There was a recent article posted on MSN about mortgage companies working with FB's to save their homes from foreclosure. This particular article is most likely part of a public relations campaign from the lending industry to show they are working on the problem. They are bracing themselves for the inevitable congressional hearings which will happen next year. There is nothing quite like an election year crisis to bring out congressional grandstanding by our leading politicians. But I digress... the MSN article got me thinking about what really could be done about the foreclosure problem.
I have written in several posts about the serious foreclosure problem looming as several trillion dollars of mortgages reset to higher payments over the next 5 years. There is no way to effectively restructure payments when a borrower cannot even afford to pay the interest on the debt. Lenders cannot lower interest rates to near zero because then they will lose money on the loan. Any borrower who thinks the lender is actually going to forgive the debt and allow them to keep their home is really living in a fantasy world (I would wager many FBs believe this). Lenders will not take a loss on a property loan and allow borrowers to keep the home: it's as simple as that.
As much as it pains me to write this, there is a short to medium term solution to the foreclosure problem: convert part of the mortgage to a zero coupon bond. For those of you not steeped in finance, a zero coupon bond is a bond which does not make periodic interest payments. Think of it a zero amortization loan. You don't pay either the interest or the principal, and both accumulate for the life of the loan. The loan would be due upon the sale of the house.
Here is how it would work for our typical homedebtor: Assume our financial genius utilized 100% financing and took out a $500,000 interest-only mortgage with a 2% teaser rate that is due to adjust to 6%. Let's further assume his real income (not what he reported on his liar loan) could support a $1,500 payment on a $250,000 conventional 30-year mortgage at 6%. The bank could convert $250,000 to a conventional mortgage, and convert the other $250,000 to a zero coupon bond at 6% due on sale. The homedebtor can now make their payment, and they get to keep their house. But here is the catch: when they sell their house, they will owe the bank a lot of money. If they sell the house in 20 years, they will owe $800,000 on the zero coupon bond note. In other words, all the equity gain on the value of the home will go to the bank.
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This would solve a multitude of problems: First, it would provide a mechanism whereby people who were victims of predatory lending could keep their homes. This would make the homedebtor happy, and it would get government regulators out of the bank's business. Second, it would make the banks more money in the long run because they are still making their interest profit even if they don't see it until the homedebtor sells the home (many may not be aware of it, but lenders book income on the increase in principal on a negative amortization loan). Third, since foreclosures would be the primary mechanism facilitating the crash, it would keep home prices from crashing by reducing the number of foreclosures.
Sounds like a panacea, doesn't it? There are some problems.
The first problem will become apparent when people start selling their houses. People are greedy. They won't want to give the bank all their equity when they sell. They will conveniently forget the debt relief and avoiding foreclosure and all the problems they had earlier. All they will see is that they sold the house for a lot more than they paid for it, and they did not make any money. And what happens when the appreciation does not match the term of the note? Do they do a short-sale 20 years down the line? This will cause a huge uproar and more calls for congressional intervention. In other words, for everyone involved the day of reckoning is merely delayed, not avoided.
Second, it does nothing for the affordability problem. If prices do not crash, a great many people really will be priced out forever. To solve this problem, banks will make zero coupon bonds available to everyone, and eventually everyone will have them. Think about where we will be then: we will be a society of homedebtors who have collectively agreed to give all our equity to the bank for the pride of ownership. Starts to sound a bit like Pottersville from It's a Wonderful Life. Is that the way we all want to live?
Third, The zero coupon bond solution would effectively eliminate the move-up market because you won't have any equity to take with you from house to house. Unless you save money or get a big raise so you can afford a larger payment, you can't buy a more expensive home. This would result in a dramatic flattening of prices. In other words, the low end would be supported at inflated levels while the high end would stagnate or decline.
Fourth, Based on the problems above, it will be difficult to find a new equilibrium in prices. How would people figure out how much anything is worth? How would all price ranges be supported equally? Small changes in the interest rate on the zero coupon bond can make the difference between hundreds of thousands of dollars at the time of sale, particularly on a long-term hold. Does anyone think this will turn out in favor of the borrower? I suspect we would see a lot of short-sales as the banks graciously agree to take all the gains and forgive the rest of the debt. This takes us back to our first problem with angry, greedy sellers.
Finally, I think this is only a short to medium term solution to the foreclosure problem. For as much as we are addicted to credit in this country, there is a point where people will say "enough is enough." When a house fails to have any investment value, people will not be so excited about home ownership. People can blather on about pride of ownership all they want, but people want to make money on selling their houses. Inflated valuations are only supported by greed. If home ownership becomes less desirable, prices will end up falling back to their rental equivalent value because the demand will not be there. In the long run, we would end up with prices where they should be anyway, it would just be a much more prolonged and painful journey. Does anyone want to experience what the Japanese went through?
When faced with the prospect of more than a million foreclosures, some Wall Street genius (I am being facetious) is going to come up with a solution very similar to what I just presented. To be honest, zero coupon bond structures and other exotic financing terms are quite common in complex real estate deals like the ones I see on a daily basis in my line of work. Exotic loan terms are the exclusive purview of sophisticated investors who understand what they are doing. They are not intended for consumption by the general public. Given the profusion of interest-only, and negative amortization loans in the market today, is it any surprise we have such a big mess now?
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Southern California is a beautiful place. The weather is perfect, there is a lot to do, and the people are generally friendly and keep out of your business. For those reasons and many others, I have chosen to make Southern California my home. However, Southern California is not perfect. The culture is infected with pathological beliefs that have led us to the huge problem with house affordability and the impending disaster in our real estate market.
What do I mean by Cultural Pathology? There are certain beliefs if widely held and acted upon by a group of people leads inevitably to collective suffering and/or destruction. One example we all see is in the American auto industry. Before imports hit our shores the American auto industry used to believe the quality of their product did not matter, people would buy their product irrespective of quality. For many years, the industry was successful despite this pathology. This belief allowed offshore competitors to enter the market, build market share, and finally take over the industry. The American auto industry's belief system has had a pathologic effect on their business which has caused much suffering in Detroit, and it may ultimately lead to the bankruptcy and destruction of our major automakers.
The best treatise on the pathology of cultural beliefs was George Orwell's novel 1984. In Orwell's vision, a totalitarian State had convinced the populace the following:
- WAR IS PEACE
- FREEDOM IS SLAVERY
- IGNORANCE IS STRENGTH
Although these statements are clearly contradictory, in the story the slogans do make sense to the State. For example, through constant "war", the State can keep domestic peace; when the people obtain freedom, they become enslaved to it, and the ignorance of the populace is the strength of the State. Just as Orwell's Big Brother convinced the populace the above contradictions were true, Southern Californians (with a little help from their own Big Brother, David Lereah, president of the National Association of Realtors) have convinced themselves the following:
- APPRECIATION IS INCOME
- CREDIT IS SAVINGS
- DEBT IS WEALTH
Just as these statements are contradictory and ridiculous, the proof that these statements are believed is that they are reflected in the actions of Southern Californians. For example, through borrowing against one's increasing home values, appreciation is turned to income; when people obtain more credit, they spend it like available savings, and a large amount of debt used to finance a large, opulent home makes one wealthy. Ask any homedebtor in Southern California, and they will tell you that makes perfect sense.
The problem is rooted in a basic misunderstanding of what separates the rich from the poor: the habit of saving. You have heard the expression, "the rich get richer and the poor get poorer." It is more accurate to say the rich save money and the poor spend it: in the end, the rich will have money, and the poor will have none. This is not one of life's inequities, but rather of of life's simple truths.
When you hear your average Joe tell you he wants to be rich, what he is really saying is he wants unlimited spending power. He wants the ability to spend like the rich people he sees wearing Rolexes and driving BMWs to their mansions in Shady Canyon. This is why, when given the chance, poor people will emulate the rich by spending beyond their means in order to be rich. Of course, in the process, they spend themselves poor.
Appreciation is Income
Look at the difference between the behavior of rich and poor when it comes to home price appreciation. The rich view home price appreciation as adding to their net worth. If lower interest rates allow them to refinance, they will restructure their debt to pay off the loan more quickly in order to increase their wealth. Poor people view home price appreciation as income; free money for them to spend. If lower interest rates allow them to refinance, they will restructure their loan to pull as much home equity as possible and reduce their payment as much as possible so they can spend more. If any net worth happens to accumulate, they obtain a home equity line of credit and spend the appreciation as quickly as possible -- it makes them feel rich even though it really makes them poor.
Credit is Savings
So how do the rich and poor deal with credit? The rich don't carry consumer debt. Why would they pay interest on a credit balance when it almost always costs more than the income they earn on their savings? The rich will use credit sparingly and most often pay off any credit balances each month as the bill comes due. In contrast, the poor carry as much consumer debt as they can afford to service. Whenever they receive an increase in a credit line, they believe they have more money to spend, just like it was savings. In a strange way, a credit account is like a savings account, only it has a negative balance. In a savings account, the saver earns money; in a credit account, the spender loses money. Again, the rich have savings, and the poor have credit.
Debt is Wealth
There are a great many Southern California residents who live in big houses, and they believe that makes them rich. To them, the possession and use of an expensive house makes them wealthy even if they have no equity in the property. The rich buy less home than they can afford and work to pay off the debt in order to maximize their net worth. 
The poor stretch their finances to possess more home than they can afford with loan terms which never retire the debt, or in the case of negative amortization loans, actually increases their debt held against the property. This ensures they either never gain any equity or only gain it by appreciation, and as mentioned previously, if prices appreciate they quickly withdraw the gain to fuel more consumer spending.
It's a California Thing
So what happens when you give poor people money? They spend it. I'm sure you have all heard the stories of people who won the lottery and managed to spend themselves into bankruptcy a few years later. These stories are classic examples of the pathology of the beliefs of spenders. A great many Southern Californians are spenders. This is why I contend that Southern California has a strong cultural pathology. The reason our house prices have been bid up to such dizzying heights is because there is a high percentage of our population in Southern California that subscribes to the spending habits I have described. They went out and borrowed as much money as they could with suicide loans, bought up all the real estate they could get their hands on, and in the process drove real estate prices into the stratosphere. In other areas of the country, reckless spending is not so trendy, and home prices have not been bid up so high.
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I grew up in the Upper Midwest in a rural farm community. Pretentious displays of conspicuous consumption are less common in the Midwest, and consumerism is often viewed with contempt rather than envy. In short, there is a smaller percentage of the general population in the Midwest with the aforementioned pathologic beliefs. To prove this, I would like to profile Minnetonka, Minnesota, a suburb of Minneapolis with very similar income and demographics to Irvine. According to Sperling's Best Places, the median income in Minnetonka, Minnesota is $84,024, and the median income in Irvine, California is $84,253. I think that is close enough to be a good comparable. The median home price in Minnetonka is $305,600 and the median home price in Irvine is $689,000 (92620 Zip Code). If my thesis is correct, one would expect to find a much higher percentage of home loans utilizing exotic loan terms in Irvine as compared to Minnetonka. Remember the Map of Misery?
In fact, according to the map, in 2006 the Minneapolis area had 8.7% of its loan originations were negative amortization, while Orange County had 32%. In all of California more than 80% of loan originations in 2006 were either option ARM or interest-only. Here we have two groups of people with the same median income, and with the same access to credit making very different choices. Potential homebuyers in Minnetonka and Irvine faced the same decision on taking out a suicide loan and buying more house than they can afford or chosing to live within their means. Very few in Minnetonka chose to overextend themselves, so they did not bid up the values of their houses. Orange County (and the rest of Southern California) chose to utilize exotic financing and thereby real estate prices were bid much, much higher. The high utilization of exotic financing was the cause of the price increase not the result of it. Nobody was forced to buy.
So if we accept the premise that Southern California has a high percentage of its population with the spending habits I have described, so what? Everyone here in Southern California is spending freely, feeling rich, and enjoying life. What is the problem? Where is the pathology? Isn't it true Californians are just more financially sophisticated than the rubes back on the farm in the Midwest?
It is pathologic because it is not sustainable: It is a house of cards. There is an inevitable Day of Reckoning when all debts must be paid. Charles Ponzi (see image below) was the most extreme example of the pathologies illustrated in this post. So extreme was his activities, that the term Ponzi Scheme has become synonymous with the use of ever increasing amounts of investment or debt. 
This scheme is also encapsulated in the expression "robbing Peter to pay Paul." At some point, the debt becomes so large that no lender is willing to loan more money and no greater fool can be found to bail them out, and the whole system comes crashing down. However, while the debt was building, the debtor became accustomed to a certain lifestyle and level of spending. When the credit is cut off, the debtor can no longer spend, and a great deal of suffering ensues (See Dr. Housing Bubble).
We are quickly approaching the Day of Reckoning in our housing market. In my view this will be Armageddon for California debtors: the spending will stop, they will lose their homes and with it their illusion of wealth, and they most definitely will not be enjoying life. The cause of all the weeping and gnashing of teeth will not be some exogenous event, but rather a direct result of the circumstances they themselves created.
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For a refresher read: Financially Conservative Home Financing
P.S. Go back and click on the images.
Many people when they first discover bubble blogs think housing bears are tinfoil-hat-wearing crackpots with extremely pessimistic outlooks on life. There are perma-bears (Roubini, Shiller, Fleckstein) as well as perma-bulls (Watts, NAR, Kudlow). The truth is generally somewhere in between. I learned long ago that extremists are never happy people because they seldom get their way. As the Buddha noted, it is the "middle path" that leads to happiness. I have spent my voting life as a independent/Libertarian voting for whoever I believed to be the best candidate, most generally a moderate. However, there are times when what is perceived as an extreme is actually the correct view. As Barry Goldwater noted, "...extremism in the defense of liberty is no vice! ... moderation in the pursuit of justice is no virtue." Many who read my post "Predictions for the Irvine Housing Market" thought the scenario I described as extreme. It only looks extreme because the psychology of the bubble as skewed the collective perspective of the market. That Predictions post was moderate; this one is extreme.
We have been witnessing a great deal of bad news lately, the impact of which cannot be good. If the perfect storm continues to form over our local housing market, things could become much worse, much faster than even the most bearish among us think possible. Have any of you noticed the carnage in Sacramento? For the doomsday scenario to take place, we would need the following: Foreclosures, unemployment, rising interest rates and tightening credit, and a decrease in home ownership. The combination of these forces could make the price collapse a catastrophe.
Foreclosures
We all know the wave of foreclosures is coming.
And it should continue unabated for 5 more years.
There isn't much more to say. It is not bad yet, but it will be very bad, and it will go on for a long time.
Unemployment
We know layoffs are coming to Irvine/Orange County. New Century went bankrupt along with numerous other sub-prime lenders based in Orange county. People are already losing jobs. I think it is save to speculate this will have ripple effects through the local economy. Even if unemployment remains low, how much will incomes decline? Mortgage brokers, realtors and others in the REIC have been living on the transactions created by the borrowing of those about to go bankrupt. They may find other work, but the $250,000 a year days are over. The only mystery is how bad the unemployment problem will become. Right now, things don't look good.
Rising Interest Rates and Tightening Credit
We know mortgage interest rates are near historic lows.
The large number of foreclosures will make lenders more cautious (either that or the losses will put them out of business). Increased lender caution will result in a tightening of credit and an increase in interest rates to compensate them for the increased risk. An increase to 8%, which is near the historic norm, would seem to be likely. If lenders become very cautious, an overshoot to 10% or more could easily take place. Interest rates have not begun to rise yet, and many are holding out hope that the FED will save them. It won't. Due to the increasing risk premiums, the best one can hope for is a lowering of the FED funds rate to compensate for the increased risk premium. We will have to wait and see.
Credit is already tightening. This cannot be denied. The increased cost and decreased availability of credit will have a severe impact on demand.
Credit Suisse estimates the most recent credit tightening just eliminated 21% of the borrowers in the market. This is assuming further problems in Alt-A or prime loans do not force credit to tighten even further (in other words, credit will tighten further.) This will crush demand and it will also put an end to serial refinancing. The inability to refinance is what will cause all the resets shown in the previous chart to go into foreclosure. Which leaves us with the most important question: Who is going to buy all of these houses in foreclosure?
Decrease in Home Ownership Rates
Ownership rates in Orange County have risen 2.8% between 1994 and 2005. This is actually behind the rest of the country where homeownership rates have increased nearly 5%. This is a direct result of lending money to those borrowers previously excluded from the housing market either because the borrower did not have the downpayment, or they lacked good credit.
Home ownership rates will decline as homeowners lose their homes in foreclosure. With foreclosure comes bad credit; those with bad credit just got eliminated from the buyer pool. Therefore, people who lose their house to foreclosure will move into a rental, and the previously owner-occupied home will likely enter the rental pool. (A popular misconception is that rents will go up. The number of rentals will increase along with the number of renters.)
There will be some new buyers (like many on this board) who have cash and good credit; however, this group is small in number, far smaller than the number of foreclosures about to hit the market (if you don't believe me, ask yourself how many potential buyers you know with cash and good credit.) This means a significant number, perhaps a majority, of the houses due to hit the market due to foreclosure will be purchased as rentals.
If the bulk of the houses going through foreclosure are going to be purchased as rentals, prices will have to decline to the point where a rental generates a positive cashflow. Prices are double that today! Home prices will have to decline at least 50% for properties to make financial sense as rentals, so if this is the fate of the bulk of the upcoming foreclosure inventory, prices will decline at least 50% before buyers will enter the market and adsorb this inventory.
Conclusions
Foreclosures, unemployment, rising interest rates and tightening credit, and a decrease in home ownership are all required in some measure to create the doomsday scenario. Do I think this will happen? Probably not, but it could. Did anyone think the NASDAQ could drop from 5200 to 1200 from 2000-2003? Did anyone think housing prices in California would drop from $200K to $177K from 1991-1996 in our last "correction?" Did anyone think real estate prices in Japan would drop 64% between 1991 and 2005? When bubbles collapse, they often drop lower and last longer than anyone thinks.
Today we do not have any of these conditions to an impactful degree. Maybe these conditions will not develop further; however, all indications are that these problems will develop and get worse. So how bad could bad get? Ask them in Sacramento, their party is just getting started.
Market Decline Extreme Spreadsheet
Get this party started on a Saturday night
Everbody's waiting for me to arrive
Sending out the message to all of my friends
We'll be looking flashy in my Mercedes Benz
GET THE PARTY STARTED by: Pink
I launched into a diatribe on Quiggleme.com on who bears responsibility for the bubble we are now watching deflate. I wanted to share it here. So who is responsible? Borrowers, lenders, investors, the FED: IMO, they are all responsible; it is only a matter of degree.
Irresponsible borrowers are like children, if you offer them something they want, no matter the terms, they will take it. The federal government realized this basic fact years ago when they passed predatory lending laws. Does that make the borrower any less responsible? No, but by definition, sub-prime borrowers are irresponsible. If they took responsibility for their debts, they wouldn't be sub-prime. So if you offer a bunch of money to the most irresponsible among us, what would you expect? I would expect them to spend it irresponsibly and not worry about paying it back. That is their history, is it logical to expect anything different from these people? In my opinion, it shouldn't have taken a rocket scientist to see this sub-prime experiment was going to end badly.
That being said, when will people start being responsible for their actions? Has our entire culture become based on having victim status and not being responsible? These borrowers should not be bailed out by any government program as it would just create more dependence. These fools who paid too much and can't pay it back need to lose their homes, lose all their assets, and file for bankruptcy. Tough $hit. They may live their lives being irresponsible, but it doesn't mean the responsible among us should pay for that. This is one of those instances where they will be made to take responsibility. It will feel like they are getting their noses rubbed in it, but that is what they deserve.
However, the lenders are also responsible in this matter. I have a dim view of the lending industry, particularly of credit cards. Consumer debt lenders are akin to drug dealers in my mind. They serve no function in our society other than to leach off people by taking advantage of their inability to save money. But I digress, at least mortgage lenders provide a service because without them most people would be dead by the time they saved enough money to buy a home for cash; however, when they start handing out HELOC's for consumption, they are as bad as the credit card / drug dealers preying on people's reckless irresponsibility. Once mortgage lenders crossed that line, they ceased to be serving the needs of homebuyers and instead began serving the wants of the credit addicted: Shame on them.
Of course, none of this would have happened without the enablers at the Federal Reserve and on Wall Street. Greenspan lowered rates and then told borrowers to take out adjustable rate mortgages. As one might suspect, he did this so his fellow bankers would not be stuck with low-interest loans for 30 years, but he gave the world of homebuyers the "green light" for taking on high risk loans. Then Wall Street investors flooded with liquidity from cheap money from home and overseas started chasing returns. These high-interest sub-prime loans looked attractive, and as long as house prices went up and nobody defaulted, everything was fine. Who do you blame for that situation? The bank of Japan for creating the carry trade? The federal reserve for lowering rates to avoid a recession? Investors chasing high yields? I don't know. That one is too big for me to ferret out a culprit.
In my opinion, the borrowers are certainly at fault; if for no other reason than they signed the papers and took the money. The lenders are also at fault because they should have known better than to give sub-prime borrowers loans they could not afford. Lenders simply cannot abdicate responsibility in this matter for financial, legal and moral reasons. The Federal Reserve and Wall Street investors are also at fault for creating the situation and enabling this to occur. In the end, all the responsible parties will be ruined: borrowers will lose their houses and go bankrupt, lenders like New Century will go out of business and/or lose billions, Wall Street investors will be sharing in those losses with the lenders, and Alan Greenspan will be remembered by history as the architect of the largest, most painful financial bubble in history.
The big discussion on Wall Street today is whether or not the problems with sub-prime will impact alt-A and prime loans and if all of this will impact housing markets and the economy as a whole. I want to examine why and how sub-prime's implosion will impact the housing market.
It is estimated that tightening lending standards are going to eliminate 21% of the buyers from the market.
We all know intuitively this sounds bad. But what is the impact?
For a deeper understanding read The Plankton Theory Meets Minsky.
This will result in lower prices. If prices are lower and standards are tightening, serial refinance will come to an end. Many, if not most of the borrowers needing to refinance over the next 5 years will be underwater when the loan resets resulting in more foreclosures.
As you can see, it will take 5 years for the existing ARM's to reset. For these people to be able to refinance, they must either have enough cash to buy down the loan (do you think any of them will?), or their house must be worth more than the loan amount. For the latter to happen, there must be a lot of buying in the market. Given that 21% of the buyers were just removed. What do you think is going to happen?
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Update: Irvine must be concerned about the sub-prime issue.
This is the final installment in my series of related posts pertaining to the Irvine residential real estate market. It is my intention in this post to bring it all together, make a prediction as to the timing and depth of the upcoming crash, and describe the variables that will influence the market decline.
Below is a chart I created to demonstrate what I believe will occur in the Irvine Housing market between 2007 and 2013.
- Median sales price will decline approximately 40% from near $700,000 to near $400,000 over the next 5 years.
- There will be a multi-year flattening of prices at the bottom.
- Sustained appreciation will not return until 2013 or later.
- Peak bubble prices will not be seen until 2027 (unless we get another bubble).
Irvine Housing Market Prediction Spreadsheet
Due to the psychology of the market participants, I believe market prices will display the same general timing and pattern of the price decline of the early 90's. The difference will be the depth of the decline which will likely be more than double on a percentage basis. It will take a 39% decline in Irvine to bring prices back in line with fundamental valuations. I am projecting house prices declining at an increasing rate over the next three years with 8% drops in 2007, 12% in 2008, and 16% in 2009. This will be a foreclosure driven decline.
Some will argue price drops of this magnitude are not likely, these would be unprecedented declines; however, if real panic selling grips the market, the rate of decline could be even greater. If you recall, the increases were unprecedented as well. The rate of decline should lessen as we approach fundamental valuations. I estimate declines of 8% in 2010 and 4% in 2011, followed by a period of 3 years with little change in prices. I am projecting a flattening of prices at the bottom because it will take time to absorb the inventory of foreclosures resulting from the drop.
I didn't show it in the chart, but fundamental valuations do catch up to current prices eventually. If rents continue to increase at 3% per year (which is typical of wage inflation and consistent with its long-term average), current price levels will be justified in 2027 -- twenty years from now. Does anyone think prices have reached what looks like a permanently high plateau.? Of course, given the propensity of the California housing market to bubble, once prices start to rise again in around 2013, they may reach current price levels by 2020.
I believe the decline depicted in the chart above will happen because of all the factors described in my previous posts:
I am IrvineRenter (Inventory Cholesterol)
Financially Conservative Home Financing
How Inflated are House Prices?
How Sub-Prime Lending Created the Housing Bubble
What is Past is Prologue
Timing and Depth of the Crash
What factors are in play that will influence the timing and depth of the crash? Throughout these posts, I have examined the psychological stages the market participants go through beginning with euphoria and the belief in continual appreciation and ending with depression and the belief that appreciation is dead. There are a number of technical factors which will influence the depth and timing of the decline:
- Percentage of Income Put Toward Housing Payments
- Interest Rates
- Forclosures
- Adjustable Rate Mortgage Time Bombs
- Government Intervention
One other factor of note is the relationship between median prices and actual prices which makes measuring the decline somewhat problematic.
Percentage of Income Put Toward Housing Payments
A change in buyer psychology which inevitably occurs during a market crash also influences people to put less of their income toward housing. Why would you stretch yourself to buy a depreciating asset? Historically, people have not. If people put smaller percentages of their income toward housing (both payments and rent), the fundamental value declines making for a lower bottom.
Notice on the chart that people put a smaller percentage of their income toward housing during price declines.
Interest Rates
Another key factor impacting the fundamental value and thereby the bottom is interest rates. As was pointed out in the comments on a previous post, interest rates went down during the last price decline which softened the impact. Mortgage Interest rates are near historic lows, and will likely increase. As lenders and investors in Mortgage Backed Securities (MBS) get burnt during the decline, they demand higher risk premiums. This increases the spread between the FED funds rate and mortgage interest rates, which is right now at a historic low. So even if the FED were to lower interest rates, the increased risk premiums demanded by lenders and MBS buyers will likely drive up mortgage interest rates. Higher interest rates mean lower prices and a lower bottom.
This is a potentially serious problem. The Federal Government must borrow enough money to service the budget deficit and the national debt. If the bursting of the housing bubble causes a worldwide credit crunch, interest rates will rise around the globe as cautious investors demand higher risk premiums. This may force the FED to raise interest rates to meet the obligations of the Federal Government. The combination of a higher FED rate and larger risk premiums could easily push interest rates back up to near the 8% historic norm or even much higher. An increase in interest rates from 6% to 8% is a 33% increase in borrowing costs. This would be disastrous for housing prices.
Notice mortgage interest rates are near historic lows and below historic averages. Is this sustainable?
Foreclosures
The wildcard in this analysis is the impact of foreclosures. The number of foreclosures will effect both the timing and the severity of the drop because it is foreclosures that drive prices lower. Based on the chart below, it is relatively safe to say that foreclosures are going to surpass levels seen in the early 90's. At the rate of increase we see demonstrated below, we should surpass the 1996 peak this year.
Forclosures are increasing at an increasing rate and prices haven't begun really dropping yet.
Foreclosures control the timing of the crash because they directly impact the must-sell inventory numbers. The greater the number of foreclosures, the greater the rate of decline in house prices. I have projected a dramatic decline in prices based on the trend in foreclosures we have seen to date. If the number and impact of foreclosures is worse than I thought, then the decline could happen even more quickly that I imagined. As I said in my first post, "Foreclosure statistics are the numbers to watch."
I cannot overstate the importance of the foreclosures. Let's be realistic, sellers will not lower their prices voluntarily. Prices will not drop without massive numbers of foreclosures to push them down. All of the "soft landing" arguments boil down to one supposition: the number of buyers in the market will be able to absorb the must-sell inventory on the market. If this is true, prices will not drop. If this is not true, prices will drop until enough buyers are found to purchase the foreclosures. There will be a number of buyers on the way down, some will be long-term homeowners who are present in any market, but many will be speculators betting on the return of appreciation. These people will be few in number, but there may be enough to them to buoy the market if there are not many foreclosures. If foreclosure numbers really spike, prices will fall until Rent Savers and Cashflow Investors enter the market and absorb the excess. IMO, the number of foreclosures will be too great for long-term owners and speculators to absorb.
Foreclosures also control the depth of the decline to some degree. Once prices fall down to their fundamental values, new buyers enter the market and begin to absorb the inventory. If there are not enough buyers at this price level to absorb all the foreclosures, prices could overshoot fundamentals to the downside; in fact, this does tend to happen at the bottom of the real estate cycle.
Adjustable Rate Mortgage Time Bombs
One of the most insidious problems of the housing bubble was the widespread use of adjustable rate mortgages. As I described in my post on conservative financing, adjustable rate mortgages are very risky; it is a risk that has been forgotten, ignored, or not understood by a great many buyers. Once prices have declined to a point where the loan balance is greater than the value of the property, mortgage holders will be unable to refinance when their mortgage reset comes due. Most often this will result in a foreclosure. In fact, this is going to be the primary mechanism of the decline, and it will also prevent any meaningful appreciation for years to come.
Imagine you are a homeowner, and your resale value has declined to where you could not cover your loan balance on a sale. You are able to make the payment on your ARM for another 3 years, but you will not be able to afford the reset. What would you do? I suspect you would list your house for sale at your breakeven value and hope the market comes back to save you. Hope is all you have. There are many, many people in this situation in the market. This is the nature of supply overhang.
These loans are time bombs waiting to go off. They have fuses of differing durations, but they will all explode eventually. These will not work their way out of the system for at least 5 to 7 years after they stop being used. They are still widely in use today. We are still sowing the seeds of the future supply overhang which will prevent home price appreciation.
Government Intervention
Because the problem with adjustable-rate mortgages is so large, this is an area where the government may intervene. There will be many borrowers who would be capable of making the payments on a conventional 30-year mortgage when their loan resets, but will be unable to refinance because they are underwater. For this group of borrowers, the government may institute a "loan guarantee" program similar to what they did for Chrysler in the 80's. It would be in both the bank's interest and the borrower's interest to make the loan and have the borrower continue to make payments, and some banks will do this on their own (or be forced to in a "cram down"); however, many other banks will not, so a government program may become necessary to prevent further disruption in the market. This won't do much for those with stated income (liar) loans, negative amortization loans, and others who are unable to make the payments (which is probably most buyers over the last 2-3 years). I don't see the government getting involved in debt forgiveness or paying off the banks losses: It would be too expensive at a time when tax receipts will be down.
Another idea that has been floated is the potential for hyperinflation to bring wages and rents up to increase fundamental valuations. The FED will never allow this. One of the primary functions of the FED is to provide a stable financial system. Since stagflation of the 70's, the FED has shown a willingness to push the economy into recession before it allows inflation to get out of control. In short, hyperinflation is not going to happen.
Related to hyperinflation is the devaluation of the dollar. Wages in the United States are already so high that jobs are being outsourced to foreign countries where people are paid much less. Wages cannot rise significantly from where they are without devaluing the dollar to prevent wage arbitrage from moving jobs overseas. In order for wages to rise in the United States (inflation) without causing jobs to move overseas, the dollar must decline in value. The FED doesn't want to see this happen either. When a country knowingly devalues its currency, it causes a severe recession as the prices of imported goods and raw materials increases dramatically. Nobody wants a severe recession.
Median Prices vs. Property Specific Prices
The final phenomenon to note with respect to measuring the market decline is the difficulty in measuring the decline in values of specific properties. The median is not a particularly good measure of property values because it only measures how much was paid, not what you got for your money. If you sell your condo in today's market for $500,000, wait a year, and buy a large detached home for $500,000, the median will not be impacted by those transactions, even though the sale and purchase represent a decline in housing prices. So it is possible this market crash could have individual properties decline 40% or more while the median is only off by 20%. It is probably more accurate to examine the sales prices on a per-square-foot basis to obtain a better measure the decline.
That being said, I think it is also likely that the median will decline 40% as well. The median is exaggerated because lenders are willing to loan people 10 times income to buy real estate. When credit tightens during the crash, lenders will pull back, eliminate the exotic loan terms, and keep their loans to the more conservative 3 to 4 times earnings. If this occurs, the median will decline as people's borrowing power is reduced.
Summary
If prices follow their historical pattern, they will fall down to their fundamental valuations over the next 5 years. This drop will represent a 40% decline in prices during that time. There are a number of variables which will influence the depth and timing of the decline which I have described in this post. Most of the risks are to the downside. IMO, there will be overshoot. What I believe we will see is a decline in the median to the levels as described, but the price declines in individual properties will be greater. By 2012 the starter homes currently going for $600,000 may be selling for $300,000. As I am sure someone is going to point out, this is all supposition and speculation; it is. Despite all the nuance and fancy analysis, everything comes down to one simple indicator: to paraphrase James Carville and Bill Clinton, "It's the Foreclosures, Stupid!"
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This post is my last in this series laying out the case for a market decline. I want to take this opportunity to thank all of you who read these posts and shared in the discussion. Your words of support and thanks I saw throughout the comments are much appreciated.
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If any of you would like to make a prediction, here is a Crystal Ball for you.
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Update: from Housing Panic
We have speculated a great deal on this board about the future of home prices in our area. The arguments all boil down to a simple conjecture: will prices fall to back to their fundamental values, or are prices going to remain permanently detached and inflated? I make no attempt to answer that question here. The chart link below is a graphical representation of what it would look like if home prices fall back to their fundamental valuations in Orange County.
Below is a link to the excel file I used. It is a bit messy, but experienced users can probably navigate it.
Orange County Median Price Projections Worksheet
BTW, I was thinking about the current state of the market, and Wile E. Coyote came to mind: An allegory for our times. The greedy FB's chasing their fortunes leading to their destruction. I found it particularly poignant the moment of realization when Wile E discovers he has a serious problem.
In my last post "How Sub-Prime Lending Created the Housing Bubble," I went through a thought experiment to demonstrate how the psychological and technical factors interrelate to create a speculative mania. In this post I intend to examine the details of the most recent Southern California residential real estate bubble to deflate, and see what it portends for the future.
Today, we are just past the market top. Predicting when a top will occur is very difficult, but recognizing when one has occurred is not: The market has topped. Volume is down as the pool of buyers is exhausted, and inventories are increasing. Flippers are looking for renters, and everyone is praying for the big spring selling season to bail them out. Denial and bargaining dominates the mindset of sellers.
Since prices are softening, there will be one last push of buyers entering the market: those who felt they were "priced out" but see this softening as an opportunity. These buyers actually believe in the fantasy of continual appreciation. They just missed out on the rally. They are classic “bitter renters.” That is why the first selling season after the top gets the most robust bear rally. Many will call the bottom, and many more will be duped into buying this false rally. The strength of the first selling season gets weighed down by the large volume of inventory that ultimately reverses prices and pushes prices lower.
Owners move from denial and bargaining to anger after seeing the failure of the spring selling season and even lower prices than the year before. Many begin to recognize they have a real problem, but many hold out hope that things will turn around “next year.” The second year after the peak, the spring selling season is even weaker than the first, mostly because sellers are more motivated and buyers less so. In year two the remaining sellers who were in denial have moved to anger and acceptance. By the end of year two, all the market participants know prices are declining and will continue to do so.
The third year after the top, selling really gets panicky. Prices are falling quickly and volume is increasing. There is no spring bounce, and prices decline every month of the year. Everyone has accepted that prices are going to fall, and owners are very depressed. This may continue for multiple years if prices remain above fundamental valuations.
In the fourth year, if prices have fallen low enough to be close to the upper range of fundamental valuations, buyers begin to enter the market. The market may even experience its first price rally in two years. However, the large number of foreclosures and large overall inventories prevent this rally from taking hold. Prices resume their descent after the spring push. At this point in the decline, most participants in the market see residential real estate as a bad investment. Why wouldn't they, most just lost money? People believe that renting is better than buying, and the belief in appreciation is dead.
In the years that follow, market prices enter the range of fundamental valuations where they find support. Prices may continue to decline somewhat, perhaps even overshooting the fundamentals due to the foreclosure inventory, but if prices fall low enough, cashflow investors will enter the market in force and create a durable bottom. However appreciation will not return quickly. The market will flatten at the bottom as the Rent Savers and Cashflow Investors absorb the market inventory. The inventory will remain high. All of the ARM’s issued during the rally are now resetting, and most of the borrowers are underwater. This forces a sale, and generally another bankruptcy.
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"What is past is prologue." William Shakespeare. The Housing Bubble vs. The Great Depression
A real estate market decline, like any market decline, is part technical, part fundamental, and part psychological. In my previous post “How Inflated are House Prices?” I discussed the fundamental value of real estate and described how and why prices fall to their fundamental values once a bubble has burst. In this post, I intend to describe the technical and psychological factors at work during a speculative mania, and demonstrate how sub-prime lending created this bubble.
A Thought Experiment
I would like to start with a thought experiment. Imagine a room with 100 people representing the pool of sub-prime borrowers. These are new entrants to the market. They were previously unable to buy due to bad credit, lack of savings, etc. All of them are told they are going to bid on an asset that never goes down in value, and they will be given the ability to borrow unlimited funds (stated income loans, aka "liar loans") The only caveat is the borrowed money must be paid back when the asset is sold (not that they would care, they already have bad credit). Imagine what would happen?
People would start to buy the asset, and prices would rise. Others in the room seeing the rising prices would come to believe that indeed the value of the asset never declines. They would then join in the bidding. As the bidding drives prices even higher, a manic quality takes over the bidding and people compete with each other, often bidding higher than the asking prices. Nobody wants to be left out. There are fortunes to be made. Greed drives prices upward at a staggering rate. As the last of the 100 people buy, prices are very high, everyone has made money, and it looks as if prices will continue to rise forever . . .
Then something strange happens: there is nobody left to buy. (A key indication of the end of a speculative mania is a huge decline in sales, just as we have witnessed over the last year or two.)
Transaction volume drops off dramatically, and prices stop their dizzying ascent. Nobody is particularly alarmed at first, but a few of the more cautious sell their asset to pay off their loan. Since there are no more buyers, the first selling actually causes prices to drop. This is unprecedented: Prices have never declined! Most write it off as an aberration and comfort themselves with the past history of rising prices; however, a few are spooked by this unprecedented drop and sell the asset. This selling drives prices even lower.
(This brings us up to today in the local real estate market. But what about tomorrow?... Let’s continue our thought experiment.)
Now those who still own the asset become worried, some maintain denial that there is a problem, and some get angry about the price declines. Some of the late buyers actually owe more than they paid for the asset. They sell the asset at a loss. The lenders now lose some money and refuse to loan any more money to be secured against the asset (notice the recent implosion of sub-prime lending). Now there are even fewer buyers and a large group of owners who all want to sell before prices drop any lower. Panic selling ensues.
Everyone wants to sell at the same time, and there are no buyers to purchase the asset. Prices fall dramatically. This asset which was sought after at any price is now for sale at any price, and there are few takers. People in the market rightfully believe the asset will continue to decline. Owners of the asset have accepted the new reality; they are depressed and despondent.
In any group of people, there are always a few who don’t believe the "prices always rise" narrative. Some recognize that asset prices cannot rise indefinitely and cannot stay detached from their fundamental valuations. These people witness the rally and the resulting crash without participating. They wait patiently for prices to drop back to fundamental values, and then these people buy. As these new buyers enter the market, prices stop their steep decent and market participants start to hope again. It takes a while to work off the inventory for sale in the market, so prices tend to flatten at the bottom for an extended period of time; however, just as spring follows winter, appreciation returns to the market in time, and the cycle begins all over again.
What is written above is true of any asset whether it be stocks, bonds, houses or tulips. In our case, it is the local housing market, and the room of new buyers are sub-prime borrowers, but the concepts are universal. One phenomenon somewhat unique to the housing market is the forced sale due to foreclosure (stocks have margin calls). Even if the psychological factors at work during the panic could somehow be quelled, the forced sales from foreclosures would drive down prices anyway. True panic is not required to crash a housing market, only dropping prices and an inability to make payments. Sub-prime lending was the leading cause of this market bubble, and its implosion will exacerbate the market decline.
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P.S. A special thanks to OC FlipTrack for the Stages of Grief.
One of the main contentions of the bearish argument is that house prices are overvalued. To determine whether or not that premise is true, there must be some way to appraise the fundamental value of a house. Once determined, this fundamental value serves as a point of comparison to the prices at which houses are currently being bought and sold. If current prices are shown to be above fundamental value, it establishes that house prices are inflated, and it also provides a measure of the degree of that inflation.
The corollary argument made by housing bears is that inflated housing prices have not historically remained inflated and have for good reason fallen back to fundamental valuations at each market decline. If this corollary argument can also be demonstrated to be true, it provides a way of projecting the market decline we can expect to see in the future.
The fundamental value of all housing prices is comparative rents. Rents define the fundamental value of real estate because rental is a direct proxy for ownership; both rental and ownership provide for possession of property. In a normal real estate market, when prices go up and the cost of ownership exceeds the cost of rental, people choose to rent rather than own, and the resulting drop in demand depresses home prices: The inverse is also true. Therefore, the proxy relationship between rental and ownership generally keeps home prices tethered to rental rates.
Rental rates tend to keep pace with wages because you normally pay rent out of current income. As people make more money, they compete for the available rentals and drive prices up at a rate about 1% greater than the overall rate of inflation. There are times when supply and demand issues in local markets create fluctuations in this relationship, but as a rule, rents track wages pretty closely.
Since house prices are tied to rents, and rents are tied to wages, house prices are indirectly tied to wages. When house prices increase faster than wage growth, the price levels become unsustainable, and if the differential is too great, you get a bubble.
Two Levels of Buyer Support
There are two categories of buyers that will enter the market and purchase real estate without regard to appreciation: Rent Savers and Cashflow Investors. These are the buyers that will buy houses even if prices are declining; therefore, they are the ones who call the bottom. Rent Savers are buyers, like me, who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them.
Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.
In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and you have an unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.
Calculating a House's Fundamental Value
Let’s evaluate the fundamental value of a house I found at 51 Sanctuary with a rental rate of $5,000 a month and a purchase asking price of $1,589,000. Assuming both the rental rate and the asking price are reasonable in today’s market, how much could you afford to pay and keep the cost of ownership to $5,000 a month using a conventional 30-year mortgage? The first debatable, simplifying assumption I am going to make is that the income tax savings will offset the cost of taxes, insurance and HOA fees. The second debatable, simplifying assumption I am going to make is that you could obtain 100% financing at 6% interest. IMO, both of these assumptions do not change the math significantly except in cases of exceptionally high HOA fees. To end up with a monthly payment of $5,000, you would be limited to a mortgage of $834,000. If you were willing to put up a 20% downpayment (and give up your interest at the bank) to purchase this property, you could pay $1,000,000. How does this house price compare to its fundamental value? If you factor in a dead-money downpayment, this house is overvalued by 58.9%. If you assume 100% financing, this house is overvalued by 90.5%. If mortgage interest rates rise, the numbers get even worse. At 7% interest, which is closer to historic norms, the mortgage is limited to $750,000 making this house more than 100% overvalued.
So what about the Cashflow Investor, how low do prices have to go before they buy? They can borrow $580,000 at 6% with a $3,500 a month payment. This leaves $500 a month for vacancy loss and expenses and $1000 a month to provide a return on their investment. If they put $120,000 down, they would be getting a 10% return on their money ($12,000 / $120,000 = 10%). This puts the purchase price at $700,000. To the cashflow investor, this house is 127% overvalued.
As you can see there are two price areas where new buyers enter the market, depending on the assumptions used and the costs specific to the property, these numbers can vary, but they will fall within general ranges. Rent Savers will pay from 180 to 150 times monthly rent, and Cashflow Investors will pay from 120 to 150 times monthly rent based on today’s financing terms. If credit tightens, and mortgage interest rates go up, these ranges will decline making prices seem even more inflated.
In summary, I would argue that house prices in Irvine are at least 60% overvalued and probably closer to 100%. Price declines of 35% to 50% are required to bring prices back in alignment with their fundamental values. Since price declines of this magnitude will take time, and since rents and wages will continue to rise while home prices are declining, expect price declines of 30% to 40% over the next three to five years before new buyers will enter the market and form a durable bottom.
