Guest Comentary: Ramsey on the Search for the Illusive Bottom

Longtime piggs will recognize the name of one Ramsey Su, a former REO broker who enjoys lengthy excursions into the data rathole. Ramsey has kindly agreed to let me post his latest analysis here (this includes the original piece followed by a clarification/update).

If you like this one, click here for Ramsey’s previous postings. This one in particular, written back in February 2007, was particularly prescient and remains one of the most widely visited articles in Piggington history.

PS — Yes, it’s supposed to be "illusive" as in "illusory," as opposed to "elusive." And yes, I had to look up "illusive."

In Search of the Illusive Bottom
Ramsey Su
September 2008

So much has been done to fix the real estate crisis, including the historic bail out of the agencies, then why is there still a lack of visibility?  Shouldn’t it be obvious that we are or already beyond the bottom?

As usual, instead of guessing, I prefer to do some analysis and let the numbers do the talking.  Here is what I think is happening.

The housing bubble was inflated by the credit bubble resulting in a nationwide indiscriminate appreciation.  The credit bubble is a combination of low rates with the simultaneous removal of underwriting standards.  As the market corrects, fundamentals such as regional demographics, affordability and supply/demand imbalances come into play.  In addition, economic conditions such as change in employment affect different regions unevenly.    Therefore, unless the “bottom” is narrowly defined, there is no such thing. 

To illustrate, I did a detailed analysis of a micro market.  The results are quite surprising.  As an added bonus, this analysis is perfectly timed to measure the potential impact of the GSE bailout.

The Sample.  I used only 4 bedroom single family residences that were built during 2000 or newer in one zip code in the southern part of San Diego.  This is about as homogenous of a sample as you can find.  I could have added all bedroom counts to provide a larger sample size but I am confident that it would not change my findings.     

The results of this study were surprisingly informative.  Here is the meat:

Inventory.  The raw numbers suggested that the sample is selling at 5 units per month.  With 55 listings, this would be reported as an 11-months inventory.  In reality, 14 REOs will sell very quickly, mostly likely with multiple offers.  39 short sales will have to overcome multiple hurdles, some of them are most likely tomorrow’s REOs.  Normal listings will not come on the market unless absolutely necessary.  That is why the inventory as reported by NAR is totally meaningless.  For this zip code, bank owned or bank controlled properties is the inventory.  There is no normal market.  No one knows how many sellers are waiting to sell if the market recovers.  Instead of watching the total listings, we need to watch the number of REOs and SSs to determine the internal health of this market.

Lesson learned here is the “inventory” number in itself is almost totally useless.  A healthy signal in this micro market would require a combination of an increase of normal listings, a decrease of REO/SS and an increase in asking price, supported by an increase in pendings.  It is possible that an increase in inventory may actually be a positive sign.  (vice versa for declining market)

Price Decline.  This is one major benefit of having such a homogeneous sample.  I can compare prices on a $/sf basis knowing that I am comparing apples to apples. 

                Active listings (using asking price)    $181/sf

                Pendings (using asking price)           $176/sf

                Solds (all sales in sample, 6 months)   $181/sf

This is a great advance indicator that should be easy to track in the future.  I can spot changes by tracking new listings and list price.  Under appreciating market conditions, active listings should be higher than pendings, followed by the solds.  The sold price of the pendings is not disclosed till escrow closes but for the current sample, the asking price is already lower, almost assuring that this batch of sales will show a decline.  The active listings typically include unrealistically priced properties averaged in the price and should be higher even under flat conditions.  That also shows no sign of appreciation.

Using the same criteria, I downloaded the 2006 sales. 

                # sold  Avg $/sf nod/not  reo      CLTV   
   Q1      2006    10      281     1       3       95.6%  
   Q2      2006    17      293     2       2       89.9%  
   Q3      2006    11      295     2       2       95.6%  
   Q4      2006    12      285     2       1       94.6%  
           Total   50      289     7       8       93.9%  

There were 50 sales for that year.  Notices of default or trustee’s sale are currently filed against 7 of those sales.  8 have already been foreclosed.  Not known is how many may be currently delinquent.  The average $/sf has declined 37% from $289 in 2006 to $181 today.

Financing – 2006 sales.  The average CLTV was 93.9%.  60% of the transactions had CLTV of 95% or higher.  None were VA or FHA loans.  Only 8 or 16% did not have a second lien.  25, or half, were 100% CLTV or higher.  I cannot determine the percentage of owner occupancy due to changes that had already occurred.

Financing – today. The average CLTV for the sales during the last six months was 85%.  None had second liens.  There were 3 VA loans and 5 FHA loans.  Without those loans, the CLTV would have been 81%.  There were 3 transactions that appeared to be all cash with no loans records.  I eliminated them from the average CLTV calculations.  If they are indeed all cash transactions, the average would be even lower.  Only two showed mailing addresses different from property address, suggesting almost all were owner occupancy sales.

Buyer Profile.  That was a “beautiful” group of buyers who bought the 30 homes in the sample during the last six months, especially when compared to the buyers of 2006.  This would be wildly bullish if they represent the available pool of buyers on the sidelines.  Based on my experience, I think this is an exceptionally strong pool and does not reflect the typical buyer profile for this area.  Going forward, this will be a great indicator.  Specifically, I would be looking for more FHA or lower down conforming loans as a sign of health.

Negative Equity.  This is the biggest problem. Forget about percentage, these houses are sitting on loans that average around $200,000 over current market value.  For this neighborhood, that could easily be 2 years of household gross income.  Negative equity is the biggest difference between this cycle and previous cycles.  During previous down cycles in residential real estate, time cured all.  The market simply went dormant until conditions improved.  With so much negative equity this round, especially in the hands of households that cannot afford to make the payments, waiting is not an option.  There are three possible outcomes:

Reflate property value – this would be great if not for two obstacles.  One, it would not address the affordability issue.  These loans were underwritten with no regards for ability to pay and an inflated would only allow the current borrowers to sell, not hold.  If they are to sell, who can afford to buy?  Two, re-inflating would take us right back to the bubble scenario that led us here in the first place and that is assuming we have the ability to re-inflate.

Extreme Work outs – basically, write down all loans indiscriminately to the level that the borrowers can afford, aka the Sheila Bair Plan.  This can be accomplished by lowering payments, with or without writing down the loans to current values.  The biggest problem with this scenario is cost and it will encourage every marginal borrower to default.

Transfer from weak hands to strong hands – this is essentially the foreclosure process that we are observing.  REOs that had been resold are now owned by new buyers who bought at a reasonable price with a financing package that they qualified for.  Even though many might have bought too early and now watch in dismay further decline in value, they are unlikely going to default.  In my opinion, this is the free market correction process.  Foreclosures are good.  Stop trying to prevent it.  Give the free market a chance.

Equilibrium.  Instead of looking for a bottom, may be it is easier to look for the equilibrium.  This is the point where supply and demand are in balance, supported by sound financing programs.  We are not at equilibrium.  Here is the simple math. 

Demand – on the demand side, there were 30 bona fide buyers during the last 6 months.  So far, this demand came from price reductions.  It is unlikely that it will increase by much from current level.  Ironically, the buyers that should be buying today are the ones trapped with negative mortgage, having been enticed to buy a few years ago when they were not financially ready.  If they are foreclosed upon today and immediately started repairing their credit, the fastest they can re-enter the buyers’ pool is 2 years, with a FHA loan. 

Supply – on the supply side, we know there are now 14 REOs on the market for the new pool of buyers, 39 short sales, a known number of properties in foreclosure, an unknown number in default, a known number of properties with negative equity and an unknown number of owners contemplating default.  (Since these studies are for my own use, I did not invest the time and effort to come up with the current supply number now.  I intend to piecemeal the work and have that ready when I update this study in the next couple of months.)

Financing – it appears we are in total chaos but that is only Wall Street.  It is not that bad on Main Street.  There is plenty of financing but you do have to qualify.  If you want low down or no down, get a FHA loan using a gift from a relative as downpayment.  If you have some downpayment, you can get a conforming loan.  If you have 20% down, you can write your own ticket.  Jumbos are a little expensive but not prohibitive for those who can afford a jumble loan today.  The no doc no qualifying loans are not and should not be available anymore.  Rates are reasonable.  In other words, financing is actual back to where it should be. 

Another Lesson Learned.  An unexpected lesson from this mini-analysis is the builders’ bubble.  These homes are quite large for the neighborhood.  Builders were pushing the price points.  These homes were selling from the high $500k to low $600k range.  Under normal financing conditions, household income required to qualify would be in the $200,000 range.  Had it not for the bubbles, these homes would have been difficult to absorb.  Now I wonder about the land in the inventory of the homebuilders.  How many maps in process are designed for products that may be excessive for the neighborhood?

Conclusion.  For this area, I can definitively say that we are not close to the bottom.  Prices may not fall much more and may not be as fast as the last 12 months but I see no sign of recovery.  There are still too many issues yet to be resolved.  However, I do feel comfortable with the miscellaneous signals and be able to recognize the turning point.

The wild card now is government intervention.  So far, the Feds, the Treasury, FDIC and others have throw everything but the kitchen sink at the problem and it is unclear if did any good.  Can anyone rule out a bail out at the Main Street level?  Would the government really start buying homes if this foreclosure trend continues?  Would we wake up one Monday morning to see Bernanke outlining the Federal Reserves’ plan to bail out the Treasury while Paulson outlines the Treasury’s plan to bail out the Federal Reserve?

UPDATE

Based on some of the responses to my “In Search of the Illusive Bottom” email, I realized my lack of writing skills has once again mis-stated my point.  Here is another attempt.

I did not finish my study because I know I would be able to arrive at a mathematic bottom for that market.  However, in the real world, I think it is a very unlikely scenario so I decided not to waste any more time.

The reason being the bottom is not “here” now.  I need to define “here”.  By “here”, I mean market condition today.  If you are using Case Shiller, NAR, OFHEO (FHFA) etc., you need to make the appropriate time adjustments since all those indicators are more than a couple of months behind. 

Now that “here” is clear, think about this scenario.  Assume that by the time Case Shiller and others report price decline of today, or “here”, the market has declined 10% from their last report.  Then from “here” to another quarter from now, the market is going decline another 10%, what would happen?

Consensus opinion today is so focused on a numeric bottom, or a calendar bottom, that they are missing the big picture.  I opine that it is not possible.

Just think about these events:

• The current level of defaults already brought down the BSC and the giant GSEs, what happens if property value goes down another 10% from here? 
• The current level of defaults has brought down Indymac and other lesser known banks.  Who are next – Wamu, Downey?  We know FDIC has less than $50b left, is it about to bring down FDIC also?  If our government is not going to let the GSE debts go under, they are certainly not going to not fund FDIC, right?
• Using a cocktail napkin approach, total real estate value in the US is almost $20 trillion.  Every 10% drop is $2 trillion.  Can the economy handle this reverse wealth effect?  While the value is variable, the debt is fixed.  What is this doing to our mortgage debt ratio?
• From the foreclosure prevention front, FDIC/Indymac led the way with Xtreme Work Out, followed by FHA, Freddie Fannie etc.  There are so many work out programs available and yet, defaults are still going up.  Just look at data provided by HopeNow. 
  http://www.hopenow.com/upload/data/files/July%202008%20Industry%20Extrapolations.pdf
  http://www.hopenow.com/upload/data/files/January%202007-July%202008%20Foreclosure%20Starts.pdf
  What do you think the level of default would go to if property value drops another 10% from here?
• Unemployment is climbing.  We know household savings rate has been non-existent.  What is the safety net for foreclosed unemployed homeowners, the street? 
• This Cagan report is undoubtedly the best piece of data for the entire cycle.  It is not only a “must read”, it is a “must digest." 
  http://www.loanperformance.com/infocenter/whitepaper/FARES_resets_whitepaper_021406.pdf
  Look at the tables on equity (thru page 12).  Do your own estimates as to what percentage of households is now sitting on negative equity. 

These are just a few key points.  I can go on and on.  That is why I do not see a numeric, or a calendar bottom.  If we go down even just 10% from here, the system will break.  If the bottom is 2009 or later, the system will break before then.  One way or another, the current trend is not sustainable.

A big housing bail out is something that I have never personally experienced so I can only guess at how it works.  Alan Blinder talked about some of them here.  I think this is the type of “bottom” that we will see for this cycle.

http://economistsview.typepad.com/economistsview/2008/03/alan-blinder-ho.html

After the dust settles, then I think we should start trying to value real estate using traditional fundamentals again.