Speculative Craze is Crashing

Commentary from Gary Shilling

A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants and investment advisers. Visit his homepage at www.forbes.com/shilling.

"The speculative housing craze is crashing from its own excesses, not Federal Reserve action."

"This is the first nationwide housing bubble since the 1920s, and it's driven by three nationwide forces: low interest rates, loose lending practices and the desperate search for a stock substitute after the 2000--02 debacle."

"Previous real estate bubbles were regional, spurred by economic cycles like the rise and fall of the oil patch in the 1970s and 1980s, and southern California's aerospace leap in the late 1980s during the Reagan defense buildup, ending with the Cold War's demise."

"If you still don't believe there's a massive housing bubble that is beginning to deflate, look no further than Toll Brothers. Toll orders fell 32% from a year earlier. The company blames the fall on cancelations by speculators."

"With dreams of huge appreciation dancing in their heads, speculators indeed drove the housing frenzy in the high end. Now that prices are flagging, they are fleeing. These investors and vacation-home buyers accounted for 40% of house sales last year, up from 36% in 2004."

"A lot of these investors rent out the properties. Despite low-payment interest-only mortgages, they cannot cover their cash outlays with rents, which are depressed by the proliferation of spec houses."

"To reduce monthly payments lenders have extended mortgages to 45 years. In 2005's second half 25% of new fixed-rate mortgages were interest-only (meaning the payback of principal is delayed) versus 5% a year earlier."

"And to buoy the subprime market, the U.S. Housing & Urban Development Department has proposed that Federal Housing Authority-insured mortgages eliminate the current 3% minimum down payment. The scheme is supposed to keep housing affordable in the face of leaping prices. But they're not leaping anymore."

"None of this will be sufficient to offset the mass exit by speculators and the hesitation of builders to slash production in the face of falling sales."

"Toll Brothers (nyse: TOL - news - people ) shows, cancelations are starting to be a problem for them. Moreover, this is an industry where small contractors dominate. These guys, who are often one pickup truck away from insolvency, will get slammed when spec houses don't sell or buyers cancel."

"The ten biggest home builders account for 25% of output, up from 10% five years ago, yet that leaves a whole bunch of small fry. Further sales drops are anticipated by the index of home builder sentiment--now at 45, down from the 72 peak last June."

"With inventories high and sales falling, the ratio of inventory to sales flow is rising. Nationwide median prices will probably fall at least 20% before the break is over. It will take a 35% fall to return prices to their long-run link to the Consumer Price Index; markets overshoot on the downside as well as the up."

"Even a 20% price decline will be devastating for many homeowners. On average, those with mortgages have 37% equity in their abodes. Of those who borrowed or refinanced in 2005, 29% have zero or negative equity, calculates First American Real Estate Solutions."

"A house-price collapse will be far worse than the 2000--02 bear market on Wall Street and will bring a serious global recession. Half of households own stocks or mutual funds, but 69% own homes. The resulting unemployment will kill many subprime borrowers' ability to make payments. Both Toll Brothers at the high end and dr Horton in the starter market will suffer."

"You can short-sell the bunch through the SPDR Homebuilders Index Fund (XHB ). Building suppliers and mortgage lenders are suspect. Golden West, the king of option mortgages that permit negative amortization (that is, your principal grows), timed its recent sale to Wachovia (nyse: WB - news - people ) brilliantly. Home appliance makers and do-it-yourself retailers are also vulnerable. Wait to remodel until contractors are hungry."