Monday, October 29, 2007

What a mess! It's going to be wild, as they say.

Here is a blog post from our friend and associate Bill Dove, a banker and financial consultant, responding to our recent posting “What’s Going On Here” and commenting on the proposed superfund conduit announced this week by Citigroup, Bank of America and J.P. Morgan.

This proposed superfund is just a Band-Aid on a gaping wound that needs major complicated surgery and a long term period of recovery. Bank of America and J.P. Morgan are in the deal to sanitize and lend credibility to what amounts to a bail-out of Citigroup, without direct government intervention. If their credibility can't raise the money for Citi, Uncle Sam may have to come in and bail-out Citi because in government regulatory banking circles Citi is “too big to fail”. As Alan Greenspan has recently pointed out, the fund delays the recognition of inevitable losses and extends the time the marketplace has to resolve the loss problem and place its negative economic consequences behind us. He believes the sooner we get this problem behind us the better and I agree.

Overall, the current residential housing disaster is probably worse than the savings and loan fiasco and could be in the magnitude of a trillion dollars or more. The savings and loan fiasco was a $500 billion dollar economic problem which ultimately cost the government $87 billion. It is estimated that the fall-out of the dot.com and high tech stock market “bubble” eventually cost our economy in excess of $2 trillion.

We are just looking at the tip of the iceberg. It will get worse before it gets better. Home buyers won't be able to obtain jumbo mortgages ($417,500) at a reasonable interest rate, unless they have at least a 20% equity cushion behind the proposed jumbo mortgage, an income of $120,000 a year, a FICO score of 700 and a stable employment history. Probably only 5% of potential first time new home buyers can meet these underwriting standards. Existing homeowners will not be able to buy a new or larger home unless they can sell their existing home and realize their cash equity, which will determine how much they can afford to spend for their next home. No one, in their right mind, will take on two residential mortgages under today's residential real estate market conditions. Lenders will insist that borrowers’ owning existing homes must sell and close on these existing homes before they will disburse a new proposed mortgage loan to purchase their next home. Buyers won't commit to buy and close with sellers until they have sold their existing homes. Residential real estate market activity will come to a "screeching halt" compared to the "hyperactive" residential buying and selling feeding frenzy of the past 15 years. The whole process of how residential real estate “changes hands” will slow down and it will be “like running in peanut butter” as buyers and sellers to go through the process.

Non-occupant residential home investors ("flippers") and second home owners, who have been a significant source of past residential buying demand, have disappeared from the residential real estate market for the foreseeable future. Inexpensive houses ($250,000 or less) in good condition located in established neighborhoods will sell relatively quickly. Very expensive houses in high-end communities will continue sell as usual to the super-rich who don’t rely on conventional mortgage financing. All homes in poor condition will sit on the market until the supply of all listed homes can be absorbed by demand within a six month period and more or less normal residential housing market conditions prevail.

Medium to high-priced homes will sit on the market until their prices are slashed 20% to 50% and will not sell until they are renovated. Prospective home buyers will not have the financial resources to make a healthy 20% down payment and also finance the cost of necessary renovations. With the cost of necessary renovations and repair completed and paid for by the seller and included in the sale price, prospective buyers, in effect, are in a position to finance 80% of the cost of these necessary renovations made by the sellers with proceeds of their new mortgage loan financing. Lenders won't lend on homes in need of necessary repairs and renovations. Gone are the days when lenders will rely on prospective home buyers to do necessary renovations and repairs after their loan closing from home-equity financing and future income resources to shore-up the value of their collateral.

Home ownership, as an important financial source of growing retirement funds, will diminish. People will be forced or will become more inclined to rent and invest their capital in securities, which is probably why the stock market and 401K type investment plans are holding up so well. Upwards to 70% of retirees currently regard the accumulation of home ownership equity as a long term savings plan. For years home ownership (because of the tax-deductibility of interest and property taxes) has been the poor man's main tax-sheltered retirement investment vehicle, which also incidentally also keeps the rain off his head while he is waiting to retire. (Securities investments don’t keep rain off his head). In the future, apartments or rental homes will keep the rain off his head without the downside financial risk of home ownership.

Sub-prime lending, rising prices and second home and non-occupant investor speculation has pushed home ownership beyond naturally sustainable limits and as a consequence, there will be an absolute downward adjustment of the incidence of home ownership from the 70 percentiles to the 60 percentiles. In the past, because of rising prices, the worst thing a home owner would likely experience is that he would make money if he were forced to sell. That is no longer the case. Home ownership for the foreseeable future will be primarily a device to just keep the rain off the owner's head and home equity will not be a reliable “risk-free” growing source of retirement savings.


Relatively, Merrill is in as bad a shape as Citi. I suspect the brokerage side of Merrill is livid about the mortgage-backed bond and investment opportunity “mess” the underwriting side of Merrill has produced. In all probability, the Merrill brokers have been pushing these "toxic waste” mortgage backs and SIV’s to their best customers.

Remember, a little number multiplied by a big number is a big number. Even a small to moderate loss experienced by a large number of home sellers is a big cumulative loss to the economy. While selling losses will be experienced on the margin by only a minority of total home owners, these selling losses will receive lots of publicity which will affect the home buying and owning psychology and thinking of all homeowners and our entire work force of 110 million people. The mobility, flexibility and spending behavior of our work force and our retirees will be greatly affected by this slowdown in residential sales. Home ownership will absolutely shrink in our society, as will home values. New home owners and existing home owners "moving up in the world" will "turn turtle" until they feel safe enough to come out of their shells and can afford the downside risk elements associated with home ownership, which could be years from now.


Historically low interest rates followed by steadily increasing interest rates, the advent of variable rate residential mortgage loan structures with beginning“ teaser rates” followed by escalating floating market rate provisions, sub-prime underwriting standards, the growth of non-occupant owner/investors and the "blind eye" of the rating agencies to the economic implications of these developments have enabled Wall Street (in its greed to acquire home mortgages to secure its popular securities and investment conduits) to franchise "fly by night" non-regulated mortgage brokers and then enable them to pursue unsound or downright fraudulent underwriting standards and practices. Large Wall Street financial institutions, not-regulated Main Street financial institutions underwriting residential mortgage loans for their own account, have been the culprits who have really screwed up the U.S. housing market for the foreseeable future by pushing the incidence of home ownership beyond economically sustainable limits.

Remember, for Joe Lunchbucket (after the basic nondiscretionary expenses for food, clothing, transportation, education and medical expenses which will always take precedence), home ownership is the biggest single discretionary expenditure he makes in his lifetime. Uncertainty about the benefits of home ownership will certainly affect Joe’s spending behavior and expectations which will significantly impact the overall economy for the foreseeable future.

Basically, our economy is going to experience an oversupply of residential dwelling units relative to demand for these residential dwelling units for a considerable period of time. Historically, our residential real estate market could support construction of an average of 1.5 million new residential dwelling units on an annual basis. Beginning in 2002 and continuing until late 2006, construction of new residential dwelling units on an annual basis approached 2.0 million dwelling units. Until the imbalance in supply and demand for residential dwelling units is corrected “chaos will reign in the residential real estate market and everyone will get wet”. It would appear that this inventory problem may be concentrated in California, Nevada, Arizona, Texas, Michigan and Florida. Perhaps we need a 24-month moratorium on the construction of new residential dwelling units in these States until supply and demand reach parity? Stay tuned.

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