Surviving the Bubble

Special Offer to Doug Fabian Followers

Welcome Doug Fabian Followers,

As a listener of Doug Fabian’s you are well aware of the need to manage your assets and protect yourself from downside risk.  Today’s real estate market presents a real threat to the wealth of homeowners with risky financing. 

Unfortunately, the last few years have seen a huge upswing in the sales of risky mortgages.  These loans, featuring adjustable rates, interest only and negative amortization payments can lead to huge increases in debt loads and potentially foreclosure.

You can take the first step to protecting yourself today by getting a free Mortgage Risk Analysis.

STEP 1:  Compete and return the attached Risk Analysis Worksheet along with copies of your current mortgage statements.  This will give me the information I need to determine exactly what loans you have and how much risk you are exposed to. 

STEP 2:  I will run comparable sales to assess the value of your home, check the index that your mortgage is tied to and measure and quantify the potential payment increases in your future.

STEP 3:  We will have an in depth telephone consultation to discuss your situation and the possible benefits of repositioning your financing for greater security.

To get started today, download the risk_analysis_worksheet.doc and return it to my office via email or fax.

I look forward to helping you chart the course to a prosperous future.

Sincerely,

Josh Lewis

Mortgage Planner

VP Consumer Direct Lending

Stearns Lending

When is A Home Overvalued? There’s a New Way to Learn

The Charlotte Observer – 10.22.2005

This article highlights a study conducted by PMI, the mortgage insurer and their recent findings on valuing property.  Their index tracks a home’s historical price appreciation values and how current home values are deviating from the norm.

It turns out that several dozen cities are overvalued according to PMI's valuation method. In fact, some areas are dramatically overvalued. Los Angeles, for example, is overvalued by nearly 34% according to the study. Las Vegas is 26% overvalued. San Diego homes are overpriced by 22%. San Jose is overvalued by 27% and Miami is overpriced by nearly 20%.

The article goes on to quantify the risk of a dramatic housing decline in certain communities. Los Angeles has a 46% probability of a significant market decline in the next 24 months while San Diego and Boston have nearly a 60% chance of decline.

The article’s advice mirrors what we have been saying. For buyers, push hard for price concessions as you may be buying at the end of the appreciation cycle and could end up with a house worth less than what you paid for it. For sellers, you may not be able to sell for the price you thought you and the price is likely to go down from here. If you want to sell, price your home reasonably to avoid larger price cuts later to move the property.

California Mortgage Defaults Rise for the First Time in 3 Years

LA Times - 10.28.05

Well, the tide is definitely turning as mortgage defaults, the bulk of which were sent to Southern California addresses, rose for the first time in 3 years.

Analysts credit the rise in defaults to a slowdown in prices and riskier loans which spell trouble for holders who depend on a rising market to lift them out of those mortgages.

Default notices were sent to nearly 13,000 homes during the quarter ending in September—that’s up over 3.5% from last year. 

Default notices can lead to foreclosures, in which owners lose their homes due to missed or late payments. Until now, financially troubled homeowners have been able to easily work through their hardship because the rising values in real estate made those homes easily sellable. Not anymore.

While the number of defaults is just a fraction of the state’s 17 million residences, it is a clear indication of a slowdown. As foreclosures continue to rise while the housing market flattens or dips, more homeowners will find themselves in a tough spot, having to put their homes up for sale at a discount in order to sell the property in a down market.

This slow downward spiral will affect the entire market, just as the buy at any costs mania pushed prices rapidly higher. 

If you have a dangerous loan you must consider refinancing while rates are still relatively low and lending guidelines easy.  If you plan to sell in the next 1-3 years you should consider doing so in the next 6-9 months before the downturn gains momentum.

Economists outline risks to housing market

Marketwatch - 10.13.05

A solid article by Marketwatch points out several of the things Doug and I have been saying for the last year.

The average U.S. home price is roughly 3.1 times the average household income, the highest in history and up from an average of 2.6 times since 1960, according to a recent report by Standard & Poor's. Driven by low mortgage rates and looser lending standards, home-ownership levels of 69.4% are also at an all-time high.

We need to ask why home prices would grow to 3.1 times income and the answer is fairly simple, low rates followed by interest only and negative amortization loans.  The more important measure is the percentage of household income going to the mortgage payment.  While this has climbed, that climb has been muted by alternative mortgages.  When rates climb the market will slow, in a slower market there will be less pressure on people to buy homes at all costs taking on the risks of these alternative mortgages.  Add it up and there is an excellent chance that the multiple in question reverts to the mean of 2.6 over the next 7-10 years through a combination of falling home values and increasing incomes.

Lastly, Mark Zandi makes a great point that the real estate market moves at a glacier's pace.  We may be hearing the first cracks in the glacier but it will still be a while before the glacier actually starts to split up and disintegrate.

Mark Zandi, president of Economy.com, warned that rising interest rates, the growing use of exotic mortgage products, and an overvalued housing market could result in falling prices in around a quarter of U.S. metropolitan housing areas by late next year or early 2007.

Pop Goes the Real Estate Bubble?

The Nation, 10-5-05 Pop Goes the Real Estate Bubble

This article explains why “The Big One”—as in major apocalyptic threat—is not the much-feared earthquake that some say could level much of California, or another hurricane along the lines of Katrina, but rather the pop of the real estate bubble.

Citing the recent news that Manhattan has suffered a whopping 13% drop in just 3 months and San Francisco and Boston are following close behind, this article states that the bursting is inevitable regardless of interest rates because people have extracted massive amounts of equity and spent $600 billion —twice the amount of Bush’s sweeping tax cuts and it accounts for 7% of spendable income—a mighty big chunk of money. Those homeowners have nothing to show for their spendthrift ways but massive debt; debt they are sooner or later going to have to extricate themselves from. Such extrication will involve what the writer refers to as a “landslide brought on by innocents.”

An International Perspective

Bloomberg, 10-13-05, Housing Bubble Threatens Global Economic Growth, Bootle Says

For an international perspective:

Famed British Economist, Roger Bootle echoes our views on the bursting of the housing bubble creating a massive economic slowdown and recession. In fact, Bootle’s remarks describe not just a domestic slowdown, but one that will span the globe. And he goes on to say that when the bubble bursts, “the world will tremble.”

More evidence against the pseudo-experts who continue to challenge our theory of a national slowdown that will result in a recession. This article parallels our premise as it lays out Bootle’s argument for global economic recession declaring that as the housing boom comes to an end, people will pare spending and layoffs will ensue. 

Bootle describes the economic condition transpiring now in Great Britain, whose housing market is preceding the decline in the U.S.. There, an economic slowdown has ensued and the national bank is expected to begin cutting interest rates to stimulate spending—an effort to ward off economic recession ala Germany and Japan. Japan has seen 4 economic recessions since 1991. Europe’s economy grew at a paltry .3% as Germany, that union’s largest economy stagnated last year when housing values declined.

Bootle goes on to say that the US real estate is following closely the market in Great Britain which saw a 15% increase in real estate values last year followed by a 2% decline year to date.

Housing Tax Breaks on the Chopping Block?

LA Times - 10.8.2005 - Tax Reformers Eye Breaks for Housing

This article rightfully calls the mortgage tax deduction a "sacred cow" and there is virtually no chance of it being eliminated.  However, there is a very good chance that the deduction for second homes and home equity borrowing could be reduced or eliminated.  This would have a huge impact on the economy in general and the housing market specifically. 

In the last 5 years many baby boomers have begun buying second homes that will eventually be used to retire in.  This increased demand would be significantly dampened if the tax deductibility of the 2nd home was eliminated.

With a policy change this significant, there is no need to worry about changes coming soon, but this is definitely an issue that bears watching.

Homeowners Confident, MBA's Doubtful

RE Journal - 9.30.2005 - Poll Shows Homeowners Expect Continued Price Increases
NY Post - 9.20.05 - MBA's Doubt Real Estate

Two quick pieces here expressing vastly different opinions.  Homeowners, with nearly a decade of rapid appreciation behind them are expecting continued price increases.  At the same time, MBA's from Dartmouth, having studied markets and investor behavior, are increasingly wary at the prospects for continued appreciation.

The Journal piece reminds me of one of my favorite visuals regarding market psychology and I want to share it here to start a discussion:

   

This chart was created by Dr. Chris Cagan, Chief Economist of First American Real Estate Services.  We'll discuss this in future posts but pay special attention to the "bubble psychology" area of the chart.  Consumers have shown time and again that they wrongly assume the current trend will extend into the future.  Hence, at the end of an uptrend consumers are their most positive and aggressive when they should actually be wary and defensive.  Food for thought.

CA Affordability Reaches Record Low

CA Affordability Reaches Record Low, $133,000/yr Income Needed to Buy Median Priced Home

The housing affordability index (HAI) for California has tied it's record low set in 1989.  Currently only 14% of Californian's can afford to purchase the median priced home in the state which now costs $568,890.  This is an extremely telling piece of data in that July of 1989 represented the peak for California housing before seven year bear market took hold. 

In July of 1989, the median priced home in California reached $201,653.  Ignoring a brief 5 month span in 1991 when prices crept just above that level, home values would not move higher until May of 1998 almost 9 years later.

Experts and economists on the no bubble side of the debate will point to the fact that the California economy went through a period of great suffering and the housing market fallout was a natural by product.  This time the market is different because our economy is solid and there is a glut of demand for a limited supply of homes in the state.  The affordability issue takes the air out of this argument.  If only 14% of people are able to afford homes, there will not be sufficient "able" demand to push prices higher.

A more important difference between the current market and 1989 is the use of adjustable rate and "gimmick" loans.  Adjustable rates were used at that time to combat low affordability brought on by high prices AND high rates.  We currently have record low rates and people are still turning to ARM's for the slight advantage they offer in terms of lower payments in the short run.

Since the HAI is calculated using a 20% down payment (which is only used by move up buyers who have built equity in a previous residence), a 30 year fixed rate and a maximum debt ration of 25% this understates the current percentage of Californian's who are able to buy homes.  As lenders have gotten more aggressive, you can borrow with a payment as high as 55% of your income using an interest only loan or even negative amortization.  Further, with a good credit score you can state your income so the ratios are irrelevant.

Such loose lending has caused the current overpriced state of housing.  People now buy homes like cars, based on payments.  Unfortunately, unlike cars, your obligation is for 30-40 years instead of 3-6.  Also, adjustable rates will rise taking the "affordable payment" you qualified with well beyond the comfort zone for many of the more recent home buyers. 

In 2006 $82 billion dollars of loans will reset to market rates as their fixed period ends.  At this time, the Fed seems intent on raising rates another .75% at a minimum.  Short term indices such as the LIBOR, which most hybrid ARM's and interest only loans are based on will rise a similar amount.  If 10% of the people holding those $82 billion of loans can't afford that new higher payment we will be looking at $8.2 billion of mortgages worth of homes coming on to the market in the form of quick sales or foreclosures.

When you consider that the entire mortgage market currently exceeds $10 trillion this amount is not significant and can easily be absorbed by the market without a significant hit to prices.  BUT, in 2007 a full $1 trillion of mortgages adjust to market rates.  Again assuming only 10% of the mortgage holders are not capable of handling the new payments, you have $100 billion dollars of mortgage debt secured homes coming onto the market.  This will certainly have a negative impact on the housing markets, especially since the majority of the hybrid ARM's, option ARM's and interest only loans are in higher priced, bubble markets.

We fully expect 2006 to look much like 1990 and 1991 did; essentially flat as the market begins it's transition.  However 2007 will be the year that we start to see falling prices.  Prepare now while fixed rates are good, lending terms are easy and equity is still abundant.

More Lenders Tighten Standards

WSJ - 9.29.05 - Lenders Tighten Credit Standards

As far back as February of this year at the KLSX Real Estate Summit, Doug and I have been warning consumers that as the housing market slows lending guidelines are going to stiffen.  This article is more confirmation that major banks are starting to tighten lending standards on mortgage money-especially the riskier loans that have fueled the speculative excesses. Determined to reduce the number and improve the quality of riskier option ARM loans, Washington Mutual is raising the qualifying standards and increasing the margins for those loans. After the teaser rate has expired, borrowers must qualify for an interest rate payment of 6% to 6.25%--up an entire point from 5.25%.

Countrywide, Downey, H&R Block and New Century financial are among a handful of lenders who have begun tightening the reins on easy money. It's only a matter of time before other mortgage lenders follow their lead.

In addition to tighter guidelines, rising short-term interest rates have made option ARM loans less attractive to borrowers. The payment difference between a fixed rate loan and option ARMs is currently less than half of a percent.  Borrowers are rightfully concluding that that is too small of a discount to justify exposing themselves to the risks of a monthly variable interest rate and the potential for negative amortization.   

The bottom line:

1. Homeowners are going to find it harder to borrow themselves out of trouble as lending guidelines tighten and equity doesn't build up as fast, or disappears altogether(NY Times - 10.2.05 - My House, My Piggy Bank).
2. Without easy money, home sales will slow. If lenders won't qualify as many borrowers, the "able" demand for homes will shrink, limiting price pressures.
3. Look for a wave of foreclosures beginning in 2007 when $1 trillion in mortgages will adjust to market terms from their current introductory or teaser rates (LA Business Journal - 10.3.05).

Investors, homeowners with little or no equity and risky mortgage holders have a decision to make and time is growing short. We strongly advise a fixed payment or get out from under the home if you can't afford the payment at a fixed rate.