Eight Key Points on the Real Estate Market

1. So Moody’s tries to clean up its act, and finds itself shut out of rating most Commercial Mortgage-backed Securities [CMBS] deals? That’s not too surprising, and sheds light on the value of ratings to issuers and buyers. With issuers, it’s easy: Give me good ratings so that I can sell my bonds at low yields. With buyers, it is more complex: We do our own due diligence — we don’t fully trust the ratings, but they play into the risk management and capital frameworks that we use. We like the bonds to be highly rated, and misrated high even better, because we get to hold less capital against the bonds than if they were correctly rated, which raises our return on capital. Moody’s was always in third place behind S&P and Fitch in this market, so it’s not that big of a deal, but I bet Moody’s quietly drops the change.
2. The yields on loans are not only going up for LBOs like Archstone, leading to further deal delays, but yields are also rising on commercial real estate loans generally. Here is an example from one of the big deals. The risk appetite has shifted. Is it any surprise that equity REITs are off so much since early March? The deals just can’t get done at those high cap rates anymore.
3. An old boss of mine used to say, “Liquidity is a ‘fraidy cat.” It’s never there when you really need it, and with residential mortgage finance now, the ability to refinance is being withdrawn at the very time it is needed most. What types of mortgages are now harder to get? No money down, Jumbo loans, Alt-A, more Alt-A, and you don’t have to mention subprime here, the pullback is pretty general, with the exception of conforming loans that are bought by Fannie and Freddie. For (perverse) fun, you can see how detailed the guidance to lenders can become.
4. Should it then surprise us if some buyers of mortgage loans have gotten skittish? No, they forced the change on the originators. A buyers strike. But maybe that’s not the right move now. Let me tell you a story. When I came to Provident Mutual in 1992, the commercial mortgage market was in a panic. The main lines of business of Provident Mutual, hungry for yield, had accepted low-ish spreads from commercial mortgages from 1989-1991, because it improved their yield incrementally. The Pension Division avoided commercial mortgages then, because they felt the risks were not being fairly compensated. In 1992, the head of the commercial mortgage area came to the chief actuary of the pension division, and told him that unless the Pension Division bought their mortgage flow, they would have to shut down, because the main lines couldn’t take any. The chief actuary asked what spreads he would get, and the spreads were high — 3% over Treasuries, much better than before. He asked about loan quality, and was told that they had never had such high quality loans; only the best deals were getting done because of the panic in the market. The chief actuary, the best actuarial businessman I have ever known grabbed the opportunity, and took the entire mortgage flow for the next two years, then stopped. (Saving the Mortgage Division was icing on the cake.) Spreads normalized; credit quality was only average, and the main lines of the company now wanted mortgages. The point of the story is this: the firms that will do best now are not the ones that refuse to lend, but the ones who lend to high quality borrowers at appropriate rates. It’s good to lend selectively in a panic.
5. Eventually the ARM mortgage reset surge will be gone. Really. We just have to slog through the next two years or so. This will lead to additional mortgage delinquencies and defaults. We’re not done yet. There is a lot of mis-financed housing out there, and unless the borrowers can refinance before the fixed rate period ends to a cheap-ish conventional loan, I don’t see how the defaults will be avoided. Remember houses are long-term assets. Long term assets require long-term financing. Floating rates don’t make it. Non-amortizing loans don’t make it.
6. Should it then surprise us that the downturn in housing prices is large? No. With all of the excess supply, from home sellers and homebuilders, current prices are not clearing most of the local real estate markets, and prices need to fall further. (Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. A win-win-win. Excess supply goes away. Current account deficit reduced. Wealthy foreigners get a safe place to flee, should they need it. )
7. As a result, the homebuilders are doing badly. They aren’t making money on the hgomes they build and the value of the land (and land options, JVs, etc.) that they bought during the frenzy is worth a lot less. Sunk costs are sunk, and though you lose money on an accounting basis, in the short run, it is optimal to builders to finish developments that they started.
8. Could I get John Hussman to like this Fed Model? It’s from the eminent Paul Kasriel, and it compares the earnings yield of residential real estate and Treasury yields, and he suggested in early June that residential real estate was overvalued. There are limitations here; no consideration of inflation and capital gains, no consideration of the spread of mortgage yields over Treasuries. The result is clear enough, though. Don’t own residential real estate when you can earn more in Treasuries than you can in rents. (I know real estate is local, frictional costs, etc., but it does give guidance at the margins.)

Comments

[tlc8386:]

Past: This
home 92677 Laguna Niguel Orange CA US
30 days -0.7% 0.4% 0.6% 1.8% -0.4% 0.6%
1 year 5.6% -2.7% -2.7% -2.6% -4.5% -4.2%
5 years 116.4% 136.1% 135.9% 148.2% 132.3% 69.5%
10 years 220.3% 230.6% 231.0% 265.1% 249.4% 121.5%
Since last sale (03/24/2005) 46.7% 24.8% 24.6% 30.4% 17.3% 12.7%

This is a typical 4 bedroom home in Orange County, California as you can see that in 5 years it went up 135.9 %. This info is from zillow.com. In ten years this home was up 265.1%

Did everyone think this would go on forever? Eventually it had to hit a income ceiling. Wages were not keeping up with the prices of housing. Something had to break and this was just a bubble like any other that involves cheap credit, speculators, flippers and a host of pressures when wages do not keep up with the cost of living

Real estate agents, mortgage brokers and the government all make more money when your home is valued and sold higher.

Even appliances stepped up, granite was the new kitchen with stainless steel. Everyone rode the wave of bigger and better.

Until the greed hit the wall which it always does. And why because without a balance this bubble broke.

It will take years for this to correct and the Fed knows this and why because this was part of the inflation picture so why would they want to help it come back to it's frenzy state again. The fed standing pat told the market you can't run away with inflation.

This was the best thing they could have done to control the costs of just about everything. Because yes it all does run into each other--it will seep into the broader market and cause a correction. And that is a good thing because we have to be balanced.

A run-away market eventually causes Infation and controlling it is what the fed does. tina c.

2007 Aug 08 12:49 PM

[wixeywaxy:]

Your scenario may or may not be a picture of the future. I'm inclined to suspect that you have an exaggerated idea of the ongoing effects of these problems. The housing bubble will have been deflated and there will be more failures of sub prime mortgages but these are spread widely among many invetors and after the initial write downs will be digested without serious risk to the economy. Vic

2007 Aug 08 09:52 PM

[Carl leason:]

Seems to me that everyone is always looking at their own state when it comes to "The Real Estate Bubble". In my opinion, it's different in every state. FL for example, has had a bigger, badder "bubble" than any state. It's still way over valued and homes are being sold at auctions and repo'ed like crazy.
I simply hate the look of Granite counters and Stainless steel as it makes every kitchen look dark, and the "broken" market affects all appliance manufacturers, carpeting, paint, roofing, concrete, ground clearing, etc. I could go on and on,....but in about 2 years those bad loans will be a thing of the past and a lot of lenders will have taken a beating, but life goes on and people still get old, die, move because of jobs, etc. so ,..yes there is a bubble but nothing lasts forever in this world of houses, loans, and labor.
CA has been very over priced for many years, Fl has now caught up with the rest of the states when it comes to prices but not for wages. The rest of the states are going thru "adjustments", but nothing that people won't cope with. For the Fed to interfere with the housing market would be insanity but then again, who ever said that those guys are so smart ? At lease that's the senario I see. LC

2007 Aug 08 10:17 PM

[Elliott:]

<i>Maybe we should offer citizenship to foreigners who buy US residential real estate worth more than $500,000. </i>

I like this idea. Except I would suggest changing it real estate worth $250,000 or more <i>and</i> can qualify for traditional fixed-rate financing with at least 10% down payment.

2007 Aug 08 11:34 PM

[Carl leason:]

What person from South of the Border has 10 pct. to put down. ?
Any money they get they send back to Mexico anyway ! And what ever happened to the fence we are supposed to be building between here and Mexico ?

2007 Aug 09 09:55 AM