Taking Risks and Reaping Rewards

Are All-Cash Home Sales Good or Bad?

Data released today by the National Association of Realtors on US home sales in February showed a decline of 0.6% and inventory surged by the most for the January-February period in 20 years.

But what may be more telling is that all-cash sales remain at a extraordinary percent of the total at 27%. Typically, all-cash sales fall around 10% of total sales.

 

 

 

 

 

 

 

 

 

What can we learn from this?

First, any data that hits a long term high or low water mark or is outside the ordinary deserves special note. To find a clue about the future, think about why this unusual event happened and what is likely to push it back toward the average.

Second and more specifically, housing prices are being supported by a tax credit that is about to expire and many of the buyers are speculators that are going to want to sell again in the future. So while those homes are off the books for now, they will come eventually. 

The good news here is that the all-cash speculators can sit and wait without default. So there will be fewer bankruptcies going forward.

But the bad news is that there will be lower demand going forward and higher supply, so prices will naturally decline for some period of time.

Speculators paying all cash can wait for years for the market to rise. If you can't, prepare accordingly.

The Sure Double Dip

It's not often we clearly see an iceberg through the windshield filled with our foggy future, but Meredith Whitney says she has seen one when she said, "The housing market surely will double dip."

When we hear such comments there are two things that we need to think about before we accept or reject what they have said.

The first is, "How credible is the source and what bias might they have?"

The second is, "How did they come to their conclusion and do we agree or disagree with their method and findings?"

In this case, Ms. Whitney's resume is solid in both education and professional experience. She was named "Power Player of 2008" by CNBC beating out Warren Buffett, Ben Bernanke, and everyone else.

More importantly she runs her own firm which means her bias is to being correct as it will reflect directly on her. In other words, she might not be right, but she's not trying to pull the wool over our eyes or mislead us in any way. If she says it, she believes it. (This is way less prevalent that you might like to think).

I also love the fact she married a professional wrestler. To me, this means that this is a strong person that makes her own decisions and isn't looking for approval from outsiders. And she has what we all should be looking for: independent thoughts.

So if we don't dismiss her comments out of hand, then we need to understand why she thinks this way and see if we agree.

Her reason is that the housing market has been supported by government programs, such as loan modifications and buying of Mortgage Backed Securities (MBS), and as those programs are coming to an end, a lot of supply will hit the market.

Basically, it's more supply, less demand, prices fall, in this case, AGAIN.

Is that true? Well, yes the Fed has said quite clearly they are ending the mortgage support. If they do, will others pick up the slack? Probably not as there isn't any profit in it for them to modify loans unless the government is forcing them or sponsoring it. So this is pretty clear analysis to me. 

Does that sound logical and right? Yea, probably does.

But can we find hard evidence to confirm our suspicion that she's really on to something?

In a previous post, I addressed wall of mortgage resets coming. That clearly showed evidence that a ton more mortgages are going to get hit with large resets, which will mean defaults for many or most of them. This will happen in the next year or two.

Read this again, then think consider that Ms. Whitney is an expert in this and has built her reputation on being right.

What can you learn from this?

It's likely that there will be another housing downturn, plan accordingly.

More importantly, there are at minimum two things to think through when you hear someone make a prediction in such clear language.

One is who they are, why they are saying it (bias) and make a judgment call about their credibility.

Two is how did they come to their conclusion and can you find evidence to confirm or reject it. Evidence counts, hoping they are right or wrong doesn't.

Remember: Hope is not an investment strategy.

Eye of the Housing Hurricane

After the first wall of the hurricane passes, there's a lull.

You're in the eye of the hurricane. 

It may feel like it's over, but it's not. It just feels better because the wind stopped blowing for a minute. But when the second wall comes through, it could be just as bad as the first.

In housing, we weathered the storm - BARELY. 

But that was just the first wall. The second wall is approaching and some us need to take cover. 

Here's a chart that shows the impending mortgages that are going to reset in the next year or so. 

 

 As you can see, the second wall is coming. The first was the subprime loans, shown here in green. The second is the Option Adjustable Rate (Option ARM) loans, shown here in beige.

An Option ARM loan is often called a pick a payment loan as the borrower can decide what type of payment they want to make. Typically they can choose between a fixed rate of 15 or 30 years or interest only or a negative amortization minimum payment. 

The first two options are basically regular loans, so while the option exists, no one chooses it. The second two are where the problems come in.

Interest only provides a lower payment as you aren't paying the prinicpal back. But eventually, you have to start paying back the principal and when that happens the loan payment resets potentially sharply upward. 

If that wasn't enough of a problem, the other option is a negative amortization payment where not only have borrowers avoiding paying on the principal, they haven't even been paying the full interest due on the loan. So the balance due has been increasing. 

For example, if you borrowed $400,000 on a house, paid less than the interest on the loan each month, you could owe $440,000 now years later, and that home might only be worth $250,000.

88 percent of Option ARMs originated between 2004 and 2007 are going to adjust higher between now and 2012. Those option ARM borrowers could see their housing bills go up as much as 63 percent, according to Fitch ratings.

 

With house values still struggling, when this next wall of payment resets hits, who's going to stay in their house with that kind of payment increase and little hope for an increase in value?

Some reports are citing almost 500,000 option ARM loans in California that will reset between now and 2012. With the state already struggling, people won't be able to make the higher payments, putting a huge block of inventory on the market, which will simply kill prices in the "Golden" State.

What's even worse is that the Federal Reserve is going to start raising interest rates to offset potential inflation. Many option ARM loans will go up with them so the payments just get bigger.

Why this matters to you

You may be thinking that this doesn't impact you because you aren't in one of these crazy loans. You may even think that some people deserve to lose their home because they acted recklessly and this should be a lesson to them. 

Well, a lesson it is, but it does impact you too. Why?

Because another wave of housing foreclosures will impact the overall economy and will certainly impact residential real estate prices.

Going from "owning" a house to renting an apartment may not be the disaster of a lifetime, but no one does it, and then goes out and throws a party. And those watching it happen on TV and talking about it around the water cooler, don't throw parties either.

Consumer spending is almost 70% of the economy and if consumers are seeing people being thrown out of their homes, their own home price falling still, and the economy slowing again, it's likely they will tighten their purse strings. Which means the economy slows just that much faster.

We rarely get such a glimpse out the foggy windshield to the future. But in this case, it sure seems like the fog parted and it's pretty easy to see the road ahead. 

The next wall of the hurricane is approaching. It's on the radar and we can see it.  Batten down the hatches, and hold on. This could be a rough ride.

This is not a drill.

Fed Meeting Press Release Changes for November 2009

The Federal Reserve bascially kicked the can down the road with their announcement after the November 4, 2009 meeting. They only made minor changes to the language, as you can see below, and the only thing they made crystal clear is that they don't see inflation on the horizon.

FOMC meetings offer opportunity to not just talk about financial markets but also critical thinking and learning new skills. If you took the last statement and used Word to compare it to this statement, you would see exactly what has changed. Viewing the information in this way not only eliminates the middle man and their filter or bias, but also provides a faster more productive way to see what has changed.

Many financial analysts use this comparison method to see what changes quarter over quarter in company statements. You can use it in your work as well. Any document that gets updated regularly can be copy/pasted to see what the differences are. It's faster and more accurate than trying to remember or figure out what changed.

To do this open Word, go to Review tab, then Compare. Select the two docs and viola! Really helpful in some situations.

Here's the result of today's meeting vs. the meeting from September 23, 2009:

There’s a Reason He’s Called King

Bill Gross, a long time favorite of mine, is often called the Bond King. Well, it was reported today that he bet 60% of his $132B fund on mortgage debt from Fannie and Freddie and reaped a $1.7B payday when the government bailed out the debt of the two failed firms. His fund has out performed all of it's peers this year returning 9.2% in an otherwise dismal year. I am not sure who first called him the bond king, but at least now are clear on why.

Fannie and Freddie get folded into the government. It’s about time.

On August 25, 2003, I posted a comment on F&F being in trouble and that the housing bubble could burst and create a huge problem for the economy. In 2003! Why? How did I know such a thing could happen over five years ago? Because of the misalignment of incentives due to the implied government backing of F&F. It was obvious before five years ago, but that's beside the point. It took awhile, but now it's finally been resolved. It's about time.

A firm is either public or private and when they try to be both at the same time, it's a problem. The current situation is case in point. F&F had the implied support of the federal government so those that ran the organization acted differently than they would of if they didn't have that support. Investors also made decisions about the firm securities based on this. The incentives to maximize personal gain can't be dismissed and when the check and balance that the market imposes gets removed, things go awry. In other words, Adam Smith's invisible hand will make an obscene gesture if messed with.

Free markets, by and large, provide reward commensurate with risk taken. When that is breached, there is a misalignment of incentives and that causes problems, some of which, like this one, are significant. Alignment of incentives, leaving the risk stay with those that might profit, is a small, but significant, difference and all that it takes to misguide an organization and lead it toward where F&F are now.

F&F were able to securitize and sell their loans to the market, basically selling debt, long beyond what they should have been if there was no implied government backing. The market simply wouldn't buy them as they were too risky. But with the implied backing of the federal government, investors and financial firms continued to buy their debt which allowed them to keep the upward spiral going (The spiral is F&F buy loans, securitize, resell, take that money and buy more). Everything is fine as long as the spiral keeps going up. But it can't go up forever.

The typical market mechanism of price to resell the securitized loans would have been what stopped the upward spiral for a typical private firm. Bu it didn't work due to the government backing. In other words, the risk of default was seen as basically risk free as the government has to pay the debt or the entire system will collapse. That being the case, the return isn't commensurate with the risk, it's much higher. It's like buying a treasure bond that pays several points more than the going rate. Typically, the market runs in cycles with an upward spiral, commonly called a boom, that leads to a cliff, commonly called the bust. If markets are functioning properly, these cycles are pretty small. But when the pricing of risk is removed, the incentives to profit are too great to ignore and the size of the boom and, therefore the bust, can grow to catastrophic size.

It's the size of the two firms that mandates the government involvement. They are so large that if they were allowed to fail the entire financial system would collapse. As we can't let that happen, we have no choice but to do what is being done and make debt holders secure. So the taxpayer is going to cover the big bets by China, Japan, and others, that we would bail out the debt holders to save our own skin. Good bet that.

On Oct 5, 2006, I posted a comment saying that, "How many things are out there that the government, essentially the tax payers, are going to have to cover in the event of a disaster? Fannie and Freddie are but two." As we look forward, the details of the next problem that will be covered by the taxpayer aren't clear. Look for misalignments of incentives and rewards that compensate greater than the risk taken. While you're doing that, get out your checkbook. This one is going to sting a bit.

Signs of the Times

In a recent survey by the AARP, they found the following startling information:

• 4 of 10 parents over 45 have had to help their kids with their bills
• 33% of retirees have had to help their kids with their bills and have stopped putting money into their retirement account.
• 14% have cut back on medications.
• 60% said they had to cut back on eating out and entertainment.
• 25% are in trouble with the mortgage or rent

There may be some issues with the validity of the number due to the survey instrument and such, but even so, these numbers would be a far better sign of the times than GDP, CPI, etc. Sure people are making it, but not by as much as macroeconomic indicators would show if these are even close to right.

But the better question here is what baseline did we start with. For example, how many of the people that are cutting back on eating out and entertainment were living beyond their means to begin with thinking that their house would go up in price forever? Or how many that are in trouble with their mortgage bought too much house in the first place? Or how many that have stopped putting money into their retirement account have plenty of money in there already? After all this was a survey by the American Association of Retired Persons.

What can we learn from this?

It’s always dangerous to accept numbers at first glance because the press is only giving us the sensational details to get our attention. But that doesn’t mean the numbers should be dismissed either. These stats are signs of the times, even if we can’t accept the actual numbers and need more data to verify their validity.

Also, if you haven’t received any money from your parents recently, feel free to use this article to say that it’s now commonplace. They probably won’t doubt the statistics like I do. :-)

Gross and Greenspan’s Long Term View

Both Bill Gross, the bond king, and Alan Greenspan, the former Fed Chair, said that it's a long road to a housing recovery and I couldn't agree more.

Gross said, the downward path of home prices "will dominate Fed policy over the next several years as will the lingering unwind of related financial structures and derivatives that have yet to be discovered by the public, and marked to market by their conduit holders," and Greenspan said, "All that I conclude is that the process of inventory adjustment has just started and we have a long way to go before residential housing and mortgage markets stabilize in the U.S."

If these two agree that this will take years, who am I to argue?

Greenspan went on to say the obvious that this is going to be bad for our economy. It's my opinion that if we don't panic, we can get through this just fine. Unlike the dot com stocks, housing has a real value. If we overpaid and some people have to take a hit, that's not good, but at least there is something standing at the end of the day, unlike dot coms that are totally vapor. In other words, housing can't go to zero, individual stocks can. So we have to adjust inventory by reducing prices and unless you are moving in the near future, this shouldn't have any impact on you. The tricky thing is that human nature being what it is, we will all feel poor and that may impact our spending habits and therefore the economy. So hopefully, while it obvious to us that this will be bad for the economy, let's hope no one else notices.

And You Wonder Why We Have Problems

In the subprime debacle there is plenty of blame to go around, but as usual, a systemic problem must exist for the problem to become this big. There are only a few credit rating agencies, notably Moody's and S&P, and all of them failed to sound the alarm in this situation. So what happened? Here's a couple ideas garnered from today's FT:

Ratings agencies don't have data for the new types of loans and relying on past traditional loan data didn't/doesn't work. For example, with a traditional loan with 20% down, there are almost no delinquincies or defaults in the first year, but with nothing down, it was astonishingly easy to walk away quickly, sometimes in the first month or two. Another example is found in which bills homeonwers paid first, typically forstalling everything for the mortgage, but now some pay credit card bills first. That's not predictable from past data.

Another major difference is that the ratings agencies don't do any due diligence as they rely on the underwriters for such. Apparently, they aren't required to do due diligence beyond that by law. Ratings agencies relied on the information provided by the underwriter and didn't check it out for themselves? Well, if you were looking for the systemic problem, that's it right there. They don't have to look beyond what the underwriter tells them? Really? Are you kidding me? So what are they doing for their money? Anything more that rubber stamping a deal? That's like the movie critic only asking the producer about the quality of the movie or the resturant critic just talking to the cook about the food. Doesn't an entity that is called a rating agency have to see the movie and eat the food, or can they just write about what others have seen and done? That can't be right, but as usual, we shouldn't be surprised at anything lawmakers or Wall St. does. The olive in the martini here is that they didn't even look at debt to income ratio even though it's one of the top three predictors of default. Now I really need a drink.

There were other things including fraud in mortgage origination, lower underwriting standards, complex and exotic loans packaged into even more complex securities. All sound like reasonable responses. But there's one thing that no one will bring up about these rating agencies. They knew. The must have known. They are full of smart people that do this for a living and not doing due diligence must have twisted some of them into a knot as they had to know that this was going to be a problem.

There is a simple explanation for why this happened. The risk was mispriced. It's that simple. If the risk was priced correctly, this wouldn't have happened as the ratings of the securities would have clearly indicated the high probability of default and the market wouldn't have kept buying the debt thus stopping the paper from being pushed through the system. Same could be said for the dot com bomb. People felt there wasn't any risk and so they paid hundreds of dollars for a stock worth pennies. They mispriced the risk then, and they mispriced the risk this time too. And like the analysts that said worthless tech stocks were worth millions, the rating agencies here gave everyone the wrong information. Was it as obviously biased, no. But it's still a systemic problem that needs to be fixed or it will happen again. And even now that we have been though this and they now have data and experience in dealing with exotic loans, and we know that this is wrong and will cause a problem anyone want to bet me that we fail to fix the system?

And you wonder why we have problems?

Is it Too Early To Get Back Into Housing?

A good friend of mine passed me at the turn today and said he just bought a condo in Las Vegas. To his credit he doesn't feel that he got in at the very bottom, but the deal look good, so he went for it. What's a few percent when you can get a view of the strip? Plus this diversifies his holdings further and provides an income stream. So why not?

The details went something like this, originally sold for over $500k, back on the market for $330K, he got it for $270k all cash, close in a week. So for about a quarter million he got a condo on the south strip with a view. The rental income is about $1200 - $1500 and so the yearly return is around 6% annually gross, under 5% net, but I don't have specific numbers. Not bad. But not the steal of a lifetime either. So should we wait?

There are several things to consider. First is that somebody paid twice what the market is now at. Ouch! That like a 50% drop in price and more than I originally projected at 40% down in the hot areas. (Who knew 40% would be low balling it?) How much lower could it go? Second, cash is king as the discount was substantial when it was an option. So there is still weakness to be had. Third, if your view of equities is poor and you need some diversification, there are some reasonable deals available, but still not a screaming deal of the century. Fourth, the market in those hot areas is really quite weak, more than the national numbers show. They, like most markets, will likely overreact on the downside, but may take some period of time to recover. Of course, this thread all started with anecdotal evidence and so could be total hogwash.

The fundamental question for someone looking to speculate in real estate is: Are we at the bottom or so close it's time to jump in? I still have to say no. There are too many adjustable rate loans out there and the fed cut doesn't help them enough to offset their plight. Buying a house to live in is always a good idea. Buying for speculation is a different matter and I wouldn't jump in here. But that begs the question...

What would I do? If I had a brain, I would start a hedge fund and collect money so that when the bottom did come, I would have the cash to get in deep. There must be dozens of these already, as the opportunity seems obvious. However, it's still risky as picking a bottom with highly leveraged assets like real estate isn't for the faint of heart. On second thought I do have a brain, it must be something else I lack.