by Ramsey Su
There are two forces that are giving the real estate market a false appearance of recovery today. They are the bulk investors and Ben Bernanke. Just imagine where the real estate market would be if either party were absent. Comparing the current condition to the subprime bubble, there are two similarities. The Federal Reserve is instrumental in starting the bubble while Wall Street provides the endless supply of air.
Let's start with Bernanke
Under Bernanke, the Fed launched three rounds of 'QE' plus 'Operation Twist' in between. One of the objectives is to drive mortgage rates lower. In theory, that should stimulate housing. Using $1,000 per month as the amount of mortgage payment that a borrower can afford, these are the loan amounts at various mortgage rates:
Mortgage Interest Loan Amount
This example illustrates that borrowers that are qualified for a $1,000 per month mortgage payment can borrow 25.9% more if the mortgage rate is 4% instead of 6%. Therefore, in theory, if Bernanke's QEs resulted in rates declining from 6% to 4%, property values should appreciate by 25% if all else were equal. The fact that property values have not appreciated by 25% (with the exception of isolated pockets) would suggest that Bernanke's QEs only succeeded in slowing down the decline in property prices.
How significant is this mortgage rate vs. price illustration? Using September data from DQNews, 25.2% of sales in Southern California were financed via the FHA, 24.7% in Phoenix and 35.2% in Vegas. Without artificially low rates, these sales would either be non-existent or be at a proportionally lower price.
Bernanke recently gave a speech entitled: "Challenges in Housing and Mortgage Markets". He suggested that lending standards are still too tight. This is a categorically false observation. Lending standards and defaults are inversely related. The tighter the standards, the fewer defaults. Since the summer of 2007, there have been no more subprime loans and underwriting guidelines returned. The fact remains that after 5 years, new defaults continue to be high. Without going into details here, readers can easily look up these data. There are many sources for default/delinquency information such as LPS. Calculated Risk has some very nice charts here. Most disturbing is the performance of FHA loans, which has been in the news lately. Its current default rate went up from 8.7% last year to 9.6% today. Chairman Bernanke, lending standards are not too tight, they are too lax.
Ever since the original QE and the placing of the agencies under the conservatorship of the Treasury, lending standards have been dictated entirely by Tim Geithner, backed by the Fed which is buying up all these loans regardless of quality. Lenders have nothing to do with lending standards so stop those worthless surveys. Lenders are simply following agency guidelines, down to the last dot on every "i". No lender dares to deviate from conforming loan guidelines in fear of putbacks. If the agencies were to buy loans made to homeless, jobless borrowers with no credit score and guaranteed there would be no putbacks, lenders would be glad to oblige.
During the eight weeks following the launch of QE3, the Fed has purchased $117 billion worth of agency MBS. I assume this includes $80b ($40b per month) as planned under QE3 and $37b of repurchases of prepaid MBS accumulated under previous QEs. For 2012, the currently estimated amount of purchase money loan origination is $400 billion. At this pace, Bernanke is buying 120% of all originations and $222 billion of the refinances each year. If this insanity continues indefinitely as stated in QE3, how long will it take before the Federal Reserve owns 100% of all agency MBS? Has Bernanke considered how to exit this position in the distant future, aside from him being long gone and leaving that problem to his successors?
The second driving force in the real estate market today are the Wall Street bulk buyers, along with lesser investors in various local markets. In the history of single family real estate, there has never been a similar phenomenon. Using September data from DQNews, investors bought 28% of all transactions in Southern California, 38% in Phoenix and 48% in Las Vegas. Based on anecdotal evidence, investors are even more active today than back in September. Not only are they buying, they are paying cash. Does that make sense?
Using the example above, it makes little difference to the FHA buyers if the price is $166,000 at 6% versus a price of $209,000 at 4%. Both scenarios will keep them at the comfortable $1,000 per month mortgage payment. To all cash investors, there is a 26% difference. If rates reverse course, they have a built-in loss. Furthermore, assuming the rental price would not change for the same house, the cap rate at $209,000 is going to be proportionally lower than if the house is purchased at $166,000. In summary, the Bernanke QEs should put investors, especially cash investors, at a huge disadvantage, when they have to bid against owner occupiers. However, the market is experiencing just the opposite. Why?
Wall Street does not care. It is a repeat of the subprime scam. Here is how it works. First, assemble large packages of assets. Then make up some glossy brochures and fancy spread sheets, converting these assets into something Wall Street investment bankers can peddle. Hire some rating agencies to put their AAAs on the instruments. This should be easy because the underlying collateral is solid un-leveraged real estate and income from rents. When they are done putting lipstick on the pig, they can sell it to the same fools who bought the subprime pools 10 years ago.
Would the scam work? Had you told me 10 years ago that a few subprime lenders could package some junk loans and sell them as AAA securities, and the scam would eventually mushroom into the biggest real estate bubble in history, I would have bet against it and lost my shirt (until the bubble burst). In comparison to subprime, this REO-to-Rentals scheme sounds totally legit.
At the moment, the bulk buyers are gobbling up everything in sight. They are even actively buying and pushing up prices in the new home markets. Money is not an issue. These bulk buyers already have far more funds than available product, hence a shortage of for sale inventory in all the active markets. The only free market force that may put a damper on this feeding frenzy is the single family rental market. If the "proformas" prove to be overly ambitious, it may be too difficult for these products to be packaged and sold.
In conclusion, we are in the early phases of a new bubble. So far, it is unclear whether these forces are strong enough to drive up prices when owner occupiers are already struggling to compete. It took the subprime bubble almost five years before having to face judgment day. How long will the current bubble last?