oversight and Government Reform Committee also wants to know more. The committee is conducting a "preliminary review" of the deal, an aide to Democratic Rep. Henry Waxman of California, who chairs the panel, said on Thursday.

A decision on whether to launch a more formal investigation or to hold committee hearings could take several weeks, said the aide, who declined to be identified. The aide added that the Bear Stearns developments dovetailed with separate hearings that Waxman's committee has conducted on compensation packages for top executives at troubled firms.

Here's a link to the full article.

And That Is It For This Week...

As usual, I have so much more I would like to discuss. But unusually, I have almost no time to dive in further.

I will leave off, however, by saying that I was pleasantly surprised while idly looking through a discarded copy of USA Today, while waiting for yet another jolt of caffeine to be delivered, to find the front page article of the Life Section of that publication dedicated to a glowing discussion of the town of Cafayate and the surrounding wine country, where my own favorite partner of all times is building out his own version of Galt's Gulch. (You can view more at

Doug has always had a spectacular eye for moving into the right real estate markets at the right time, and it looks like he's done it again.

In any event, it is time to wrap these weekly musings and rush madly for the airport. Next week I will be writing from the forebodingly named Jekyll Island, Georgia, where Doug and I will be spending a few days in good company further pondering the world as we know it.

Until then, thank you for reading and for subscribing. And a special tip of the hat to all of you who attended our Summit. I have said it before, and I'll say it again, our subscribers are a remarkably philosophically sound and interesting lot. It is always a pleasure to spend time with you, and the Scottsdale Summit was no exception.

Very sincerely,


David Galland
Managing Director
Casey Research, LLC.

Posted 03-31-2008 3:08 PM by David Galland