Over the weekend the NYT Magazine ran a piece that called down the mortgage banker’s association (MBA) for suggesting that homeowners had a moral obligation to pay their mortgages, even when it wasn’t in their economic best interest.  The article was along the lines of what I wrote here in December, where I pointed out that the hubris of the MBA, calling on homeowners to make good while members default at will and get government bailouts, was laughable.  The fact that this topic is gaining ground in the MSM is worth noting.  Earlier in December I wrote about the choice of strategic defaulters, weighing the economics of lower payments, which leads to greater standard of living, and mobility against credit impairment for a period of time.  The rationale of this approach is obvious, but so is the moral breakdown of a contract not honored.

We are moving very quickly down a path where economic contracts no longer carry the weight of moral certainty, and it is a worrisome trend.  If we look at mortgages, they all carry the “promissory” language, meaning that every homeowner promises to pay.  Then the contract goes on to list the actions that will be taken if the debtor does not pay, which always involved foreclosure of the property and in some states can mean forfeiture of other assets.  Yet we all know there are other costs, including what it means to each of us to not honor his or her promise, or word, when (as in the case of strategic defaulters) it was within our ability to do so. 

As we go down this road, it would seem logical that the penalties for non-payment would become much more severe, and the ability to secure credit in the first place would also be hindered.  As more people choose to default, what lender would choose to put more capital at risk? 

This is where our government becomes the originator of the perverse incentive.  Through a variety of programs (TARP, TALF, etc.), direct involvement (FNMA,  FHLMC, HFA, GNMA), and back door approaches (Fed buying mortgage backed securities), our government is making credit much more available that it currently should be.  Instead of there being a substantial backlash against those who default, there is instead a rush to force lending institutions to make credit available to anyone willing to borrow. 

Obviously it is harder to get credit today than it was two years ago, but the hold up is at the point of lending, it is not caused by a lack of available funds.  As we get further into this year and next, I fully expect to see very forceful calls from our government for lenders to be much more flexible in determining to whom they will lend.  Strategic defaulters will constitute an interesting class of people -those with capital who take on debts but when things look bleak they cut their losses.  That makes them sound a lot like mortgage bankers, who have their own set of well publicized issues for which they have gotten government help assistance.

I fear the consequences of such actions by strategic defaulters, just as with mortgage bankers, will be greatly minimized.  I know that taxpayers will be stuck paying for them both.

We saw this coming, of course: Pending Home Sales Fall 16 Percent in November.

The AP writes,

The number of buyers who agreed to purchase previously occupied homes fell sharply in November, a sign sales will fall this winter, undermining last summer’s recovery.

The report Tuesday indicates consumers are taking their time following the extension of a tax credit deadline. The incentive of up to $8,000 for first-time buyers was set to expire at the end of November. But Congress pushed back the date and broadened the program with a new credit of up to $6,500 for buyers who relocate.

Untold numbers of home purchases were pulled forward when it looked like the tax credit were being phased out.  So, we’d expect sales to disappoint for November through probably February, with another big spike in March and April, when the credit is scheduled to expire (for real, this time!).

What this means is that it’s going to be difficult to draw meaningful conclusions from housing data over the next several months.  The big improvement in the late 3rd and early 4th quarters were obviously artificial.  But then, so was the drop-off in November.  It will be several months before we really know what is happening.

Charles Sizemore, CFA
Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Bloomberg reported that US existing home sales had an incredible month — up 10% in October to the highest levels since February 2007!  That’s the good news.  Now for the bad: even with a surge in buying interest, prices continued to fall. (See “U.S. Economy: Existing Home Sales Jump as Prices Fall“)

The primary reason for the spike was the impending expiration of the $8,000 new homebuyer tax credit.

The continued fall in prices despite the increased interest is disturbing, and the tax credit has a way of understating it.  Let’s think about this for a minute.  At a median price of $177,900, an $8,000 credit amounts to a 4.5% discount on the price of the house.  Prices have “only” officially fallen by 7.1% year over year.  But if you assume that buyers calculate the affect of the tax credit into their purchase decision, you have to assume that the “real” price at which the house would have changed hands would be approximately $8,000 less.  This means that, year over year, prices in the absence of the subsidy would have been down nearly 12% — a devastating blow to the typical mortgaged homeowner.

Interestingly, the share of foreclosed homes rose to 30 percent of all sales…and delinquencies remain high, indicating that the supply of foreclosed homes flooding the market is nowhere near exhausted.

The good news is that, over time, Gen Xers and Echo Boomers will absorb the massive amount of excess housing inventory.  Even in a deep recession, the demographic buying trends are strong.  The bad news is that the final clearing price is likely to be considerably lower than it is today.  At some point, the supply/demand balance will favor the seller again.  But that day is still a long ways off.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

A friend of mine looking to sell his home in suburban Fort Worth got a rude awakening.  The estimated market value of his home dropped $20,000 almost overnight.  When he asked the realtor what happened, he found out that the last comparable sale in the neighborhood was a foreclosure.  And even though that foreclosure price was not a “normal” market price, by virtue of being the last sale in the neighborhood, it became the new market price, dragging every other home in the neighborhood down.

The greatest benefit of a liquid market is it role in allowing “price discovery.”  The interactions of buyers and sellers send the signal of what an object is worth via the clearing price.  But the key here is “liquid.”  When sales are infrequent, prices become stale and no longer reflect reality.

In the housing market, this can be seen in a couple different ways.  If demand is in freefall and it’s been a while since there was a sale, the “market” price will grossly overstate the “real” price.  But likewise, if demand is relatively strong but the last sale was an aberration (such as a low-ball foreclosure sale), the market price can understate the real price.   In either event, it can make the sale of a house complex and downright tricky to negotiate for both buyer and seller.

The NY Times ran a good story this morning about this topic: “Getting Real About Home Prices”

The Times writes,

Even in the best of times, it’s hard for individuals to objectively value their homes, which often reflect their sense of self and personal style. Making things even more difficult has been general market inactivity lately, if not paralysis, which has provided little in the way of pricing guidance. But by using online resources, investigating neighborhood trends, consulting real estate experts and perhaps even asking the opinions of brutally honest friends, homeowners can arrive at a reasonably accurate appraisal even in these uncertain times.

Of course, as the Times tells us, in the end “the value of a home is the price the buyer is willing to pay.” And in most areas, it is still very much a “buyers market” in the sense that sellers have very little negotiating power.  This is not something we see changing any time soon.

Charles Sizemore, CFA
Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

Apparently state governments are fightin’ mad at the fact that foreclosures are wrecking their economies.  They are eyeing mortgage lenders for creating the debacle, and on top of that, those pesky banks and other lenders are not helping to remedy the situation, often taking much too long to deal with loan modifications and other initiatives aimed at slowing the rate of foreclosure.  In an effort to take control,  states are weighing the possibility of suing mortgage lenders for fraud.  Take a moment to ponder this.  State governments, who have wildly over-promised what they can support through their own funding, are contemplating suing mortgage lenders for fraud because they potentially lent money to people who couldn’t pay it back.  This falls into the “I can’t understand that” category.

If a lender makes a loan that can’t be paid back, isn’t that sort of a bad business practice?  To say that the lender did it for profit is a bit confounding, since the business model - lending to people who were marginal borrowers - seems like it is doomed from the beginning.  In fact, many of those lenders are out of business.

But let’s entertain the idea for a moment.  Someone out there is responsible for creating a boom in economic activity through the promise of cheap home ownership - or at least that is the working theory here.  That boom created an unsustainable flow of capital and economic activity within states that they became accustomed to having.  Now the spigot is turned off, so let’s blame the group that created this mania.  To do this, you have to keep asking for the next step.

It can’t be the mortgage lender.  Barring out and out fraud (which of course happened, and was always illegal), we are talking about the sweet talk of easy home ownership at a low price, getting in on the fastest game in town, the real estate bubble, and directed at those who were at best marginal buyers and at worst non-qualified buyers.  This of course came through the lenders, but it started a little further up the chain.  You have to look at the Fed with their insanely low interest rate policy, which kept prices low.  But that’s not the end of the line. 

For the end of the line, you have to look at the bucket of money that eventually purchased a big chunk of those mortgages backed by low income borrowers who are now in trouble.  That would be me and you, through our agents Fannie Mae and Freddie Mac.  In the 1990s we gave direction to those two government sponsored entersprises (GSEs) to make sure that a large percentage of the loans they purchased were those backed by low or modest income borrowers.  So in this line of thinking - that someone, somewhere, created all this mess in housing by making homes TOO affordable and persuading people to buy homes they couldn’t afford - would have to lead you back to the big buckets of money that kept buying the loans.

When are the states going to sue the federal government for fraud?  I don’t know, but if it does, it will be interesting to watch!

Don’t get me wrong, I do not think Congress is responsible for this mess.  I think this was a group effort - CDS’s which were gussied up insurance contracts with no capital behind them, rating agencies who pandered to issuers, the Federal Reserve, and Congress had a bit part.  There are many others, including borrowers themselves.  In this post I’m just addressing a current issue with states, I’m not agreeing with their analysis.

Here’s a headline we all saw coming: “Mortgage applications slide as tax credit expiration looms.”
CNN Money reports that “Mortgage applications fell last week for the third week in a row, even as interest rates edged lower…  The drop in activity came as a popular tax credit for first-time homebuyers faced an uncertain future. The credit, which can be worth up to $8,000 for eligible buyers, is set to expire at the end of next month.”

Economics is always best understood “at the margin.”  The aggressive selling and lax mortgage lending practices in the mid-2000s pulled forward a significant number of sales of marginal buyers.  This includes both subprime borrowers (who probably should have never considered home ownership in the first place) and higher-quality borrowers who were persuaded to buy a home sooner than they might have due to the attractive financing options.

We see the same basic conditions today: the tax credit for first-time buyers has also convinced more than a few marginal buyers to step up and buy a house sooner than they might have in the absence of the tax credit. This has been one of the biggest forces driving the nascent recovery in new home sales.

There are two big problems with this, however Read the rest of this entry »

Cheers to the Wall Street Journal for publishing Brett Arends excellent piece on the housing market: “Home Prices: There’s No Quick Recovery Ahead.”

Arends makes a quick summary of the bullish points for the housing market: The Case-Shiller Home Price Index has more or less flattened after falling for three years, while some cities actually showed mild improvement.  Inventories of unsold homes have also improved, falling to 3.8 million from 4.5 million the month before.  This improvement is deceptive, however.  As Arends writes,

The picture on inventories isn’t as good as it sounds, either. A lot of unsold homes have simply been put up for rent instead, especially in the most difficult markets like Miami. The result? A glut of empty rentals as well.

It is likely that many of these money-losing rentals will be put back on the market within the next few years, nipping any would-be recoveries in the bud.  Arends continues,

New waves of foreclosures and distressed sales may be coming, too. In states such as California, it can take many months for delinquencies to turn to foreclosures, which means last winter’s bad news may still be coming down the pike. Meanwhile, vast tranches of teaser-rate mortgages are due to reset later this year and in 2010.

So, while there is indeed some improvement in the housing markets (and by improvement, we mean going from truly horrid to just plain bad), it’s still not time to break out the cognac and cubanos.   Demand from Echo Boomers will eventually absorb the excess supply of starter homes and rentals in many areas, even creating a mini-boom in some.  But we expect weakness to persist in McMansions for years…if not decades.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

With all the talk of economic recovery — even in these pages — we think it’s a good idea to keep things in perspective.  Yes, nationwide, things are getting less bad.  But the aftermath of the property bust will be with us for quite some time, particularly in Southern California, where there was overbuilding of practically everything — houses, retails, offices, you name it.

This WSJ headline pretty well sums up the situation: “Vacancies Suppress Southern California Recovery.”

How  bad is it?  Office vacancies in San Bernardino and Riverside counties have more than tripled, rising to 24.6% from 8% in 2006.   Orange County’s office vacancy rates stands at a comparable 20%.   The Inland Empire’s retail vacancy rate has more than doubled to 10.6% from 5% in 2006 (and will likely rise further in the sluggish consumer environment we see ahead).  Anecdotal reports tell of new office buildings sitting completely empty and shopping malls defaulting on bank loans.  It is truly a depressing picture. Read the rest of this entry »

We read today in a press release that President Obama said “We may be seeing the beginning of the end of the recession.”  Our own analysis of the leading economic indicators has led us to the same conclusion; things are getting less bad, and we may enjoy a mild recovery in the months ahead.  But this does not at ALL suggest that we are going to return to a period of robust growth.  As we’ve said before, “less bad” does not mean “good.”

After a true bubble like the one we witnessed in Florida real estate, it can take years or even decades to work off the excesses.  Earlier today, a friend sent me a story about a high-end, 34-story condo tower in Fort Myers, Florida.  The building has exactly one resident — yes, one!

So, the rest of the building remains vacant, a monument to the most absurd American real estate bubble in history.  Will it ever be leased or owner occupied?  Maybe.  Maybe not.  Dallas, Texas — our hometown — was one of the centers of the late 1980s condo binge associated with the S&L debacle.  The I-30 corridor was littered with condo developments that FAR exceeded local demand.   Many properties remained vacant eyesores for years before finally being demolished — having NEVER been occupied.  The areas most affected are still blighted, 20 years later.   That part of the city is hideously ugly, and probably always will be.

When development finally returned to the DFW metroplex, builders largely ignored the area and chose instead to go a different direction.  Quite frankly, that part of the city may never recover.   Perhaps some of the federal stimulus money could be used to build a monument there — “Speculative Bust National Park.”

At any rate, the recession may or may not be ending.  But we are definitely NOT returning to the way things were, at least not any time soon.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy

One of our readers passed on an article of note: “Fewer New Households Formed in Recession.”

The headline caught our eye, because with the huge number of Echo Boomers graduating from high school and college the number of new households being formed should be exploding.  It appears, however, that the recession has kept quite a few nests from getting empty.  As the Washington Post writes,

The recession has wreaked havoc on all sorts of life plans. Tumbling stock prices have cut retirements short. Layoffs have forced middle-aged children to move in with mom. Falling home prices prompt unhappy couples to rethink divorce. The larger consequence of all these discrete decisions is that Americans are forming fewer households, which in turn helps prolong the downturn….

Demographers and housing experts attribute the drop in household formations to millions of individual decisions to forgo immigrating to the United States, to put off a move, or to bunk with friends and family for a while.

The highlighted sentence summarizes HS Dent’s research methodology.  What we think of as “the economy” is nothing more than the sum of millions of Americans going about their business, buying and selling.   During recessions, EVERYONE does not simultaneously stop spending money.  But at the margin, one person forgoes a Starbucks coffee here, another forgoes a new car stereo there…and in aggregate, we buy less, businesses invest less, and the economy shrinks.  And sometimes, it shrinks by quite a lot.

In the article, we see that the number of new households — defined as a group of people sharing living arrangements — grew by 772,000 in the year ended March 31, compared with an increase of 1.63 million a year earlier.  That is an incredible 53% drop!  And this, as we said earlier, was in a year in which million of young adults graduated from high school and college!

With immigration all but grinding to a halt, we have lost one major contributor to household formation that is not likely to return any time soon.   But, we still have the Echo Boomers, who can’t continue living with mommy forever.   Recession or not, most of these teenagers and 20-somethings will set out on their own in the years to come, and when they do, they will mop up a fair amount of the excess housing supply.  They won’t be buying McMansions, of course.  But they will be buying starter homes and renting entry-level apartments.  Perhaps some will live with roommates for a few years, and there will be a few that continue to live with family.  But given the size of this generation — the largest since the original Boomers — there will be enough of them to populate many of the apartments and houses we see vacant today.  

The controversial housing report released last month by Harvard University calculates that the glut of 1.5 million surplus homes from the boom years would have already been soaked up if household formation rates had remained at normal levels.  This fails to consider price, of course, and in many areas home prices would need to continue falling for them to be affordable for these young would-be buyers.

The sooner the household formation rate increases, the better.   Because in the meantime, we still have a housing glut and a massive amount of oversupply throughout the economy. For our economy to recover, we need the Echo Boomers to get off of Mom’s couch…and buy their own…preferably on credit.

Charles Sizemore, CFA

Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy