Jan232013

One man’s mortgage debt is an entire neighborhood’s equity

Residential real estate is generally valued by comparable neighborhood sales. When a property sells for a new high price, it doesn’t just affect the value of that property, it impacts the value on all similar properties within a mile of the new sale. During the housing bubble, neighbors cheered each new higher comp because it added to their (illusory) net worth. With unrestricted access to equity with no-doc loans and 100% LTV HELOCs, everyone near a new high comp was basically given free money.

The late arrivals all eagerly waited a greater fool to come along and buy at an even higher price so they could get their share of the HELOC booty too. Obviously, under such circumstances, the desire for real estate was very high, and with no impeding lending standards and an eagerness from investors to fund new loans, actual demand as measured by dollars was very high as well. We ended up with a massive housing bubble.

Since the housing bubble collapsed, prudent lending standards were put back in place, and prices dropped precipitously largely because buyers could not borrow the prodigious sums previously made available to them to bid up prices. This put the banks in a bind because the huge reduction in collateral value backed the bad loans they made during the bubble era. The price collapse put between a quarter and a third of American loanowners underwater, and if the banks were forced to liquidate, it would cause hundreds of billions in losses bankrupting our banking system and triggering a deep economic depression. Something had to give.

The US government and the federal reserve took a number of steps to solve the problem. First, in early 2009, regulators relaxed mark-to-market accounting rules allowing banks to hold bad loans on their books at a fantasy value to avoid loss recognition. This bought the banks time. Further, in order to placate pressure from loanowners to “do something” and to provide lenders with a few additional debt service payments on these bad loans, the government embarked on a series of failed loan modification programs. These were sold to the public as ostensibly helping struggling borrowers, but they were really designed to allow banks to kick-the-can on loan recognition and squeeze a few more payments out of hopeless borrowers before they imploded. These programs have been an abject failure for loanowners, but it has been successful for bankers in getting a little operating cash while delaying loss recognition.

Ultimately, banks don’t want to recognize losses. They would far rather delay their necessary foreclosures until the loans had collateral backing which will allow them to recover their capital. However, since potential buyers of these properties couldn’t afford to pay an amount which would recover the outstanding debt, the bubble needed to be reflated before the foreclosures could go forward.

To facilitate reflation of the housing bubble, the federal reserve lowered interest rates to zero, and embarked on a program of buying 10-year Treasuries (operation Twist) and directly buying mortgage-backed securities to ensure the flow of capital into the housing market and dramatically lower mortgage interest rates. At the peak of the housing bubble, mortgage interest rates were between 6% and 6.5%. They are 3.35% today — a near 50% reduction. These super-low interest rates give today’s buyers the ability to borrow amounts commensurate with peak prices under stable loan terms.

The stage was set to reflate the bubble and allow lenders to foreclose and recover capital at peak prices. There was only one problem. Due to the collapse of prices when the housing bubble burst, comparable sales were far below peak prices, and continued foreclosure processing was keeping prices down. The solution was simple; stop foreclosure processing and restrict inventory until the housing bubble reflates. That’s were we are today.

Lenders stopped foreclosure processing to dry up the inventory. Loanowners are in no hurry to list their properties because if they wait, they might get out without a ding to their credit scores, so both foreclosures and short sales are in short supply. Foreclosures used to be a third of the market, and with 25% of owners underwater, more than half the supply has been removed. The few organic sellers are also have incentive to wait because they will make more money by selling later. The result is a huge decline in inventories and rapidly rising prices.

How much higher can prices go?

A shortage of inventory alone is not enough to make prices go up. Buyers also have to be able to raise their bids. With 3.5% interest rates, buyers can raise their bids. Even the OC housing market has significant room for prices to rise before affordability becomes a problem. The OCHN housing market report has a page devoted to valuations. I took the stable values from 1993 to 1999 as a basis and compare the current cost of ownership relative to those norms. Nearly every market in Orange County is significantly undervalued by this metric, most by 25% or more.

The median home price relative to rental parity is undervalued, and this also shows up in the comparison of the current cost of ownership to rents.

It’s not just Orange County. San Diego county is even more undervalued.

The banks are set to hugely benefit from a rapid increase in prices brought about by their policy of restricting foreclosures. Each new sale in a neighborhood raises the comps. One man’s mortgage debt is an entire neighborhood’s equity. New higher comps provides equity for many, but of much greater interest to the banks, higher prices provides an increased collateral value behind a delinquent mortgage loan. When they do finally foreclose, they will recover more money. That’s why inventory is low and will likely stay that way until we see peak prices in most markets, which may happen sooner than most think.