Greed. Pure, unbridled greed motivated many buyers during the Great Housing Bubble. Greed is one of the seven deadly sins, and it is responsible for the downfall of flippers, specuvestors, and ordinary homeowners who thought they could make a fortune buying and selling homes. In the movie Wall Street, Michael Douglass's character, Gordon Gecko, famously opined, "Greed is Good." Our entire capitalist system functions on the belief that individuals doing what is in their own best interest will result in the most efficient allocation of capital and the greatest good to society. Trial and error has shown us that sometimes this is not the case. Monopolies and other market price manipulations are one example of capitalism gone awry. Ponzi Schemes, like witnessed during the Great Housing Bubble are another. To prevent these abuses, we regulate the free market. Of course, our attempts to regulate and manipulate have their own problems. Maybe, someday we will figure it all out. Of course, we have been living under the delusion that we had it all figured out for many years. It takes a series of events like we are witnessing today to humble us all and make us realize we still do not know what we are doing.
When the Titanic set sail in April of 1912, the world was suffering from another mass delusion: the belief that our species had overcome nature. The Titanic was unsinkable. They considered the possibility of disaster at sea so remote that they did not even provide enough lifeboats for all the passengers. The sinking of the Titanic was a paradigm changing event. The world's collective feeling of security and control over their lives was shaken to its core. The same is happening today.
The collapse of our economy and the inability of our leaders to prevent it is spooking everyone. Our concepts of financial security are being called into question; they should be. Our financial leaders respond to our calls for ever-increasing asset prices. They found a way to do it for a while by steadily lowering interest rates and creating massive debt structures supported by dubious insurance contracts and blind faith. We act like meth addicts taking economic stimulants one after another until our financial body bursts. There must be a better way.
I see angels burning, falling down in ruins Looking down I see me, I'm my own enemy
We saw in yesterday's post how stupid lenders in Quail Hill inflated house prices by offering 100% financing to property flippers. I wrote back in February about how Quail Hill was going to become Quail Hell for those who bought there. Today we have another property on the same street. It is a bit larger, but it is also in distress, and the decline from the peak is extraordinary.
There was certainly a great deal of kool aid being consumed during the bubble. People were paying ridiculous prices for real estate only because prices were going up. Since there is no valuation metric that makes any sense in a financial mania, it is difficult to tell if the late buyers were simply stupid, or if there was something more sinister going on.
So what is mortgage fraud?
High CLTV financing, particularly the widely offered 100% financing, is the ideal tool for fraud. Fraudulent transactions require “straw buyers” willing to sacrifice their credit for a fee (or identity theft,) appraisers willing to inflate the houses value, and realtors and mortgage brokers either willing to go along with the transaction for cash or too ignorant to see the truth. In a transaction, the straw buyer purchased a house for greater than its true market value, and the excess payment was used to pay off the corrupted parties. Fraud was much easier to commit with 100% financing because the bank loaned the full amount of an inflated appraisal. It is much harder to commit fraud when the bank only loans 80% of a property’s value. Most often the seller was in on the scam and was using the transaction to get out of a bad deal, but sometimes sellers were also innocent victims. The straw buyer had no intention of repaying the loan from the start, and the property quickly went into foreclosure.
Today's featured property has an interesting history. I will let you decide whether the last buyer was a "straw buyer" who was part of a fraudulent transaction or simply a fool. I do not know, and I have no way to tell.
This life is filled with hurt When happiness doesn't work
In case you haven't noticed, major economic disruptions are painful. It is mentally painful, emotionally painful, and sometimes physically painful. Mentally we all try to figure a way out of this mess. How can we make more money? What can we do about our current circumstances? We tie ourselves in knots trying to solve the enigma. It has no solution. These circumstances lead to emotional pain most often caused by the scarcity of money. We are unable to support our lifestyles, we have to cut back, and sometimes this is not enough. Sometimes the cutbacks are made for us. Creditors close financial lifelines, and lenders foreclose on homes. This can lead to destructive behaviors: divorces, alcoholism, smoking, and a whole host of other problems. This emotional pain leads to stress and physical pain. People start having health problems, and since they can't afford a doctor's visit, these problems often go unattended. In short, recessions really suck.
I was watching an HBO comedy special with Ricky Gervais the other night. In part of his routine, he was making fun of the lessons we learn in children's stories. One of these stuck out because it speaks to today. He tells the story of the industrious mouse and the lazy mouse. The industrious mouse is busy gathering food and storing it away for the coming winter whereas the lazy mouse eats until he is full then either parties or lies around and does nothing. When winter comes, the industrious mouse is safe in his warm shelter and has plenty of food. The lazy mouse is cold, hungry and in pain. Finally the lazy mouse knocks on the door of the industrious mouse and pleads for some food and a place to stay. What does the industrious mouse do? He invites him in and gives him food and shelter.
Hmmm...
What lesson is being learned here?
From a spiritual standpoint, the actions of the industrious mouse are the correct ones. You should always be generous in times of need, particularly if you have plenty. But what of the lazy mouse? What has he learned? He has learned that he can party and be irresponsible and some compassionate fool is going to take him in and save him. The industrious mouse did not evaluate whether or not the lazy mouse deserved to be saved, and he did not concern himself with the precedent this sets. He acted as his conscious told him. In doing so, he did a terrible disservice to the lazy mouse who is being rewarded for his bad behavior. But then again, perhaps he saved his life.
Anger and agony Are better than misery Trust me I've got a plan
When thinking about the behavior of everyone caught up in The Great Housing Bubble, it is easy to see how most were acting like the lazy mouse. They were borrowing huge sums of money, living the good life, and having no concern for tomorrow. It is winter now. There is pain ahead. There is no fruit on the money tree, and people are being thrown out of their homes. The decisions we make now as a society will have lasting implications. Do we bail out all the foolish speculators and lenders who created this mess? If we do, aren't we guaranteeing we will see this behavior again? If we do not bail these people out, are the rest of us failing to be compassionate? Should we do more to help out our fellow man?
I don't know what the answers are. These are questions we must grapple with as a society. It will be interesting to see what we choose.
Our new President will need help to address the problems in the residential real estate financing system that resulted in The Great Housing Bubble. My full proposal is here: Preventing the Next Housing Bubble.pdf. The following is an exerpt from this proposal:
The secondary mortgage market was created in the 1970s by the government sponsored entities, Freddie Mac, Fannie Mae, and Ginnie Mae. This market was expanded by the creation of asset-backed securities where mortgage loans are packed together into collateralized debt obligations (CDOs). This flow of capital into the mortgage market is a necessary and efficient tool for delivering money to borrowers for home mortgages. This market must remain viable for the continued health of residential real estate markets. The problem during the Great Housing Bubble was that the buyers of CDOs did not properly evaluate the risk of loss through default on the underlying mortgage notes that were pooled. The reason these risks were not evaluated properly is due to the appraisal methods used to value real estate serving as collateral backing up these loans.
There is one potential market-based solution that would require no government regulation or intervention that would prevent future bubbles from being created with borrowed capital: change the method of appraisal for residential real estate from valuations based exclusively on the comparative-sales approach to a valuation derived from the lesser of the income approach and the comparative-sales approach. Both approaches are already part of a standard appraisal, so little additional work is necessary – other than appraisers will have to focus on doing the income approach properly. In the current lending system, the income approach is widely ignored. This change of emphasis in valuation methods could come from the investors in CDOs themselves. When the fallout from the Great Housing Bubble is evaluated, it is clear that the comparative-sales approach simply enables irrational exuberance because the past foolish behavior of buyers becomes the basis for future valuations allowing other buyers to continue bidding up prices with lender and investor money. Prices collapsed in the Great Housing Bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. There is no way to prevent future bubbles, and the commensurate imperilment of our financial system, as long as the comparative-sales approach is the exclusive basis of appraisals for residential real estate.
Investor confidence in the market for CDOs and all mortgages was shaken
during the decline of the Great Housing Bubble – and rightly so.
Investors were losing huge sums, and nobody clearly understood why.
There was a widespread belief these losses were caused by some outside
factor rather than a systemic problem enabled by the lenders and
investors themselves. For investor confidence to return to this
market, investors must first ascertain a more accurate evaluation of
potential losses due to mortgage default. This requires an accurate
appraisal of the fundamental value of the residential real estate
serving as colla-teral for the mortgage loans that comprise the CDOs.
Since the fundamental value of residential real estate, the value to
which prices ultimately fall during a price decline, is determined by
the potential for rental income from the property, revaluing properties
using the income approach would provide a more accurate measure the
value of the mortgage note and thereby the CDO.
The ratings agencies who rate the various tranches of
CDOs must adopt the method of valuation utilizing the lesser value of
the income approach and the comparative-sales approach. The ratings
agency’s recommendations and ratings carry significant weight with
investors, and the ratings agencies clearly made a tragic error in
their ratings of CDOs during the Great Housing Bubble. If the ratings
agencies properly evaluate the underlying collateral backing up the
mortgages that are pooled together in a CDO, investors will regain
confidence in the ratings, and money will return to the secondary
market. If investors in CDOs recognize the chain of valuation as
described, they would be unwilling to purchase CDOs valued by other
methods. If investors are unwilling to purchase CDOs where the
underlying collateral value is measured using the comparative-sales
approach and instead demand a valuation based on the income approach,
the syndicators of CDOs will be forced to respond to investor demands
or they will not be able to sell their syndications. Investors and the
ratings agencies can mandate a new valuation method for residential
home mortgages.
In September of 2008, the Federal Government
took “conservatorship” of the GSEs responsible for maintaining the
secondary mortgage market. With the collapse of the asset-backed
securities markets and CDOs, the GSE swaps were the only viable market
for mortgage paper. This provides a unique opportunity for changing the
market dynamics with limited government intervention. If the government
in its role as conservator were to decide to mandate a change in
appraisal methods, the secondary market would be forced to accept this
change. Like any sweeping change in methodology, it could be phased in
over time to properly train appraisers and work out the details of
implementation. If the GSEs lead, the rest of the market will follow.
The
main objection with the income approach is the difficulty of evaluating
market rents, particularly in markets where there may not be many (or
any) comparative properties for rent in the market. This is an old
problem, one that has been studied in great detail by the Department of
Labor Bureau of Labor Statistics. Comparative rents have been
collected by the DOL since the early 1980s as part of their calculation
of the Consumer Price Index. The problem of irrational exuberance in
the late 1970s in coastal markets, particularly California, caused the
consumer price index to rise rapidly. Since the CPI is widely used as
an index for cost-of-living adjustments, volatility in this measure
caused by the resale housing market needed to be urgently addressed.
After over a decade of study, the DOL decided to value the change in
housing costs by a comparative rental approach rather than a change in
sales price approach used previously. This smoothed the index and
reduced volatility because the consumptive aspect of housing services
were tethered to rents and incomes rather than being subject to the
volatility caused by irrational exuberance in the housing market.
The
Department of Labor Bureau of Labor Statistics measures the market
rental rate in markets across the United States. It breaks down the
market into subcategories based on the number of bedrooms, and it does
a good job of estimating market rents in the various subcategories.
These numbers are updated each year. The figures from the DOL would
serve as a basis for evaluation of market rents, and it may be the only
basis in areas where there are few rentals. In submarkets where there
is sufficient rental activity, the income approach can use real
comparables to make a more accurate evaluation. Appraisers will decry
the lack of available data on rentals as many rentals, particularly for
single-family detached homes are done by private landlords who do not
report these transactions; however, if this method of appraisal were
the standard, private companies would spring up to track these
transactions and maintain an up-to-date database. Valuing properties
based on the income approach may be more difficult than the
comparative-sales approach, but when the latter method is fundamentally
flawed, ease-of-use is not a compelling reason to continue to rely on
it.
There is also the objection that the income approach
method of valuing residential real estate has the same problems as the
comparative-sales approach because both approaches rely on finding
similar properties and making an estimation of market value by
adjusting the values of comparative properties. In both approaches the
appraiser must explain their reasons for the adjustments to justify the
appraised value of the subject property, and this is a potential source
of abuse of the system. No system is perfect, but the potential to
inflate prices though manipulating appraisals based on the income
approach is far less than the potential problems emanating from the
comparative-sales approach because the basis of adjustment in the
income approach is a properties fundamental value whereas the basis of
adjustment in the comparative-sales approach is the prices paid by
buyers subject to bouts with irrational exuberance. If lenders start
accepting appraisals where the income approach contains adjustments to
value that increase the appraised amount 100% – something that would
have been required to justify pricing seen during the Great Housing
bubble – then the system is hopelessly broken. The main argument for
using the income approach is that its basis is the fundamental value
whereas the basis for the comparative-sales approach is whatever price
the market will currently bear. Prices are not likely to decline below
a properties fundamental value where as a property may decline
significantly from a point-in-time estimate of market value. Using the
income approach lessens the risk to lenders and investors and ensures
the smooth operation of the secondary mortgage market. Using the
comparative-sales approach exclusively results in the turmoil witnessed
during the price decline of the Great Housing Bubble.
Lay awake at night, Oh so low, just so troubled. Can't get a job, Laid off and I'm having double trouble.
Financial markets have no mercy. They take no prisoners, except maybe those that are now imprisoned in their homes. The financial markets do not care what the prices mean to you or to anyone else for that matter. If falling house prices costs people money, ruins their credit, and forces them into bankruptcy, well, that is what can happen when people speculate in financial markets. There are likely many people losing sleep over their losses in real estate and the stock market while simultaneously worrying about their job. These are not carefree times.
This too shall pass. Despite all the turmoil, the sun will rise tomorrow, and it will be another beautiful day in Southern California. People will meet, fall in love, get married, start families, and look to buy a house. Hopefully, they will chose to rent for a while instead.
Enjoy the new Suzanne Researched This video, now with subtitles.
