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Tuesday, August 22, 2006

RE: Home Loans

Tomorrow the existing home sales update is due, and on Thursday the new home sales update will be published. Those figures will be for July.

I'm not even that interested, because what will determine the future of residential real estate in the US will be underlying market forces. The main forces driving the market are a lack of affordability combined with a desperation to move product. We are seeing a paradox of some types of credit tightening while other types are loosening.

See this post at The Housing Bubble Blog for background. All the market reports that I am reading indicate that many nonprime lenders are experiencing a drop in profitability. I blogged about this earlier, but here's another article on the same topic:
Buybacks of defaulted loans demanded by whole-loan acquirers, particularly Wall Street firms, have in recent quarters led some lenders to incur losses and set aside more money in their reserve funds for potential loan repurchases in the future. An increase in those reserves then cut into their profits. To shield themselves from future buybacks, some lenders including NetBank Inc. and Fremont General Corp. have backed away from offering loans that have seen greater delinquencies, such as those featuring higher loan amount relative to the property value and lower credit scores.
At subprime lender Fremont General, the amount of home loans repurchased and re-priced reached $238.4 million in the second quarter, up from $67.7 million in the year-ago quarter and $107.7 million in the first quarter of this year. The Santa Monica, Calif., company said it had cut back on "certain higher loan-to-value products and lower FICO" loans during the second quarter to reduce early payment defaults and thereby loan repurchases from investors.
Okay, note that the buybacks are being caused by loans that go into default almost immediately, which generally indicates either a combination of fraud, crazy lenders and crazy borrowers or money laundering. But the money launderers are generally more subtle these days, and they put down higher downpayments, so the craziness factor must be pretty great. Since they can't offload the risk, these lenders are cutting back on terms that produce an early default. This is reducing demand somewhat. Some of these lenders are clearly not increasing reserves in sufficient numbers to offset the buybacks, and I think that their losses will start to increase as underwater borrowers stop being able to refinance.

However, at the very same time it appears that brokers and homebuilders are dropping their OVERALL credit standards in order to keep cash flowing. See, for example, this description posted at Piggington's of Beazer-like offers in CA by Centex:
*0.875% Interest Rate / APR 6.053%. APR is subject to increase. Loan package consists of a first lien for 80% of the purchase price. First lien has interest-only payments for the first 5 years. Followed by 5/1 LIBOR ARM with 10 year interest only payments. The discounted rate of 0.875% will remain in effect for 12 months, followed by a rate of 1.875% that will remain in effect for 12 months (months 13 – 24), followed by a rate of 2.875% that will remain in effect for 36 months (months 25 – 60). Loan terms shown assume fully documented owner-occupied financing, no origination fee. Maximum of 3% seller contribution towards interest rate buy-down. APR and monthly payments may increase after consummation. On sample loan of $417,000, assuming a home price of $522,000 with 20% down - 12 monthly payments of $304, followed by 12 monthly payments of $652, followed by 36 monthly payments of $999, next 299 monthly payments of $3,150 and final month payment of $3,142. Buyer must close escrow by November 2, 2006 to obtain loan terms shown.
So people are able to move into homes for which they cannot possibly pay longterm, and taking loans which they are not going to be paying down. True, no one's going to default on a mortgage payment of $304 a month. But note the escalation curve. The payment doubles after the first year, triples compared to the original starting the third year, and multiplies by ten in the sixth year. If builders are genuinely trying to sell houses this way, it indicates that the collapse in demand is very severe, and they are desperately pushing those losses out to the future.

So don't expect a short downturn. It won't be. Many people are on their second and third refinances of their original funny-money loans, and their ability to refi will stop only when a prospective creditor demands a new appraisal, looks at the underlying value, and says no, thank you. And then what will happen? When demand has been inflated this way, the correction in the market forces demand down below normal levels.

An article about builders in CA:
"Demand has hit a wall" in Southern California as skyrocketing prices over of the past few years have made homes less affordable, said Barron. Builders have responded by offering higher incentives and steep price cuts, and by allowing buyers to put down shockingly small deposits - of less than 1% - on homes, he said.

"Deposits below 1% are a very ominous sign as it signals to us that demand is very weak and homes have now become very unaffordable," said Barron.

"If it's a $700,000 home and suddenly the builder has cut the price for similar homes to $650,000 or $600,000 - and you only put down a $5,000 deposit, why wouldn't you walk away from it?" he asked.
Walking away is exactly what people are doing. The builders are walking away from their land options, and the consumers are walking away from their new home sales contracts. I don't think these tactics are productive, although the builders may be nearly desperate to stave off disaster by this time. Overall, they are introducing new elements of instability and uncertainty into the markets, and probably producing a rolling disaster that will extend at least four years into the future.

Note also that the article above quotes Barron citing an example of speculative home-building, and the particular culprit was Beazer, but that Barron notes that other companies have been doing the same.

I think the Fed has now realized what's coming and is trying to inflate the stock market to minimize the impact of the RE tumble on the overall economy. I doubt that it will work this time. You can't remove so much money from an economy so quickly without producing a broad, radiative effect.

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