San Diego Housing Bubble News and Analysis

The recent announcement by FNMA, that (subject to criteria) lenders would take title to property from delinquent occupant-borrowers and lease back to them, is extraordinary, to say the least.

The last thing any lender wants to do is become an on-going landlord, becoming involved in issues of upkeep and liability for extended periods. This is definite proof of what some have asserted for some time, that there is an organized, aggressive plan to prevent properties with defaulted loans from proceeding through foreclosure. Lenders would not join this plan without a promise from the Federal government of eventual rescue.

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If you are a future home buyer, it is attractive to assume that the "investors" who lost money to the real estate bubble Ponzi scheme are all large banks and private equity funds. But that is not the case. Ponzi scheme losers include those who held MBS directly, and those who bought ownership shares in MBS-holders (stock companies, mutual funds). The list is long, and includes the following:
individuals directly
individual retirement accounts
union retirement funds
corporate retirement funds
state and local government retirement funds
insurance companies (investing premium revenue)
state governments (tax revenue holding accounts)
county governments (tax revenue holding accounts)
city governments (tax revenue holding accounts)
school districts (tax revenue holding accounts)
foreign governments

Decision makers planning the Federal response had to choose between two options:
1. Favoring future home buyers.
2. Favoring those who lost money to the real estate bubble Ponzi scheme.
They decided to favor those who lost money to the Ponzi scheme.

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Elements of the Federal plan:

1. Using "printed" money, Federal Reserve buys over $1 trillion worth of agency MBS.

2. Using "printed" money, Federal Reserve drives mortgage interest rates to 40-year lows.

3. FHA defines the price of single family houses as
"whatever the rental rate will buy at these low interest rates".

4. FHA guarantees loans in unlimited volume at these prices.

5. Tax credit for owner-occupant buyers allows maximum number to get in on the FHA loan action.

6. Federal Reserve and other loan owners instruct servicers to go slow on foreclosures and REO's.

7. Short sales and REO sales using FHA loans gradually pay off "really bad loans" at a much higher percentage of par value than would have been the case in a free market without intervention.

8. When the "really bad loans" problem is mitigated sufficiently, interest rates will be allowed to rise to more natural levels, and house prices will fall accordingly.

9. Upside down FHA borrowers will find no relief from bailing out of their loans, because the rent for similar housing will not be significantly less than their net carrying cost to continue.

10. There will be significant losses to FHA when FHA borrowers cannot continue due to loss of employment, forced relocation, illness, etc (known and accepted in advance by the decision makers).

Expanded discussion of selected line items follows.

1. The Federal Reserve is using "printed" money to buy agency MBS.

http://newyorkfed.org/markets/mbs/

This grants some level of relief from impaired MBS values to whomever the Federal Reserve buys from. Since the Federal Reserve is not subject to external audit, and reveals only what it chooses to, it is unknown to the general public from whom they are buying, and at what percentage of par value they are buying. In making these purchases, the Federal Reserve wields great power, choosing how much value is recovered by what entities.

If the selling organization is a bank affected by reserve requirements, their reserve position is immediately improved. The Wall Street Journal recently reported that some banks were putting the proceeds of sales to the Federal Reserve into GNMA securities. GNMA securities are government guaranteed, and consequently require no reserves behind them. This 3-party scheme would kill two birds with one stone, improving the bank's books and providing more money for funding of FHA loans (which is where most of the money used to purchase GNMA securities comes to rest).

3. I predict that the FHA will approve any deal in which the purchase price and current interest rate combine to yield a net borrower carrying cost that is similar to fair rental price for the single-family property.

Net borrower carrying cost is:
principal + interest + property taxes + hazard insurance + mortgage insurance - income tax benefit from housing deductions.

They will do this knowing that property values will decline significantly in the long run. When the property value declines, and the new borrower is upside down, the renting alternative will not provide significant relief, and there will be a much greater tendency for the borrower to stay the course, by whatever means are available.

In San Diego, for a 1200 square foot 3 bedroom house in Clairemont, late 2005 prices ($540K) were around triple the early 1998 prices ($180K). For that house, with interest rates at 5%, the price would settle in the short term in the vicinity of $400K, rather than the $270K or less which would be the price if the market had proceeded without subsidies or Ponzi scheme.

4. Note that FHA loans are not funded with government money. Mortgage brokers fund loans from money at their disposal from various sources. Loans conforming to the rules are guaranteed by FHA. Authorized packagers then assemble the FHA-guaranteed loans into GNMA securities. The GNMA securities are sold to all comers. The securities are marked up to pay for packaging and servicing costs. The bulk of the GNMA securities sale proceeds find their way back to the mortgage brokers to fund more loans. Only FHA losses are funded by taxpayers, the original loan money comes from the public market.

6. Foreclosures may be forced to continue for homes where loan ownership is fragmented due to complicated MBS contract provisions.

For homes where the ownership of the loan is not fragmented, and the home is still borrower-occupied, foreclosures may be put on hold, waiting for the flood of new-buyer FHA loans to raise/hold home prices, and to replace the really bad existing loans with less bad FHA loans.

7. Note that when properties are sold, the Federal Reserve will be a recipient of payoffs for some portion of the loans it bought. It would sure be interesting to know the buying parameters. Is the Federal Reserve buying low to make a profit, buying high to help the seller, or trying to predict the future payoff to break even?

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Why is any of this interesting? Because understanding the plan, whether you like the plan or not, can help you choose your individual best path to the future. If you agree with the preceding analysis, then you will be guided by what follows.

A. In the short run, prices for "sufficient, nothing special" single-family residential real estate will rapidly adjust to a point where the net monthly carrying cost (as defined above) is similar to rent. At the current artificially low interest rate, this may calculate to a minor price increase.

B. Higher tier communities/properties will eventually adjust to traditional ratios as compared to the entry level housing.

C. Near-term price increases are not an indication of a new bull market for real estate. In the long run real estate prices will fall back to their 1998 REAL levels. This means 1998 dollar prices adjusted for true inflation, which is normally a few percentage points per year. However, the Federal response to this problem may cause inflation to be higher in coming years.

D. The pace of future price declines will be governed by the pace of interest rate increases. In setting interest rates, the Federal response must consider other factors outside the housing market. Gradual change will be the goal, but other forces may overrule (e. g., if major players around the world start balking at buying U. S. Government debt).

The Federal response has driven real estate interest rates to artificial 40-year lows. Go to finance.yahoo.com to view the 50-year graph of 10-year Treasury yield.

http://finance.yahoo.com/echarts?s=^TNX#chart2:symbol=^tnx;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

Mortgage rate ups and downs generally follow 10-year Treasury ups and downs. You can expect mortgage rates to be 1.5 to 2.0 percent higher than 10-year Treasury yield when the mortgage market returns to normal (i. e., everything is not guaranteed by the government). I predict mortgage interest rates not below 7.5%, 8.5% more likely, when the market returns to unsubsidized long-term stability. It is left to individual speculation if/when the unsubsidized part will happen.

If you:
are a no-down payment buyer,
are buying at a price that yields net carrying cost similar to rent,
look forward to good health,
feel secure against job loss or transfer out-of-area,
are buying a house you will be satisfied with for the indefinite future,
you can buy at any time.

Future price will go down only as interest rate goes up and total net carrying cost for a no-down-payment borrower will not change that much. You should not expect to be able to buy more by waiting.

Anybody else will be putting their down payment at risk for quite a few years. Individual circumstances will determine what amount of down payment may be risked to get the "right" house "now", without threatening long-term financial health.