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Future house prices, “It’s up to the banks, stupid.”

Economists and housing market observers pour over sales numbers each month to divine the direction of future house prices. Everyone has their pet theories on whether house prices have bottomed or if there is more pain ahead. Many rely on these numbers as gospel forgetting that these numbers are generated by the actions of people responding to the conditions around them. Change the conditions, and the numbers can change quickly.

For example, in February of 2012, lenders across the Southwest abruptly stopped processing their backlog of foreclosures, not because they exhausted the supply of delinquencies but because of internal policy changes brought about by the foreclosure settlement with state attorneys general around the country. The story of the housing bubble is really the story of unprecedented market manipulation by lenders, legislators, regulators and the federal reserve. Predicting how this all plays out is fraught with difficulty, not because the basic economics are hard to understand, but because there is no way to predict when one of the key players will change a policy, what that change will be, and how that change will effect the market. So far, even when the bulls have been right, they have been right for the wrong reasons. Unpredictable and unprecedented policy responses are what has stopped the deep correction in house prices from becoming a complete catastrophe for loanowners and lenders.

The bears were right

Back in 2005 and 2006, the bears predicted a collapse in housing prices. Toxic mortgage products proliferated driving prices up beyond all reasonable measures of value. Many ordinary citizens became real estate speculators, and housing bears postulated that these people would default resulting in a violent contraction of credit, millions of foreclosures, rising interest rates to compensate lenders for the risk, and a dramatic crash in prices as product was forced into a market with a greatly diminished buyer pool.

The story of the housing market since 2006 has been one of unprecedented manipulations of the market by lenders and regulators. First, in response to the weakening economy, the federal reserve lowered interest rates counter to what the market would have done if left to its own forces. When it became obvious that mortgage lending would soon implode and take the GSEs down, the government reneged on 60 years of promises and took the GSEs into conservatorship. Without the backing of the US taxpayer, mortgage interest rates would have skyrocketed, or mortgage lending would have stopped. Four years later, the government still insures over 95% of the loans in the mortgage market, and there are few signs of private lending returning. The jumbo loan market is still moribund and likely to stay that way.

By late 2008, prices were crashing hard in nearly every market in the country because lenders were doing what the bears said they would do; they foreclosed on those who defaulted and resold the properties. These foreclosures were concentrated in low-end neighborhoods dominated by subprime lending because those loans went bad first. Bears said it was only a matter of time before the alt-a and prime borrowers defaulted and those neighborhoods crashed too. And they would have if banks and bank regulators hadn’t changed the rules.

In response to the crash of prices in subprime neighborhoods, lenders slowed the rate at which they filed foreclosures and finally processed them. Shadow inventory was born. Prior to late 2008, lenders had not done this since the Great Depression. To allow lenders to sustain shadow inventory, government regulators suspended mark-to-market accounting rules which allowed lenders to keep loans on their books at full value rather than reflect what these loans were really worth. Further, regulators allowed lenders to sustain these fantasy values until they foreclosed on the property providing a huge incentive not to foreclose. As a result, when the alt-a and prime borrowers defaulted as the bears predicted, no wave of foreclosures followed. How could bears know that banks and regulators would change the rules? How could bulls know that? Many bulls have smugly said the bears were wrong about the wave of foreclosures. That much is true, but the bears were certainly right about the wave of delinquencies that should have been foreclosures. Only the unprecedented response to these delinquencies was in error.

The completely unpredictable and unprecedented actions taken by banks and regulators did not end with the takeover of the GSEs, the creation of shadow inventory, and suspension of mark-to-market accounting rules. No, the federal reserve took interest rates down to zero, and for the first time in their existence, they bought something other than short-term Treasuries. The federal reserve loaded up on mortgage-backed securities paying prices the private market wouldn’t in order to further drive down interest rates. Who could have reasonably predicted that? The federal reserve had never done anything like that before.

By 2009, some markets began to stabilize while others continued to crash. This mostly sorted out by concentrations of subprime loans. Markets like Las Vegas or Phoenix which were almost entirely subprime crashed very hard. Markets like Orange County which were mostly alt-a and prime were spared thanks to a healthy dose of shadow inventory and high-end squatting.

In response to the continuing deterioration in the subprime markets, government legislators stepped into the fray and passed a series of tax credits designed to stimulate demand. Again, neither the bulls or the bears could have predicted such a response, but both the federal government and the State of California passed tax credits which served to pull demand forward, temporarily raise prices (and hopes), and trap another group of hapless buyers in underwater mortgages.

When the tax credits failed to reignite the housing market — something the bears did predict — prices rolled over and went on an 18 month decline until the spring of 2012. Aided by a 20% to 30% reduction in borrowing costs as interest rates continued to fall per the federal reserve’s plan, the cost of ownership fell below the cost of a rental in most markets.

This prompted many hesitant buyers to act, and it also caused investment hedge funds to enter the market with significant capital to buy up low-end properties. I predicted this back in March of 2007:

Two Levels of Buyer Support

There are two categories of buyers that will enter the market and purchase real estate without regard to appreciation: Rent Savers and Cashflow Investors. These are the buyers that will buy houses even if prices are declining; therefore, they are the ones who call the bottom. Rent Savers are buyers, like me, who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them.

Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and you have an unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.

BTW, if there were any inventory right now, I would be looking to buy a home.

So what does the future hold?

Two thousand twelve will be remembered as the year the chorus called the bottom. Perhaps they will be right, or perhaps not. One of the most influential bottom callers is Bill McBride of Calculated Risk. In a recent post, he stands by his recent call and presents one of the better arguments to date against further significant price declines.

House Prices and a Foreclosure Supply Shock

by Bill McBride on 8/14/2012 12:25:00 PM

Those making the argument for further house price declines usually start with “shadow inventory”. Although there is no formal definition of “shadow inventory” it usually includes 1) some properties with homeowners who are current on their mortgages, but have negative equity in their homes, and 2) properties not listed for sale, but where the homeowner is seriously delinquent on their mortgage or already in the foreclosure process.

This can lead to some pretty scary numbers being bandied about. As an example, CoreLogic recently reported that “11.4 million, or 23.7 percent, of all residential properties with a mortgage were in negative equity at the end of the first quarter of 2012”. And LPS reported 1.6 million loans were 90+ days delinquent at the end of June, and another 2.1 million are in the foreclosure process.

These numbers suggest a coming “flood” of foreclosures to those arguing house prices will fall further. I think this is incorrect.

Let’s be clear on semantics here. I don’t think many bears are pushing the “flood” scenario (except perhaps in some judicial foreclosure states). The banks have been remarkably successful controlling the release of REOs over the last four years, and they will likely continue that success for the next four years while their inventory still dominates the market. If they lose control to some degree, or if there is an unexpected exogenous shock, then prices may drift lower and even take out the recent bottom, but with super low interest rates, it’s unlikely a 20% drop is forthcoming.

If we look at negative equity, it is a serious issue for many homeowners, but it seems unlikely they will default en masse. Recent homebuyers who have negative equity are probably less than 10% underwater. And homeowners with significant negative equity probably bought in the 2004 through 2006 period; and they’ve been paying their mortgage for 6 to 8 years – so it is unlikely they will just default without some unfortunate event (divorce, death, disease).

I don’t think this is a proper way to look at this issue. Most people own a home for about 7 years. The loanowners trapped in those homes are entering a different stage in their life cycle, and many will want to move. They may not default due to an unfortunate event, but they may want to short sell to move on with their lives. If they don’t get the bank approval they seek, then they might strategically default. Normal mobility in an age of underwater borrowers may prompt more defaults than the bulls want to acknowledge.

Probably the biggest impact on the housing market is that people with negative equity can’t sell, and this restricts supply (the opposite of the “shadow inventory” argument). For more on this, see: Zillow chief economist Stan Humphries has been discussing this: The Connection Between Negative Equity, Inventory Shortage and Increasing Home Values: Why the Bottom Won’t Be as Boring as We Expected.

This is certainly what is preventing more properties from coming to the market now. When lenders abruptly stopped their REO processing, it left a void in the market, and with so few owners with equity, nobody can come forward to list their houses.

And I expect with the recent increase in house prices that the number of reported homeowners with negative equity will be down sharply in Q2. The HARP refinance program will help too.

Keep in mind that the number of underwater borrowers has always been under reported because these reports don’t take into account selling costs. And we know loan modifications programs fail over and over again. Most of those loans will simply be recycled.

A more immediate concern is the 3.7 million homeowners currently 90+ days delinquent or in the foreclosure process. Many of these properties will eventually be a distressed sale, either a foreclosure or short sale, although some will receive loan modifications. It is important to remember that some of these homes are already listed for sale (so they are included in the “visible inventory”), and there has been a significant shift by lenders from foreclosures to short sales (short sales have less of an impact on prices than foreclosures).

Very few delinquent mortgage holders are listing their homes. I recently measured this number in Orange County at 4%. Most of these people are committed to squatting until foreclosure. Lenders may want more borrowers to sell in short sales, and the first-lien approval process has shortened quite a bit, but second lien holders still hold up the process, and committed squatters are more motivated to keep receiving free housing than they are to sell and move into a rental.

But here is the key: Although forecasting house prices is very complex, we can make some simplifying assumptions and think in terms of supply and demand with foreclosures being a supply shock (increased supply). It is important to remember that national prices are an aggregate of many local prices (although there are national impacts, housing markets are local). And housing prices are more complex than say commodity prices (as an example, house prices tend to be stick downwards).

Imagine a multi-year supply shock with a bell curve shape. The supply shock shifts the supply curve to the right relative to the height of the bell curve. Prices will bottom when the supply shock is at the peak, NOT when the supply shock is over.

I do not believe this is accurate. Perhaps in the days prior to shadow inventory this may have been true, but prices will not bottom when the supply shock is at the peak, and in fact, they did not bottom when supply peaked in 2008.

There is an threshold for foreclosure processing determined by market demand, which is currently still weak. When supply is above this threshold, prices fall. When below, prices are not pressured downward. Supply has been elevated above this threshold from 2008 through early 2012. And the only reason it fell below this threshold now is due to policy changes and market manipulations. It is entirely possible lenders will be able to keep supply below threshold while they process shadow inventory, but it’s also possible they might lose control again.

Thinking in terms of threshold levels is much more productive than thinking about the peak and trying to rationalize why the peak was not predictive.

The supply shock from foreclosures probably peaked in late 2008, with a second smaller peak in 2010. Prices didn’t bottom in 2008 because 1) prices are sticky downwards (so the bottom happens after the peak of the supply shock) and 2) fundamentals such as price-to-income and price-to-rent were still out of line.

Now fundamentals are close to normal, and any supply shock will probably be smaller than the 2008 or 2010 peaks.

If the supply shock is smaller it’s only because lenders are more adept at managing threshold levels.

And this analysis assumed demand was stable. Actually there was a demand shock too (less demand) due to tighter lending, and buyer psychology (potential buyers were afraid that prices would fall further). There were few investors in 2008 when the supply shock hit – just a few individual and small group investors buying REOs. Now there are large well capitalized groups looking to buy. Of course lending standards are still tight, but as the recent Senior Loan Officer showed, demand is picking up.

Demand is not picking up. Bill’s own charts show that. Any anecdotal perception of improved demand is not reflected in the data.

 

The bottom line is house prices have probably bottomed, and the concern about more distressed sales coming is real – but will probably not push house prices to new post-bubble lows.

Though I may quibble with some of Bill’s details, I agree with him overall. Based on what we are seeing today in the market, it doesn’t look like prices will go lower. However, as I also demonstrated, the entire housing market is subject to the whims of bankers, legislators, and regulators. A policy change with any one of those players could have far-reaching impact on house prices. Of course, all of those groups also want to see house prices go up, so expect any policy changes to be geared toward that end.

Markets have a funny way of making fools of us all. It may turn out the forces of the market are larger than any of those groups can manage.

Far too many took far too much free money

One thing positive about featuring a property each day is that readers get a daily reminder of what really caused this mess. Lenders gave out far too much free money to borrowers who were running personal Ponzi schemes. The behavior of bankers and borrowers motivated by greed is the root of all our problems. Unfortunately, nothing enacted in the aftermath of the housing bubble addresses this core problem. In fact, the federal reserve is lamenting the lack of mortgage equity withdrawal as an economic stimulus. They want the “wealth effect” to come back. Apparently, they want everyone raiding the housing ATM out of blind ignorance to the instability this creates.

The former owners of today’s featured property were small-time Ponzis by Orange County standards. I recently profiled a borrower to took out over $3,000,000. By comparison the $150,000 pilfered by today’s former owner is pocket change.

  • This house was purchased on 2/15/2002 for $305,000. The owner used a $221,000 first mortgage and a $84,000 down payment.
  • On 4/30/2003 he refinanced with a $250,000 first mortgage.
  • On 2/3/2005 he refinanced with a $365,000 first mortgage.
  • On 12/15/2006 he refinanced with a $382,000 first mortgage and obtained a $95,500 stand-alone second.
  • He was served notice on 11/23/2010, and he squatted until 7/11/2012 when Fannie Mae bought it back.

Countrywide strikes again.

[idx-listing mlsnumber="P831273" showpricehistory="true"]


Proprietary OC Housing News home purchase analysis

1231 North MOSSWOOD Dr Anaheim, CA 92807

$379,900    ……..    Asking Price
$305,000    ……….    Purchase Price
2/15/2002    ……….    Purchase Date

$74,900    ……….    Gross Gain (Loss)
($24,400)    …………    Commissions and Costs at 8%
============================================
$50,500    ……….    Net Gain (Loss)
============================================
24.6%    ……….    Gross Percent Change
16.6%    ……….    Net Percent Change
2.1%    …………    Annual Appreciation

Cost of Home Ownership
——————————————————————————
$379,900    ……..    Asking Price
$13,297    …………    3.5% Down FHA Financing
3.64%    ………….    Mortgage Interest Rate
30    ………………    Number of Years
$366,604    ……..    Mortgage
$96,042    ……….    Income Requirement

$1,675    …………    Monthly Mortgage Payment
$329    …………    Property Tax at 1.04%
$0    …………    Mello Roos & Special Taxes
$95    …………    Homeowners Insurance at 0.3%
$382    …………    Private Mortgage Insurance
$0    …………    Homeowners Association Fees
============================================
$2,481    ……….    Monthly Cash Outlays

($252)    ……….    Tax Savings
($563)    ……….    Equity Hidden in Payment
$16    …………..    Lost Income to Down Payment
$115    …………..    Maintenance and Replacement Reserves
============================================
$1,797    ……….    Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$5,299    …………    Furnishing and Move In at 1% + $1,500
$5,299    …………    Closing Costs at 1% + $1,500
$3,666    …………    Interest Points
$13,297    …………    Down Payment
============================================
$27,561    ……….    Total Cash Costs
$27,500    ……….    Emergency Cash Reserves
============================================
$55,061    ……….    Total Savings Needed

6121 VIA NIETOS, Yorba Linda, CA $449,000
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0.24 miles
2 bd / 2 ba
1,471 Sq. Ft.
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1,460 Sq. Ft.
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1,459 Sq. Ft.

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