Wednesday, February 06, 2008

Doom and Gloom Becomes a Debate of Ideas

The Doom and Gloom post of 2 days ago was prompted by a comment thread on Bizzyblog. The primary participant of that debate has asked to keep the discussion going in an open thread. Tom, the owner of Bizzyblog has suggested we move the discussion here and I am open to it.

I will post his first comment here and continue the discussion in the comments. I hope you follow along.

If we had to spend $150 billion, it should not be thrown up in the air to shower down aimlessly in the vain hope some of it will keep things going in a pump priming effort. Pump priming was always a failure in the long run since it never addressed the real economic issues, since it was throwing money at a problem instead of targeting the problem.

The problem as I understand it, is focused upon the solvency of the banking system to make home mortgages. Without the loans, essentially houses can not be bought or sold, few people have $300k in their pockets. The government would be better off injecting the $150 billion into Fannie Mae or Freddie Mac to undo the credit lock that has brought everything to a screeching halt. Secondly, any loans created by this injection would be disqualified from any derivative hedging action. It's ok to package a group of loans, but it's not ok to hedge them, the risk of default must be born by the mortgage borrower in the amount of the interest rate charged. In my mind, the amount of interest charged is no different than a credit card account, except with the important distinction of collateral. Then at least in 30 years time, we will get most of our money back ($150 billion) with interest.


tracy said...

The solvency issue can not be solved by money. Right now banks and other entities (hedge funds, wealth funds, central banks) are actually holding on to large amounts of cash...practically hoarding it. The solvency issue is one of trust. Most loans, trillions of them, use some form of asset as collateral. The most common asset pledged in Western economies is real estate. Given the relative stability of real estate, it makes real estate secured lending among the 'safest' of loans and one of the reasons such loans get high ratings.

No one that pledges real estate wants to lose it through default. So, often, borrowers will cut everything else before defaulting on the loans secured by real estate. Homeowners don't want to lose their homes, businesses need the real estate to continue their business. Default rates on real estate loans historically run less than 1%. A range of .3 to .5 is 'normal'. Other advantages of real estate are: a) they stopped making it; b) value tends to increase over time.

Two things changed in 2006. First, default rates began climbing. Second, as the defaults began to climb, lending on real estate slowed down. It was harder to see the second because as lending slowed (partially because rates had climbed back out of the deep hole they had been in) money began chasing fewer deals, boosting prices even higher despite the defaults. From outward appearances, not only was the market continuing to grow, it was growing faster and higher.

In 2007, with defaults still climbing, buyers of the loans began to get concerned with the quality of the loans. When you get concerned with borrowers paying back, you begin to focus on the underlying asset.

By last summer, the buyers of loans began to worry that the increasing default rates called into question the value they were placing on the loan packages. In August, it came to a head. Once the crowd realized the Emperor wore no clothes, they turned to each other and realized, they too, were naked. And default rates continued to climb, not just on residential loan packages, but on commercial loan packages also.

The money is still there, waiting for loan packages. The difference now, is that want to know the value of the underlying assets. And they don't believe what they are being told. So, they wait.

In many real estate markets, appraisers were manipulating their reports. Why is a matter for courts (and a bunch of them are looking into it). If you can't trust the appraisers, you have to trust the market. But markets need sellers AND buyers. And buyers have disappeared. Real estate prices are falling 10, 20, 30 even 40% from their highs. Imagine buying a home in mid 2006 for $500k and last week, a house on the same block finally sold (after a year on the market and repossession) for $310k. You look at your $400k first mortgage and 85K second and think, what the hell. Especially now that the payment on your first jumped $400 a month. You are paying $4k a month but your neighbor is only paying $2.5k.

The second shoe is dropping. Values are falling and the desire to save the house at all costs is gone. Default rates that were alarming at .9% are gone. Some loan packages from late 2006 and early 2007 are defaulting at rates as high as 50%

Lenders do not trust the valuations of the underlying assets. With good reason, the values are FALLING. Until there is some stabilizing, no one wants to lend money on an asset that is decreasing in value.

No amount of money injected into the system will change the problem. Asset prices are falling. How far is anyone's guess. Residential real estate needs to get back into alignment with some traditional numbers. Look at a post below to see where the median incomes for the states are and where a reasonable median home price should be. The difference between that number and reality is where real estate prices have to go to.

$150 billion, no matter where it goes, is a rain drop in a hurricane. Real estate prices are going to drop a couple of TRILLION.

dscott said...

Asset prices are falling. How far is anyone's guess. Residential real estate needs to get back into alignment with some traditional numbers.

Well that's the problem isn't it? The chicken or the egg has to come first. Without loans, no one can buy, if no one can buy the assets devalue because of supply and demand. The amount of housing inventory can not come into balance with demand if there are no loans. Few people other than the rich or the Amish plunk down $300k to buy property. (Amish don't borrow to my understanding).

So this leaves us in a quandry, either we supply some external liquity via an injection to start the ball rolling or we hope for another Huricane Katrina to thin down the inventory. You are perfectly right that there isn't enough capital to waive the wand to make the problem go away, however, on the otherhand you must start somewhere. The injection of funds would allow a restart of the housing market to clear out the foreclosed homes and those who are bordering on foreclosure. In the past, a borrower faced with foreclosure had the option of selling to get out from under the mortgage, at this point that option essentially doesn't exist and hence IMO the high foreclosure rates.

tracy said...

I understand your point. However, let me offer an example that may illustrate mine:

I have a Treasury bond worth 100k in my hands. I walk into a bank and ask for a loan for 90K and offer the Treasury bond as collateral. I show the bank that I can make the loan payments by proving my income. The bank offers me the loan.


I own a piece of real estate. I have had two independent appraisers value the property at 100k. I go to the bank and ask for a loan for 90K and prove I have the ability to make payments. What is happening now is that the bank doesn't trust the appraisers. Further, it expects the value of the real estate, even if it is 100k now, to decrease. Therefore, it does not offer a loan.

I offer (and your suggestion is) to over-collateralize the loan. Ok the banks says: how much? I offer 20% in additional real estate. Nope. How about 50%. Nope. How about 100%. Nope. Why? Because they don't know the value the real estate will stabilize at. Now, if I offer 30 or 40% cash to the collateral, that might do it. But only if I am willing to pay a premium on interest...say 8% and forego interest on the cash collateral too.

That is why some money (or lower Fed rates) can loosen some lending. It just makes it TOO profitable to ignore for the bank. But you can bet they will be all over me if the loan is even a day late.

Trust. There is NONE currently in the market that relies on Real Estate in virtually any form. Until trust is established and a bottom on real estate prices settled, lending is going to be minimal.

Will some lending happen? Sure. There are always a few oil barrons with an extra few billion to buy cheap assets.

dscott said...

Given there is a trust issue over real estate, there is a way around that as in Government guaranteed loans similar to student loan guarantees. The caveat being, if the borrower defaults, that property has to go the government to resell on the open market through some arrangement like the RTC, (Resolution Trust Corporation) or some other private sale version that shares the profit in a manner that gives incentive to sell at the highest price possible.

The underlying premise is what you alluded to being asset value, if foreclosures are being dealt with in an orderly manner say through either resale of the home with a government backed loan or a refinance, then asset values will stop dropping. The caveat here being, no loans for new housing unless the borrower is overly qualified with an LTV of say 60% until the supply imbalance is resolved. As long as someone is holding a fire sale, the asset value must drop for everyone else's house because as we all know the value of any product is what the market will bear. If the market is flooded with foreclosures, then the market will only bear houses selling at foreclosure prices.

So let's say the government puts up $150 billion as the insurance fund guarantee, the banks then are in the position of loaning money without any risk which also translates into low interest loans. This means in effect no monetary outlay unless there is a default. The interest rates are determined by risk vs reward. The lower the risk, the lower the reward.

tracy said...

DC, your idea may be about a year. The inventory of housing currently available is more than a year's supply in many areas and growing.

It takes many months for a home that goes into default for the house to actually hit the market. We are seeing houses hit the market know that defaulted in April/May of 2007.

Again, your reliance on LTV requires knowing V, and we are no where near knowing that. All of this is a small part of the problem as far as lending entities are concerned.

One of the rating services notified firms in the last 24 hours that they are putting over 150,000 debt instruments on a negative ratings watch. Their reasoning? The assumptions underlying their ratings have been called into question.

Another thought experiment for you: Let us say that you have watched a house in a nice neighborhood for years. It is a great old Victorian. It last sold in 2002 for 500k, way beyond your price range of 300k. Last week, the Victorian next to it sold for 350k at a sheriff's sale back to the lender. Today, your dream home went on the market, asking price, $500k.

Your banker, knowing you and your desire, offered to lend you 250k towards the house at 8%. How much will you offer?

Here is Victoria's answer (Victoria is my partner who has been watching just a scenario): I wouldn't offer anything. First, if no one wants to offer 350k for the house next door, I don't know how much the house is really worth, and, I don't want a 250k mortgage at 8% even for my dream home.

THAT is the problem with the market today.

dscott said...

Yes, there are houses in the foreclosure pipeline which will continue to pile up if nothing is done. So a second line of defense has to be built, that means re-qualifying those borrowers currently in the pipeline for foreclosure. Of those borrowers who went in over their heads, what percentage are at the margins where if they had a lower interest rate could make the payments on a 30 year loan? My impression is that the major reason for growing mortgage defaults beyond what I have already addressed is the ARMs where the interest rate ratcheted up to the point where the borrower can't meet their obligation. But I don't know this information for certain, however let's say for the sake of argument that 50% are borderline where a restructuring of debit would keep them off the market.The result would be to remove some of the downside pressure for an orderly clearing of the market.

Additionally, your scenerio while valid does not factor in those people who are relocating to the area, there maybe some people who will make the counter offer of $350K for the Victorian home. Again, I can't say with authority what percentage of out of area buyers constitute the real estate market, but it seems to me that most would-be buyers are not local so they have no basis of comparison with your scenerio.

Back to the valuation part of the LTV, at some point the trust factor has to be reset, which means if you have to get two appraisors to value the home taking the "lowest appraisal" then that's what you have to do. Most mortgages I've seen there is only one appraisal. A second opinion would cut off the kick back issue and the lowest appraisal would cut out the over valuation of the property.

tracy said...

Your tenacity is inspiring!

A little more background on me: I work for a bankruptcy attorney that focuses on people facing foreclosure. It is a category I know a lot about.

Yes. Forcing a lender to modify their CONTRACT would help a significant number of people facing foreclosure because of interest rate resets. How many? Maybe 200,000 people over the course of a year. There is a maxim in real estate: only a first time buyer takes a home off the market. Everyone is just playing musical homes.

Out of state buyers: we were in California in late August. Looking at real estate was surreal. A 1100 sq ft home in a unremarkable neighborhood, $1.3 million. Now, California is near the top of the list for home prices, but coming from an area of $200-300k homes, nice, big, $1.3m is just nuts. Someone from California will be joyful looking to buy in our neighborhood.

However, we have gotten a little away from the original issue on Tom's site and the concern I have raised: the impact the current financial mess is going to have on the economy. Tom has been a pretty strong voice that the economy is doing well and us doom and gloomers were just trying to talk the economy down. I have been saying the economy is in trouble for months. Our clients prove it. Yes, we are seeing a lot of foreclosure people, but more of them are in trouble because of job loss and other issues than because the loan reset. The loan reset may have been the final straw. But the source of the problem was economic.

We are in recession. It won't be official for another 6 months. But it is here. I figured it would hit after Christmas and it has, with a vengeance.

Under normal conditions, real estate sales would contract. Prices would hold steady, level off. Maybe still climb a percent or two. But not this time. We are facing a housing led, financial market driven, distrust supported, recession.

Regarding appraisals. You may not understand the process. Most appraisers of real estate take sales of similar properties in the area and compare the 'features', assigning values to the differences. If all the prices in an area are dropping, then you CAN'T use comparisons. The alternative is something like income producing or new construction costs. If actual new construction is sitting vacant in large numbers, that doesn't work. So, using income, the appraiser finds out how much a similar property is renting for in a market, using local valuations of rentals v rental income can give some idea of value. In areas where the bubble is worse, this comparison would result in significant downward price pressure.

Good appraisers can not appraise properly in areas of rapidly changing prices (up or down).

Trust. It seems so easy to offer, but so very hard to rely on once it has been lost.

dscott said...

Yes, I am familar with your background in the bankruptcy area from the other discussion. But the discussion needs to be "how to extracate ourselves from the mess" not "all is lost so let us go wallow in the mud."

Your point about CA is correct for CA but that is not so for large portions of the nation. As Tom Blumer pointed out a number of times in the past months, housing prices (decrease or increase) by regions are being lumped together giving a false picture of the housing market as a whole. What this means is in places like CA where insanity clearly had taken hold, those untenable prices must come down to something approximating the national average. Your suggestion of possibly using the cost of replacement if you had to build it new may have some place in the appraisal process where homes are rediculously overvalued. So what I'm saying here is there is no panacea fix, regions like CA are going to have to pay for their excessive valuations. But just because a region is over valued doesn't mean the rest of the country is, nor should they dictate that everyone go down the drain for the sake of equality. I call that false equality when a cookie cutter approach is insisted upon in order to mitigate the foolishness of a small group.

Your analysis is correct for as for a housing lead recession for markets that are "over valued" like CA, but not for the rest of the country. CA is not the whole of the US, it is only a portion of it.

But let's focus on some solutions which stop the asset value decline such as an RTC type corporation to hold foreclosed houses. And how much a $150 billion insurance fund gets you. IMO, you have four choices in dealing with foreclosed property.
1. Immediate sale it if the housing inventory is less than 6 months.
2. Rent with option to buy if the housing inventory is greater than six months.
3. Keep the property vacant and off the market until either option 1 or 2 is feasable. or
4. when the first 3 options won't pan out, Bulldoze the house, sell it as an unimproved lot.

The caveat for option 2 is
a. rental rate must be inline with the prevailing rental rates so as not to depress those rates,(meaning regardless of supposed value of the property, you can charge only what the market will bear even if it means a loss because the monthly loss is better than a total loss)
b. any damage done by the rentor must be paid by the rentor or their credit report receives a bad mark thus disqualifying them for 7 years.
c. any rentor who does not make on time rent payments must be immediately evicted and their credit record is given a bad mark. (Having been in the landlord business, those conditions for the RTC must be inviable)

Option 3 is tenable given the proposed $150 billion insurance fund. If default rates say run at 1%/yr of government sponsored loans, that means $1.5 billion will be expended every year to keep those houses off the market. That means conversely, in theory $1.5 trillion in government backed loans are possible over a ten year period. Ten years is long enough to sort out the market.

The upshot of all this is most of the country will come through in a reasonable fashion, some regions like CA will get the stuffing kicked out of them, but that's their fault in the first place for being insane, it's not my problem, it's theirs so in this light, no one gets off without some accountability. Which brings me to the current holders of the derivatives, tough cookies! They engaged in a highly speculative market, they knew the risk but went ahead anyway. Caveat Emptor!

In the future, there has to be some market reform and restraint on the lenders. One of those reforms must be a review of the housing inventory for the market they serve. If that inventory is greater than say 6 months, LTVs must go up significantly to dissuade house flippers and builders from engaging in ponzi schemes. Those who are actually moving into the houses should not be penalized. Local government zoning officials who issue construction permits must also watch the housing inventory, anything approaching a 6 month inventory must progressively limit the number of permits issued and those permits must be time limited to prevent builders from gaming the controls.

IMO as far as jobs go, that is going to depend on whether politicians have the guts to do the right thing were illegals are concerned. They have to go, so the wages of those citizens at the bottom of our society will hold steady, increase and keep their jobs. Enforce the law of the land, if you don't belong here you don't work here.

tracy said...

"But let's focus on some solutions which stop the asset value decline such as an RTC type corporation to hold foreclosed houses. "

You don't stop an asset value decline. It reaches equilibrium using the market.

"And how much a $150 billion insurance fund gets you. IMO, you have four choices in dealing with foreclosed property.
1. Immediate sale it if the housing inventory is less than 6 months."

This assumes that there is a market for the property. It depends on the price the holder of the foreclosed property is seeking. Even assuming the price is rational, there still might be a significant loss associated with it.

"2. Rent with option to buy if the housing inventory is greater than six months."

This option requires qualification for the buy loan. Under the more traditional lending standards rapidly being re-introduced, many people will no longer qualify to buy. Also, why a six month inventory? Why not 9 or 3?

"3. Keep the property vacant and off the market until either option 1 or 2 is feasable. or"

Deterioration of property and neighborhoods with numerous vacant properties are major factors in value...

"4. when the first 3 options won't pan out, Bulldoze the house, sell it as an unimproved lot."

See previous comments about value and demand.

I am also concerned by your apparent willingness to jump into the marketplace to 'save' it. Let the market sort things out. Yes, it is going to be painful, but anything else just asks for either a prolonging of the issues or a false bottom.

tracy said...

There is another section I wanted to comment on. From what I have read and can discern, 40 states have median home prices above a level that median income buyers can afford - using traditional methods of loan qualification. Although CA might be the most egregious, it is certainly not alone. And of course there are places in every state (including CA) where prices are more in line, as there are place where they are way out of line. The point is that real estate has gotten out of line. It has been a bubble. Every bubble pops, the question is how bad.

The Fed wants to ease us down, but that option has failed. The financial markets across a broad range of products, fundamentally and structurally can not tolerate the stress.

When banks and savings and loans and institutional lenders kept to their respective markets, damage in those markets got contained. Now, lenders have paper from residential mortgages, commercial real estate, consumer auto and credit cards, business equipment leasing and municipals all in their portfolio. And all of them have participated to one degree or another in all the derivative and hedging markets. Worse, the markets have spread across continents and economies. There is no containment, no firewalls.

Read the post above this one, we may be facing a $3 trillion hit on real estate, Spain and the UK will add multi-billion dollar/pound/euro losses on top of that. $150billion is going to be rounding error after this is over.

Let's add some more fuel to the fire: if GDP was growing 3% a year over the last 5 and we get 1 quarter of -1%, that is a 4% swing or about 130b difference in the economy; based on research, we need about 150k new jobs a month to absorb new workers. If we have 10 months of little job growth or worse, 5 or 6 months of negative job growth, we could be 2 million jobs short by fall.

I do not believe, though there are certainly many that do, that government intervention (or Fed intervention) can prevent a recession.

Ever seen an avalanche?

dscott said...

Ok Tracy, you made some good points about the potential pitfalls of the government injecting $150 billion into the housing market via guarantees. However, today let's focus on what can be done to save part while not all of the home mortgage industry.

This assumes that there is a market for the property. It depends on the price the holder of the foreclosed property is seeking. Even assuming the price is rational, there still might be a significant loss associated with it.

"2. Rent with option to buy if the housing inventory is greater than six months."

This option requires qualification for the buy loan. Under the more traditional lending standards rapidly being re-introduced, many people will no longer qualify to buy. Also, why a six month inventory? Why not 9 or 3?

Implicite in the assumption there are buyers is contingent on said buyers getting loans. No loans, no buyers, back to the chicken and egg scenerio. Of course we must conceed that not everyone who previously participated in the mortage market will be able to. It is not an all or nothing deal, some people buying is better than no people buying.

As far as meeting loan criteria for renting, I'm going to disagree with you on that one. The reason being, you can be more flexible on your criteria with a rentor than a buyer. Only when the rentor takes the option to buy do they need to meet the more stringent standards. The point is, that foreclosed house was off the market for at least a year giving time for other houses to sell.

The time period of 6 months was an arbitrary choice by me as it seemed reasonable from a sellor's perspective. Having a house sit on the market more than the typical listing term of 6 months means the house is not going to move. Prudent sellors pull the property and wait for more a more favorable market.

I am all for the free market solving the problem, however, it was not a "free" market that created the mess, therefore a regulated market is required to resolve the problems. The overbuilding, the loose loan terms, the speculative purchasing of houses, the inattentive construction permit issuers, use of illegal labor to build those houses to flood the market all contributed to the problem, therefore all of them must participate in it's solution and that requires a regulated market. The point of government is to provide an orderly infrastructure for commerce to flurish, not a top down centrally planned solution. (Republican view)

Ok, now it's your turn. You raised some valid objections and concerns. How would you address your concerns in a comprehensive manner? Simply letting the chips fall where they may is not a solution that is acceptable because that is anarchy.