May282010

The Speculative Housing Bubble Mentality Still Governs the Market

bullish on real estateThe housing bubble and the kool aid mindset it spawned has been very disruptive to American life. Large segments of our population are addicted to Ponzi finance, and the prudent are being robbed to pay for the mistakes of the Ponzis. I find the IHB is an outlet for the frustrations with the insanity being inflicted upon us all. The sad part is how little has been done to correct the mistakes. We will do this again.

The Root of the Housing Bubble Remains Unchanged

Charles Hugh Smith (May 27, 2010)

The fundamental root of the housing bubble–the collusion of the Central State and banks to extend home ownership to millions of citizens who did not qualify for that burden– remains firmly in place.

The Federal government continues to pour tens of billions of dollars into … subsidies to Fannie Mae, Freddie Mac and FHA. Mortgage lenders have been delighted to write mortgages in our completely nationalized market in which the government backs literally 99% of all mortgages and the Federal Reserve bought $1.2 trillion in mortgages that no sane private investor would touch.

Fannie Mae seeks $8.4 billion from government after loss: Fannie Mae, the largest U.S. residential mortgage funds provider, on Monday asked the government for an additional $8.4 billion after the company lost $13.1 billion in the first quarter.

Because of current trends in housing and financial markets, Fannie Mae expects to continue having a net worth deficit in future periods and to need to tap more funding from the Treasury.

“Promoting sustainable homeownership and maintaining ready access to liquidity are our guiding principles in serving the residential markets,” said Michael Williams, the firm’s chief executive.

The government has relied heavily on both companies, which buy mortgages from lenders to stimulate more lending, to stabilize the housing market.

In other words, the housing market would collapse without this massive Federal support, and there is no end to the losses this subsidy will require. Propping up the nation’s fundamnetally insolvent housing market is truly a financial black hole.

The props to the housing market provided by the GSEs and FHA are a direct transfer of losses from banks to the Federal Government just like loan modification programs. Whether it stablizes the market or not is yet to be seen. The fact that lenders are being bailed out of future losses is certain. Losses from 2009 and 2010 vintage loans will all be covered by the US Taxpayer.

Meanwhile, the default rate on low-down-payment FHA loans is a staggering 20% on loans written in 2008–after the housing bust had already unfolded and the risk was undeniable: F.H.A. Problems Raising Concern of Policy Makers:

F.H.A. commissioner, David H. Stevens, acknowledged that some 20 percent of F.H.A. loans insured last year — and as many as 24 percent of those from 2007 — faced serious problems including foreclosure.

The Federal government has thus shown that it is so committed to propping up an unsustainable policy and housing market that it is ready to write off 1 in every 4 mortgages within a year of origination.

The problem with that willingness to absorb risk for the sake of incentivizing borrowing for home ownership is that next year another 20% will default, and then the following year another 20% will default, and by year Five the vast majority of those loans backed by FHA will be in default.

The theory is that the FHA buying will become the support the market needs to put in a durable bottom and prevent the 20% default year after year. It might work — if kool aid intoxication can form a durable bottom.

I have always stated it takes cashflow investors with a genuine reason to buy (outside of kool aid intoxication) to bring enough buyers to the market to stabilize pricing. The government has changed the dynamics of the trade. Instead of waiting for cashflow valuations to prompt buyers, the government is handing out 3.5% down payment mortgages and allowing people to take speculative option positions for little cost. The program does not entice cashflow buyers who will withstand a decline in price, it seduces the kool aid intoxicated who will bail if their position moves against them.

FHA Facing “Cataclysmic” Default Rates:

The Federal Housing Administration (FHA) has guaranteed about 25% of all new U.S. mortgages written in 2009, up from just 2% in 2005.

The key phrase here is “borrowing,” not “home ownership.” The key feature of State support of housing is not legitimate “home ownership,” it is the enabling of massive new sources of income and transactional churn for lenders and Wall Street loan and derivatives packagers.

Home “ownership” when there is no equity in the purchase and no equity being built via principal payments is a simulacrum of ownership.

I wrote about this phenomenon in Money Rentership: Housing and the New American Dream. “Since lenders behave like owners of a borrower’s real estate, and since lenders have right to force sale if a borrower defaults, lenders are owners, and owners are money renters.” A property with no equity position is renting; it is either renting money or renting property. Renting money feels better because at least their is hope of free money later through appreciation.

If a buyer puts almost no money into the purchase–even now, FHA and VA loans can be had with a mere 3% down payment–and the loan is of the interest-only or adustable-rate (ARM) variety favored during the housing bubble’s heyday, then there is no principal payment being made and thus no equity being built.

These “buyers” don’t “own” anything; all they’re doing is renting the money in the hopes that rising home prices will create equity for them out of thin air. What they “own” is essentially an option on a property which they “rent” monthly. If the government manages to reinflate the housing bubble (it won’t, but hope and greed spring eternal), then the option will pay off handsomely. The “owner” put no money into the speculative bet, but they can then sell their option for a huge profit.

If housing plummets, then the “bet” was lost. But since “renting” the mortgage didn’t cost much more than renting a real house, and there was no capital at risk, then the downside is modest indeed.

The author is aptly describing Mortgages as Options. “Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage. Another method speculators and homeowners alike used was the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. If fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks.”

In other words, heavily subsidized mortgages at low rates with little money down incentivizes not home “ownership” but speculation in credit-based bubbles.

In the “old days” (circa 1994), the expectation was that equity would be built by paying off the mortgage principal over time. Equity was a result of reducing the mortgage due, not the result of speculative gambling on future asset bubbles.

I wrote about the Ponzis all week. The defining characteristic of housing bubble Ponzis is their belief that income and wealth come with no sacrifice or effort. Free money is showered upon those who speculate by purchasing residential real estate. They don’t need to save or be frugal; they obtain all their entitlements through borrowed money rather than industrious contribution to society.

The key feature of middle class wealth is thrift, not massive leveraged debt. What Washington and its financial Power Elite partners presented as “the road to middle class wealth” was in fact a mere chimera, a simulacrum of the road to middle class wealth. That road is fiscal prudence and thrift.

Immigrants have prospered in the U.S. for generations because they were thrifty and sacrificed for their children by sweating blood to save money for college educations and for 20% down payments on homes. They did not prosper by snagging Central State supported mortgages with no down payment on homes they could not afford under any prudent calculation of risk.

From this point of view, the entire “home ownership is for everyone” policy was a gigantic fraud, a con job sold to an American public greedy for a short-cut to middle class wealth. The bankers and the Central State government both profited immensely, as the bankers and Wall Street minted tens of billions in profits off the mortgage machine and its derivative spin-offs, and the government (at all levels, Federal, state and local) gorged on billions of dollars in transfer fees, capital gains taxes and the sales taxes on all the gewgaws home “owners” bought to fill up their new McMansions.

The California Economy Is Dependent Upon Ponzi Borrowers. The transition from a Ponzi economy to a thrift economy will be painful, and the economic malaise will drag on for quite some time.

Debt destruction or wage inflation are the answers

I believe only two reasonable solutions to this problem exist; either the debt gets destroyed through bank write-offs and debt destruction, or workers see massive wage inflation to make the debt affordable.

I have seen many articles suggesting that inflation is the cure, but that isn’t accurate. Price inflation in the absence of wage inflation merely lowers everyone’s standard of living and would cause widespread debt destruction as the over-burdened are crushed. Wage inflation without price inflation would be a miraculous panacea; house prices could get pushed back up to peak levels, and borrowers would still have disposible income without HELOC borrowing. With massive unemployment, wage inflation does not look iminent, and without it, debt destruction becomes the only viable option.

Short term, expect to see a great deal of squatting while the lenders remain in denial.