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Thursday, April 20, 2006

Foreshadowing The Broader RE Market

Okay, a few commenters have harshly reproved me about my prediction of a recession beginning in 2007 and becoming severe in 2008. I don't like my own prediction, but I think the broader markets are just beginning to realistically assess the effect of so radically changing the mortgage structure (from amortizing loans with downpayments to non-amortizing loans with no or insignificant downpayments) in just 4 short years. This is why I am so much more pessimistic than the average commenter.

The traditional RE metrics don't hold true because this capital market is not traditional. Normally you don't have a problem with falling home values in a time of low unemployment. However, over the last few years the flood of negative-amortization and interest-only loans have deferred affordability issues a couple of years down the road. If interest rates were not rising, the effects would be less dramatic, but many homeowners are going to see their mortgage payments rise by 20 to 70% over the next two years. That will force them to get out, but those who have little equity in their homes will only escape with their lives. The institutions and investors who hold their mortgages are going to take losses too. We are not really seeing a demand bubble popping, but a risk bubble popping. See this excellent article about the San Diego market for more details.

Leading edge indicators of the degree of risk inherent in this market:
1) Last week Acoustic shut up shop. It could not write loans profitably.
2) USA Capital filed for bankruptcy:
The company, with an office in Reno and Incline Village, raised investment funds to make short-term mortgage loans secured by real estate development and commercial properties.
It's the latest in a series of private lenders who have failed in Las Vegas, including Harley Harmon Mortgage, Interstate Mortgage Group and Global Express Capital.
Lenard Schwartzer, an attorney for USA Capital, told bankruptcy Judge Linda Riegle on Monday that the company continued making distributions to all of its 3,600 investors even though many borrowers stopped paying interest on their loans.
I wrote before about the palpable uneasiness about commercial lending. This is an example of why. You will see the same happening in Florida.
3) Look at Denver and Colorado:
Colorado earned a distinction in March it would rather avoid - the highest ratio of foreclosures in the country.

One out of every 339 homes in the state was in some stage of foreclosure during March, according to RealtyTrac, an online provider of foreclosure listings.
Borrowers here also lead the nation in their reliance on adjustable-rate and interest-only mortgages. Payments on those loans have risen as interest rates have ticked higher.

"We made it easy for people to buy houses and difficult for them to hold onto them," said Tom Clark, an executive vice president with the Metro Denver Economic Development Corp.
No s--t, Sherlock. Affordability over the life of the loan is extraordinarily low. I don't think it has ever been this bad since the 1920's, and I don't find that a comforting economic comparison. We were lending on RE based on the expectation of rapid equity increases, and now we have to face the fact that in areas where most of these loans were made, many homes will lose a minimum of 10 - 20% in appraised value over the next two years. This guarantees many homes moving back on the market and a lot of short sales or foreclosures, which will contribute to push prices down further. It's a self-reinforcing cycle which is already working overtime in Denver. I have read articles and comments from brokers there commenting that 30% of their listings come from bank sales.

3) We are in a very inflationary period, with real GDP growth souring, and the Fed has no ability to intervene. Long term interest rates for mortgages will rise as the market recognizes the higher degree of risk in these investments and due to the overall expectations about inflation. This raises the effective price of houses and exerts strong downward pricing pressures.

4) The current decline in local housing markets such as Boston, Phoenix, big chunks of CA and Florida is only due to investors stopping purchasing properties. Estimates of total homes held by investors range from 15 -20%. Demand from people seeking to buy a home in which to live this spring has actually picked up, due to better pricing. But a lot of new home building in home markets was really catering to investors, which was why you saw an over 20% drop in new home sales in the west. In Florida, the condo overbuilding is ludicrous. I want to repeat that some areas in Florida now have a 5-year supply of condos on the market at current purchase rates.

Investors seeking to clear their portfolios and the higher mortgage rates for new home buyers (which affect even interest-only loans) will operate synergistically over the next six months to push prices lower. As the default rates on loans begin to rise, we will start to see a tightening of mortgage lending standards (which hasn't happened yet). That will contribute to the trend. Mortgage lenders and real estate brokers are already laying off employees in many markets. With housing starts dropping, there will be less construction employment. In a few areas of the country, such as some parts of Florida and SoCal, the effect on the local economy will not be subtle.

5) The higher interest rates on HELOC's (home equity loans) will constrain consumer spending and exert a drag on the economy. The stagnation or regression in appraised value will prevent homeowners from taking more money out of their houses to spend, which will be a significant drag on the economy. The worry over commercial loan portfolios will also tighten business credit and exert a drag on the economy.

6) The current demographics don't favor the housing market. The leading edge of the baby boom generation will be retiring over the next ten years. Many of them will be looking to sell their current homes. However, many of them have already bought second homes. In some cases, they've bought five or six! Over the next five years, more of these people will be selling than buying.

Stepping back and looking at the overall picture, it is clear that investors worldwide have been concerned about risk in general and perhaps global instability. Thus the flight to gold and RE, which has been considered a safe investment. In many ways, the low cost of money over the last few years in the US has been a trade-off of high returns in exchange for low risk. Our markets will adjust over the next few years, the risk will shake out of the market, and then RE will become a safer investment. So long term buyers who are not getting in over their heads need not feel great concern; they really don't need to see immediate price appreciation, although they should think twice about buying in markets in which rents are below 80% of carrying cost of a home. They can afford to wait.

To track the market overall, Hanley Wood offers an excellent set of housing statistics.

If it's any consolation, Europe seems to have a worse problem than we do. In Ireland, for example, the 10 year interest-only mortgage is a common way to buy a home. Global concerns over credit risks and instabilities (such as the derivatives market) continue to increase.

There is a possible upside to this for the US. Suppose (and this is a big supposition), we got serious about an energy policy. Suppose we built refineries, opened new oil fields as prudent, pursued any new energy technologies that had a chance of success, and started to invest heavily in nuclear power. The flood of money leaving housing could find a very profitable investment in these new endeavors, which would generate good jobs and help increase our manufacturing competitiveness. Instead of investing in bubbles, we would be investing in the fundamental US economy. The net effect over a decade would be to reduce inflation and increase employment.

Enhanced energy independence would also be a big national security asset. This could be a very, very healthy development for the long term future of the US. Of course, first the US would have to remove barriers to energy development in the US, so this is a big if. Yet there is no barrier to this now except our own stupidity. Why not contact your legislators about this issue?

"Suppose we built refineries, opened new oil fields as prudent, pursued any new energy technologies that had a chance of success"...the primary thing slowing down alternative-energy investment, IMNSHO, is fear of a sharp decine in oil prices which would make these capital investments uneconomic. If you put a billion into a biofuels plant that provides a good return on capital at $60/bbl, and the long-term price goes down to $30/bbl, you're pretty screwed. There seems to be considerable worry about this scenario in the industry. One possible solution would be for the government to sell PUTS on oil which comes from entirely US (traditional or alternative) sources...the producer would pay $X/bbl for the PUT, which would give it the right (but not the obligation) to sell oil to the government at a defined price.
David - I agree about the problem. It is real. The extreme upset from the Saudis when Bush starting talking about energy independence the other day proves that they are very nervous about exactly this possibility.

I haven't thought about the solution, but that's at least worth discussing. You realize that if the government did this it would produced outraged shrieks about Haliburton and Cheney, don't you?
That will force them to get out, but those who have little equity in their homes will only escape with their lives.

I like St Paul's imagery better: "Escaping as through a fire".

I haven't thought about the solution, but that's at least worth discussing. You realize that if the government did this it would produced outraged shrieks about Haliburton and Cheney, don't you?

Stripped of all the Concerned & Compassionate Activism (TM), more like "GIMME MY BREAD AND CIRCUSES! MORE BREAD! MORE CIRCUSES!"
Well - this sort of thing isn't romantic and can easily be spun. I am afraid we are out of circus money altogether and our bread money is running short.
I'm sure you're right about the "outraged shrieks." This could probably be minimized if the PUTs were applicable only to "alternative energy," however that might be defined.
It scares me how much people I talk to are in such willing denial about the possibility of anything going wrong.

It furthermore scares me how much of any economic improvement in the last three years or so has been thanks to retail spending - and how much of THAT has been due to people taking equity out of their homes to give them extra spending money - and what proportion of new jobs and expansion has all been in the housing market, fueled by low interest rates and boom demand.
Morven - your point about consumer spending and the massive mining of home equity to support that spending is something about which the FRB has been expressing concern for over a year.

I work in the banking industry. Right now the competitive pressures are such that they are leading the non-bank financial sector to dump any reasonable standards of credit qualification down the drain, which has been steadily pushing banks to loosen their own.

If RE prices drop 10% overall (and in Florida an average 20% drop is virtually locked in already), then the number of homeowners upside down will be historically unprecedented since the Great Depression.

I cannot model a scenario under which this does not lead to a significant recession. Our government cannot intervene in any significant way either.

We need an economy with a stronger base, and the best way to generate that is to develop our ability to produce energy economically in the States. We cannot do that purely with alternative energy at this point, so we need to turn to nuclear power. I don't see any national recognition of that at this point.
If RE prices drop 10% overall (and in Florida an average 20% drop is virtually locked in already), then the number of homeowners upside down will be historically unprecedented since the Great Depression.

In the last real-estate crash here in SoCal (10 years ago), property values dropped 60% in two years before bottoming out in 1997.

One side effect was unbelievable nastiness and scapegoating among property owners, especially in condo homeowners' assocations: "WHERE DID MY PROPERTY VALUES GO? WHOSE FAULT IS IT? HOW! DARE! YOU! BRING *MY* PROPERTY VALUES DOWN!" (i.e. Somebody had to pay for the drop in *MY* property values, and it's not gonna be *ME*!) We were getting slashed tires, cut phone lines, and threats of false rape and drug accusations thrown around; so many of the latter the Anaheim cops put any complaint coming from our complex in the "nut file".

P.S. Check out a website called "America's Overpriced Real Estate" sometime. Google the string "overpriced real estate" to find it.
You're talking about this blog. It is extremely funny.

However I stopped reading it when I encountered the 2 million dollar cottage in Newport Beach seen here. I hurt myself laughing.
PS: You are right. Some of these places will lose more than 50% in value.
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