Moving to Higher Ground

A major earthquake, in the form of the sub-prime mortgage crisis, has unleashed a tsunami that will engulf most residential housing markets and have significant repercussions for the economy in general.

One big cause of the disturbance can be traced back to financial engineering, in the form of exotic mortgage backed securities and E Z credit terms. This allowed marginal and unqualified consumers to buy homes, by artificially lowering the initial costs of ownership. The trap is that these consumers, like most home buyers, were convinced that ever-increasing home values would allow them to keep their payments low by refinancing (for awhile it worked).

Add to the story other problem factors along the economic fault line: real estate speculators; some good old fashioned fraud; the ever sunny disposition of the real estate sales professional; a flawed appraisal process; and a bulging builder inventories. Squeeze this all together, and you’ve got the seismic pressure for a Financial Panic.

One result is that a massive credit crunch in the home mortgage market is under way. Such a “credit crunch” occurs when investors who buy home loans decide not to invest in these loans because too many borrowers are not paying them back. The “crunch” is a fancy way of saying that would-be home buyers aren’t going to find someone to lend them the money to buy a home. (This doesn’t make sellers very happy, either.)

A further reason for concern is that there is far too much complacency on Wall Street regarding the broader economic implications of the mortgage lending debacle.

As this is being written, I have begun selling stocks in client portfolios in order to reduce our exposure to what I believe will be a very frightening economic environment for the unprepared.

My current evaluation has been fueled by a careful following of recent developments in the real estate securities markets and the real estate markets. To begin with, what is coming will be worse than the dot com debacle that began this decade. Interestingly, it’s been brought to you by many of the same people although this time the banks got in on it too. Lending institutions have a long history of being at the epicenter of financial crises and many were left on the sidelines in the dot com / accounting fraud episode.

Second, we are in the early stages of a housing debacle that will produce significant losses (10 to 30% or more in some cases) in home values for most Americans. Many of those who have 30% equity or less will see most if not all of it wiped out.

Third, until now, a bad real estate market has been a more localized experience. In this cycle, the housing markets will be more correlated than ever before. Among the reasons for the change:

  • Industry wide use of standardized, yet faulty, lending assumptions. These assumptions are based on historical relationships between consumer credit scores, default and recovery rates that are found in mathematical models of default risk used to securitize mortgage loans.
  • Lack of financial and capital constraints in terms of lending capacity for a geographic region. Evaporation of moral obligation in the pursuit of more lending business. In other words, the loans were going to anonymous investors rather than being housed in community financial institutions. Corporate addiction to “growth” and Wall Street pressure for ever-increasing earnings, which could only be obtained by compromising loan quality.
  • Outsourcing of mortgage origination to independent mortgage brokers whose income was entirely dependent on their ability to say ‘yes’ to borrowers.
  • Synchronized home builder actions including inventory build up due to national home builders acting on the same metrics to make development decisions. Small builders followed their lead.
  • Pressure on appraisal firms to be a ‘good partner’ in enabling the home purchase to proceed.
  • Near universal misinterpretation of projected housing demand as qualified homeownership demand. It’s like saying that the demand for transportation to work is the same as the demand for a Lexus.
  • A higher degree of real estate speculation and fraud in this cycle vs. past housing cycles.
Forecast for the next year   
With all of these factors in place, a clearer picture is emerging over what can be expected next year in (1) the economic picture, (2) real estate, and (3) a prudent investment strategy.

Overall, it’s not a pretty picture, with better than 50/50 odds that there will be a recession. Even gloomier, the odds of a depression are something like 5 to 15 percent. And the odds of it feeling like a depression are, for many, over 50 percent, especially if you were employed in a real estate related field.

Taking a look first in the economic arena, lower interest rates (the magic elixir that spawned this mess) will not rescue the housing market. As it becomes obvious that lower rates won’t prevent the home buyer from losing a big chuck of their equity to downward price pressures, prospective home buyers will decide to wait and wait and wait and then sit tight. For qualified home ownership, negative demand probably exists already (although desire remains intact). This is because lending institutions and Wall Street teamed up to provide mortgages to people that were never qualified to own a home and thus encouraged home speculation. What follows is that unemployment in industries related to real estate will rise rapidly and then ripple out into the broader economy.

    In short, the American Dream becomes a nightmare, with profound psychological damage to consumers’ misguided expectation that a home is a sure-bet investment. On a broader front, consumer purchases, which make up two-thirds of the economy, will be negatively impacted.  And in the stock market, a decline of 1,000 points on the Dow Jones Industrial Averages in a single day would not be surprising. (Dow is currently around 13,000)

Real Estate Buyer and Seller Outlook
Look for that species of “trade up” home buyers to become nearly extinct, while “trade down” buyers multiply. A new species of locked out home owners (those who can’t move because they have so little or negative equity left) will emerge, while a sub-species of Own to Rent (the opposite of Rent to Own) consumer will appear. Meanwhile, “There goes my retirement” will be a common refrain from the many Americans who have counted on their home equity as a source of retirement capital.

From knowing friends, neighbors or relatives who lost their home, the inclination to spend money freely (for those that have it) will become very uncomfortable. Contributing to the downbeat attitude will be increasing unemployment, while “home for sale” signs sprout like mushrooms after a rain. For many neighborhoods, foreclosure prices will be setting the “comps.” Even those real estate “investors” who get in early on foreclosure buys will become victims of further eroding prices. On the construction end, condo / townhome builders will be particularly hard hit as buyers back out and all the condo developer’s inventory comes to market at one time. Historically, condo / townhome owners have always been among the hardest hit in real estate downturns.