Is Wall Street Smarter Than a 5th Grader?

I should have written this article a year ago, but like my 5^th grader waiting until the last minute to build his shoebox diorama for the Science Fair, I put it off as long as possible. However, after enduring 6 months of exasperation over the “subprime contagion” handwringing by the smartest financial pundits of our time, I realized I could wait no longer.

Folks, the analysts on Wall Street are making this subprime issue WAAAY too complicated. In fact, if it were up to me, I’d get Donald Trump and Jeff Probst to appear on CNBC and tell them all, “You’re Fired” and vote them off Long Island. But I’ll give them immunity – it’s not their fault they missed the story - because the entire scenario is playing out hundreds and thousands of miles away – on Main Street. In spite of how complicated the capital market gurus attempt to make this situation, it all comes down to Spelling one 13-letter-word: A-F-F-O-R-D-A-B-I-L-I-T-Y, and the Math is so easy, even a 5^th grader can do it.

Once Upon a Dime….

To keep things simple, I’ll use my own story as an example. In January 2001, I was recruited by a technology firm in the DC metro area to serve as VP of Marketing with a salary of $110,000. Upon accepting the position, our family of four purchased a 16-year-old single family home in the DC suburb of Germantown, MD at a price of $300,000. It was a 30 year loan with an interest rate of 7%, putting our payments at roughly $2400 a month, which represented the absolute maximum debt-to-income ratio loan criteria available on a $110K income.

Over the next 4 years, housing prices skyrocketed. In 2005, our house, which was now 20 years old, was appraised at $600K, and all I had done was mow the lawn. Something was clearly wrong here, but I wasn’t complaining. In fact, real estate had us all becoming like the “day traders” of the dot-com era. Neighbors would gather and talk giddily about how a small house on the next street had just sold for $400K, then $500K, then $600K. Like many others, we refinanced at 6 ½ percent and then again at 6%, each time grabbing a little more equity to pay for life. Sensing the peak of the market insanity in 2005, we made the decision to “cash out” and moved to an even larger home in Ohio at half sticker the price.

Like the dot-com bubble, the real estate bubble was basically a pyramid scheme. The folks that got in the earliest and then cashed out did fine - as long as there was a bigger sucker behind you, life was great. In the late 1990’s, once word of the “get rich quick” opportunities in day trading made the water cooler rounds, everyone became a player and nearly everybody won – until one day when the combined weight of inflated valuations came crashing down and whoever was left holding the bag got burned – badly. Nobody was complaining while the 200% returns on Lucent were coming in, but after the dot-bomb bust, shareholders were filing lawsuits. As we learned in the aftermath, the bubble and bust was a ‘perfect storm’ of stocks supported by inflated valuations by analysts supported by IPO’s ad nauseam, until the house of cards came tumbling down, and an entire industry of day traders evaporated overnight.

What happened in real estate was actually quite similar to the dot-com pyramid scheme. If you were lucky like me and got in early AND got OUT early, you did fine. Actually, in 2001, real estate wasn’t something you got “in” to. Back then, a house was just a house, a place where you lived and raised a family and surfed the Internet. With real estates’ annualized return from 1978 – 2004 of 8%, any financial upside from appreciation was merely icing on the cake from the utility of the lumber and dry wall that offered protection from the weather. It wasn’t until 2 or 3 years of $60,000 annual appreciation that people started talking and the real estate BOOM was launched. Just like day traders and the California gold rush in January 1848, real estate speculators appeared almost overnight in the form of real estate agents, loan originators, appraisers, flippers, and bankers, creating yet another ‘perfect storm’ of greed.

Real Estate Boom: No Loan Left Behind

If my brother – four years my junior – was offered in 2005 the exact job I was recruited for in 2001, he would have had a problem. The $110,000 salary would have increased with inflation to $130K by then, so he would have been able to buy a $350K house, but there were no longer any single-family homes in the area for $350K. In fact, by 2005, even townhouses and condos were selling for $450K! However, the “speculators” - who had no desire to see the party end until THEY could get out – became increasingly creative, as it became obvious that people would give an ARM and a leg to get in on the real estate boom. New financial products sprung up like For Sale signs to finesse the required paperwork, including “interest only” loans, delayed interest, no money down, adjustable rate mortgages, the 40 year mortgage introduced in 2003, and finally, the coup de grace – the introduction in California of the 50 YEAR MORTGAGE in May 2006! And if this wasn’t bad enough, there was even the introduction of the new “stated income” option – whereby the buyer provided no documentation of income whatsoever – whatever the buyer “stated” his income was, that was good enough for the lender, which is why they came to be commonly known as “Liar Loans.” The entire supporting industry collaborated to create an “un-real estate” market, like pushers enabling their addicts with one more fix, including the appraisers who used the escalating home prices of recent sales to inflate the appraised value of the next sale to meet even the flimsiest of loan requirements. In the end, it was the millions of stated income buyers that provided the HGH (Housing Growth Hormones) of the real estate boom, the speculative, performance-enhancing steroids that enabled instant, outsized, Herculean growth with very little effort.

The Day the Music Stopped

Just like day traders, the real estate speculation bubble burst suddenly, I think it was on a Tuesday. Instead of multiple offers complete with escalation clauses for their home posted on the Internet the night earlier, the couple selling their Nixon-era rancher for $620K woke up to find their driveway, voicemail, PDA, and In-Box empty. And then, like Wile E. Coyote in a helium balloon that had just exhausted its last breath of air, the euphoria ended. Like a cup of black coffee the Sunday morning after Y2K, our irrational exuberance was replaced with the sober reality of a country propped up on inflated valuations and Liar Loans. The smart money – the top of the pyramid - had already left the building with their pockets full and a one-way ticket for a First Class flight to Quality (complete with soft landing). Left holding the empty bag were the masses who got to the party late but didn’t realize it. Caught in the crosshairs were speculative flippers, fresh from their $14,000 2-Day “No Money Down” real estate course, who now have 4 spec houses to liquidate and builders who were constructing condos faster than the rate of population growth.

Whose (De)Fault Is It Anyway?

Just like the dot-com bust, the blame fingers are now starting to look for a target, but here’s the bottom line. Somewhere in 2002, when real estate took on the characteristics of a high-reward investment, it also took on the associated high-risk characteristics as well. There’s a great commercial (ironically for home lender Ditech) that asserts “People are Smart” and for the most part I agree – but they’re also greedy. During the dot-com era, people could have invested their money in railroads, but the appeal of exploding tech stocks was so enticing that they chose instead to plow their life savings into Cisco. They understood full well the risks, but the rewards of 200 to 300% returns repeated over and over by their cubicle colleagues were just too enticing. The same thing happened in real estate, where “the ends justify the means” mentality overtook rational thought. People were so bent on just “getting in” they forsook logic and basic math. Compounding this problem was the growing popularity of shows like HGTV, which helped reset American’s expectations for a baseline dwelling from the 1400 sq ft home our family of 6 shared growing up, to a 4200 sq foot tear-down McMansion. (If you don’t believe me, pick up next Sunday’s Home Depot or Lowe’s flyer and see the “typical” house featured on the front page). Even worse was the blatant “Flip This House” series, a show which has “inexplicably” dropped in popularity and may be poised to be relaunched as “Flip This Burger.”

Just like you can’t blame a jockey for not winning the race, or your stockbroker for selling you Enron stock, people can’t blame their lender for giving them the loan they begged for. If the real estate market was still going up, there wouldn’t have been a peep out of these peeps! Even a 5^th grader knows that buying a $600,000 house is a big deal and shouldn’t be done in haste, and frankly, I don’t think any of this was done in haste. Millions of normal people in our instant gratification society (where we now require microwaves because popcorn takes TOO LONG to make on the stove) made the conscious decision to roll the dice, leverage their futures, and take on sizeable risk, all for the chance to get rich in real estate. And now, when it’s their turn to roll the dice and it turns up snake eyes, they need someone to blame, because personal accountability is no longer a popular concept in our society.

Can’t AFFORD It? That’s the Math Problem

Single-family home prices in major metro markets like DC, Boston, and Vegas, plus nearly the entire states of California and Florida have increased over 100% since 2001, in my case, from $300K to $600K. Incomes during that time have increased much less, in my case from $110K to $130K. It ALL COMES DOWN TO AFFORDABILTY! Incomes have increased 20%, homes have increased 100% - this didn’t matter when loans were based on lies, but those days are over now. When I bought my home in 2001, my mortgage was $2400 a month. The person that bought that same house in 2005 is paying $4200 a month, requiring an income in excess of $200K! It’s not that people don’t WANT to buy houses now, it’s just that the simple math of loan debt-to-income ratios don’t allow it. With the nationwide “Don’t Ask, Don’t Tell” loan approval policies finally curtailed, people are no longer able to AFFORD homes. The result – according to global outplacement consultancy Challenger, Gray & Christmas - is that more than 156 institutions have filed for bankruptcy since the subprime collapse, and banks with ties to the subprime mortgage industry laid off more than 26,000 employees in August, more than any month since Challenger began keeping such records, with many more layoffs (and foreclosures) on the way.

American Hangover: The Aftermath of “Don’t Ask, Don’t Tell” Lending

Just like the tech stock prices lost touch with reality, so has the price of real estate. Nothing will happen in real estate until the price of housing becomes realigned with REAL (not stated) family income. If housing went up 100% and income went up 20% in the past 5 years, then there will have to be significant discounting in the price of housing to get this back in line. Dropping the price of a house that went from $300K to $600K in 4 years “all the way down” to $550K isn’t going to cut it. While it shouldn’t be necessary to trace an 8% price increase from 2001 to 2007 to find that balance, a sub $490K price is a good first step towards restoring sanity. Unfortunately, the problem that many of the existing homeowners trying to sell into this market are finding is that the 1400 sq ft split-level they purchased in 1975 (complete with 1.5 bathrooms and a kitchen the size of a Sub-Arctic Freezer) is no longer considered desirable by many in an era of granite countertops and stadium-seating home theatres. This fact is reinforced by the recent housing numbers, which showed new home sales (complete with builder-laden incentives) far outsold existing home sales in the most recent quarter. To their credit, builders – with inventories of hundreds of brand new homes for sale, have been far more willing to discount price than individual home owners, still clinging to the “Comparable Sales” figures of the hay days of 2006. You’d think with all of the “reality shows” on TV that people would have a better understanding of this concept! The fact is, until the voodoo economics which created this bubble are worked out, the real estate frenzy which created these fantasy prices are simply doodoo economics. (Note: As I write this, Hovnanian Builders just announced a “Deal of the Century” sale on their burgeoning inventory of new homes nationwide. Hovnanian is offering buyers incentives and perks if they will sign a contract in the next 72 hours, with website examples featuring a condo in NY recently reduced by $240K to $862K (22% reduction) and a 2-bedroom home in NJ reduced 25% to $300K. With a glut of over 10 months of housing inventory already on the market, foreclosures up 93% from a year ago (adding even MORE houses), and housing starts and permits for new houses at their lowest level in 12 years, home builders confidence in the market just hit a 16-year low in August…and so begins the real estate “Fire Sale”).

How will Main Street and Sesame Street Affect Wall Streeters on Easy Street?

The impact of the real estate implosion on Main Street means that, for the first time in nearly a decade, Americans will be forced to live within their means. The “lucky” ones that got IN and OUT of the dot-com and real estate bubbles at the right time will have plenty of cash to spend on high-end luxury goods like Porsche (with a stock price up 100% the past 12 months) and Tiffany’s (with a stock price rising from $33 to $53 the past year), and still live within their means. However, there are many, many more who will struggle just to survive, as the broadening chasm between the haves and have-nots expands. Foreclosures will continue to rise as ARM’s reset, and any promised help from the government will arrive too late. The suburban legend of “disposable income” will be a thing of the past for millions, as vehicle, furniture, homes, and other high-dollar purchases will be postponed for as long as possible. Every dollar will be spent frugally, a phenomenon already evidenced by McDonald’s yearlong stock rise from $35 to $55 a share, and the simultaneous plummet of Ruby Tuesday’s stock from $30 in February to $20 last week. When cash is hard to come by, a McDonald’s salad for $3.50 always wins over a smaller portion for $7.50 somewhere else. Remember, when push comes to shove, Americans will ultimately put their money where their mouth is.

Unfortunately, it’s not just restaurants that are taking a hit – the stock prices of these popular retailers foretell an ominous future, as evidenced by the following sampling of malaise: Wal-Mart: Stock dropped from $52 in June to $42 in September. JC Penney: From $87 in February to $64 in September. Sears: From $195 in April to $127 in August. Kohl’s: From $79 in April to $52 in August. Macy’s: From $46 in February to $29 in September. Dilliard’s: From $40 in May to a 52 week low of $19 on September 14^th. Circuit City: From $28 in November to $18 in April to a four-year low of $8 on September 21^st. If 2/3 of our economy is truly dependent on the consumer, then a recession is all but guaranteed, with these Main Street stock prices all PLUMMETING by 20-50% just in the past 3-6 months! Expect retail numbers to continue to fall into Fall, and price discounting for Christmas will be unlike any we’ve seen before – with “Black-Friday-like” sales inching closer to Halloween than Thanksgiving, as stores wage an all-out war for the consumer with PRICE being the exclusive driver and brand loyalty becoming a thing of the past.

Wall Street will finally have to stop waving their “Bernanke Hanky” and realize that any incremental interest rate cut this “House Whisperer” makes will do nothing to stop the bleeding and rebalancing of real estate affordability brought on by the original Bubble Boy Alan Greedspan. It’s not a credit crunch – it’s a CASH Crunch, and it’s the reality checks that are bouncing. People don’t have enough CASH to go out to dinner, let alone purchase homes at the inflated prices reflected in today’s real estate market, and so they will buckle down, batten down the hatches, and a nation of desperate housewives will make do with what they have.

So to answer Wall Street’s question, subprime contagion is inevitable – in fact, it’s already started. Local steakhouses have recently added Subprime Rib to their menu, math curriculums are now including a subprime numbering system, and “The Transformers” have since renamed their upcoming sequel, “Optimus Subprime: A Farewell to ARMs.”

I find it ironic that Countrywide Home Loans is the poster-child for this countrywide problem, and that Bear Stearns was the harbinger of the Bear market destined for our immediate future. And even though you can turn on the TV and find “insiders” who say we’re about to enter a Bull market a month after LIBOR Day – it’s a load of crap – in fact, that’s why they call it a “Bull” market...any 5^th grader knows that!

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ADDENDUM: 5^th Grade Math = Good News for Cleveland

Cleveland has enough political and emotional baggage for a guilt trip to the planet previously known as Pluto, but through the hopeful Buckeyes of a 5^th grader, things start to look pretty good. Cleveland is one of the few big cities remaining after the real estate bubble where you can still “Have It All” – premium quality lifestyle at a value price. Cleveland offers convenient playoff-caliber major league sports teams (baseball, basketball, and football), major league performing arts, major league airport, rail, and interstate transportation, and world-renowned health care facilities – at a fraction of the price of cities on the coasts. As of 2007, here are the stats:

San Francisco: Median Home Price: $835K Median Family Income: $88K

Years it takes Median Family to Buy Median Home: 9.4 years

Germantown, MD: Median Home Price: $450K Median Family Income: $97K

Years it takes Median Family to Buy Median Home: 4.6 years

Greater Cleveland: Median Home Price $153K Median Family Income: $60K

Years it takes Median Family to Buy Median Home 2.5 Years

So, it takes NEO residents 2.5 years of income to equal their home value, versus nearly double (4.6 years) in the DC metro area and nearly quadruple (9.4 years) in the San Fran area! Cleveland is a place where the American Dream is still within reach for 83% of the population. Plus, the U.S. had the warmest April on record this year (4.5 degrees above normal) - so even global warming is working in our favor!

Because NEO was not part of the euphoric real estate highs, it is now buffered from the tumultuous lows brought on by Appraisers Gone Wild, and continues to offer residents a glimpse of Greenwich Village style at Bay Village prices. So whether you’re a Public Square or a University Circle, Cleveland is increasingly becoming a place where Superior and Commerce meet, as more than one CEO comes to NEO. A Great Lake deserves a great city – so bring your Cavalier attitude and join the Tribe working to put the “You” back in Euclid…..or my 5^th grader will come to your house and sing High School Musical II songs until you beg for the return of The Wiggles.

Written by Douglas J. O’Bryon, Soundbite Laureate

September 24, 2007