A journey into Main Street economics.

Real Estate: The War Behind The Scenes

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The $8,000 first-time home buyer tax credit has generated a lot of debate lately as NAR and NAHB have been campaigning (or more accurately, buying support) for the extension of the credit by claiming that it is necessary for stability in the housing market. The sentiment among budget conscious Americans has shifted firmly against the tax credit extension in recent months as the U.S. public debt grows to levels unimaginable just two years ago. Both parties have legitimate arguments, but there will only be one winner…. let’s take a look at who the most likely winner will be.

The argument for: Government programs to buy mortgage-backed securities and Treasuries are scheduled to end in the next 6 months which will likely cause mortgage rates to climb. In addition, the transition into the winter season will surely have a negative impact on the purchase market. First-time home buyers have made up 43% of the purchase market this year and NAR estimates that about 17.5% of those sales would not have happened without the tax credit. Home sales already seem unlikely to recover significantly in 2010 given the increasing unemployment rate, declining wages in many states, and increasing delinquency rates on all loans.

The argument against: Using NAR estimates of 2 million buyers who qualify for the credit, we can come up with a $16 billion cost to the American public (2,000,000 buyers * $8,000 credit). Since the actual tax-credit is the lesser of $8,000 or 10% of the sales price, we’re likely overstating this number for home sales in the lower-end and seriously distressed markets like Detroit and Las Vegas. Either way, an extension of this tax credit likely means another $15-25 billion added to our tab. The question the budget conscious person asks is…. is it worth it? If the tax credit only resulted in 350,000 sales as NAR suggests, then this is a valid question. Bill McBride at Calculated Risk estimated that “this tax credit cost taxpayers about $45,000 per each additional home sold.” To put that number into perspective, the median home sales price in Detroit is $51,600 as calculated by Zillow.

In theory, both sides are absolutely correct. The housing market does need some form of stimulus to maintain a healthy level of demand at current price levels, however an extension or expansion of the tax credit will be a costly and perhaps inefficient method of providing that stimulus. The problem that I have with this back and forth argument is that neither party realizes their true enemy in the battle for stability in the housing markets: financial institutions.

Cause and Effect

Let’s go back to the cause of the housing market collapse to identify who was hurt the most by the collapse of residential real estate prices.  In the early portion of this decade, mortgage lenders were giving unconventional (interest-only, liar loans, option ARM) mortgages to unqualified borrowers with zero money down which led to a huge surge in demand, rampant speculation, and of course increasing home values. Lenders sold these mortgages in bundles as MBS (mortgage-backed securities) which were valued based on credit risk, prepayment risk, and interest-rate risk. The problem was that these securities were given high credit ratings in cases where the default risk was obviously high. Once mortgage defaults began to rise, investors in the securities market closed the door and the game was over. Demand for MBS suddenly disappeared which meant the banks had to actually hold these risky and declining assets on their balance sheets. That was the cause of the credit crisis and it resulted in many bank failures and markdowns due to mark-to-market accounting rules which required a bit of honesty for once in an otherwise dishonest field. So where are all of these securities and assets today?

Bernanke, Paulson, and Co. convinced our government (scared them into believing) that the banks (aka credit market) needed billions of dollars immediately to prevent the American economy from collapsing due to a worldwide credit freeze. We were led to believe that these billions of dollars would be used to restore credit conditions to a healthy level and that the banks would resume their lending as soon as conditions returned to “normal”. The problem with this scenario is that lenders weren’t the true drivers of mortgage credit in this boom, but instead acted as pass-through agents between the American public and MBS investors.

With the MBS investment market completely dead due to risk aversion, who would step up to take on these securities with default risk rising every month? Answer: The government and Fed.

In other words, we gave away nearly a trillion dollars and STILL had to foot the bill to keep the ponzi scheme alive. But how long can the market support rising default rates and a growing shadow inventory? As long as asset deflation doesn’t kick into overdrive, the ponzi scheme will indeed continue for another cycle since the banks will have shifted some of their credit risk onto the public balance sheet. That’s the fight that’s going on behind the scenes right now and the public is losing the battle against private balance sheets.

Who Wants The Risk Now?

The FHA has stepped in to maintain sub-prime lending by growing from 3.5% of the market share in 2005 to 37% in the 2nd quarter of 2009.  In other words, the same risks that caused the collapse of the banking system in 2007 have been shifted to the FHA. If another wave of defaults and foreclosures occurs for FHA loans, then they will be in a world of pain and will almost certainly request, and receive, a government bailout paid for by the American public.

TARP (Troubled Asset Relief Program) funds have been used over the past year and a half to fatten the accounts of financial institutions, but a second portion of the program was designed to purchase distressed securities from them and put the risk directly in the hands of the public. The P-PIP program was designed to eliminate another trillion dollars of distressed assets from bank balance sheets (at about 90% cost to the taxpayer), but the FASB’s ridiculous decision to change mark-to-market accounting rules during economic downturns has allowed banks to continue falsely reporting asset valuations (one of the main causes for the surge in stock prices for financial institutions since March). Financial institutions holding garbage (or as Geithner wants us to call them, “legacy” products) now have no reason to show the public the true value of what they hold when they can lie and claim par value for any asset on their books. I’ll get into P-PIP further in another post since it has the potential to be the final nail in the coffins of the American public.

The Federal Reserve’s program to purchase $1.25 trillion of agency MBS accounts for roughly 80% of gross issuance (projected at $1.5 trillion) for the year 2009. The risk of ending this program is that private investors may not be willing to suddenly assume 500% more of this market at similar cost.

The War Behind the Scenes

The bottom line for the future of housing is that the basic rules of supply and demand will eventually determine future house prices. The FTHB tax credit resulted in a reasonable increase of demand, but the supply side of the equation remained a problem.

The OCC and OTS Mortgage Metrics Report released by the Treasury for the second quarter of 2009 painted a very troubling picture for residential real estate. The number of foreclosures in process rose 79.4% from Q2 ’08 to 992,554 while newly initiated foreclosures have only risen 28% to 369,226 and the number of completed foreclosures dropped 9.6% to 106,007. The backlog of foreclosures has been rising each quarter along with delinquency rates in a sign that the worst of the housing crisis lies ahead, NOT in the past as many would have you believe today.

Programs such as HAMP are simply delaying the inevitable in many cases as proven by the 32% re-default rate within 6 months after loan modifications. Instead of using the now popular figure of 7 million homes of shadow inventory, we’ll instead simply compare expected supply with existing home sales.

Newly initiated foreclosures from Q2 ’09  (369,226) + 32% of Newly initiated home retention actions from Q4 ’08 (293,668 * .32 = 93,973) = 463,199 homes added to the market per quarter at the current pace. That’s an annual addition of 1.85 million distressed homes to the existing home supply. Existing home inventory in July was 4.06 million.

With those kinds of numbers, it’s obvious to most sensible onlookers that prices have nowhere to go but down. However, the media’s message brought to you by NAR is that the creditworthy renter in today’s market should leap headfirst into home ownership due to the huge supply of homes available at distressed prices. At least that would be the case if these houses were actually available, but alas they are not available thanks to the foreclosure moratoriums and HAMP program that have created the “shadow inventory” effect. This shadow inventory serves the purpose of distorting reported supply and demand which artificially elevates home prices.

Who gets hurt the most by shadow inventory? First-time home buyers looking for a good deal.

Don’t be fooled for a moment into believing that either the banks, government, or the real estate industry actually have genuine care for the first-time home buyer. They simply understand that you have to feed a pig before it is ready to be eaten. The $16 billion spent on this tax credit is chump change compared to the amounts being spent to fatten the pockets of the financial industry, but keeping the public focus on trivial matters is a tried and true method of fleecing them behind the scenes.

The main street Americans who benefit the most from this tax credit are not first-time home buyers, who are basically getting a $8,000 loan financed over the term of their mortgage at4-6%. The real winners in this scenario are the baby boomers who watched in horror while their retirement dreams faded away as equity markets and home values crashed. The baby boomers who bought or took equity from their homes in the early to mid portion of the bubble still have hope for a shameless exit from the debacle, but only if house prices remain around current levels. The foolish ones who took all of the equity out of their homes and/or bought into the top of the bubble can only hope and pray that house prices return to previous levels. The middle-class baby boomers hoping to downsize and retire don’t have the luxury of waiting 10 to 20 years for housing prices to recover.

These are the people who the financial institutions are betting on. The banks win as long as the baby boomers continue to believe in and support the Ponzi scheme. The baby boomers win as long as the banks can keep up the Ponzi scheme. The battle lines have been drawn and the sad truth for today’s generation of hopeful first-time homeowners is that nobody is on their side.

The tax credit WILL be extended for first-time home buyers and the general sentiment will be positive, but today’s actions are only sowing the seeds for the next wave of wealth destruction.

My message to first-time home buyers looking to get into the market now: Make sure you have adequate downside protection before you take the risk. Otherwise, stand your ground against the bankrupt banking institutions, baby boomers, and Federal Reserve financiers and declare a stalemate by not buying anything with debt financing until prices reach truly affordable levels. The Fed has reached the zero bound, underwriting standards are under intense scrutiny, and the only buyer left on the market with adequate cash and hope for future earnings is the first-time home buyer. First-time home buyers are the key to the housing market and their decisions will ultimately determine where prices go in the next couple of years. I’m hoping they (we) are the ones who end up winning this war, but all signs continue to point in the other direction.


Written by Myron

10/05/2009 at 12:41 PM

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