Ok, one more "bad news" article for you:

Housing is unlike any other asset. If, for instance, you want to sell a stock, you just sell it. There is a pool of ready buyers willing to buy the stock on the open market. Housing, on the other hand, being such a large, indivisible asset, is much more difficult to move.

For example, let's say Abel needs to sell his house, and Brian wants to buy it. Brian, however, must first sell his house to Charlie. Charlie must first sell his house to David, and so on until someone buys a house from someone who does not first need to sell his own house.

If we would put a dot on the map for Abel, Brian, Charlie and David's houses, then connect the dots, from Abel to Brian, Brian to Charlie and so on, we would have a line zig-zagging across the map. This line from end to end represents one successful housing transaction. The only way for any one in the chain to complete the sale or purchase of his house is for everyone else in the chain to complete the sale or purchase of every house.

The housing market consists of a large number of these “lines” of transactions. Think of the map looking like a bowl of spaghetti with all of these extending through it. Typically when talking about a system, this kind of relationship is called a “chain” with, in this case, each link being a purchase or sale of a house. A chain must have a beginning and an end, the importance of that fact is something we'll get to in a moment.

The number of successful real estate transactions is determined by the number of these chains that form, times the average number of links on each chain. You can increase the amount of successful transactions by either lengthening the chains or making more of them.

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Each chain must have a beginning and and end. It must start on what I call a “fresh” purchase, one that does not require the sale of another house to complete. There are only two kinds of possible fresh purchases:

A first-time buyer, i.e. someone who has just gone from renting, living with parents or living in a dorm room.

A speculator, who is buying an additional house as an investment.

In the last few years, low mortgage qualifying standards, toxic loans and “stated income” loans have increased the number of first-time buyers. In addition, the rising values of real estate have brought in more speculators. The combination of these two effects have much multiplied the number of housing chains in the marketplace, since each chain is rooted in a fresh buyer.

What this means is a 10% cut in prices of McMansions won't reinvigorate the housing market. The number of $1 million behemoths successfully sold depends on the number of $200K starter homes sold in the same area. Without a new supply of fresh buyers, the number of chains dries up. This is what we have begun to see in the real estate market, with rising cancellations indicating that chains are not successfully being built.

The other end of a chain is also important. A chain ends in one of the following types of transactions, all of which do not involve the seller buying another home:

A purchase of a brand new home.

Someone selling a house and returning to renting

A speculator selling an “extra” house

Liquidation of foreclosed property

Death or infirmity of the owner.

The more ends of chains there are available, the less the number of links in the chains since an end stops a chain dead. With less links in each chains, there need to be more chains available to make up the same number of successful transactions.

With the overbuilding of many markets around the country, we are seeing more new homes coming on the market at the same time that the number of fresh buyers is dropping. This shortens the chains and simultaneously reduces the number of chains. It cannot be good news, and it will not resolve itself in a quarter or two.

FSU Editorial: "Chained to Housing" by Pete Koziar 01/09/2007