May202013

The 10 biggest obstacles to reflating the housing bubble

The federal reserve in conjunction with government officials are working diligently to reflate the housing bubble. Banks are still exposed to $1 trillion in unsecured mortgage debt, so reflating the bubble is considered necessary to restore collateral backing to lender’s bad loans.

Whether or not this is a good idea depends on your perspective. If you’re a renter whose tax dollars are being diverted toward this endeavor, these efforts are not particularly welcome. Renters receive no benefit from this intervention, and the resulting high home prices make it more costly for renters to become homeowners, so it’s a double whammy. If you’re a homeowner, it’s a very welcome government intervention. It costs homeowners nothing, and they get all the benefits.

Whether or not we think its a good idea, policymakers do, and these efforts will continue until the bubble is fully reflated and the banks are no longer in danger of insolvency or bankruptcy. However, making home prices go up quickly to peak bubble levels is not easy. The first round of government interventions in 2009 and 2010 failed. The tax-credit stimulus merely pulled demand forward, and when the tax credits expired, house prices reversed and fell for 18 consecutive months and ultimately made new lows.

The second round of market manipulations have so far been more successful. Banks went “all in” betting on success of loan modifications. By changing from a policy of foreclosure to one of endless and repeated loan modifications, banks managed to dry up the MLS inventory and force the few active buyers to concentrate their bidding activity on a much smaller number of houses. This bidding pressure combined with low interest rates that allow buyers to increase their bids has caused prices to go up sharply, which is exactly what the banks want.

There are many challenges to maintaining such an artificial set of market conditions which favor bubble reflation. There are a number of obstacles the powers-that-be must contend with. Changes in any of the key conditions could easily cause prices to falter or reverse. After all, this is not a market recovery based on fundamentals. It’s a market manipulation based on government and lender policy.

The 5 biggest threats to the housing recovery

By Ilyce Glink — MoneyWatch — May 16, 2013, 8:42 AM

… Despite large gains in home prices, foreclosures drying up and millions of homeowners recovering the equity they’d lost during the subprime crash, a few lingering risks are worth keeping an eye on.

This was not a subprime crash. It was a total market collapse caused by dodgy loans given to all borrower classes. To characterize it as a subprime crash makes it seem like only that one segment of borrowers were to blame. The housing bubble was a massive systemic problem that was clearly not isolated to subprime loans.

And the question with some of these threats isn’t if, but when, they will actually occur, and what the reaction will be.

Here’s a look at the top five threats to the housing recovery:

1. Interest rates will rise

Super-low interest mortgage rates are driving buyer demand, so it’s no surprise that a rise in these rates will at least change the pace of the recovery.

As interest rates begin to increase again, that will probably have the single most visible impact on the housing recovery,” said Jacob Frydman, CEO of United Realty, a real estate investment and advisory firm. “I don’t have a crystal ball. I can’t tell you when rates will increase, but I can tell you with certainty they will increase.”

Note the very long duration of interest rate cycles. In my opinion, we are likely to embark on a 30-year cycle similar to what we witnessed between 1950 and 1980.

Historically, interest rates have hovered in the 6 to 7 percent range, and when they return to those levels homes will instantly become less affordable. Pricier loans obviously make buying a house more expensive, curbing demand and how much buyers can spend. That’s a recipe for falling prices.

That analysis is right on. My monthly reports on housing affordability convert current pricing to monthly payments which takes into account interest rates. Affordability based on that measure is very good because interest rates are so low. However, once interest rates begin to rise, loan balances begin to fall, and that will put pressure on home prices.

2. Employment is not growing fast enough

You need a job to buy a house. Trouble is, employment growth in the U.S. is still slow and uncertain.

“While unemployment rates have been improving marginally, the real number to watch is job-creation,” said Rick Shargas, executive vice president of Carrington Mortgage Holdings. “Until we see steady, sustainable job growth, hundreds of thousands of would-be borrowers are unable to participate in the housing market.

Slow job creation combined with credit impairment are the primary reasons owner-occupant demand is moribund.

Excitement over the U.S. economy adding 165,000 jobs in April stemmed not from a sign that the economy is ready to soar, but that it’s not set to slide over the edge, as the March job numbers seemed to suggest. The economy only generated enough jobs to tread water — it’ll still take about five years of this kind of growth to return the economy to unemployment levels last seen in 2008. The reality is that millions of Americans remain out of work, and many of them may never find some.

3. The government’s role in the mortgage market will change

The U.S. government currently backs about 97 percent of mortgages though the Federal Housing Authority, Fannie Mae and Freddie Mac. That’s unlikely to continue. It may take years, but the feds will eventually start edging out of the mortgage market. Private mortgage financiers will have to fill the void. But exactly how that will happen and what effect it will have on borrowers remains to be seen.

For the government to reduce its footprint in housing finance, private money must be able to make a risk-adjusted profit. The government gurantees eliminate risk for mortgage investors, so they are willing to pay a high premium for these securities, which keeps interest rates low. If the government guarantee were removed, investors would demand better returns to compensate for the risk. That will inevitably drive up interest rates, the effects of which were described above.

“The entire lending industry needs [government] leadership as to what the bulk of the market is going to look like in the long run,” said David Reiss, professor at Brooklyn Law School and editor of real estate finance industry site REFinBlog. “How tight or loose will credit be? The Federal Housing Finance Agency will decide this to a large extent, as seen by the recent announcement that Fannie and Freddie will no longer buy interest only mortgages.”

4. Another bubble bursts

The rate at which home prices are increasing — about 9 percent year over year — is growing at rates not seen seen since the last bubble.

“The rate of price increase seems unsustainable,” said Glenn Kelman, CEO of real estate brokerage firm Redfin. “There are traffic jams outside of listings where there are 20 or 30 offers on a home.”

The steep competition for a limited number of homes is driving these price increases. And what happens if more homes hit the market as demand begins to ebb? Prices stagnate or drop.

If prices keep rising much faster than wages are increasing, or if interest rates rise, the demand for housing will flag. The higher the prices on houses go, the fewer the number of people who can afford them. And even if demand remains strong, once prices near the peak and loanowners start facing increasing housing costs from expiring loan modifications, more inventory will hit the market. More supply or less demand will slow appreciation. Given the nature of cloud inventory, it doesn’t seem likely that prices would reverse, but they could stagnate for a very long time.

5. Student debt is weighing down young buyers

There’s a total of $1 trillion in outstanding student debt, and the delinquency rate for borrowers who started repaying their loans is more than 30 percent, according to Bankrate.com. Even buyers who are current on their student loans are having trouble repaying their loans.

“Often, potential borrowers are told they don’t qualify for a mortgage because their monthly student loan payments are too high compared to their income,” said Polyana da Costa, senior mortgage analyst at Bankrate.

First-time homebuyers — financially stable singles, newlyweds and young families — are having trouble establishing credit and saving a big enough down payment to please lenders. That means the next generation of homebuyers may be stuck renting rather than buying homes of their own.

Student loan debt is going to be a long-term drag on housing demand. When buyers try to qualify for a loan, lenders look at both their capacity to make housing payments (front-end ratio), and their capacity to cover all debt service (back-end ratio). Student loan debt impacts the back-end ratio. Perhaps the lucky few that don’t have car payments or credit card debt may be able to finance a house purchase, but the normal 20-something with maxed-out credit cards and a leased car has no chance.

6. The bond bubble bursts

The elephant in the room with interest rates is the huge bubble in bonds caused by the federal reserve’s zero interest rate policy. At some point, interest rates will not be zero. When the federal reserve starts to raise rates, it will have a cascading effect across all asset classes. One of the first assets to get whacked will be longer duration bonds, such as the 10-year Treasury and the highly correlated mortgage-backed security pools. A sudden pop in the bond bubble would send mortgage interest rates soaring and cause housing to crash — hard.

7. Government regulators reinstate mark-to-market accounting

This rather esoteric issue is what’s enabled banks to avoid widespread foreclosure processing. Lenders are currently allowed to show loans on their books at values much greater than the mortgage market would actually pay. These artificial values make their capital ratios look better than they really are and disguises their insolvency. If government regulators were to go back to the mark-to-market accounting model — and force banks to tell the truth about their financial condition — banks would begin processing foreclosures to recover their capital, and the market would again be hit with a wave of foreclosures.

It’s unlikely government regulators will do this because they also know it would cause the housing market to crash and imperil our banking system.

8. Banks increase foreclosure processing

At some point, the stronger banks may start processing more foreclosures to finally boot out all the squatters and put their financial house in order. This would actually be a wise strategy for stronger banks to weaken their competition and make them ripe takeover targets. Right now, none of the banks have the strength to do this, but at some point in the future, one or more of the stronger banks may consider it in their own best interest to process their remaining foreclosures. Cartels typically don’t endure forever.

9. Continued credit impairment

Millions of people have damaged credit due to losing a home during the crash and even for missing a few payments to get a loan modification. The lingering effect of these issues will last for another decade.

There are some that believe we should just waive a magic wand, forgive these borrowers their sins, and let them get another loan. This overlooks one basic fact; many of these people can’t handle making loan payments.

The culture of Ponzi borrowing has taken hold. Ponzis should never be given loans because they won’t pay them back. People who live on mortgage equity withdrawal are lender parasites, and now that we are backing their loans, they are taxpayer parasites.

Lenders have created an entire generation of debt-dependent irresponsible Ponzis. We know these people will default as soon as the next creditor fails to come along. Giving these people loans is a game of Russian Roulette where the final lender is the one who takes the bullet. Until we purge this style of financial management from the system, and re-educate them on how to property manage their finances in a sustainable way, they shouldn’t be extended more credit, and they certainly shouldn’t be given massive home loans.

10. Economic recession

As consumers and business continue to deleverage, the economy sputters. We have delayed this inevitable consequence of an out-of-control credit orgy, and with record low interest rates, we have made these debts more manageable, but until consumers have paid for the sins of the past, they won’t have money to spend in the present. The lack of discretionary spending makes for a weak economy, and even the slightest disruption could tip us back into recession. Any economic contraction could increase unemployment and put the housing market back into a tailspin.

Right now it looks as if lenders will be successful in reflating the housing bubble; however, it may not be the orderly and permanent reflation lenders and homeowners hope for.