5 Reasons Why The Housing Market Will Continue to Decline Until 2010: Extrapolating The Free Ride Bird and Dancing with the Housing Pied Piper.

Many know the story of the Pied Piper of Hamelin. Legend has it, that in 1284 the town of Hamelin Germany was suffering from rat infestation. The townsmen where worried and desperate for any help. In comes a man in colorful garment promising the town that he would lure the rats away. The townsmen in return promise to pay the man. The man accepts the offer and plays a musical tune on his flute luring the rats away where they are led to water to drown. Even though he succeeded as promised, the people in the town refused to pay. The man left but later returned to the town to seek revenge. After returning, he played his pipe once again but this time lured children of the town away never to be seen again.

Now Im sure many of you have used the term pay the piper but apparently many are now reneging on this promise and simply walking away from their mortgage obligations. What we suffer in this decade is a consumption infestation built on credit and when push came to shove, many people werent too attached to their homes. From a business stand point, if you are severely underwater on your mortgage walking away may be the best option. In fact, we are now seeing people employ this technique on auto loans and also credit cards. After all, if you are having a difficult time paying a resetting mortgage you may also opt to let the $80,000 luxury car go with it. In a USA Today piece there is a new trend emerging, some mystics and erudite economist are calling it Spend Less Than You Earn (SLTYE):

Theres no turning back soon for mortgage loan originator Martin Richardson of Suffolk, Va. He used to buy four suits a year at J.C. Penney (JCP). In the past year, he didnt buy any and will make do with his wardrobe again this year.

I cant afford it , he says. Nothing could lure me back. Not two-for-ones. Not 20% off. Nothing.

Its not just leaner times, Richardson says. I wont go back to my old ways when the economy improves, he says. Its hard for friends to understand, but Im working on becoming more of a minimalist. Its a relief to have less.

I think Henry David Thoreau just shed a tear from heaven. This is all well and good but the transformation is happening more out of necessity than the idea that it is now trendy to spend within your limits. What has occurred over the past two decades is an incredible consumption society that with stagnant wages, used credit to bridge the gap over the Nile river into believing they were somewhat wealthier than they truly were. So what are the five reasons housing will continue to decline over the next three years? There are many more but here is a brief list that we will go over; free ride bird no longer flying, new budget line item of servicing debt, down payments be gone, rewriting universal laws, and salt in the consumption engine.

1 The Pied Piper Wants your Custom Home and Mercedes

*click to see free ride bird leave our economy for a few years.

The picture above sums up the past decade of our economy. At a certain point, the gig was going to end and we were going to have to face the music. The assumption made by many people, especially here in California, is that we had a large enough base of wealthy consumer that would contribute to ever increasing housing prices. As I wrote back in April of 2007 in Americas Codependence on Housing: 30% of Job Growth Contributed by Real Estate. 5 Point Plan on how the Bubble Will Burst , I looked at the Catch 22 that we found ourselves in. We became so reliant on housing that the only way the economy would continue to grow is if housing kept going up. Housing took a larger chunk out of our paychecks. You can read the article for greater details on this but the final point I made was we would be facing a housing led recession before any perma-bulls were willing to admit the fallacy of their own perpetual motion machine built on mortgages.

The free ride was built on easy access to credit fueled by the lax lending standards of the Federal Reserve and the lack of any enforcement of any laws. We had a monumental shift in psychology during this time. Through financial alchemy and risk management, it was no longer necessary for you to save to purchase homes or any other consumption items. Through the art of loans, you were able to have that $70,000 car on a 6 year note or that glorious $600,000 McMansion with a 2/28 Option ARM Mortgage. So what if your income was only $75,000 because you had to keep up with folks making $14,000 passing you up in the fast lane buying homes in the $700,000+ range. But all this spending was nothing more than a pyramid scheme. You had to keep getting new credit via refinancing or credit cards to simply keep the game going. In fact, many homes were the gift that kept on giving. With HELOC, you had a built in ATM machine with your house and many came to rely on their home as another source of credit.

Like any Ponzi Scheme, the game ends when there is no new money coming in. The housing market, even when it was stalling not even declinding, started showing cracks in early 2007. The gig was up.

2 When Servicing Debt Eats into Your Nonexistent Savings

Take a long hard look at the above charts. How can it be that a booming housing market with so many artifacts of wealth floating around have underneath its hood, a society that was heading toward a negative savings rate and had a larger percentage of each paycheck being eaten up by servicing debt? There is a sense of irony that in 2005 when we hit the absolute peak of the housing bubble, that is the same year that we solidly entered a negative savings rate as a nation. That is, we were spending more than we were taking in. Weve learned well from our government who has a continual monthly trade deficit.

This didnt seem like a problem when credit was easy and the only requirement to get a loan was the ability to fog a granite countertop. Now, with the August 2007 credit crunch, easy credit is becoming more and more of a historical footnote. You may be thinking, but didnt people need to have some cash to purchase homes during this boom? If you say that housing was accelerating while savings was dwindling, how were so many millions of Americans able to purchase homes with negative savings rates? Well my friends, creative financing had a solution to that one and it was called no money down .

3 Down Payments are Coming Back!

You may be surprised that in 2006, 21% of all California buyers went no money down. This is a stark contrast from 2000 when only 3.9% of buyers went no money down. Keep in mind that well into the middle of 2007, many of these absurd mortgage products were still floating out in the market. However, with the advent of tighter credit standards the market has completely dried up. Bringing the down payment back and simply looking at income (refer to point #2) was enough to pop the entire housing market. Nationally, we already know that we are facing a correction. But just take a look at the data for California:

Data for January 2008