Occasionally people in Government tell the truth. Usually this is a gaffe, but the Trustee in charge of the TARP program has written a well-researched and accurate report on the miserable state of the TARP program. I am impressed.

Today's featured property is a ridiculously priced Northwood tract home. I am not impressed.

Irvine Home Address … 2 BLUE SPRUCE Irvine, CA 92620

Resale Home Price …… $1,249,000

{book1}

Do what I want cause I can and if I don't

I do believe I told you so.

The Hives – Hate To Say I Told You So

People ignore contrary or inconvenient information, particularly once they have made up their mind to do something. When our Government decided to act to save stupid wankers bankers, they ignored the obvious problems their solutions were going to create — or to be more accurate, Government officials knew public relations problems were on the horizon due to the way taxpayers are being defrauded, and that these problems would require a bounty of bullshit to smooth over, but saving corporate campaign contributors (and enriching Goldman Sachs) was deemed more important, so you and I pay the price.

I came across the story TARP overseer says bank bailout program has mixed results that lead me to the SIGTARP Quarterly report to Congress (PDF). When I browsed the report, I was pleasantly surprised to read robust analysis and an accurate evaluation of the success (or lack thereof) of the TARP program:

This time of transition provides an opportunity to take a step back and examine whether Treasury’s efforts in TARP thus far have met the goals of the program. On the positive side, there are clear signs that aspects of the financial system are far more stable than they were at the height of the crisis in the fall of 2008. Many large banks have once again been able to raise funds in the capital markets, and some institutions — including some that appeared to be on the verge of collapse — have recovered sufficiently to repay their TARP investments years earlier than most would have predicted. These repayments and the sales of the warrants associated with them have meant that Treasury (and thus the taxpayer) has turned a profit on some of the individual TARP investments; as a result of these repayments, among other positive developments, it now appears that the ultimate cost of TARP to the American taxpayer, while still substantial, might be significantly less than initially estimated.

Many of TARP’s stated goals, however, have simply not been met. Despite the fact that the explicit goal of the Capital Purchase Program (“CPP”) was to increase financing to U.S. businesses and consumers, lending continues to decrease, month after month, and the TARP program designed specifically to address small-business lending — announced in March 2009 — has still not been implemented by Treasury. Notwithstanding the fact that preserving homeownership and promoting jobs were explicit purposes of the Emergency Economic Stabilization Act of 2008 (“EESA”), the statute that created TARP, nearly 16 months later, home foreclosures remain at record levels, the TARP foreclosure prevention program has only permanently modified a small fraction of eligible mortgages, and unemployment is the highest it has been in a generation. Whether these goals can effectively be met through existing TARP programs is very much an open question at this time. And to the extent that the Government had leverage through its status as a significant preferred shareholder to influence the largest TARP recipients to carry out such policy goals, it was lost with their exit from TARP. As important as assessing the effectiveness of TARP programs is, in the final analysis, TARP can truly only be a success if TARP is both managed well and its positive effects are enduring. The substantial costs of TARP — in money, moral hazard effects on the market, and Government credibility — will have been for naught if we do nothing to correct the fundamental problems in our financial system and end up in a similar or even greater crisis in two, or five, or ten years’ time. It is hard to see how any of the fundamental problems in the system have been addressed to date.

• To the extent that huge, interconnected, “too big to fail” institutions contributed to the crisis, those institutions are now even larger, in part because of the substantial subsidies provided by TARP and other bailout programs.

• To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.

• To the extent that large institutions’ risky behavior resulted from the desire to justify ever-greater bonuses — and indeed, the race appears to be on for TARP recipients to exit the program in order to avoid its pay restrictions — the current bonus season demonstrates that although there have been some improvements in the form that bonus compensation takes for some executives, there has been little fundamental change in the excessive compensation culture on Wall Street.

• To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices — as discussed more fully in Section 3 of this report — risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.

Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.

Kevin R. Puvalowski, SIGTARP's Deputy Special Inspector General, just earned my respect. The honesty and clarity of this assessment is remarkable for a bureaucrat — the program is not working, and the administrator says so. Perhaps I shouldn't be so cynical about our Government, but truth and reality are in short supply in Washington's public pronouncements, and this report contrasts and demands attention.

As Christopher Thornberg noted in Beacon Economics 2010 Orange County Forecast the main problem with our financial system is incentives and moral hazard, and Mr. Puvalowski hammers Congress with the truth — not that anyone is listening — but at least truth is being told.

Section 3 of the report (pages 109-130) contain great historical and current information on the GSEs, FHA and other programs the Government controls and uses to prop up house prices. It is worth taking the time to read in full:

Mechanisms for Supporting Home Prices

Supporting home prices is an explicit policy goal of the Government. As the White House stated in the announcement of HAMP for example, “President Obama’s programs to prevent foreclosures will help bolster home prices.”

In general, housing obeys the laws of supply and demand: higher demand leads to higher prices. Because increasing access to credit increases the pool of potential home buyers, increasing access to credit boosts home prices. The Federal Reserve can thus boost home prices by either lowering general interest rates or purchasing mortgages and MBS. Both actions, which the Federal Reserve is pursuing, have the effect of lowering interest rates, which increases demand by permitting borrowers to afford a higher home price on a given income. Similarly, the Administration is boosting home prices by encouraging bank lending (such as through TARP) and by instituting purchase incentives such as the First-Time Homebuyer Tax Credit. All of these actions increase the demand for homes, which increases home prices. In addition to direct Government activity, home prices can be lifted by general expectations among homebuyers of future price increases. Figure 3.7 provides a graphic representation of the relationship between possible Government actions and their impact on home prices.

Little things jumped out at me as I scanned the report. Did you realize that the Federal Reserve's program of buying GSE debt has now printed more money to buy toxic mortgages than it previously held in Government Treasuries? The Federal Reserve's balance sheet is bloated and holding more waste than patrons at an all-you-can-eat buffet.

Northwood is Immune?

When I saw the asking price on this home, I was floored. Can you pick out the estate asking $1,249,000 in the images below?

If the asking price was about half of what it is, the price may be reasonable, particularly when you factor in the upgrades, but I can see no justification for this asking price; in fact, I can see no rational for any price over $1,000,000. When I first saw the nearby 20 SILVEROAK for sale asking $958,000, I thought it was overpriced and likely to sit, but it wasn't so far out of reality to earn a WTF award; in contrast, today's featured property's pricing is beyond the pale, and both the realtor and the owner should be embarrassed.

Irvine Home Address … 2 BLUE SPRUCE Irvine, CA 92620

Resale Home Price … $1,249,000

Income Requirement ……. $260,092

Downpayment Needed … $249,800

20% Down Conventional

Home Purchase Price … $326,500

Home Purchase Date …. 12/19/1996

Net Gain (Loss) ………. $847,560

Percent Change ………. 282.5%

Annual Appreciation … 10.1%

Mortgage Interest Rate ………. 5.05%

Monthly Mortgage Payment … $5,394

Monthly Cash Outlays …..….… $7,110

Monthly Cost of Ownership … $5,100

Property Details for 2 BLUE SPRUCE Irvine, CA 92620

Beds 5

Baths 3 full 1 part baths

Home Size 2,900 sq ft

($431 / sq ft)

Lot Size 5,917 sq ft

Year Built 1998

Days on Market 4

Listing Updated 2/5/2010

MLS Number S604335

Property Type Single Family, Residential

Community Northwood

Tract Lexi

THIS IS IT!!! A beautifully remodeled Lexington home that shows like a model. The main living area has been opened into a spacious and elegant Great Room. The kitchen boasts granite counters, distressed hard wood cabinetry, double convection ovens, 5 burner range, built-in fridge/freezer, island with wine fridge, and more…. There are two entertainment areas, one down with surround sound and the other up in the added bonus room / loft. This home has a full bedroom and 3/4 bath downstairs and a full downstairs office. The outside is also an entertainers dream, with a large corner lot, the rear yard has a BBQ island, fridge, and sit up bar, covered eating area with a built in space heater and ceiling fan. There is a nice size yard and a raised 12 seat spa that is built into a vault. This home is a must see!!!

THIS IS IT!!! Is it just me, or do you smell the word shit in there somewhere?

This home is a must see!!! Can you feel the urgency?

entertainers dream? Perhaps Tempo MLS does not permit apostrophes?

Congratulations New Orleans Saints!

Sometimes Super Bowls are super duds, but last night's game was very well played by both teams on both sides of the ball, and I enjoyed the game thoroughly. As the Colts were driving for what looked like a game-tieing touchdown, only to be denied by a decisive interception, I thought it was a shame that one of these two great teams had to lose. The game was a marvelous capstone to a great NFL season.

Investment Value

The United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence). They make this distinction because a house has both a consumptive purpose and an investment purpose. The consumptive value is measured by rent or rental equivalence. There is legitimate financial reason to pay more than the rental equivalence price. The normal rate of house appreciation–not the unsustainable kind witnessed during the Great Housing Bubble–can provide a return on investment. The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage. The investment premium, which is about 10%, is less than most people think.

The rental equivalence value is the fundamental value of real estate, and it is also its consumptive value. This value can be easily measured as demonstrated in the previous section. There is an independent investment value that can also be measured and added to the consumptive value to arrive at the maximum resale value of the property. Investment value is derived from two sources: the increase in property value through appreciation and the long-term savings over renting caused by inflation. These two components are measured separately to demonstrate how they function and how much each of them is worth.

Since the return on investment generated from residential real estate occurs in the future, a discounted cashflow analysis is required to determine the net present value of the future returns. Calculating net present value sounds complex, and manually going through the calculations is quite cumbersome, but electronic spreadsheets make this an easy task. The concept is simple: how much money would investors put in an investment today if they knew the rate of growth and the cash value to be realized in the future. For instance, if investors put $100 in a bank earning 5% interest, they would have $105 at the end of the year. Net present value looks at the situation in reverse. If investors knew they would receive $105 at the end of the year and the market interest rate was 5%, they would be willing to pay $100 for it today. Similarly, the investment value of residential real estate is the value today of an amount of money to be received in the future either through sale or savings on rent.

Discount Rates

The investment value of a property can only be measured against other investment opportunities available to an investor. If investors can earn 4.5% by investing in government treasuries, they will demand a higher return to invest in an asset as volatile and as illiquid as residential real estate. The rate of return an investor demands is called a “discount rate.” The discount rate is different for each investor as each will have different tolerances for risk. During the Great Housing Bubble discount rates on most asset classes were at historic lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the investment value. Because of the risks of investing in residential real estate, a strong argument can be made that a low discount rate is unwarranted and investors would typically demand higher rates of return for assuming the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate underestimates the investment premium and makes an investment appear less valuable.

The US Department of the Treasury sells a product called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS increases with inflation, and it pays a semi-annual interest payment providing a return on the investment. When a TIPS matures, they buyer is paid the adjusted principal or original principal, whichever is greater. This is a risk-free investment guaranteed to grow with the rate of inflation. The rate of interest is very low, but since the principal grows with inflation, it provides a return just over the rate of inflation. Houses have historically appreciated at just over the rate of inflation as well; therefore a risk-free investment in TIPS provides a similar rate of asset appreciation as residential real estate (approximately 4.5%). Despite their similarities, TIPS are a much more desirable investment because the value is not very volatile, and TIPS are much easier and less expensive to buy and sell. Residential real estate values are notoriously volatile, particularly in coastal regions. Houses have high transaction costs, and they can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the yield on TIPS or the rate of appreciation of residential real estate as the discount rate in a proper value analysis.

Another convenient discount rate to use when assessing the value of residential real estate is the interest rate on the loan used to acquire the property. Borrowed money costs money in the form of interest payments. A homebuyer can pay down the loan on the property and earn a return on that money equal to the interest on the loan as money not spent. Eliminating interest expense provides a return on investment equal to the interest rate. Interest rates during the Great Housing Bubble on 30-year fixed-rate mortgages dropped below 6%. An argument can be made that 6% is an appropriate discount rate; however, 6% interest rates are near historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid 80s after the spike of the early 80s to quell inflation. The average contract mortgage interest rate from 1986 to 2007 was 8.0%. If a discount rate matching the loan interest rate is used in a value analysis, it is more appropriate to use 8% than 6%.

Investors in residential real estate (those who invest in rental property to obtain cashflow) typically ignore any resale value appreciation. These investors want to receive cash from rental in excess of the costs of ownership to provide a return on their investment. Despite their different emphasis for achieving a return, the discount rates these investors use may be the most appropriate because it is for the same asset class. Cashflow investors in rental real estate have already discounted for the risks of price volatility and illiquidity. Historically, investors in cashflow producing real estate have demanded returns of near 12%. During the Great Housing bubble, these rates declined to as low as 6% for class “A” apartments in certain California markets. [1] It is likely that discount rates will rise back to their historic norms in the aftermath of the bubble. If a discount rate is used matching that of cashflow investors in residential real estate, a rate of 12% should be used.

Once money is sunk into residential real estate, it can only be extracted through borrowing–which has its own costs–or sale. Money put into residential real estate is money taken away from a competing investment. When buyers are facing a rent versus own decision, they may choose to rent and put their downpayment and investment premium into a completely different asset class with even higher returns. This money could go into high yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-return investment vehicles. An argument can be made that the discount rate should approximate the long-term return on high yield alternative investments, perhaps as high as 15% or 18%. Although an individual investor may forego these investment opportunities to purchase residential real estate, it is not appropriate to use discount rates this high because many of these investments are riskier and more volatile than residential real estate.

The discount rate is the most important variable in evaluating the investment value of residential real estate. Arguments can be made for rates as low as 4.5% and as high as 18%. Low discount rates translate to high values, and high rates make for low values. The extremes of this range are not appropriate for use because they represent alternative investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because these represent either credit costs (interest rates) or the rate used by professional real estate investors. The examples in this section will use these two rates to illustrate the range of values rational investors in residential real estate would use to value an investment premium.

Appreciation and Transaction Fees

The portion of investment value caused by appreciation can only be evaluated by an accurate estimate of appreciation during the ownership period. The general public grossly overestimates the rate of home price appreciation. [ii] Historically, houses have appreciated at a rate 0.7% over the long-term level of inflation. From 1983 to 1998, a period of low inflation and declining mortgage interest rates before the Great Housing Bubble, the rate of house price appreciation was 4.5% nationally which was 1.4% over the rate of inflation. [iii] Appreciation rates are tied to income and rents because this is the fundamental value of residential real estate.

Profiting from house price appreciation requires getting more money from the sale of a property than was originally paid for it and not having that profit cancelled out by moving costs, transaction fees, and a large spreads between the cost of ownership and the cost of rental during the ownership period. Buying and selling residential real estate incurs significant transaction costs that are not reflected in the price. It is quite common for properties to sell for more than their purchase price and still be a loss for the seller. When people purchase residential real estate they pay numerous closing costs including title insurance, recording fees, document stamps and taxes, mortgage application fees, survey fees, inspection fees, appraisal fees, et cetera. These fees often total between 2% and 4% of the purchase price not including any prepaid interest points on the mortgage. When people go to sell residential real estate they generally go to real estate broker who will charge them a 6% commission. There has been an increasing popularity in the use of discount brokers, but the National Association of Realtors has done a remarkable job of keeping brokerage commissions at 6% despite market pressures to lower them. These transaction costs are part of every residential real estate transaction, and they take a substantial portion of the profit on properties with short holding periods, and if the holding period is not long enough, transaction fees create losses.

The negotiating abilities of buyers and sellers and the overall market environment greatly impact the profits from real estate. Sellers almost universally believe their properties are worth more than the market will bear. People become emotionally attached to their houses, and because it is very valuable to them, they assume it is just as valuable to a person who is not attached to the property. Sellers always hope to find the buyer who will appreciate their home as much as they do and thereby pay top dollar for it. The vast majority of homeowners have unrealistic expectations of appreciation. The combination of emotional attachment and unrealistic appreciation expectations cause sellers to believe their house is more valuable than it is, and when it comes time to sell, they price it accordingly.

Sellers usually are forced to discount a property from their perceived value in order to sell it, except in raging bull markets when sellers can sometimes get more than their asking price. In bear markets, they may have to discount the property significantly in order to sell it. Bear markets are the most difficult because sellers have difficulty lowering their prices, particularly if they must sell at a loss. [iv] Sometimes the difficulty in lowering price is caused by the amount of debt on the property, and sometimes it is caused by seller’s emotional issues. No matter the cause, the seller’s aversion to lowering asking price often results in a failure to sell the property. Since this process of discounting to sell is already reflected in the historic appreciation rate, no further adjustment is required to account for it.

The key variables for the calculation of the portion of investment value due to appreciation are the rate of appreciation, the investment discount rate and the transaction fees. In the calculations that follow the rate of appreciation is 4.5%, the discount rate is 8%, and transaction costs are 2% for the purchase and 6% for the sale. There is a 20% downpayment, and the loan is assumed to be an interest only to avoid the complications of a decreasing loan balance in the calculation and isolate the appreciation premium.

Due to the high transaction costs, the property does not reach breakeven until two full years of ownership. In a discounted cashflow basis, the property does not break even until after 4 full years of ownership. It is these high transaction costs that compel many with short-term housing needs to rent rather than own. Assuming an 8% discount rate and a term of ownership of 10 years or more, there is a premium for ownership of approximately 10%. This means the owner could pay up to 10% over the rental equivalent value and still obtain an 8% return on their money–assuming they can sell it for 10% over rental equivalent as well.

There is a tendency in the general public to assume the leverage of real estate provides excessive returns. It does magnify the appreciation, but since the historic and sustainable rate of appreciation is a low 4.5%, the leverage is applied to a small growth rate resulting in less than stellar investment returns. In the previous examples, if the downpayment is lowered to 10%, the investment premium at an 8% discount rate rises to 15%, and with a 12% discount rate, there are some ownership periods justifying a premium. If the downpayment is dropped to 1%, the ownership premium rises as high at 20%. At its most extreme with 100% financing, any positive return becomes infinite because the investor has no cash investment. Ownership premiums of 10% to 20% sound large, but in coastal markets during the Great Housing Bubble, buyers were paying ownership premiums in excess of 100%. There is no fundamental valuation justification for these price premiums, only rationalizations and hopes that a greater fool will appear and pay continually higher prices, or in the case of 100% financing speculation, that losses can be passed on to a lender if market prices decline.

Table 3: Appreciation Premium and Holding Period using an 8% Discount Rate

Larger discount rates eliminate the appreciation premium on residential real estate. The money tied up in a 20% downpayment on residential real estate appreciating at 4.5% provides a rate of return less than 12%; therefore when the gains from appreciation are discounted at 12%, the net present value never goes positive. When investors demand returns equal to or greater than 12%, there is no investment value from appreciation in residential real estate.

Table 4: Appreciation Premium and Holding Period using a 12% Discount Rate