Archive for the ‘Mortgage Lending’ Category
First, I hope everyone had a great Thanksgiving! For those of you who in countries that don’t share our festival of thanks, I hope you had a great Thursday!
Kuddos to Neil Irwin, writing in the Washington Post yesterday. I agree 100% with his list, and wanted to reproduce it here:
1. Household debt is way down. Neil lists this as his first item, but I would suggest it has plusses and minuses to it. On the plus column, we really WERE over-debted as a society. On the minus side, changes household debt carries with it complex implications for the consumption side of GDP, as well as corporate investment (see my prior blog post) and even trade relationships. Nonetheless, this is, on net, a good thing.
2. The cost of servicing that debt is way down — as Neil points out, from 14% of disposable income in 2007 to 10.7% today. Of course, remember that one person’s interest EXPENSE is another person’s interest INCOME. Nonetheless, this constitutes a significant wealth transfer from people who HAVE money back to people who NEED TO BORROW money.
3. Electricity and natural gas prices are falling. It’s hard to find a downside to this one. From last year, consumer natural gas prices are down 8.4%, and electric rates are down 1.2%. I would add to Neil’s analysis that more of this money is staying at home — the U.S. is well on its way to being import-neutral on energy. Of course, this has some geopolitical implications, which we’ll deal with on another day.
4. Businesses aren’t firing people. While unemployment remains high at 7.9%, at least the arrows are pointed in the right direction.
5. Housing is dramatically more affordable. Neil points out that in 2006, the typical homebuyer faced a payment equal to 41% of the average wage of a private-sector worker. Today that’s 26%. This is a combination of both lower house prices (which proportionally lowers down payment requirements) and lower mortgage interest rates.
Congrats to Neil Irwin and the Washington Post for an insightful and timely article!
Sustainability seems to be the real estate buzz word du jour. A “google” of “sustainable real estate” brings me slightly over 56 million hits. Number two on the list is the Journal of Sustainable Real Estate, (a more-or-less joint presentation of the American Real Estate Society and CoStar) of which I’m apparently on the editorial committee. Go figure.
I don’t want to sound too cynical here, but as a “finance guy” in the real estate field, I tend to follow the money. A lot of what’s going on in real estate, particularly at the individual building-level, has a lot to do with sustainable energy (e.g. — LEED Certification, Energy Star) or sustainable architecture. There was a nice paper out of Clemson University by David Heuber and Elaine Worzala recently on sustainable golf course development (click here for a link) which begins with the irony that no one is building golf courses today. Scott Muldavin has a great book on underwriting and evaluation sustainable financing (reviewed here) which gets close to the heart of the matter.
However, Ben Johnson, writing for the current issue of Real Estate Forum, seems to have caught the scent, to use a hunting dog analogy. In his article, “When CalPERS Talks, People Listen”, he notes that this mega-pension fund n($228 billion) has about 8% of its total invested in real estate. (My own estimate is a bit higher and more current than that — see here for details.) The noteworthy thing, however, is that CalPERS just made a $100 million stake in Bentall Kennedy outt of Toronto. B-K is one of North America’s largest real estate investment advisors, resulting from the 2010 merger of the Canadian firm Bentall with Seattle’s own Kennedy Associates.
Two things make this all very interesting. First, B-K earned the top spot this year on the Global Real Estate Sustainability Benchmark Foundation’s ranking of fund managers in the Americas. This ranking, covering 340 of the world’s largest funds, measures social and environmental performance. (Given B-K’s Pacific Northwest and Canadian pedegrees, this doesn’t surprise me at all.)
Second — and this may be the biggie — as CalPERS goes, so goes the industry. The focus of Mr. Johnson’s article was to note that now every pension fund in the known universe will need to consider using an advisor like B-K. Johnson notes that this deal “gives the largest public institutional player in the US a deeper investment in understanding real estate as an asset class and a unique insider’s view of the industry’s dynamics.” More interestingly, I would posit, it puts a leader in sustainable real estate front-and-center in the view of the sorts of pension managers who, until now, have very little cross-pollination with the real estate industry. In short, as institutions look to find good real estate partners, sustainability will be a key element of consideration.
Much has been said in recent days about the Census Bureau’s August 23rd announcement about new residential home sales in July. To summarize, 372,000 new homes were sold last month, which is 25.3% above the July, 2011. This is good news for a lot of reasons — construction workers get jobs, banks get new loans, etc., etc.
Naturally, it begs the question, “what’s the right number of homes?”. Here at Greenfield, we’ve posited that the U.S. housing price “bubble” was really a demand bubble, fueled by easy money, which led to an artificial inflation of the nation’s home ownership rate. (Housing bubbles in other countries were fueled by similar problems.) We’ve also suggested that the market won’t get healthy again until several things happen, including a stabilization of the homeownership rate at long-term equilibrium levels, a restoration of “normal” conventional lending (both for home mortgages as well as for development financing) and a restoration of the housing infrastructure (development lots in the pipeline, local regulatory department staffing, hiring & training skilled construction workers, etc.) . It is highly doubtful that we’ll see housing starts and new home sales “bounce back” to normal levels anytime soon, and our own projections suggest several years before we get back to “normal”.
But this begs the question: What’s normal? (A great t-shirt from the Broadway play, “Adams Family” simply said, “Define Normal”.) Anyway, as new home sales go, it’s helpful to glance at the experience over time. It may surprise you.
One might actually expect the graph to be less erratic, but there are good explanations for the “bobbing and weaving” you see from year to year. During recessions, new home sales decline, and then bounce-back afterwards. During periods of economic overheating, the FED tightens the money supply, thus causing home starts/sales to decline. (In practice, this is a major tool in the FED’s toolkit, simply because it has a great multiplier effect on the economy.) Of course, the bubble is quite apparent, and following it the inevitable decline.
With all that in mind, though, we can see that there is a decided upward trend in the chart — that makes sense, since a growing population, coupled with a fairly consistent homeownership rate, will generally demand more new homes each year than it did the year before.
The second graphic adds a simple linear trend line for simplicity sake, which is not far removed from the actual household formation trend line during that same period. Note that from the beginning of the chart until about 2001, we had a nice cycle going, and in fact around 2001, the blue line should have turned negative to account for the recessionary impacts. However, money got very loose during the early part of the last decade, and rather than housing starts serving its normal “pressure relief” role, it was driven into a counter-cyclical path. This created the oversupply we are now trying to work through (often referred to as the “shadow inventory”) and we won’t see a healthy market until this inventory is mopped up.
Good news, though — if you glance quickly at the second chart, it becomes clear – albeit from a very simple visual perspective — that we must be close to a spot where an up-turn in the chart would give us as much negative area red line as we had during the previous cycle above the red line. In short, we’re not at the end of the tunnel yet, but this simple way of looking at things suggests we may be able to SEE the end of the tunnel in the not-too-distant future.
Big news today — new home sales hit an annualized rate of 369,000 in May, compared to 343,000 in April. That’s 20% higher than a year ago. It also beat economists collective prognostications of 350,000.
Wow…. and only about 63% less than the 1,000,000 per year we would consider health.
And about 74% below the peak of 1.4 million during the boom years.
Obviously, there’s a problem here, and unless and until we get back to “normal”, the portion of the economy which is driven by home development, construction, financing, and sales will continue to suffer. Three things are currently terribly broken, and fixing them is no easy task.
1. The lending market is utterly disfunctional. There was a great headline in one of the papers the other day — if you don’t NEED money, there’s plenty of it. Unquestionably, one of the contributing factors (not a major one — but one, none the less) to the market meltdown was the sale and financing of homes to folks who had utterly no idea how they were going to meet their mortgage payments. However, even in good times, we know that a certain percentage of loans will go sour — call it about 2%. The straw that broke the camel’s back was when the recession hit, that “sour loan” percentage went up to about 4% – 6%. Unfortunately, the secondary market had “priced” these loan pools with the notion that only 2% or so would go bad. The loan pools themselves were so badly over-leveraged (at Lehman, apparently, the pools were leveraged something like 35-to-1 or more) that an increase into the 4% range completely destroyed the secondary mortgage market. Today, the pendulum has swung too-far in the other direction, and first-time homebuyers, who often have good jobs but little in the way of demonstrable credit, are completely shut out. If they can’t buy “starter” homes, then the “move-up” market suffers, and the retirees (who want to buy in places like Reno and Ft. Lauderdale) can’t sell their homes to “move down”. Fixing this lending crisis is the first order of business.
2. The land development business is broken. Even if we magically ”fixed” the lending problem tomorrow, there is a real shortage of land in the development pipeline. It takes years to turn a vacant field into a subdivision full of lots (or a condo site), with extensive engineering, planning, financing, and entrepreneurship efforts. Even in good years, there is a fair amount of risk-taking and capital expenditure. We can’t just pick up where we left off a few years ago, because many (most? nearly all?) of these development projects burst like soap bubbles during the recession. Thus, we have to completely hit the “re-start” button on subdivision development in America. Unfortunately, there is absolutely no appetite for financing these projects, and many of the players have gone out of business. After World War II, the country was able to kick-start the housing market with extraordinarly favorable financing (remember VA and FHA loans?). None of that exists today, and the secondary market to sustain all of that has gone away. In the absense of a Federal mandate to kick-start housing, comparable to the GI Bill of 1944, this aspect of the market will continue to be flat-lined.
3. Local community infrastructure development is broken. Housing development requires a substantial public-private partnership. In many communities, much of this is paid for as a “public good”, while in others there is the expectation of significant developer contribution. Nevertheless, local planning agencies, transportation and utility departments, and even school districts and fire departments have to stand ready to provide infrastructure for housing. Local government fiscal crises have frequently broken the back of these agencies. Nationally, we’ve laid off something like 50,000 teachers in the past few years, yet new housing development and household formation will require increasing numbers of schools. The same is true for fire fighters, EMTs, police, road maintenance, and utilities. Until our cities, counties, and states are back on their financial feet, this segment of the equation will continue broken
Sadly, these are interactive parts of the same equation. For example, local governments fund planning departments with fees paid by developers. Hence, the city or county reviews tomorrow’s building permits with fees paid by yesterday’s developers. Restarting the system will take talent, money, and some significant leadership, none of which is currently apparent.
…and welcome to Florida. I’ve been in the southeast corner of the U.S. for the past two weeks in a hearing. I happen to love Florida, and if I ever get around to retiring, I’ll probably end up here. Thanks to personal choice, some business, and just a little bit of kismet, I get to travel here at least 3 or 4 times a year. Indeed, by the end of April, I will have made 3 trips here in 2012, with at LEAST two more planned.
In many ways, Florida is the poster child for the current economic problems plaguing the U.S. It has all of the hotbutton issues in one place — overbuilt housing, lending practices to match, and huge demographic shifts. The latter is almost humorous — Florida is jokingly referred to as “God’s waiting room”, not withstanding the fact that suburban Las Vegas, Orange County, California, and Scottsdale, Arizona, are all fighting for that moniker. Indeed, about 15 years ago, I was relegated to represent my university at the annual meeting of the American Association of Retirement Communities. I learned (among other things) that the two Carolinas, when taken together, actually get as many retirees every year as does Florida. However — and here’s the funny part — the “source” of Florida’s retirees is primarily the New England and Mid-Atlantic region. The “source” of the Carolinas’ retirees is Florida — they’re called “half-backs” because they move to Florida, find the weather to be abysmal, and move half-way-back home.
Being that as it may, Florida is still the destination for seemingly millions of retirees, a large proportion of whom seem to be “snow-birds”. They live in Florida 6.01 months of the year (just enough to qualify for Florida citizenship, and thus preferential Florida taxes) and then head back up north on March 31 every year. (I was in Florida on March 31, and the out-migration seemed to clog the interstates).
Before the melt-down, the whole housing industry in Florida existed to provide half-year housing for these snow-birds. Pick what you want — condos, townhouses, detached homes, we’ve got it at every price-point, size, color, and configuration. It would be hard to imagine a housing solution that wasn’t available in Florida. Financing? No money down? No problem. Move right in. While a surprisingly large number of homes were paid for with cash, there was certainly lots of available financing for the retiree who didn’t want to tap his funds for a down payment. And why tap your funds? When the stock market is growing at 10% per year, and real estate is going up by 15% per year, who would avoid a 4% mortgage? And what bank wouldn’t make that mortgage? After all, Grandpa and Grandma are great credit risks, and if they die before the loan is paid off, certainly the property can be re-sold for a profit. It’s a win-win, right?
Yeah, we don’t need to re-visit the meltdown, but the aftermath is a fascinating war zone. First, a lot of cond0-dwellers simply walked away. A lot of single-family dwellers tried to hang on, but often to no avail. Nothing would re-sell, so the market just froze. But, remember that a LOT of the buyers paid cash or had very low LTV loans. Those folks are particularly harmed — they are sitting on nearly unsellable property, with no end of the pain in sight.
If you visit Sarasota or Naples or any of the dozens of “retirement” communities on the Florida coast, you’ll get two distinct pictures. The beaches are filled, the hotels are filling back up, and the neighborhoods look healthy. Visit the county government complex, though, and you get a distinctly different picture. Floridians are a distinctly tax-averse lot, and so many county and city governments thrived on fees paid by developers. With that market frozen, the local government finances are a mess. Couple with it an actual and meaningful decline in property tax collections, and you get a local finance problem that won’t get fixed anytime soon.
With that in mind, millions of Americans (and an increasing number of South Americans and Europeans) see Florida as the best of all retirement solutions. The weather is great most of the year, there is excellent infrastructure and health care, and plenty of recreational opportunities. The cost of living is among the lowest in the U.S., providing ample opportunity for “worker bees” who move here to care for the retirement cadre. However, the housing market continues in the doldrums. A good friend of mine, with excellent credit and not unsubstantial resources, recently bought a Florida condo. The BEST loan he could get was 40% LTV, and even that was a paperwork nightmare. There is plenty of demand for Florida housing, but the financing side of the equation continues to be an issue. Unless and until the financing problem gets fixed, the housing problem will still be with us.
The always excellent S&P Case Shiller report came out this morning, followed by a teleconference with Professors Carl Case and Bob Shiller. First, some highlights from the report, then some blurbs from the teleconference.
The average home prices in the U.S. are hovering around record lows as measured from their peaks in December, 2006, and have been bounding around 2003 prices for about 3 years. Overall in 2011, prices were down about 4% nationwide, and in the 20 leading cities in the U.S., the yearly price trends ranged from a low of -12.8% in Atlanta to a high (if you can call it that) of 0.5% in (amazingly enough) Detroit, which was the only major city to record positive numbers last year. In December, only Phoenix and Miami were on up-tics.
One thing struck me as a bit foreboding in the report. While housing doesn’t behave like securitized assets, housing markets are, in fact, influenced by many of the same forces. Historically, one of the big differences was that house prices were always believed to trend positively in the long run, so “bear” markets didn’t really exist in housing. (More on that in a minute). With that in mind, though, w-a-a-y back in my Wall Street days (a LONG time ago!), technical traders — as they were known back then — would have recognized the pricing behavior over the past few quarters as a “head-and-shoulders” pattern. It was the mark of a stock price that kept trying to burst through a resistance level, but couldn’t sustain the momentum. After three such tries, it would collapse due to lack of buyers. I look at the house price performance, and… well… one has to wonder…
As for the teleconference, the catch-phrase was “nervous but hopeful”. There was much ado about recent positive news from the NAHB/Wells Fargo Housing Market Index (refer to my comments about this on February 15 by clicking here.) The HMI tracks buyer interest, among other things, but the folks at S&P C-S were a bit cautious, noting that sales data doesn’t seem to be responding yet.
There are important macro-economic implications for all of this. The housing market is the primary tool for the FED to exert economic pressure via interest rates. Historically (and C-S goes back 60 or so years for this), housing starts in America hover around 1 million to 1.5 million per year. If the economy gets overheated, then interest rates can be allowed to rise, and this number would drop BRIEFLY to around 800,000, then bounce back up. However, housing starts have now hovered below 700,000/year every month for the past 40 months, with little let-up in sight.
Existing home sales are, in fact, trending up a bit, but part of this comes from the fact that in California and Florida, two of the hardest-hit states, we find fully 1/3 of the entire nation’s aggregate home values. The demographics in these two states are very different from the rest of the nation — mainly older homeowners who can afford now to trade up.
An additional concern comes from the Census Bureau. Note that for most of recent history, household formation in the U.S. rose from 1 million to 1.5 million per year (note the parallel to housing starts?). However, from March, 2010, to March, 2011, households actually SHRANK. Fortunately, this number seems to be correcting itself, and about 2 million new households were formed between March, 2011, and the end of the year. C-S note that this is a VERY “noisy” number and subject to correction. However, the arrows may be pointed in the right direction again.
Pricing still reflects the huge shadow inventory, but NAR reports that the actual “For Sale” inventory is around normal levels again (about a 6-month supply). So, what’s holding the housing market back? Getting a mortgage is very difficult today without perfect credit — the private mortgage insurance market has completely disappeared. Unemployment is still a problem, and particularly the contagious fear that permeates the populus. Finally, some economists fear that there may actually be a permanent shift in the U.S. market attitude toward housing. Historically, Americans thought that home prices would continuously rise, and hence a home investment was a secure store of value. That attitude may have permanently been damaged.
“Nervous, but hopeful”
John K. McIlwain is the Senior Resident Fellow/J. Ronald Terwilliger Chair for Housing at the Urban Land Institute (ULI) in Washington, D.C. I don’t necessarily agree with everything he says, but he stimulates some interesting thinking in a piece this week titled “Fixing the Housing Markets: Three Proposals“. (click on the title to link to the article itself.)
In summary, he proposes:
1. Renting federally held REO
2. Creating a mortgage interest credit
3. Divide mortgages for underwater homeowners into a “paying” first and a “delayed” second.
He admits that in the current political climate, none of the above stands a ghost of a chance (nor would any other solution, good or bad), but even though I might disagree with some of what he says, I’m a firm believer in the old In Search of Excellence adage: ready, shoot, aim. Really excellent organizations (and government entities — which are rarely even CLOSE to achieving excellence) have a proclivity for doing SOMETHING. The Marine Corps calls it the “70% solution”, which dictates that you attack as soon as you think you have 70% of the information needed for success. Why not 100%? Because fate favors the side with the initiative and momentum, that’s why.
So, please indulge me for a moment to comment on McIlwain’s proposals, but DON’T take my criticism as an indication that I wouldn’t vote in favor of doing exactly what he proposes, because in the current climate, a half-good idea is probably better than no idea at all.
1. Rent federally held REO – Well, even McIlwain admits (or at least implies) that the government is a terrible landlord, so he would propose turning this over to the private sector via pools of “privatized” REOs. What he’s essentially saying is to sell these REO’s (currently about 250,000, and expected to grow to a million) to investors with the caveats that they be held off the market as rentals for a period of time, AND that there be adequate maintenance to keep them from turning into slums.
My ONE disagreement with this is that less government involvement is usually better than MORE. Plenty of investors stand ready to buy REOs right now, and the resale market is sufficiently poor that these investors recognize they have to be in it for the long haul. Local planning ordinances are usually adequate vis-a-vis slum prevention IF they are enforced properly (as is not always the case). There is no reason to believe that additional Federal caveats would improve the situation. In short, this is actually being accomplished already, and deserves facilitation by the government, not regulation.
2. Mortgage interest credit – McIlwain notes, and we concur, that the current mortgage interest deduction benefits taxpayers earning over $100,000, but hardly those earning less. He suggests replacing this with a flat 15% tax credit, which would have the double-barrelled effect of raising the effective tax rate on those earning over the 15% marginal break-point, but directly benefitting dollar-for-dollar those below that break point. It’s an intriguing idea, but would require the Realtors’ and Mortgage Bankers’ buy-in. In today’s troubled market, it’s difficult to see how they would agree to anything that tinkers with the status quo.
3. Divide mortgages for underwater homeowners into a “paying” first and a “delayed” second. As much as I like this one on the surface, it ONLY works for homeowners who plan to stay in their houses until prices rise (on average) about 20%. We don’t see that happening for quite a few years, so this essentially just kicks the can down the road a bit. Even that, though, is an improvement over the status quo, and keeps homeowners in their homes for the time being. The real problem, of course, is how to deal with the “delayed” paper on banks books.
In short, McIlwain’s proposals at least stimulate some conversation about solutions for the terrific vacant REO problem. One big issue is lack of credit for suitable property managers — banks are loathe to loan on “second” homes today, and investment property (REOs turned into rental homes) is a troublesome loan to get. I would propose that the agencies/banks holding paper on vacant homes simply privatize it immediately — if a bank holds a $100,000 loan on a vacant house, then a reasonably creditworthy investor who is willing to start amortizing that loan should be able to walk in, pick up the keys, and walk out the door. Sure, this would violate all sorts of down-payment caveats in place right now, but it would get interest payments moving again, provide much-needed rental housing, and get some local entrepreneurs busy managing otherwise dead assets.
A few days ago, I kicked off this series with some comments about the asset side of the residential market. Today, I’ll discuss the finance side of that market. Later on (parts 3 and 4) I’ll talk about the asset and financial side of the commercial market. Keep in mind that these markets are all very different, albeit intertwined.
A quick caveat — don’t use ANY of this to answer Econ 101 exam questions. I’ve over simplified nearly all of this to make it readable.
If you watched the really excellent HBO movie, Too Big to Fail, you saw and heard the actors talk about huge losses in “real estate”. While many of these players actually owned real estate assets (see my commentary about Archstone), the real thing that brought them down was their ownership of real estate derivatives. Now, this may sound like I’m side tracking, but it’s very helpful to understand how we got here, if we’re going to understand how to fix it.
Imagine John and Jane America go to Main Street Bank (MSB) and borrow $100,000 to buy a house. In the course of a year, Main Street Bank may make 100 of such loans, totaling $10,000,000. In a typical pool of 100 loans, two of them will go bust, resulting in $200,000 in “paper” losses to MSB. Now, before you start feeling sorry for the depositors and shareholders of MSB, it’s important to note three things:
1. This was a fairly predictable set of losses. Hence, every borrower paid a slight premium on their loan to “share the burden” of everyone else.
2. The bank has the house as collateral. While foreclosure sales rarely fully compensate the bank for the losses, they really do cut the pain down to a small headache, and then #1 above kicks in.
3. Many mortgages have private mortgage insurance, etc., to compensate even further.
Hence, in a normal year, a small number of foreclosures is expected and manageable. However, the period leading into this recession was anything but normal. House prices peaked, and actually started tumbling downward, meaning that #2 wasn’t working very well. The losses started bankrupting the PMI companies, thus making #3 ineffective. Finally, foreclosure rates got up to huge levels.
Still, you might say, these numbers should have been reasonably manageable, right? Well, not so quick, partner. Now we need to introduce two new concepts: the mortgage backed security (MBS) and the default swap. An MBS is a really strange, hybrid, derivative instrument. Fully explaining it here is nearly impossible, but let’s take a stab. Remember the $10m in mortgages? (In actuality, we were usually dealing with pots of loans that were ten times that big.) Let’s say the average yield on that pool was 6%. Now, I’ll chop and dice that pool three ways. First, I’ll sell $5 million of it to widows and orphans, and promise them AAA safety by giving them first crack at the principal and interest. However, their yield will only be, say, 4%. Next, I’ll sell some speculators the next $2.5 million of AA rated paper, and give them the NEXT crack at the payments but only a 5% return. The last $2.5 million will get all the residual returns, which should work out to an 11% yield if nothing goes wrong (see numbers 1 – 3 above). However, everything went wrong, and these last slices of the pie went down the tubes.
Now, if you’re Lehman Brothers, you take that last slice, and sell IT off in slices to investors. However, you promise THEM AAA security by entering into a credit default swap. Essentially, you’re getting Bear Stearns to guarantee YOUR pools, and you guarantee theirs. To find out how that worked in reality, go see the movie.
Unfortunately, so much of our investment banking establishment was hinged on these derivatives, and the underlying asset values went so far down, that the system totally broke down. It’s very close to broken today, which is why getting low-down-payment loans is nearly impossible now-a-days (in effect, the default rate on 80% LTV loans is nearly zero, so that’s the only part of the system that’s working fairly well now).
Fannie-Mae and Freddie Mac had Congressional mandates to buy tons of these mortgages. While they were not in the MBS and credit default swap business, they were in the business of borrowing money to invest in loans. A default rate of 6% or more might have been manageable if the values of the underlying assets hadn’t fallen by 20% – 40% in some parts of the country. Note that 6% of several trillion dollars is a lot of money when the short-sale only recovers 60 to 80 cents on the dollar. There is also a huge shadow inventory of properties (by some estimates, 5 million homes with a potential loan overhang of a trillion dollars) that haven’t yet even been foreclosed on but the loans are either non-performing or in serious arrears.
How do we fix it? The system depends on a complex network of institutional trust coupled with complex insurance and hedges (essentially, a credit default swap was an insurance policy). Most of that system is irreparably broken. Following the Savings and Loan Crisis of the late 1980′s, the nature of residential mortgage lending was significantly changed in the U.S. and many other countries. This situation is far, far more complex than that one, and probably calls for the same level of overhaul we saw in the Great Depression, when the very nature of home mortgages was completely stood on its head. Unfortunately, we’ve wasted several good years with no settlement in sight. My guess is that the rest of this decade will be wasted, at the pace we’re currently seeing.
Any good news? I think so. There are some great private sector minds who are currently realizing that the Federal Government is NOT going to step up to the plate with a solution like it did in the 1930′s. Hopefully, the pace will pick up as the market starts realizing that it needs to find new financing instruments to satisfy the demand for housing and restore health to this sector of the economy.
When we say the “real estate market” we’re really talking about four distinct but somewhat inter-related components: housing sales (and values), housing finance, commercial real estate (starts, occupancy, etc.), and commercial finance. Each of these components has plenty of sub-groupings. For example, commercial apartment development is going well, although commercial apartment finance still has some problems. Housing development finance is on life support. Many aspects of commercial development (e.g. – hotels) are moribund.
I’ll start today with the most significant problem in the housing sector — the one which may take the longest to fix — and that’s housing starts. The market is worse than it’s been since we’ve been tracking data (40+ years) and certainly the worst in my experience. The attached graphic comes from the National Association of Homebuilders, and shows their tracking of both housing starts as well as the NAHB/Wells Fargo Housing Market Index (HMI).
The HMI is based on a survey of current new home sales, prospective sales in the next six months, and ”traffic” of prospective buyers (seasonally adjusted). While the two graphs seem to track one another, as you can see, the HMI is a bit of a leading indicator of the direction of housing starts. On a historic basis, this makes sense, since homebuilders will “start” houses they think will be sold six months from now, and they will heuristically base that on traffic from prospective buyers. (Back when I was in the game, we talked about a ”qualified buying unit” being a prospective buyer or housing unit – such as a family – who actually had the capacity to buy a home and were actively in the market for a new home.)
As you can see, back during a period of relative housing stability (1985 – 2005), housing starts generally cycled between 1 million and 1.4 millin per year. With the bubble in home ownership rates, starts got up to 1.8 million for a short period then collapsed. More interestingly is the period between 1989 and 1993, when home starts dipped to about 600,000 per year, then rapidly bounced back to a healthy level. That was a period marked by real problems with acquisition, development and construction (ADC) loans, but the underlying demand and value equations still held firm. Thus, when the market cleared (when demand sapped up any supply overhang), the homebuilding community was ready to go back to work.
Today, it’s VERY different. ADC lending is still nearly non-existent (compared to a half-decade ago). The decline in values means that in many markets, it’s difficult to build a home for less than the selling prices. Further, the permanent lending market is also problematic. A big chunk of homebuilding is the “move-up” market, with a secondary chunk in the vacation or second-home market. Down payments for “move-ups” and second-homes traditionally come from equity in existing homes. However, a substantial proportion of homes in America have no net-equity. Reports talk about the high percentage of homes which are “under water” (that is, the value is less than the mortgage. However, for a home to have positive “net equity”, the value needs to exceed both the mortgage as well as anticipated selling costs. A handy rule-of-thumb in many markets is that a home needs to be valued around 110% of the mortgage for a seller just to break even on a sale. Worse, for there to be sufficient equity to “move up”, the home needs to be valued more like 120% to 130% of the mortgage. That simply doesn’t exist in most of America right now — trillions of dollars in paper equity disappeared over the past few years.
Additionally, there is a huge overhang in shadow inventory. As I noted in a recent blog post, Americans are currently buying under 5 million homes per year (new plus re-sale) and in a healthy market, the inventory for sale is about a six-month supply. However, the shadow inventory alone is close to 6 million right now (and that doesn’t include “regular” homes on the market). Thus, we’re looking at a couple of years of absorption just to get the market back to some level of stability. Even THAT presumes that the home ownership rate will stabilize right where it is (it’s been falling precipitously for several years). Bottom line, I wouldn’t be betting on home construction any time in the near future.
This is important for several reasons. First, home construction is a very big chunk of the economy. When homes aren’t getting built, lots of carpenters, plumbers, electricians, materials suppliers, real estate agents, bulldozer operators, bricklayers, and such don’t have work. Second, these are skills which are being lost to the economy. Further, if America is going to get the employment picture fixed, these people have to get back to work.
Good news — such as it is — is that the HMI is trending upward, ever so slightly. It’s currently standing at 20, up from a bottom below 10 about 3 years ago (and a near-term bottom of about 15 earlier this year). It needs to bounce all the way back up in the 50 range if the leading-indicator relationship holds true for it to point toward a healthy housing market. It actually went that far in the 1991 – 1993, range, when it bounced from 20 to 70 in about 3 years. However, that was a market with pent-up demand, good values, and a healthier lending climate.
I just saw HBO’s “Too Big To Fail”, staring a whole host of Hollywood “names” (James Woods, John Heard, William Hurt, Paul Giamatti, Cynthia Nixon, Topher Grace, Ed Asner etc.). Sadly, it’s a fairly boring movie, albeit about a terrifically exciting piece of near-term history. It focuses on the collapse of Lehman Brothers, mostly through the eyes of Treasury Secretary Hank Paulson (played spot-on by William Hurt). Asner does a wonderful Warren Buffett (who almost, albeit reluctantly, came to Lehman’s rescue) and Giamatti is a wonderful Ben Bernake. (As an aside — Bernake is the most dead-pan person I’ve ever met. Giamatti’s version of Bernake is even more deadpan than reality.)
The movie gets one thing right and one thing wrong. First, the wrong, and then the right.
The movie keeps referring to Lehman’s “real estate”. No one will buy Lehman if they have to buy its real estate holdings, too. Lehman’s real estate “problem” is at first estimated at $40 Billion, then $70B, then “who knows”. The truth, of course, was “who knows”. Cynthia Nixon plays Paulson’s press secretary, who serve as an amiable foil to allow Paulson and his Chief-of-Staff Jim Wilkinson (Topher Grace) to explain the nature of the crisis to her (and thus to the viewer). Unfortunately, Lehman’s “real estate” isn’t “real estate” but “real estate mortgages”. More to the point, they have “tranches” of real estate mortgage pools, and to understand what a “tranche” is would be well beyond the capacity of a two-hour movie. Tranche, by the way, comes from the French word for “slice”. Imagine we pool $100 million or so in mortgages, then split up the ownership into three equal parts — an “A” tranche which will get paid in full, including interest, before anyone else gets paid; a “B” tranche which gets paid next, and a “Z” tranche which only gets paid after everyone else gets paid.
In theory, all three tranches should be good securities, since the underlying mortgages are pretty safe bets, and in practice the “A” and “B” tranches really were pretty good. However, the “Z” tranches will bear all the default risks. Banks (both mortgage and investment) made tons of money on these things, because the default risks could be “priced” as long as market continued to rise. Various investment banks then borrowed money to buy “Z” tranches, and coupled with credit-default swaps (essentially, a mutual insurance pact among investment banks), they were able to borrow huge amounts of money with very little capital.
The Paulson/Wilkinson explanation in the movie makes it sound like the whole problem came from mortgage defaults and foreclosures. In reality, mortgage defaults DO cycle up when a recession comes along, but these are usually predictable cycles. The REAL problem came from borrowing huge amounts of money — with almost no capital — to buy “Z” tranches that didn’t reasonably price the increased in defaults. A slight up-tick in defaults sent everyone to the emergency room, and when owners couldn’t sell or re-finance, the whole market went down the tubes. THAT was the “real estate” problem which plagued Bear Sterns, Lehman Brothers, Salomon Brothers, Morgan Stanley (my old alma-mater) and all the others. Sadly, the movie perpetuates the myth that the real estate down-turn was an exogenous event, and fails to discuss the sins of the secondary mortgage market which took a simple, cyclical downturn and turned it into a long-term, world-wide crisis.
But, even with that, the movie got one thing so very right that made up for the mistakes. In one pivotal scene, Paulson and his team are presenting the TARP idea to the leaders of Congress. (Central Casting found some excellent look-alikes for Pelosi, Dodd, Shelby, Frank, and the rest.) Note that this comes very late in the movie, well after Paulson (an almost billionaire, who really didn’t sign on for this level of stress) and his team have tried ever possible solution to stem the crisis. The movie does a great job of playing Paulson up as the unsung hero who really saved the world’s economic life, by the way. Anyway, the leaders of Congress don’t “get it” until Giamatti’s Bernake gives the most important 2-minute economic lecture in history. He notes that while the Great Depression started with a stock market crash, it was the failure of the credit markets which made the depression last so long. The current crisis, if left un-solved, would spin the world into a much worse, much longer economic depression. Giamatti really nails the tone of the reality which was facing the nation’s top economic thinkers at the time.
Anyway, I don’t watch very many movies. I saw Adam Sandler and Jennifer Anniston in “Just Go With It” on an airplane last week, and thought it was a hoot. As movies come-and-go, “Too Big To Fail” doesn’t even rise to the entertainment level of “Just Go With It”, but as an educational piece, it’s a must-see, even with its critical flaws.