Nine months ago, I wrote about Vertical Capital Income Fund as a way to participate in the bottoming of housing through an investment in mortgages. On November 28th, I checked in with management to get their take from the frontlines regarding the on-going recovering in housing. Once again, Vertical's Chairman, Gus Altuzarra, a 30-year veteran of the mortgage industry, was kind enough to take my call and speak to me for about an hour.
I asked a series of questions regarding the condition of the market, including pricing, demand-side economics, and credit conditions. I categorized Mr. Altuzarra's responses using themes. Overall, the near-term outlook is for more of the same: a housing market in recovery but far from booming. Credit conditions remain tight and investors remain the dominant players in the market. From what I understand, once real credit conditions ease, the market could experience a swell of pent-up demand from people whose buying power will be unleashed through access to loans.
I divide up the interview responses into themed sections. All of the content is paraphrased, and I made some edits for clarity.
Who are the home buyers?
Investors who pay cash dominate the housing market. They are not taking advantage of today's low interest rates because they do not qualify for the loans. These buyers are frequently self-employed. Their income is not "cookie-cutter"; the tax returns are so complicated that it is easier for underwriters to reject the application. Underwriting systems cannot come up with the income. Also, these buyers often already own several properties. Thus, overall, they are unattractive to bankers despite their ample liquidity.
First-time buyers are having difficulty getting a loan unless they have been in their job for at least two years, have had no change in pay scale, have had no change in job, are not a big user of credit, and have some savings. This kind of profile has a great chance at a loan. The banks are looking for the utmost of stability and clarity in the buyer's financial situation.
The implication is that 9 out of 10 applicants for a loan do not get approved because the guidelines are still very tough. Underwriting standards have not changed in the last year and remain very hard. The credit market remains effectively illiquid.
Refinancing is similarly difficult. For example, Mr. Altuzarra has discovered that he cannot refinance his own house if he wanted to because of his self-employment status.
Borrowers in a special program designed to keep people in their homes (who want to stay), like the HARP 1 or HARP 2 program, are notable exceptions. In these cases, the underwriting guidelines are adjusted in order to keep current occupants in their houses, thus creating a twisted set of rules. In HARP 2, a homeowner can be upside down 125% on the mortgage, yet there is no way a regular borrower can even get close to 100% financing. However, these programs have helped some people, and they help prevent properties from going back to the agencies. The government does not want homes going back to Fannie Mae and Freddie Mac.
Overall, for the foreseeable future, the market will remain dominated by investors paying cash.
Credit conditions are tight and credit markets remain plugged up.
The secondary market, private investors, insurance companies, and banking institutions used to allow for some underwriting guidelines with flexibility that went above and beyond relative to Freddie Mac, Fannie, FHA. The credit conditions do come down to the regulatory environment. The pendulum has swung in a huge way to counteract the problems that occurred with extremely loose underwriting. We now need to normalize.
On the appraisal side of things, a high percentage of transactions do not get closed because the agreed upon number ends up higher than the appraiser's valuation. This gap then necessitates a higher down payment which the buyer may not have or may not want to pay.
The Federal Reserve's actions will not resolve this credit tightness. Banks will make a loan if they know they can get it off their books and send it to an agency. There are a lot of unknowns with loans. The liability is higher than it was in the past given the situation with qualified mortgages. The lender has problems because borrowers have recourse. Borrowers will say what they need to say to get a loan, but when things go bad, they will turn around and point the finger at the lender. In general, bankers did not purposely give people unaffordable loans. Sub-prime firms who were feeding mortgage product to Wall Street were notable exceptions. Their underwriting did get sloppy.
Investors paying cash are not the same kind of buyers as owner-occupants who want to move in. Owner-occupants can afford to pay more than these investors since they can get loans. So, the buying demand from investors happens at an otherwise lower price point. If loan conditions were more reasonable, homes would appreciate much more. Liquidity will be the big factor that loosens things up.
In certain areas of the country, prices are firming up. There is some appreciation. Relative to the previous bubble in prices, this appreciation is minimal. However, it is also hard to imagine home values could go down further with the amount of depreciation that has already occurred in the last 5 years. Some values are below replacement value of the house. In other words, you could not build the house at its current sales price. Overall, it seems property values will hold steady. Perhaps increases will occur in certain areas.
If the mortgage interest deduction is taken away, property values would get negatively impacted. The advantage over renting would go away. (For a discussion of the potential impact of losing this deduction see "Capping Mortgage Interest Deduction Could Have 'Chilling Effect' on Housing: Sharga" on Yahoo!Finance's Daily Ticker).
Attitudes Toward Home Ownership
In excess of 87% of borrowers pay on time whether upside down or not (for more details on this, see my recent piece titled "With Housing Demand Rebounding, Negative Equity Now Supports Housing Values"). People take borrowing seriously. They are invested in their house - whether it is an emotional tie, or whether it is because they provided a down payment when they bought the house. You have to pay to live, whether you rent or own. A great majority of borrowers will continue to pay because they feel an obligation.
For example, during the recession in the mid-80s, interest rates were very high and property values dropped. Borrowers who got upside down continued to pay their loans. They feel that at some point in the future their decision will pay off for them. There are definitely bad apples who have created a large problem for everyone. The people who do strategic defaults never had any hard equity that they put in on their own. But it was a house of cards. The minute they found out they could get out, they did so.
Luckily, the majority of people see things differently. The promissory note does not have a caveat guaranteeing that house must never go underwater. On the flipside the lender is not participating on the upside in any appreciation in the home's value.