Benson's Economic & Market Trends
Home Values Built on Rotten Foundations
By Richard Benson
November 4, 2004
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 five 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 eight 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 in order to keep a $12 Trillion economy moving forward.
The good news is that home ownership rose 2 percentage points 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 two 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 percent 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 five percent down payment. (Since a home builder was giving the charity their funds anyway, he could easily "give back" five percent of his 30 percent 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 median income, your neighbor - the US taxpayer - will give you the greater of $10,000, or six percent 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 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 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. In Baltimore, Maryland and Queens, New York, FHA loan default rates are 21 and 25 percent. Perhaps more lenders could do what FNMA does with loans heading to default: Rewrite 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 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 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). 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 have a bit of a fudge factor in the total honesty of 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 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, five to six 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".
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 home. Fewer than four workers in 10 save anything at all.
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.
Do housing 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, housing 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. The national public has heard that the large developer, Pulte Homes, has cut new home prices by between eight to 25 percent, and that 25 percent of orders for new homes have just 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 95 percent, and they know 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 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 percent and REPO, carry, and marketing costs can run another 10 percent 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 afford 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, please 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.