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Tuesday, May 30, 2006

Real Estate: The Wall Of Silence Is Broken

Reality is beginning to penetrate the world of real estate, and maybe it's a good thing. Those who have been anticipating a "soft landing" in the housing market have been greatly overestimating the risk of inflation and therefore the need to raise interest rates.

Several current articles discuss the reality of real estate in a way of which NAR would not approve. The current situation is that real estate values in many areas have fallen 10% or more, but that at least another 5% is in the works from the funny-money loans that were made. With foreclosures escalating around the country, that much is certain.

The formula to use is that prices will drop by 1/2 of the current price decrease in your area in the next year. That's a floor, not a cap. So if same house sale prices have already dropped 20% in your area, then you can count on real prices being down 30% before prices can possibly rise again. If they have dropped 8%, then you can count on 12%. If they are rising, then the effect will be to curtail prices. However if they are rising and more than 40% of the borrowers are using adjustable-rate, exotic or funny-money(low-doc, no-doc) loans to buy, you are more likely to see price reductions within two years. This appears to be the rule across most of the US, so be very wary about purchasing now. If you can't afford to buy using a fixed-rate mortgage, don't.

Barron's is uncommonly realistic:
"If you want to sell, you've got to go back to '04 prices," says Chip Harris of Coldwell Banker Previews International, which is handling the property.
Though the official figures on sales prices have yet to reflect the current round of cuts, interviews with real- estate pros and others strongly suggest that the averages are deteriorating in a number of key markets.
For starters, many second homes have been sold not to serious vacationers but to speculative investors hoping to cash on the national real-estate craze. How else to explain why six out of 10 second-home owners surveyed by the Realtors group own two or more homes in addition to their main residences?
The Barron's article has a chart of National City's overvaluation estimates that will sober you up quickly, and lists examples of significant prices cuts.

Another article that pulls no punches is the Herald-Tribune's look at the Florida market:
If a consumer compares what a given home would sell for during the market's hey-days in 2004 and early 2005 to now, they would likely see declines ranging from 15 percent to 20 percent, and in some cases even more.
That's true in many hot markets. In markets with less investor participation, prices seem to have dropped 8-12% on average. What's really bad about this is that we have not yet seen much impact from the huge rise in funny-money and exotic loans since 2002. Here is what one insider posted about those on the Inman blog:
Here's my two cents (and this is coming from a mortgage loan officer):

When you get people working on commission who don't get paid if they don't close loans, and you start giving them loan programs that are easily abused to allow a purchase to proceed in nearly ANY situation, you are setting everyone up for disaster.

There are a lot of wholesale lenders these days that have incredibly stupid loan programs available that are intended to take advantage of incredibly stupid/uninformed borrowers who are obsessed with owning a home.

I'm talking about negative amortization loan programs that require no income verification and allow the borrower to qualify for the loan based on the negatively-amortized payments, and they need not bring a downpayment.

I'm talking about loan programs that require no asset verification.

I spoke with the FBI the other day to see what they were doing about fraudulent income disclosure on stated income loan programs (those are the kind where you don't document income). The response I got was astonishing:

"Well, we know about those programs, but they're really only available to people with good credit who are less willing to commit fraud".

The guy was stunned to find out that people with total garbage for credit history can get one of these loans.

In a lot of areas in Florida and California, housing prices are so out of line with levels of income that NOBODY can afford a traditional loan on their wages, so they do these programs that allow them and their mortgage broker to lie about their income.

What's the result?

Housing prices inflate past the point they should have. Where appreciation should have stopped when nobody could afford the prices, it instead continued because people are simply lying about their income just to make the deal fly.

Mortgage brokers, Realtors, consumers - they're all to blame. The funny part is that there's no end in sight. The FBI is clueless (mortgage fraud is a federal crime, so it falls in their jurisdiction), and banks couldn't care less because they're making money on the loans by trading them on the secondary market. As long as they write the loan and get it traded before the person starts making late payments and going into foreclosure, the original lender couldn't care less.
We are in a decidedly unvirtuous cycle with regard to most real estate markets in the US, and you can expect significant further declines in the market. Banks are exposed to losses, because they do hold many non-conforming mortgages, and in addition they hold many home improvement/home equity/HELOC/purchase piggyback loans. The majority of these are last-dollar loans, which means that the bank is last in securitization, and that if the borrower defaults, those holding the primary mortgages will get paid first. The bank will get what is left over, and in some cases that won't be anything.

The impact that this will have on the economy is unknown, but the combined effects of the end of the housing ATM and bank losses are going to exert an strongly contractionary force on consumer spending and banks' willingness to lend. If the Fed keeps raising rates it is running the risk of causing a very significant financial shock.

"if same house sale prices have already dropped 20% in your area, then you can count on real prices being down 30% before prices can possibly rise again"...do you mean 30% from the current base, or 30% overall including the 20% that's already happened?
30% overall.

If a house peaked at $500,000 and can now only be sold at $450,000 (lost 10%), the odds are very high that if you have to sell next year you'll be selling somewhere around $425,000. (But remember, you many have purchased 2-3 years ago at anywhere from $399,000 to $420,000.)

Rate resets on badly qualified borrowers in a dropping market produce forced sales or sales by banks, and that pushes prices down. We are just starting to see the impact of the rate resets. Almost all of the current dropping is from the change in speculation and investor activity.

Of course, if you don't have to sell - you can afford your payments for the next three years and you expect no transitions in your future - then this is all academic. Eventually the curve will straighten out.

How quickly it will straighten out depends on interest rates, the degree of historic speculation in your area, the general economy, the Fed's actions and the regulator's actions. If the regulators put out a rather strict guidance on "layering risk", i.e. the types of lending practices the Inman commenter described, it will have an impact on future qualifications and further restrict demand.

For what it's worth, the estimate in San Diego is still an affordability rate of 9%.

The homeowner participation rate peaked at between 69 and 70%. It is now down to 68.5%. Another indicator to watch for is 65 or 66%. Six months after that is reached the overall risks of further price drops will be much less.
How about a few words on property tax valuations? They raised mine by 50K last year and are proposing 45K more this year. I wonder if they will be reduced?
I'm getting the feeling that a lot of areas were rushing to get them in at the peak.

No, they will not be reduced. My mother had hers hiked over a $100,000. She certainly couldn't sell the place for the valuation.
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