Only the Names have been changed

Out here in the foreclosure belt, many blame the securitization of real estate for the boom-bust cycle we are now enduring. Securitization of loans allowed for a huge influx of cash into mortgages and huge group of middle men who profited from the sale of loans--and laughed all the way to the bank even if the loan later went into default.

While securitization was touted as something new and different, a recent article in the New York Times (click here) points out that securitization was first created in the 1920s--and may have played a major role in the financial collapse of 1929 that led to the Great Depression.

Here are some gems from the article:

“Easily obtainable financing via public capital markets corresponded with an urban construction boom,” reported William N. Goetzmann and Frank Newman in a paper just released by the National Bureau of Economic Research, titled “Securitization in the 1920s.”

“Regulation and centralization were glaringly absent,” they add. “Ultimately the size, scope and complexity of the 1920s real estate market undermined its merits, causing a crash not unlike the one underpinning our current financial crisis.”

Yet the lessons of that boom and bust have largely been ignored. Everyone remembers the 1920s and the stock market crash of 1929, but there has been little data collected on what happened to real estate securities or even on how large a market it was. It turns out that real estate securities constituted a major market, and began to falter before stocks did.

“The breakdown in their valuation, through the mechanism of the collateral cycle, may have led to the subsequent stock market crash of 1929-30,” they wrote.

The writer goes on to conclude:

That fact should raise questions about whether the securitization machine should be patched up and back in business to operate without government guarantees.

Perhaps, instead, we should find a way to get banks and other long-term investors, like insurance companies, to make — and keep — most of the real estate loans that are needed in society...

It was, instead, the same old speculative enthusiasm, even if it was wearing fancy new clothes. Investors who had seen real estate prices rise thought that trend could not end. Wall Street sharpies thought they had found a way to make lots of money while not bearing the ultimate risk if the game suddenly ended.

As it turned out, the sharpies were wrong. They too got swept up in the carnage — just as their predecessors had in the 1930s.

Great words to ponder as we look to our leaders to regulate future financial programs.

Happy New Year - Let's start with Positive News

Here's a "positive" report from the LA Times to start out the new year:

More bad news is on the way for commercial real estate, but it won't be bad enough to bring down the economy, a leading property analyst said today.

Bob Bach, the chief economist at brokerage Grubb & Ellis, refuted an assertion made often last year by other analysts that pending commercial-property bankruptcies could throttle recovery and push the country back into recession.

"Many have called commercial real estate ‘the next shoe to drop,’ but that’s really an exaggeration,” Bach said. “It implies that commercial real estate could wreak damage on the financial system equivalent to the subprime residential mortgage losses, which is highly unlikely because the value of outstanding commercial mortgages is a fraction of the value of outstanding residential mortgages."

Nevertheless, Bach said, losses will mount over the next several years for commercial-property owners and their lenders.

"If banks aren’t lending because they’re coping with losses in their real estate portfolios," Bach said, "this could impede the economic recovery.”

He predicted commercial real estate's decline in value will slow this year and begin to turn around in early 2011.

-- Roger Vincent

Shadow Inventory - The latest real estate "buzz word"

As we continue to find ways to cut costs and survive through these lean budget times, all of us that worry about city budgets continue to monitor the indicators that let us know when we might expect to see property taxes and sales tax begin to increase. For property taxes, the most important indicator is foreclosures--which don't seem to show any signs of abating.

Foreclosures continue nearly unabated at record levels, with San Joaquin County still ranking in the top five counties nationwide nearly every month (we were 2nd last month). Two current trends demonstrate that we'll be continuing to see high rates for quite some time. The first indicator is the current delinquency rate for mortgages. According to a recent L.A. Times article:

For the first quarter ever, the number of homes in foreclosure with mortgages serviced by U.S. national banks and savings and loans topped the 1-million mark, according to figures released Monday by the Office of Thrift Supervision and the Office of the Comptroller of the Currency...and

The percentage of prime borrowers whose loans were 60 or more days past due doubled from the July-to-September period a year earlier. And more than half of all homeowners whose payments had been lowered through modification plans defaulted again.

Of the mortgages serviced by national banks and thrifts, only 87.2% were current and performing. It was the sixth straight quarter that the quality of those home loan portfolios had slipped.

"Mortgage performance continued to decline as a result of continuing adverse economic conditions including rising unemployment and loss in home values," the report said.

Seriously delinquent mortgages -- loans 60 or more days past due and loans to delinquent borrowers who have filed for bankruptcy -- rose to 6.2% of the servicing portfolio. That's a 16.7% increase over the second quarter and a 73.8% increase from a year earlier, the report said.

Of those seriously delinquent loans, the number of homes in the foreclosure process reached 1.09 million, about 3.2% of all the loans surveyed.

The report highlighted some troubling trends as the housing market continues to struggle despite increasing sales and prices in many areas. Difficulties increased for holders of prime mortgages, with the percentage of those loans that were 60 days or more past due increasing to 3.2%, up almost 20% from the second quarter and more than double the rate of a year earlier.

These numbers are absolutely stunning. Another L.A. Times article adds piles on additional troubling news. It talks about the new banking buzzword "shadow inventory".

Shadow inventory properties are homes that have not been tallied into official inventory numbers tracked by Realtors and other real estate professionals. They include homes taken back by lenders through foreclosures and similar actions, as well as homes whose owners are at least 90 days delinquent on their mortgage payments.

The article notes that one of the reasons that price drops have been less drastic this year is due to the number of homes being held off the market by lenders. The article estimates 1.7 million in shadown inventory -- a 55% percent increase in the last year.

Thus, one would postulate that even after foreclosures finally wane, there will be another 1-2 years worth of shadow inventory to sell off. I find this a good news, bad news scenario. The good news is that the lenders are doing everything they can to keep market values from dropping further. The bad news is that we can expect little or no appreciation in real estate in the middle of the upcoming decade.

Smart Growth - "Valley Style"

I'll be speaking at a conference on Friday morning about "Smart Growth". Smart Growth is a buzz word for trying to create more liveable, walkable communities that don't create a negative impact on the environment. Smart Growth proponents push higher density living near transit and jobs as a way to reduce our impact on our environment and improve the overall quality of life for all of our citizens.

In reality, particularly out here in the Valley, it is a challenge to make communities more compact and nearly impossible to build housing near jobs, since so many of our jobs are east of the Altamont. I'll be focusing on how suburban valley cities can grow smarter--and more cost effectively while acknowledging the limitations placed on us due to our location.

Below is a link to the power point presentation I'll be giving tomorrow:




Final%20CALAFCO%20Presentation.ppt

House Sizes Shrinking

I found this post on a USC professor's real estate blog interesting. It talks about the disconnect between median income and housing size. As I look at the homes we are building out here in the central valley, I'm very concerned that we are over consuming housing--which in the long run diverts dollars from other parts of our economy. I'm worried that our retail sales will suffer in the long run as many of our homeowners will be forced to put a disproportionate amount of their income into maintaining homes they can't really afford in the long run--particularly after the kids leave home.

In addition, large homes on large lots typically means more miles of roads, water lines, sewer lines and storm drains to maintain. At an time when we seem to be getting less income per household instead of more, this is a disturbing trend. We need to look at what size home and housing subdivision is sustainable for both the city and the residents. In any case, here is the post:


One thing that has led me to believe that the housing market in Southern California is largely at bottom is the fact that many houses are selling at less than replacement cost. While such a discrepancy can exist for a long time in places with declining population, replacement cost is a pretty sound fundamental for determining the minimum sustainable house price in areas with growth.

The report on median incomes released yesterday, though, suggests to me a flaw with my line of reasoning. While the average new house has grown about 20 percent in size over the past ten years, median household incomes have actually fallen a bit. If house size is a proxy for house quality (and we have good statistical evidence to think that it is), then house quality has outstripped the ability of people to pay for it.

When comparing market prices to replacement cost, we really need to think about depreciated replacement cost. Depreciation comes in three flavors: physical, functional and economic. Physical depreciation happens because things wear out as they age--it is what Congress is thinking of when it allows depreciation deductions for investment property and plant and equipment.

Functional depreciation happens when a component of a capital asset does not perform its function well by current standards. Think of a furnace that uses lots of energy, and could be replaced by something more efficient. It is possible that it could work as a furnace for years, but it still would be best replaced by something more efficient.

Finally, there is economic depreciation, which happens when the demand for something (like Detroit real estate) disappears. It is possible that large houses have incurred economic depreciation because people lack sufficient income to afford them. If this is true, values can fall below original construction cost and stay there for some time.

Such considerations do not, of course, apply to reasonably well located, modest homes--I continue to believe that 1500 square foot houses in the San Fernando Valley and the central part of the San Gabriel Valley are reasonably priced now. But the market for larger houses may be troubled for some time yet to come.One other implication: builders should construct smaller houses in the years to come. This vindicates a prediction I once made. Unfortunately, I made it in 1990.

Real Estate Prices Fall Statewide

Here's one of the latest posts from California City News:
(P.S. That isn't a typo, that really says "1933"!)

State Property Values Fall for First Time Since 1933
As if you needed any more data to confirm the dire straights of the state economy, the Board of Equalization reported this week that total state and county property assessments dropped 2.4 percent from last year. We've all been hearing about property values in a tailspin for months, but this number is actually pretty significant -- it's the first time values have declined since the Great Depression.
Of course this means big trouble for state and local revenues, but that's no surprise. Here's the lowlights:
Assessed values dropped 9.9 percent in the northern San Joaquin Valley,
4.8 percent in the greater Sacramento area
4.2 percent in the southern San Joaquin Valley.
San Francisco and Trinity Counties both saw values increase by 5% or more.
Read more in the SacBee and LA Times. And a glimmer of hope: Realtors said home sales were up 12 percent last month.

Mortgage Modifications

Ten years from now, I think we'll all finally realize that we spent the last decade living during the largest real estate roller coaster ride of all modern times. And those of us who live in San Joaquin County probably will have had the biggest roller coaster ride of all. We've gone from one of the most affordable markets in California to the one of the least affordable markets in the country and now we'll likely end up again as a great low-cost alternative to the coast.

In the meantime, this vicious roller coaster ride has left us with one of the largest foreclosure rates in the country, which likely means one of the largest foreclosure rates of all time. While the pace has slowed lately, there is fear that the foreclosures are about to pick up again after a government-forced slowdown in repossessions. One of the reasons that the government (both state and federal) mandated this slowdown was under the false assumption that it would give homeowners more time to renegotiate their terms with their lender. A recent study has shown that fewer than 10 percent of all mortgages have been modified.

Many blame the lack of modification on the fact that so many of our mortgages were sliced, diced, and then sold off to investment pools all around the country. In reality, the data indicates that the lack of loan modification is likely due to the fact that most of the loans still wouldn't work out for the homeowner. I believe this is particularly in the states that experienced the greatest drop in prices, and the data supports that. When a house is worth half or less of the original loan amount, the lender will likely opt to resell the property in the future.

USC professor Richard Green's recent study (click here) does a great job of explaining the paucity of modifications:

Since we conclude that contract frictions in securitization trusts are not a significant problem, we attempt to reconcile the conventional wisdom held by market commentators, that modifications are a win-win proposition from the standpoint of both borrowers and lenders, with the extraordinarily low levels of renegotiation that we find in the data. We argue that the data are not inconsistent with a situation in which, on average, lenders expect to recover more from foreclosure than from a modified loan. At face value, this assertion may seem implausible, since there are many estimates that suggest the average loss given foreclosure is much greater than the loss in value of a modified loan. However, we point out that renegotiation exposes lenders to two types of risks that are often overlooked bymarket observers and that can dramatically increase its cost. The first is “self-cure risk,” which refers to the situation in which a lender renegotiates with a delinquent borrower who does not need assistance. This group of borrowers is non-trivial according to our data, as we find that approximately 30 percent of seriously delinquent borrowers “cure” in our data without receiving a modification. The second cost comes from borrowers who default again after receiving a loan modification. We refer to this group as “redefaulters,” and our results show that a large fraction (between 30 and 45 percent) of borrowers who receive modifications, end up back in serious delinquency within six months. For this group, the lender has simply postponed foreclosure, and, if the housing market continues to decline, the lender will recover even less in foreclosure in the future.

We believe that our analysis has some important implications for policy. First, “safe harbor provisions,” which are designed to shelter servicers from investor lawsuits, are unlikely to have a material impact on the number of modifications and thus will not significantly decrease foreclosures. Second, and more generally, if the presence of self-cure risk and redefault risk do make renegotiation less appealing to investors, the number of easily “preventable” foreclosures may be far smaller than many commentators believe.

So basically, about 80 percent of those who defaulted could either make their current loan payment or are never likely to keep up their payments, thus leaving a small group to work with. Hopefully our federal and state policymakers will figure this out and stop trying to manipulate the market. The sooner we can get the foreclosures sold off, the sooner we can start stabilizing the real estate market.

What's next for Housing Prices?

PMI Mortgage Insurance Company, one of the largest residential mortgage insurers in the country, has just released their quarterly forecast of future home prices. Their forecast is closely watched by Wall Street and the lending industry. The forecast has typically been very accurate, particularly during down markets.

The forecast--which looks at all 381 U.S. metropolitan areas--is incredibly bearish about home prices over the next 24 months. For the Stockton-Manteca-Tracy-Lodi metro area, they believe that there is a 99.9% chance that prices will be lower in 2011 than they are right now! On the bright side, we are not alone, they include about 40 other metro areas in the 99.9% category. Additionally, 98% of the housing markets in the country became more affordable over the past year. Overall, due to low interest rates and dropping home prices, homes are 33% more affordable than 1995, when they first established the affordability index.

The most stable housing markets over the next two years include Cleveland, Columbus, Pittsburgh and San Antonio. The forecast believes there is only a 3% chance of prices dropping in the next two years in these areas. However, the overall U.S. forecast is dim as they predict lower prices in 324 of 381 U.S. housing markets.

This is certainly not good news for our future revenue forecasts. We received our property tax numbers, and they came in just about where we expected. Manteca's assessed value dropped a total of 14.7% this past year (we forecast 15%). If home prices continue to fall, we'll likely need to reduce our revenue forecasts again in 2010-2011.

To read the full report, click here, Bloomberg's take here and if you want to see the detailed report, click here.

No Money Down the Culprit

Living and working in the center of the national foreclosure crisis keeps one's interest piqued in the many theories that abound as to what happened...and what will happen next. While much of the media has focused on subprime loans, there is hard data that shows that subprime loans were just part of the sideshow.

Since I'm a numbers guy at heart, I put the most stock in the analyses that take an objective look at the numbers. In last week's Wall Street Journal, a University of Texas professor presented findings that were based on the analysis of over 30 million mortgages. While subprime loans were one of the culprits that led to this mess, negative equity was the biggest contributor to homes going into foreclosure. Here is an excerpt from the article:

Many policy makers and ordinary people blame the rise of foreclosures squarely on subprime mortgage lenders who presumably misled borrowers into taking out complex loans at low initial interest rates. Those hapless individuals were then supposedly unable to make the higher monthly payments when their mortgage rates reset upwards.

But the focus on subprimes ignores the widely available industry facts (reported by the Mortgage Bankers Association) that 51% of all foreclosed homes had prime loans, not subprime, and that the foreclosure rate for prime loans grew by 488% compared to a growth rate of 200% for subprime foreclosures. (These percentages are based on the period since the steep ascent in foreclosures began -- the third quarter of 2006 -- during which more than 4.3 million homes went into foreclosure.)

Sharing the blame in the popular imagination are other loans where lenders were largely at fault -- such as "liar loans," where lenders never attempted to validate a borrower's income or assets.

He goes on to note that mortgage resets (common in subprime loans) were a minor factor and that while only 12% percent of homes had negative equity, they were 47% of all foreclosures.

The conclusion of this article should be disconcerting for our federal and state policymakers, who seem to focused on bailing out owners with bad loans. The author notes:

The difference in policy implications is enormous: A significant reduction in foreclosures will happen when and only when housing prices stop falling and unemployment stops rising.

Although the government is throwing money -- almost $2 trillion and counting -- at the mortgage markets with the intent of stabilizing house prices, its methods are poorly targeted. While Federal Reserve actions have succeeded in reducing mortgage interest rates, low interest rates induce refinancings more than they do home purchases.

His solution is much more simple, we go back to the way residential real estate used to function:

Rather, stronger underwriting standards are needed -- especially a requirement for relatively high down payments. If substantial down payments had been required, the housing price bubble would certainly have been smaller, if it occurred at all, and the incidence of negative equity would have been much smaller even as home prices fell. A further beneficial regulation would be a strengthening, or at least clarifying at a national level, of the recourse that mortgage lenders have if a borrower defaults. Many defaults could be mitigated if homeowners with financial resources know they can't just walk away.

To read the article in its entirety, click here.

Not all the economic news is bad...

We're deluged daily with depressing economic news. Every week we hear about the unemployment rate heading north as mass layoffs impact every business sector. However, the New York Times had an excellent article today about job growth. It points out that despite being in the worst economic downturn since the Great Depression, millions are still being hired. In fact, while 4.8 million workers were fired or left their jobs in February, 4.3 million workers were hired in that same month.

If you are interested in reading a little good news, click here.

Another story in the New York Times focuses on Sacramento real estate. The story is entitled "Where Home Prices Crashed Early, Signs of an Early Rebound". The story basically concludes that we've found the bottom of the market. While not great news, let's hope they're right and we don't have another year of free falling prices. You can access the story here.

The Los Angeles Times also weighs in on today's residential real estate market. While higher end homes and homes in outlying areas are suffering, moderately priced homes are being snapped up quickly in today's low interest rate environment. While LA prices are now yet down to 2005 Manteca prices, there are a lot of homes now selling for less than $500K as noted in the story you can access here.