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Monday, May 01, 2006

In a less than rosy WaPo article, Mark Zandi of Moody Economics is cited as predicting drops in housing values for the Washington area:
Condominiums will be hardest hit, Zandi predicted Thursday at the National Association of Home Builders' spring construction forecast. He said during his presentation that there are no hard data to pin down how far prices might fall or how the prices of single-family houses would be affected, compared with condos. In an interview later, he said that the growing inventory of condo units that are for sale or being built here suggests that the slide would be worse for that sector.

"I could say roughly that prices would fall about zero to 5 percent for single-family homes and about 15 to 20 percent for condos," he said.
I think Zandi is too optimistic for the nation as a whole, based on lending patterns over the last few years. His prediction is that nationally prices will be flat through 2008, with only localized corrections or crashes (greater than 10% drop in prices).

Zandi sees interest rates as being the major factor; I believe we have a downward spiral with multiple trigger stages already built into the US housing market. The first trigger was the investors getting out of the market; now we only have speculators left in. The exit of the investors is what has produced almost all of the sales drop in hot areas. See, for example, this article on NJ real estate discussing a presentation to a group of homebuilders by Jeffrey Otteau:
According to his data, median home prices statewide increased about 10 percent during the 12-month period ending in March, and most of that growth was in the period through August 2005.
Statewide, the average number of sales dropped by 12 percent and the average number of listings jumped by 65 percent in the first quarter, compared with the same period last year, he told the crowd.
The factors he lists for the sales downturn are:
But if sales are only down 12%, it's clear that so far only the impact of lower sales to investors has been felt. The average homebuyer is still in the market, and in fact more of them are in the market than late last year, because people who were looking to buy last year and couldn't are finding that they have some better pricing now. Since interest rates are still quite low and underwriting requirements are exceptionally low, they are both motivated and able to buy now.

Going forward we will see investors staying out of the market for several years. The last big surge of primary-residence homebuyers will be drying up this year. The wave of resets is already producing more foreclosures and forced sales nationally, and this wave will continue to mount for the next several years. Nervous about losses and possibly even forced to it by the regulators (banks only), finance companies and banks will begin to tighten credit underwriting standards later this year. This spring, those credit underwriting standards have not yet been tightened for most of the country. That tightening of underwriting standards will further contract the pool of available borrowers.

To put it bluntly, with homeownership around 70%, most of those who can handle a mortgage already have one, and unfortunately at least 5% of those who do have one can't handle it. Because of the built-in wave of forced sales and the relatively high level of new home inventory, anyone buying in most of the country will have lower-priced options from which to pick. If you have to sell within a few months, in most of the country you will have to price below the median. One cannot continue that trend for more than six months without seeing a fall in prices, because the median will keep dropping.

I have written about all of that before. Tonight I want to look at the risks for banks in particular, and explain why real estate woes will bleed into the general economy quite quickly. The basic reason is that amount of homeowner housing equity has shrunk even while the price of homes have risen. Far too many people who did have home equity have tapped into it, and far too many of the homebuyers of the last few years were relying on non-amortizing, low-or-no downpayment loans.

Let's look at Home Equity Lines of Credit (HELOCs) in a banking environment such as this one. We have a negative savings rate nationwide, in part because of the epic flood of borrowing on home equity. For years banks have been offering HELOCs on very good terms to borrowers. In part this was to shelter themselves from interest rate risks, because most HELOCs are variable rate, and most are indexed to WSJ Prime. In Florida, for example, many banks have been offering ten year interest-only HELOCs with no closing costs indexed to WSJ Prime. Many of these HELOC's were lent on a 0% margin.

In an environment with rising interest rates and stagnant or dropping housing values, the quality of an average bank's HELOC portfolio degenerates rapidly. In March of last year the monthly bill for a $100,000 balance on an interest-only WSJ Prime zero-margin HELOC was $458.33; in March of 2006 it was $625.00. That's because in March of 2005 WSJ Prime was 5.5% and less than the average 30-year fixed mortgage rate. In March of 2006 it is 7.5% - more than 1% above the average 30 year fixed mortgage rate.

That 1% spread between mortgage and HELOC rates is significant. It means that many borrowers will pay down the line as quickly as they can, and some will refinance their mortgages while rolling their HELOC balance into their mortgage.

The better credit risks will refinance out or pay down. What the banks will be left holding are those with low balances (they don't make much on those and may lose money), those who do not have enough equity in their homes to refinance, and those who are poor credit risks altogether. This sets a bank up for an unpleasant degree of lower profit and higher risk. These are mostly second and third liens, so the HELOC lender is last in line to recover capital if the borrower defaults. If the bank has been lending up to 90 or 95% of appraised value of the home and prices decline or stagnate, the bank will lose capital if the homeowner defaults.

Certainly the bank is now less competitive in writing new lines due to the higher cost of borrowing compared to other options. The borrowers who are stretched to make ends meet will be the ones drawing on their established lines. By law, banks have few options that will allow them to accelerate the HELOC or refuse to make further credit advances. In many cases they have fewer options than for their portfolio of non-conforming mortgages. Credit card companies can raise an over-extended borrower's interest rate or lower the borrower's credit limit, but the holder of a HELOC cannot raise the interest rate and generally cannot make demand for principal repayment until default.

(The only circumstances under which a HELOC lender can make demand for the principal or freeze credit advances are found in Title 12, Part 226, Subpart B (f), i.e. Reg Z 226.5b(f)(2-3). The lender can call if there was fraud or material misrepresentation, if the borrower fails to meet the repayment schedule, or if the borrower is lessening the value of the security or the lender's right to the security by action or inaction - for example, leaving a roof unrepaired or not paying the taxes. The lender can generally only halt credit advances under the plan if the appraised value of the dwelling drops significantly, if there is a material change in the borrower's financial circumstance such that the lender reasonably believes the borrower will not be able to repay, if the borrower is in default, or if the lender is notified by a regulatory agency that further advances would be unsafe or unsound.)

So how does the bank recover? Well, it will certainly be careful about the new HELOCs it underwrites, even though it needs them badly to offset the sifting effect described above. It will likely extend less of the appraised value of a home on those lines. It may increase credit score qualifications for those lines. And, overall, the lender will enhance its scrutiny of its HELOC portfolio, including conducting reappraisals of the homes on which it has lent money.

But its ability to recoup credit quality on this portfolio is not great. The bank will also tighten other credit standards, including for business purpose credit, in order to make sure that its overall capital requirements don't increase. The bank may well call some business purpose loans in order to lower its exposure to this range of credit risks. This means that small business owners in particular will be hit by increased borrowing costs and tighter credit. So not only will consumer spending contract over the next two years, but the very important small business sector will face credit challenges. Most job generation in the US occurs in small businesses, and many of these businesses are financed by personal or commercial lines of credit secured by the borrower's home.

And that, my friends, is how a small rural community that has never seen the inflation in housing values over the last three years will be adversely affected by the end of the real estate runup in California, DC and Florida. Credit markets are national, and increased risk in California equates to tightened lending standards in Podunksville, SD. Even if the credit is purely local with a small local bank, you can be sure that the regulators will be scrutinizing that bank's loan porfolio and its collateral more carefully within the next two years than they did the last time the examiners visited. Every banker out there with any experience knows this is coming and is trying to prepare for it.

This is a really good post- lots of good info.

Still, the facts are hard to ignore: RE listing up, number of buyers, down. While some segments of the market may avoid the tsunami, most will not.

As a rule, loosely anchored trailer homes get sucked up by the tornado.

Prayer won't help, no matter how pretty the trailer.
Yes, there does seem to be quite a tornado swirling around those FL condos that were being sold two or three times before they were even finished last year.

But some places in the country are still good. Texas. Big hunks of NC.
Headless Unicorn Guy, still holding the fort in SoCal.

Been around a lot of housing bubble blogs recently? They're starting to sound more and more like DU, Creation Science Institute, or Art Bell's phone lines at 3 ayem. Including the "gold, assault rifles, freeze-dried food, assault rifles, escape routes from the cities, and assault rifles" crowd. (Just like the Late Seventies/Early Eighties fringies all over again.)

Judging from Zillow.com's price-history graphs, I expect a drop of 50% locally (Anaheim, CA) within the next two years, and that's not counting Bird Flu or Iranian Nukes. (However, current prices are so inflated I can take a 75-80% drop if I had to and still come out ahead; the last crash 10 years ago was a 60-70% drop.)
You're tougher than I am. The idea of a 50% drop ANYWHERE freaks me out. It's, um, a banking thing.

Still, eventually we will come up the other side of the valley. Like you say, we've seen this before.

I can't deal with the hysterics of some of the bubblers. I have noticed that some of them seem to have a deep, deep animus towards those who bought and made profits. To me that's silly. After all, I'm sure that most of those who bought would have preferred to have cheaper prices.

What bothers me is those who bought toward the end of the cycle. Most of them probably just wanted a home. Because of the irresponsibility of lenders, many of them will take a bad hit that they in no way deserve. They got very bad advice and it will be no consolation to them that someone else somewhere down the line will also be taking a loss.

The Headless Unicorns would be a great title for a band - or even for a bubble blog!
Great article! Mortgage. Find best mortgage rate and mortgage calculator.
Great article! Mortgage. Find best mortgage rate and mortgage calculator.
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