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Values Built on Rotten Foundations We have been gleaning facts ‘brick by brick’ in order to write this story on the housing market and what it all means for Wall Street and the economy. The story is simple: While the Federal Reserve is slowly raising interest rates, it is our observation that the housing bubble is already bursting of its own accord. Let me begin with the sale of a property located near our modest casa in Palm Beach, where the big houses have names. Casa Apava, an estate with ocean and lakefront land totaling 18 acres, is under contract for about $70 million by its owner, Ronald Perelman. If the sale goes through, it will be the largest residential real estate sale in US history. This same property sold for $14.25 million in 1987. In 2004 it was assessed for $33.4 million, and taxes were a modest $664,000 a year, or $55,333 a month. The buyer is reported to be the chairman of NVR, Inc., the nation’s eighth-largest home builder. Clearly, selling homes at inflated prices to average Americans, who bought them using other people’s money, has paid off handsomely for this buyer. The size of the housing bubble should not be underestimated. In middle America, prices are up 44 percent over the past five years. In momentum markets such as Las Vegas and Southern California, annual ‘price pops’ of 20 to 40 percent have commonly been recorded until just recently. Housing is big business. In 2004, about eight million new and used homes will sell for a total transaction value of $1.9 to $2.0 trillion. Mortgage debt will rise about $800 billion, to $7.5 trillion by the end of this year. The increase in mortgage debt represents the spending that the Bush administration needed in order to keep a $12 trillion economy moving forward. The good news is that home ownership rose two percent to an all-time high of 67.2; the bad news is what had to be done to get it there, while the labor force participation rate has dropped two per cent! In other words, easy credit and record low interest rates have boosted home sales. In previous economic cycles, the boost came from rising incomes and more jobs. Easy mortgage credit has been fostered by new mortgage products. New types of mortgages have been introduced over the past couple of years that transfer interest rate risk from the financial institution (the mortgage owner) to the borrower, while allowing the borrower to take out the largest possible mortgage. Long gone are the days when borrowers borrowed what was considered a safe, prudent amount that they could actually repay. Today, they take every penny that lenders will lend. Lenders have also gone crazy because at the end of the day, the lender is not lending ‘his’ money. The loans go to a GSE security or into a rated mortgage security, which in turn is bought by a bank or hedge fund that is invested short-term in the ‘cash and carry trade.’ Today, new lenders are offering various types of mortgages to keep mortgage volume and quick origination profits up. They include Adjustable Rate (ARM), Interest Only, 40-Year, and Piggy Back. A piggy back mortgage is a senior mortgage combined with a junior mortgage that can leave a borrower owing more than 110 percent of the cost of the house. These lending tactics leave the borrower more than a bit stretched, so it is no surprise that new mortgages that allow borrowers to skip payments and add the interest to the principal sum are becoming popular. What will lenders who don’t lend their own money think of next? As if these new types of mortgages weren’t enough to stretch a consumer’s buying capacity, a few years ago special charities sprang up to give home buyers their five percent down payments. (Since a home builder was giving the charity its funds anyway, it could easily ‘give back’ part of its 30 per cent profit. After all, charity begins at home!) On top of that, President Bush signed the American Dream Down Payment Act of 2003. This legislation authorized $200 million per year in down payment assistance to at least 40,000 low-income families. His goal was to increase the number of minority homeowners by at least 5.5 million before the end of the decade. Under Federal law, if you are a first-time home buyer and your income is 20 per cent less than your local median income, your neighbor — the US taxpayer — will give you $10,000 or six percent of the price of the home you buy, whichever is greater. Thus, sub-prime borrowers have influenced home ownership rates considerably. However, there are some sobering statistics about sub-prime borrowers. They are twice as likely to pick an ARM. (ARMs already constitute 30 percent of new home loans and, as the Federal Reserve raises interest rates to normal levels, the monthly payment on an ARM will go up over 25 per cent.) Sub-prime borrowers frequently refinance. Borrowers who refinance for cash-out are twice as likely to default as those who don’t take cash out. Currently, 70 to 80 per cent of sub-prime mortgages are debt consolidation loans which add credit card and other debt on to the house! These sub-prime mortgages have a terrible record. At least 16 per cent are delinquent or in foreclosure, and 4.6 percent actually are in foreclosure. The ‘funny money’ down payment mortgages are even worse, with defaults running close to 20 percent. The Federal Housing Administration (FHA), which insures these loans, says national FHA mortgage defaults are 11 percent. In Baltimore, Maryland, and Queens, New York, FHA loan default rates are 21 and 25 per cent. Perhaps more lenders could do what the FNMA does with loans heading towards default: Rewrite half of them and call them ‘good.’ Remember: ‘A rolling loan gathers no loss.’ While the Fed makes money free and the government offers money to sub-prime borrowers regardless of their willingness or ability to pay, the private sector is trying to get back to the front of the easy money free-for-all. The FBI reports that in the first nine months of 2004 there were 12,100 complaints of suspicious activity in the mortgage market. Fraud hotspots include the usual states of Florida, California and Nevada, with honorable mentions to Michigan, Illinois and Missouri. (At least this restores my pride in the Midwest.) Reported fraud would be higher still except that (i) most FBI agents are out looking for terrorists, and (ii) fraud big enough to interest the FBI has to be a scam such as non-existent real estate or borrowers. Most mortgages written today are less than completely honest about the borrower’s income and net worth. Much information is left off debt and payment histories, and appraisals are either wish or myth. Even the Mortgage Bankers Association recognizes that the home appraisal process is broken. With easy money allowing home prices to rise, fraud has become a way of life in the mortgage market because every participant makes a commission or a fee if the mortgage closes. The higher the house price, the bigger the mortgage! Looking at the facts, it is easy to see that the foundation for housing prices is rotting. Buyers have stretched the truth in every possible way in order to buy the most expensive house for the lowest possible monthly payment. Given the fraudulent loan underwriting and emphasis on ARMs and sub-prime loans, it is clear that any rise in mortgage rates will bury the market. At the high end of the market, there are reports of ‘yuppie fatigue.’ Supersizing homes also supersizes heating and utility bills, insurance, and maintenance costs. Those vaulted ceilings sure look nice, but watch out for the heating bill! Foreclosures on million-dollar homes are picking up. In the general market, five to six per cent of homes have more debt than home value, and owners are loading up with home equity loans and lines of credit. These loans and lines will be up to $400 billion in 2004. Home equity can be spent, but as home prices stop going up, more and more homes will have no equity left. Wages and salaries have not kept up with inflation despite ‘economic recovery’; bankruptcies will hit another all-time record of over 1.6 million in 2004. Forty-five percent of workers have total net assets of less than $25,000, including the value of their house. Fewer than four workers in 10 save anything at all. All these facts were established well before oil and natural gas prices headed north for the economic winter. Reasonable estimates show the average household bill for gas for the car and energy for the home will be $9,000 in 2005, up from $6,000 last year. Other household running costs would put people in the poorhouse, but it’s too expensive to check in. This Christmas, Santa might skip households that are draining their home equity. Do prices always go up? In the United Kingdom, where housing prices have soared like in America, they fell last month. Real estate agents can’t be found to talk about it, as it is bad for business. In San Diego, prices have been flat the last couple of months while the supply of homes for sale has jumped from a two-month supply to eight months. In Las Vegas there is an unfolding house price debacle. Many people have heard that a large developer, Pulte Homes, cut new home prices by between eight and 25 percent, and that 25 per cent of orders for new homes have been cancelled. However, the public has not been told that (i) 20 to 40 percent of sales in new planned unit developments were to speculators, or that (ii) For Rent signs are everywhere in the complexes because buyers of second and third homes planned to make some easy rent money before flipping the houses, or that (iii) homes that sold for $750,000 just three months ago are across the street from homes that the same developer is offering today at a nice profit for $550,000. The Las Vegas housing market has crapped out! Across the United States, vacant new homes have risen steadily to a 275-day supply. Six of the 14 largest home builders have debt-to-equity ratios of at least 95 percent, and they know what the car companies know: If you want to cut inventory, cut the price! If lenders would only read history, they would know that from 1975 to 1995 the average home price rose only 0.4 percent. With prices sagging now, they should ask for a larger down payment, and fast, or they will be facing big losses. In a flat market, it takes a 15 to 20 percent down payment to protect a lender against loss. The sales commission is six per cent, and REPO, carry, and marketing costs can run another 10 per cent or more. What effect would a rational down payment have on house prices? Today, a buyer who can scrape up $20,000 for a five percent down payment can buy a home priced at $400,000. If you ask him for 10 percent down, he can suddenly afford only a $200,000 home! Rational down payments will force housing prices down. Whatever you do, do not share this observation with existing homeowners. They might want to sell before I have had a chance to follow Mr. Perelman’s example. © 2004 Richard Benson for Realty Reality About
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