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Home Values Built on Rotten Foundations
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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 price bubble
is already bursting of its own accord.
Let me begin with the sale of a property located a short distance
away from 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 current owner, Ronald Perelman. This same property
sold for $14.25 Million in 1987. If the sale goes through,
it will be the largest residential real estate sale in United
States' history. (In 2004, the property was assessed for $33.4
Million and taxes were a modest $664,000 a year, or $55,333
a month). Needless to say, 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, housing prices are up 44 percent over the
past 5 years while in the 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 8 million new and
used homes will sell with a total transaction value of $1.9
to $2 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 to keep a $12 Trillion economy moving forward.
The good news is that home ownership rose 2 percent to an
all time record of 67.2; the bad news is what had to be done
to get it there while the labor force participation rate has
dropped 2 percent! In other words, easy credit and record
low interest rates have boosted home sales. In previous economic
cycles, the boost to home sales 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 (mortgage owner), to the borrower, while
allowing the borrower to take out the largest possible mortgage.
Long gone are the days when a borrower borrowed what was considered
a safe, prudent amount that they could actually pay back.
Today, the borrower takes every penny that lenders will lend.
In turn, lenders have "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 just for a short term in the "Cash and
Carry Trade".
Today, the new mortgage lenders are offering various types
of mortgages to keep mortgage volume and quick origination
profits up. These mortgages include Adjustable Rate, Interest
Only, 40-Year, and Piggy Back. A Piggy Back mortgage is a
senior mortgage combined with a junior mortgage that can leave
the borrower owing more than 110% of the cost of the house.
Moreover, these lending tactics leave the borrower more than
a bit stretched and short liquidity, so it is no surprise
that new mortgages that allow the borrower to skip payments
and add the interest to principal are becoming popular. What
will lenders who don't lend their own money think of next?
If these new types of mortgages aren't good enough to stretch
a consumer's buying capacity, a few years ago special charities
sprang up to give a home buyer his 5% down payment. (Since
a home builder was giving the charity their funds anyway,
he could easily "give back" 5% of his 30% profit
to charity. Clearly, charity starts 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 percent less than the local medium income,
your neighbor - the US taxpayer - will give you the greater
of $10,000, or 6% of the cost of the home to buy it! Thus,
sub-prime borrowers have influenced home ownership rates considerably.
However, there are some sobering facts about sub-prime borrowers.
They are twice as likely to pick an ARM mortgage. (ARM mortgages
are already 30% 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 percent).
Moreover, 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 percent
of sub-prime mortgages are debt consolidation loans which
add credit card and other debt onto the house!
These sub-prime mortgages have a terrible record. At least
16 percent are delinquent or in foreclosure, and 4.6 percent
are actually in foreclosure. The "funny money" down
payment mortgages are 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, while in cities like Baltimore, Maryland and Queens,
New York, the default rates for FHA loans are 21 percent and
25 percent. Perhaps more lenders could do what FNMA does with
loans heading to default: Re-write half of them and call them
"good". Remember, "A rolling loan gathers no
loss."
Also, with the Fed making money free, and the government trying
to give money to sub-prime borrowers regardless of their willingness
or ability to pay, the private sector is trying to get back
in the lead of "the easy money free for all". The
FBI has reported that in the first 9 months of 2004, 12,100
complaints of suspicious activity in the mortgage market have
been reported. Fraud hot spots include the usual suspect states
such as Florida, California, and Nevada with honorable mention
to Michigan, Illinois and Missouri. (At least this restores
my pride in the Midwest). Moreover, the reported fraud would
be higher except that i) most of the FBI are out looking for
terrorists, and ii) fraud big enough to interest the FBI only
includes something like the house or buyer not even existing.
Most mortgages written today have a bit of a fudge factor
in the total honesty of income and net worth. Much information
is excluded from debt and payment histories, and "appraisals
are either wish or myth." Even the Mortgage Bankers Association
recognizes that the home appraisal process is totally broken.
In reality, 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 fee if the mortgage
closes. The higher the house price, the bigger the mortgage!
Looking back at the facts, it is easy to see that the foundation
for housing prices is rotting fast. 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 Adjustable
Rate mortgages and sub-prime loans, it is clear that any rise
in mortgage rates will bury housing.
At the high end of the housing market, there are reports
of "Yuppie Fatigue". Super-sizing homes also super-sizes
the heating and utility bills, insurance and maintenance costs.
Those vaulted ceilings sure look nice, but watch out for the
heating bill! Million dollar home foreclosures are picking
up.
In the general housing market, 5 to 6 percent of homes already
have more debt than home value, and homeowners are loading
up with home equity loans and lines of credit. These home
equity 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".
Currently, 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) and less than
4 of 10 workers save anything.
All of these facts were in place 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 costs of running a household would
put people in the poorhouse, but it's too expensive to check
in. This Christmas, Santa might skip homes that are draining
their home equity.
Does housing always go up forever? In the United Kingdom
where housing prices have soared like in America, prices fell
last month. Real estate agents can't be found to talk about
it, as it is bad for business. In San Diego, housing prices
have been flat the last couple of months while the supply
of homes for sale has jumped from a 2-month to an 8-month
supply.
In Las Vegas there is an unfolding house price debacle. The
national public has heard that the large developer, Pulte
Homes, has cut new home prices by 8 to 25 percent, and 25
percent of new homes on order have just been cancelled. However,
the public hasn't heard that i) 20 to 40 percent of sales
in new planned unit developments were to speculators; ii)
For-Rent signs in the complexes are everywhere. (To make some
easy money on the flip, buyers of second and third homes planned
to rent them out first); and, iii) Homes that sold for $750,000
just three months ago are across the street from homes that
the same developer is selling today at a nice profit for $550,000.
"The Las Vegas housing market has crapped out!"
In the United States, the supply of new homes has risen steadily
to a 275 day supply. Six of the 14 largest home builders have
debt-to-equity ratios of 95 percent, and home builders know
exactly what the car companies know: "If you want to
move inventory, cut the price!"
If home lenders would only read history they would know that
from 1975 to 1995, on average home prices rose only 0.4% and
with prices sagging now, they should ask for a larger down
payment, and fast, or they will be facing big losses. In a
market where housing prices are flat, it takes a 15 to 20
percent down payment to protect a lender against loss. The
sales commission is 6% and REPO, carry, and marketing costs
can run another 10% or more.
What would a rational down payment mean for housing prices?
Today, a buyer who can scrape up $20,000 for a 5 percent down
payment can afford a home priced at $400,000. If you ask him
for a 10 percent down payment, he can suddenly only afford
a home costing $200,000! Rational down payments will force
housing prices down. Whatever you do, please do not share
this observation with existing homeowners; they might want
to sell before I have had a chance to follow up with Ron Perelman's
example.
Richard Benson
President
Specialty Finance Group LLC
Member NASD/SIPC
www.sfgroup.org
800-860-2907
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