Factors to watch while lenders reflate the housing bubble
The success lenders enjoy in reflating the housing bubble is remarkable. Since they stopped foreclosing on delinquent mortgage squatters and focused their efforts on can-kicking, lenders managed to dry up the MLS inventory and force prices to rise 20% to 40% in a very short period of time. This will enable many previously underwater borrowers to sell without a short sale, which ultimately prevents another bank loss. Further, higher prices will increase the lender’s recovery amount when they do foreclose on the most committed squatters.
The success of lenders efforts is not without concerns. Back in May I discussed the 10 biggest obstacles to reflating the housing bubble. Today, we revisit that topic with an overview from the Wall Street Journal. But first, I want to enumerate my own list of concerns.
Factors to watch while lenders reflate the housing bubble
1. Fed Taper, and Bond Prices, and Interest Rates.
Rumor is that the federal reserve will begin tapering its purchases of 10-year Treasuries and mortgage backed securities as early as next week. This is important because the prices and yields of mortgage-backed securities determines the interest rates borrowers much pay when they want to finance a home purchase. It seems likely mortgage interest rates will continue to rise, and this will cause houses to be less and less affordable. If interest rates rise too high, or if the pace of increase is greater than wage inflation, house prices will hit a ceiling, and this ceiling will be lowered periodically as interest rates move even higher.
Nobody really knows what will happen with interest rates as the federal reserve tapers its purchases. Perhaps they’ve already pulled the selling pressure forward, and bond prices will rise despite the loss of federal reserve demand. That would cause interest rates to fall. Perhaps if they taper slowly enough, the diminished demand will hardly be noticed by the market and interest rates will stabilize. This is certainly what they hope will happen. Or it may be that decreasing demand from the fed will also scare other buyers out of this market, bond prices will fall significantly, and interest rates would move much higher. This is an all-too-real possibility, and it would crush housing demand.
2. Employment and Income.
The economy continues to underperform on job creation. Further, the quality of jobs created is also low. People without jobs don’t buy houses. People with part-time jobs also don’t buy houses. People who don’t get raises can’t raise their bids, and they won’t participate in a move-up market if they already own. We must have increasing employment of good-quality high-paying jobs if housing is going to move higher on a sustained basis. That isn’t what we have today.
3. Can-kicking’s end game.
Housing market bulls and Pollyannas want to believe the declining delinquency rate is a sign that borrowers have permanently resolved their mortgage woes. Unfortunately, that isn’t reality. The decline in delinquency rates is almost entirely due to loan modifications with temporary terms most reminiscent of Option ARMs. When these modifications are granted, missed payments and fees are added to the loan balance, and the terms generally have temporary (teaser) rates and interest-only features that prevent any amortization. Basically, these borrowers are just treading water until prices rise back to the level of their loan balance. At that point, they will get squeezed out of their properties by rising loan costs as these temporary terms reset to their original form.
Further, lenders are still allowing millions of borrowers to squat in houses they aren’t paying for at all. These will be the first targets of foreclosures as prices move higher, but for right now, lenders are ignoring the problem because they can’t afford the write-downs, and they are making money on appreciation while prices rise.
At some point, lenders are going to have to resolve all their legacy loan issues from the housing bubble. If they can’t get prices to rise enough to liquidate at the book value on the loan, they will absorb a loss. If these losses are large enough, it will wipe them out. Perhaps they can kick the can long enough for prices to rise enough to bail them out, but even at the torrid pace of appreciation in 2012 and early 2013, it will still take many years for most markets to recover. Are banks going to play this game for another decade?
For the past year, more U.S. housing markets have had the feel of a blowout flea-market sale.
Prices were low and financing—while hard to get—was cheap for those who could get it. Once it was clear prices had found a bottom, bidding wars broke out as buyers competed over a shrinking supply of homes to get a good deal.
That sent prices up—sharply, in many markets—and for a while, buyers didn’t much mind. Falling interest rates made it possible for buyers to offer slightly higher prices without raising their monthly ownership costs.
But now, mortgage rates are up by a full percentage point over the past four months, and affordability has taken a hit, prompting concerns about a short-term “soft patch” as buyers and sellers adjust.
Here’s a look at four keys to the housing puzzle:
1. Housing became less affordable in a short span. Typically in a recovery, sales pick up and then prices follow. But the current recovery has been “flip-flopped,” said Ivy Zelman, chief executive of Zelman & Associates Inc., a research and advisory firm.
“We’ve had pricing accelerate out of the box” as builders took advantage of rising demand and low interest rates while adding little in the way of new construction. “That’s not typical of an upturn.”
In a typical upturn, volumes and pricing improve because all the problems that made prices go down were resolved. We didn’t do that. We merely delayed resolution until another day when prices are higher. We will need another period of flattening to work off the lingering problems.
Now, with prices up by double-digits from one year ago, rising rates have been “almost like a red light on the frantic price inflation,” said Ms. Zelman. A Zelman report last week showed that new home orders in August rose by just 1% from one year earlier, compared to year-over-year gains of 11% in July and 25% during the second quarter. “I hear more often now from builders, ‘We pushed prices too far,’” she said. “Consumers got sticker shock.”
Yes, they did. We may need to see another price adjustment as the builders accept the new reality. Unlike banks who can kick the can forever, builders inventory is must-sell, and they will do whatever’s necessary to move it.
2. Inventories are still depressed. Demand is only part of the equation of course, and some real-estate agents say the biggest drag on sales continues to be the lack of homes for sale. While the number of listings in August was up by 20% from the beginning of the year, the supply of homes for sale is below the already-depressed levels of one year ago. “There’s just not enough inventory to justify price declines,” said Ms. Zelman.
There have been a few articles circulating about the burgeoning inventory as a supply problem. I don’t accept that view. Yes, inventories are up significantly from the lows, but inventories are still nowhere near what they normally are, and supply is still artificially tight. As long as inventory is tight, prices won’t go down. Sales volumes may collapse, but prices won’t.
Buyers are also being pickier today because they’re looking for a home that they can live in for a long time, said Jim Klinge, a real-estate agent in Carlsbad, Calif. “Buyers want the right house,” he said. “They’ll pay more for it, and they’ll pay a higher rate.” But if it’s not available, they’ll wait.
With the frenzy gone, this makes more sense. People would take any home if it’s a bargain, but once it reaches the limits of affordability, they better like it, particularly since they may be stuck there for a while if prices flatten for an extended period.
Data tracked by John Burns Real Estate Consulting shows that in the vast majority of the nation’s 20 top markets, demand exceeds supply. In Phoenix, new-home sales are being hindered by a lack of supply, said Mike Orr, a housing analyst at Arizona State University in Tempe, Ariz. “There’s not any new homes in the places where people want to live,” he said. “People are frustrated.”
3. This should help quiet the bubble talk. Earlier this year, some worried that the housing market was back in a bubble. Any cooling down should soothe those worries. “I was more scared of the market at the beginning of the year than I am right now, because I knew that was not sustainable,” said Greg Markov, a real-estate agent in Phoenix, a market at the center of the home-price rebound over the past year.
“People were behaving irrationally, and it set us up for more ups and downs,” said Glenn Kelman, chief executive at Redfin, the real-estate brokerage.
Actually, I don’t think this will quiet the bubble talk at all. If interest rates keep rising and current pricing becomes unaffordable, we may end up with a bubble because affordability collapses. It’s an unusual scenario, but we’ve never seen 3.5% mortgage rates before either.
While incomes have been growing at roughly 1% a year, home prices have been rising much faster—by around 12% nationally. Some of this happened because home prices had fallen below their traditional relationship with incomes. But a 12% pace of growth was “simply too high and not sustainable,” said Chris Flanagan, a mortgage analyst at Bank of America Merrill Lynch in a recent report.
The dramatic rise in home prices while incomes were stagnant was entirely due to record low interest rates.
Think about this: imagine we had no housing bubble and the housing market was stable. What would happen if the federal reserve actions lowered mortgage rates from 6.5% to 3.5%? House prices would skyrocket because borrowers could finance much more with their incomes. This would create an enormous bubble as well. Since we already had our bubble, the lower rates are merely serving to reflate the bubble we already had.
4. How smooth a hand-off? As rising prices ease investors out of more markets, there will be less competition for some homes, slowing the pace at which prices are going up. The key going forward is how well owner-occupant, mortgage-dependent buyers are able to pick up the slack from investors, especially in an environment where rates are rising.
So far, owner-occupant, mortgage-dependent buyers are not picking up the slack at all.
And it a longer-term historical context, the picture is far worse. The increase from early 2011 to mid 2012 is barely noticeable.
Unemployment is still high, especially among younger workers who would normally be first-time home buyers. Mortgage credit remains tight, and many borrowers may already have high debt loads or irregular incomes that make them marginal candidates for a loan anyway.
When interest rates normalize, “any future improvement in housing will be entirely dependent on the jobs picture,” said Jeffrey Otteau, chief executive of Otteau Valuation Group, an appraisal firm in East Brunswick, N.J. The key, he adds, is how many jobs are being added “and are they part time temporary contract workers at the bottom of the income ladder or are they the high paying jobs we need to sustain a housing recovery?”
The answer to that question will go a long way towards clarifying how fast housing heals.
Rising wages are needed to offset rising interest rates
House prices are largely set by financed buyers. Typically, the all-cash auction market sales transact at prices 20% below MLS comparable sales where financed buyers bid up prices. And the only reason they are that high is because flippers will bid up to values where they know they can turn them quickly for a profit. If financed buyers were entirely removed from the market, house prices would be much lower than they are now.
Financed buyers establish their bids based on their incomes and current interest rates. Low rates like we have today allow borrowers to greatly leverage their incomes and finance relatively large mortgage balances and bid up prices. The three key variables involved are income, interest rates and allowable debt-to-income ratios.
Rising interest rates reduce the buying power of prospective house shoppers because their incomes can’t be leveraged into large loans. The only way to offset the reduced borrowing power is to increase income or debt-to-income ratios. Lenders can’t increase debt-to-income ratios due the 31% cap on GSE loans that dominate the market and recent qualified mortgage rules that cap back-end debt-to-income ratios at 43%. This leaves only rising incomes to push prices higher, and that won’t be happening any time soon.
Now that OC and many Coastal California housing markets have hit the ceiling on affordability, we should be entering a stage of gently rising prices. However, with the many market manipulations and unanswered questions, the path forward will likely be volatile with periods of both rising and falling prices depending on the factors discussed above.
How long has this borrower been delinquent?
Today’s featured property is shown as a short sale. It’s owned by a Ponzi who extracted $361,000 from the property from 1997 to 2007. It has a notice of default filed in June of 2013 that suggests he became delinquent in March. However, with his $599,000 asking price, he should net far in excess of the $461,000 origination amount on his final refinanced. What would make this a short sale.
Well, if the borrower had been delinquent for much longer than the last six months, the missed payments, late fees, and other charges could add significantly to the outstanding loan balance. If he has really been delinquent for the last several years (and hiding in shadow inventory), then his loan balance could easily exceed the amount he expects to gain from the sale.
This owner will turn a profit of nearly $400,000 and walk away with nothing.
[idx-listing mlsnumber=”OC13183121″ showpricehistory=”true”]
2542 OXFORD Ln Costa Mesa, CA 92626
$599,000 …….. Asking Price
$176,000 ………. Purchase Price
1/10/1997 ………. Purchase Date
$423,000 ………. Gross Gain (Loss)
($47,920) ………… Commissions and Costs at 8%
$375,080 ………. Net Gain (Loss)
240.3% ………. Gross Percent Change
213.1% ………. Net Percent Change
7.5% ………… Annual Appreciation
Cost of Home Ownership
$599,000 …….. Asking Price
$119,800 ………… 20% Down Conventional
4.55% …………. Mortgage Interest Rate
30 ……………… Number of Years
$479,200 …….. Mortgage
$119,467 ………. Income Requirement
$2,442 ………… Monthly Mortgage Payment
$519 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$125 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$3,086 ………. Monthly Cash Outlays
($488) ………. Tax Savings
($625) ………. Principal Amortization
$203 ………….. Opportunity Cost of Down Payment
$170 ………….. Maintenance and Replacement Reserves
$2,346 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$7,490 ………… Furnishing and Move-In Costs at 1% + $1,500
$7,490 ………… Closing Costs at 1% + $1,500
$4,792 ………… Interest Points at 1%
$119,800 ………… Down Payment
$139,572 ………. Total Cash Costs
$35,900 ………. Emergency Cash Reserves
$175,472 ………. Total Savings Needed