Interesting Look At Housing Market (Bust)

[Overpaid Slacker]

So I've held off on buying a place b/c I have no faith in the markets and think they're out of whack with reality. Last Autumn, the talking heads, after sales of existing homes had fallen off the charts, were saying "oh, it's just a minor correction/blip. Nothing to see here; move along."

Well, things have continued to plummet (with certain regional exceptions, I stipulate, but not regions in which I was going to buy)... and here's a straightforward look at why, and a bit of (dire) prognosticating. Hold on for the ride, guys....

From The Weekly Standard

House of Cards
The unsound loans that fueled the housing boom are starting to collapse.
by Andrew Laperriere
03/12/2007, Volume 012, Issue 25

Last week the stock market experienced one of its largest drops since the 9/11 terrorist attacks. While there were a number of causes, one major factor is investor concern that problems in the subprime mortgage market--which caters to consumers with poor credit ratings--are going to spread. This could lead to higher-than-expected foreclosures, job losses in construction and real estate, lower consumer spending, and possibly a recession.

Despite low interest rates and an economy operating at essentially full employment, during the past few months subprime mortgage delinquencies have spiked to record territory. About two dozen subprime lenders have closed their doors, and the stocks of several major subprime lenders have plunged. Home prices are roughly flat nationwide in the last year, but, as the chart shows, the rate of appreciation is in free fall. After soaring the past few years, real estate prices in southern Florida, once the epicenter of the housing boom, have dropped in the past year by 6 percent in Miami and 18 percent in Sarasota-Bradenton, according to the National Association of Realtors. What's going on?

It is becoming increasingly clear that the housing boom was built on a weak foundation: easy money. The boom started in earnest when the Federal Reserve slashed interest rates in response to the 2001 recession. The lower rates cut monthly payments, boosting demand for housing and pushing up home prices. As home prices kept rising, loan terms became easier but fewer loans went bad, because homeowners in financial distress could usually refinance or sell their homes at a profit.

But the Fed's loose monetary policy also created a credit bubble that led to today's problems. Confidence in ever-rising home prices and cheap money fueled speculation, which in turn boosted demand and pushed home prices higher still. Another major factor: the insatiable demand by investors for mortgage-backed securities, which provided the funds for a five-fold expansion of subprime lending. (Because "subprime" borrowers have a less than stellar history of paying their bills on time, they pay a higher rate of interest, always alluring to investors with a stomach for risk.) Some of the growth of subprime lending was a favorable development that put home ownership within reach for millions of lower-income people.

But in the past couple of years, loans once known in industry parlance as "toxic waste" have become standard practice. For example, borrowers with checkered credit histories have been able to buy a home with no down payment and no verification of income. What's worse, the initial mortgage payment typically accounts for close to half of the borrower's (nonverified) gross income--and even that high payment is based on a teaser rate. Most subprime loans are 30-year adjustable rate mortgages (ARMs), but the interest rate resets after two years, and the payment rises significantly. Critics call these so-called 2/28 loans "exploding ARMs." The Center for Responsible Lending estimates that one in five subprime loans originated in the past two years will end in foreclosure.

But the lack of prudent lending standards hasn't been confined to the subprime market. In fact, the same risky practices (little or no down payment, no verification of income, high payments as a share of income, low teaser rates) began in the Alt A market, a not-so-easy-to-quantify middle ground between subprime and prime borrowers. Fully 81 percent of Alt A loans were extended with reduced or no documentation required from borrowers, according to First American LoanPerformance. Inside Mortgage Finance, an industry publication, estimates that subprime loans accounted for 24 percent of the consumer market last year and another 16 percent were Alt-A loans. So, fully 40 percent of mortgages originated in 2006 were risky.

Given the relatively fixed supply of homes, the spike in demand fueled by risky mortgages was a key factor in the unprecedented increase in home prices. Even as the housing market has cooled, the price-to-income ratio and other common-sense metrics of home valuation are still off the charts. It now costs half as much to rent as to own in the Mid-Atlantic and many other regions, powerful evidence that the market price of real estate is divorced from its underlying economic value.

Credit bubbles that create these kinds of economic anomalies inevitably produce a financial train wreck, which is already happening in the subprime market. Speculators who bought homes in the heady days of the boom started selling once the momentum turned, which, along with modestly higher interest rates, helped stop price appreciation in its tracks last year. Now that losses from bad subprime loans are climbing, investors in mortgage-backed securities are bailing out and banks are tightening their underwriting standards. What's more, the bank regulators, who in this case were quicker to spot the problems than investors, have been tightening lending standards, and under pressure from Congress are in the process of tightening standards on subprime loans.

It's already harder to get a risky loan--and about to get harder still--and these tighter credit conditions will reduce the demand for housing at a time when the inventory of homes for sale is near record levels. Therefore, the boom's virtuous cycle (easy money, increased demand for housing, higher home prices, looser lending standards) is now reversing and becoming a vicious one (higher foreclosures, bigger losses for banks and investors, tighter credit standards, less demand for housing, lower home prices, still higher foreclosure rates).

But the tighter credit conditions are only just beginning, so the worst of the economic fallout from the housing slump is probably ahead of us. The issue economists and investors are wrestling with is how much lower home prices and rising delinquencies will reduce employment, business investment, consumer spending, and overall economic growth. No one knows by how much, but these forces will lower growth and leave the economy vulnerable to recession.

Naturally, as more and more families lose homes to foreclosure, two questions will increasingly be asked in Washington: "Whose fault is this?" and "What can we do about it?" The truth is, there is plenty of blame to go around, but there are not many productive policy options.

Politicians won't be inclined to blame consumers, but most home buyers knew--or should have known--that there is no free lunch. The consumers who paid higher rates for "no doc" loans so they could fib about their income and qualify for a bigger mortgage, the speculators who gambled on Vegas condos, or borrowers who cashed out the equity in their home and exchanged their 30-year fixed rate mortgage for a "pay-option" ARM had to have known they were taking a risk.

But one also doesn't have to sort through too many junk-mail solicitations to find unscrupulous lenders who misrepresented the risks of these loan products. In addition to the mortgage brokers and banks, the Wall Street firms that securitized these mortgages and the credit rating agencies that blessed their creditworthiness will make especially inviting political targets.

Unfortunately, there isn't much Congress can do without making the problem worse or creating a significant moral hazard. If Congress tries to punish the lenders beyond the harsh penalty financial markets are likely to inflict, it will further discourage banks from making loans and will create a credit crunch. If it tries to bail out consumers, as some on Capitol Hill are contemplating, it might make the problem worse by giving homeowners, many of whom could muddle through without a bailout, perverse incentives (default and lower your mortgage payment). If a bailout is less about debt relief and more oriented toward restructuring debt, it might drag out the downturn, just as the Japanese government's efforts to insulate banks and businesses from bad loans delayed for years Japan's recovery from its real estate bust. A better approach would have been to allow bankruptcies and a fresh start.

Policymakers need to proceed with caution. The Federal Reserve went too far in cutting rates to cushion the economy from the fallout of the tech bubble, and today's problems in the housing and mortgage markets are the unintended consequence. If, as the evidence strongly suggests, many consumers have taken out risky loans they cannot afford to pay back, then home prices will continue to drop, and significant financial hardship is largely unavoidable.

Andrew Laperriere is a managing director in the Washington office of ISI Group, a Wall Street economic research and brokerage firm.His "Housing Bubble Trouble" appeared in our April 10, 2006 issue.

[TerryBPP]

The drop appears to be very hit or miss. All the houses in my neighborhood (500+ homes) are selling at the same price I bought mine for a year ago. But condos have dropped from $300k+ to sub $200. Alot of the little towns around our area that had huge market hype last year are feeling the most hurt.

People still have money and will pay top dollar for the perfect home but the days of investors flipping junk for 300% profit are over.

[Jim Richards]

Dated 03/12/2007? Wow JP, nice Back to the Future move.

[Jim Richards]

Actually, this has been covered in a few recent threads here on OT.

[legion]

Originally posted by Jim Richards
Dated 03/12/2007? Wow JP, nice Back to the Future move.

Probably the official publication date for the magazine.

I got my April issue of Excellence in February...Pete must have a DeLorean in his collection...

[kach22i]

Part I

March 5, 2007
Mortgage Crisis Spirals, and Casualties Mount
By JULIE CRESWELL and VIKAS BAJAJ
Even in affluent Orange County, Calif., the growing wealth of executives and brokers in the booming mortgage industry was hard to miss.

For Kal Elsayed, a former executive at New Century Financial, a large lender based in Irvine, driving a red convertible Ferrari to work at a company that provided home loans to people with low incomes and weak credit might have appeared ostentatious, he now acknowledges. But, he says, that was nothing compared with the private jets that executives at other companies had.

“You just lost touch with reality after a while because that’s just how people were living,” said Mr. Elsayed, 42, who spent nine years at New Century before leaving to start his own mortgage firm in 2005. “We made so much money you couldn’t believe it. And you didn’t have to do anything. You just had to show up.”

Just as the technology boom of the late 1990s turned twenty-something programmers into dot-com billionaires, and leveraged buyouts a decade earlier turned Wall Street bankers into Masters of the Universe, the explosive growth in subprime lending turned mortgage bankers and brokers into multimillionaires seemingly overnight.

Now an escalating crisis in the market, which seemed to reach a new crescendo late last week, is threatening a wide band of people. Foremost are the poor and minority homeowners who used easy credit to buy houses that are turning out to be too expensive for them now that mortgage rates are going up, but the pain is also being felt widely throughout the business world.

Large companies that bought subprime lenders during the boom, like H&R Block and HSBC, are now scrambling to sell them or scale back their exposure. Many investors are also likely to suffer: Wall Street firms made billions in fees, commissions and trading revenue from packaging and selling subprime mortgages to them as bonds.

New Century has emerged as a poster child for the lenders that rode that boom to the top and are now in free fall. The company disclosed on Friday that federal prosecutors and securities regulators were investigating stock sales and accounting errors. The latter could jeopardize billions of dollars in financing for the company, which issued $39.4 billion in subprime loans in the first nine months of last year.

Weakening home prices and rising default rates have rocked the subprime business. But for those who cashed out before the market turned, the ride up was particularly sweet. The three founders of New Century, for example, together made more than $40.5 million in profits from selling shares in the company from 2004 to 2006, according to an analysis by Thomson Financial. They collected millions of dollars more in dividends, salaries, bonuses and perks.

The company said in a statement yesterday that the founders were “still significant shareholders,” noting that they collectively owned about 7 percent of the company at the end of last year.

New Century’s stock price, which seemed to mirror the trajectory of the subprime business, peaked at nearly $66 a share in December of 2004 and traded in the $40s most of last year; on Friday, it was trading at $11 a share after the market closed. In a series of sales from August to November, two of the company’s founders sold shares for an average price of about $40 a share, for a total profit of $21.4 million.

It is not known whether the stock sales by the founders are among the sales being examined by federal investigators. Some of them had been part of scheduled stock sales that are often used by executives to diversify their portfolios. But some of the sales occurred on the same day that the executives entered the plans. A New Century spokeswoman, Laura Oberhelman, said that executives declined further comment.

The founders’ stock also rose in the social circles of southern California, the epicenter of the boom in subprime. Five of the 10 biggest providers of subprime mortgages last year had their headquarters in the region.

Robert K. Cole, 60, a co-founder who retired as chairman and chief executive last year, lives in a 6,100-square-foot oceanfront home in Laguna Beach that is valued at tens of millions of dollars and was once owned by the chief executive of Pimco Advisors, the giant bond trading and management firm. Edward F. Gotschall, 52, another co-founder who is vice chairman of the board, donated $3 million for an expanded trauma center at Mission Hospital that will be named for him and his wife Susan.

The executives from New Century are by no means alone in cashing in on the bonanza, and they do not appear to have scored the biggest profits. That title may be claimed by Angelo R. Mozilo, the chief executive of Countrywide Financial, the nation’s largest stand-alone mortgage company and one of the largest subprime lenders last year. He reaped more than $270 million in profits from sales of stock and the exercise of stock options from 2004 to the start of this year, according to the Thompson analysis.

Of course, most of the 500,000 people who work in the mortgage industry did not cash in so grandly. The wealth was concentrated among executives, loan officers and brokers, because the greatest rewards were meted out in the form of commissions, bonuses and stock awards.

“In the hot times, it was not unusual to see a broker make a million bucks,” said Guy Cecala, publisher of Inside Mortgage Finance, a trade publication. “You can carry that up further to people who ran the companies. The whole business revolves around personal compensation.”

The hot times are clearly over. New Century’s disclosure of the federal investigations on Friday was the most serious in a string of shocks to have rocked the industry in the last three months.

A handful of lenders have sought bankruptcy protection, several have been acquired and a few have been shut down. Also on Friday, Fremont General, a top-five lender, said it planned to leave the business. Industry officials say they are seeing an exodus of executives and salespeople as companies fold, cut jobs and push out early leaders.

“Everyone has run for the hills,” said William D. Dallas, whose company, Ownit Mortgage, filed for bankruptcy protection in December after it lost financing from Merrill Lynch and other banks.

For the borrowers of these mortgages, it may become more difficult to refinance if lending standards are tightened significantly. Many are already facing the prospect of payment shock when low, fixed-interest mortgage rates adjust to higher, variable rates. On Wall Street, big investment banks could lose a significant source of revenue if the appetite for bonds backed by mortgages dries up.

In the last two years many skeptics began warning that the red-hot housing market and adjustable-rate loans would blend into a toxic brew. Last year, subprime loans totaled $600 billion, or about 20 percent of all mortgages, up from $120 billion and 5 percent in 2001, according to Inside Mortgage Finance. More than half of subprime loans have adjustable rates.

See part II

[kach22i]

Part II

March 5, 2007
Mortgage Crisis Spirals, and Casualties Mount
By JULIE CRESWELL and VIKAS BAJAJ


Many of the problems that have surfaced thus far are not tied to the resetting of rates. Rather, they stem from a sharp and early spike in the default rates among loans issued last year.

For example, about 13.8 percent of the loans in a group of mortgages New Century sold to investors in April were behind in payments or in foreclosure by January. By comparison, only 6 percent of loans in a pool sold to investors in March 2005 had met that same fate by January 2006.

Investors and regulators fear that the problems will only worsen as so many borrowers have fallen behind so quickly, especially at a time when the overall economy is healthy. The phenomenon suggests that lending standards were significantly weakened last year and that lenders were not as watchful for fraudulent transactions.

For New Century, the early payment defaults pose significant financial problems. In the first nine months of last year, Wall Street banks and investors that it does business with forced it to buy back $469 million in loans it had sold to them, up from $240 million for the same period in 2005.

The company was able to sell back about half of those loans at a discount of 26.5 percent. How it handled the remainder — about $227 million — is now under scrutiny. According to accounting rules the company should have valued the loans on its books for what they were worth today, not their previous face value. But it did not.

If it had, the company would have seen its earnings fall by about $60 million before taxes, wiping out most of its profit in the third quarter, according to Zach Gast, an analyst at the Center for Financial Research and Analysis, a forensic accounting firm.

This is important, because the company’s financing agreements require that it not lose money for any rolling six-month period. On Friday, New Century said it did not expect to make a profit in the six months that ended in December and that it was negotiating with lenders to waive the requirement but has only secured six of 11 waivers it needs. “They had losses sitting on their balance sheets,” Mr. Gast said.

In August, the company’s chief financial officer, Patti M. Dodge, announced she was stepping down from her post to oversee investor relations, a department that typically reports to the chief financial officer. Taj S. Bindra, a former executive at Washington Mutual, replaced her in November.

For the second time in a decade, New Century finds itself fighting to survive. The firm’s roots were planted at Plaza Home Mortgage Bank where the three founders of New Century — Mr. Cole, a longtime mortgage executive; Mr. Gotschall; and a lawyer named Bradley A. Morrice — worked together. The three formed New Century in 1995 after Plaza was sold to Fleet Mortgage Group, now a part of Washington Mutual.

In the late 1990s, New Century narrowly survived accounting concerns and a scare in the bond market after Russia’ s default in 1998. It pulled through thanks to an investment by U.S. Bancorp, a bank based in Minneapolis. With interest rates at historic lows, it quickly grabbed a big share of the fast-growing subprime market during the housing boom.

“They walked into a niche industry at a time when everything was lining up perfectly for what they did,” said W. Scott Simon, a managing director at Pimco Advisors. “In 2001, 2002 and 2003 the subprime business was just phenomenally profitable. Home prices kept appreciating and it seemed that no loans ever went bad.”

[Jim Richards]

Originally posted by legion
Probably the official publication date for the magazine.

You're too serious.

[legion]

And I thought you were trying to latch onto a seeming inconsistency in an effort to invalidate the whole article. I should have known better, no one does that around here.

[Jim Richards]

Me? Never!

[Overpaid Slacker]

kach -- interesting read!

Chris & Jim -- good parry and riposte!

JP

[Jim Richards]

[speedkillz]

Look to see 50 year payment plans to keep people in these homes. If the banks loose it will be as bad as when the S/L went under, only uncle sam doesn't insure private morgage co's.

[legion]

Originally posted by speedkillz
Look to see 50 year payment plans to keep people in these homes. If the banks loose it will be as bad as when the S/L went under, only uncle sam doesn't insure private morgage co's.

That's good in a way. Less of a moral hazard.

[Bill Verburg]

I figured there was going to be a real estate crash when I found out how many Californians were buying private luxury homes around here as investments.

[Joeaksa]

Originally posted by Bill Verburg
I figured there was going to be a real estate crash when I found out how many Californians were buying private luxury homes around here as investments.

Ditto here in Arizona. At one time 40% of the houses being sold in the Phoenix area were Cali investors. Purchased and let sit empty for months on end, the bubble had to burst eventually.

Just looked and my house is well on the road to recovery after taking a $100k hit last year. Houses are starting to sell here again and by summer/fall looks like things may be on the right track again.

[turbo6bar]

Subprime and Alt-A segments (estimated at 40+% of the mortgage marketplace) have been hit with a neutron bomb. The effects have not been felt in the housing market (sales and pricing), yet.

A few weeks ago, analysts questioned whether subprime problems would transfer into Alt-A. Early reports suggest it is, and now we have to consider the likelihood of problems flowing into prime. If it does, the housing market is toast. Consider potential fallout on the economy, and then things start getting serious.

At this point, I see 2007 being worse than 2006, and potentially, much worse if the lending market does not regain its feet soon.