Financials and Housing: The Outlook Remains Ugly

Financial stocks crashed in the first half of July and then rallied in the second half.  Shorting these stocks had become widespread (often paired with going long oil and commodities), resulting in the shorts became very crowded.  Thus, in mid-July when the government stepped in to eliminate naked shorting, prevent Fannie Mae and Freddie Mac from failing (at least temporarily; we are short both) and pass (yet another) housing bailout bill, financial stocks experienced a quick, sharp reversal that fed into itself as momentum-driven short sellers rushed for the exits and a clumsily unwound their trades.

We believe this is yet another bear market rally in this sector, of which there have been many over the past year, as this chart of the Financial Select Sector SPDR Fund makes clear - click to enlarge:

We remain short many financial stocks, primarily the bond and mortgage insurers, the GSEs and a few banks, because we believe that, in general, their fundamentals remain awful and they have not yet fully fessed up to big losses, which will require them to raise substantial additional capital on highly dilutive terms (if they’re lucky).  At their lows a month ago, perhaps this scenario was built into their stock prices, but at much higher levels today we believe there’s limited upside and substantial downside.

The State of the Housing Market

In general, we are bottoms up stock pickers, but on rare occasions we develop a high degree of conviction on a particular macro view and apply this to our stock picking, both long and short.  One such view is that a worldwide debt bubble of unprecedented proportions – the largest component of which was the U.S. mortgage market and its various derivatives (RMBSs, CDOs, etc.) – built up over a number of years, peaking in mid-2007, that is now in the process of unwinding.  We believe that the unwinding of this bubble – and the resulting credit crunch – will last many years, the dollar amounts involved will eventually be measured in the trillions and the total losses will likely exceed $1 trillion, of which only about $400 billion has been recognized to date by the world’s financial institutions.

There are many factors impacting this ghastly mess, but surely one of the biggest is the unprecedented decline in U.S. home prices.  Simply put, we do not believe that the financial sector will stabilize until U.S. home prices do.  So, the key questions are: how much further will home prices fall and when will they reach a bottom?  Our best guess is that home prices, which through May were down 18.4% from their peak in July 2006 (based on S&P Case Shiller data), are only about halfway finished declining – meaning that home prices will eventually fall 30-40% from their peak – and that a bottom will not be reached until 2010 at the earliest.  Needless to say, our view is significantly more pessimistic (we prefer to think realistic) than that of most analysts, CEOs of financial companies and other “experts”.

Presentation on the Housing Market
We have put together an 18-page slide presentation with our latest analysis of the U.S. housing market, which is posted at www.valueinvestingcongress.com (click on the link on the right side of the page that reads: “READ the presentation or VIEW THE VIDEO from T2 Partners on the Bursting of the Housing and Credit Bubbles.”).

Here are our comments on each of the 18 slides:

Slide 1) This chart shows that prior to this decade, the average American household was able to borrow approximately 3x its pre-tax income to buy a house.  As the decade progressed, lenders became increasingly irresponsible and, at the peak from early 2006 to early 2007, they were willing to lend 9x a household’s income!  This madness was exacerbated when lenders frequently didn’t bother to verify a borrower’s income or assets – these low/no-doc loans are only somewhat jokingly referred to as NINJA loans: no income, no job, no assets. 

The far right side of the graph shows that, as of the beginning of this year, due mainly to lenders tightening their debt-to-income ratio limit back to historical levels around 35%, the amount that can be borrowed to buy a home had fallen by 39.4%, to 5.2x income (as of today, the decline has been even greater, as Amherst Securities estimates that the leverage has fallen to 4.6x).  Keep in mind that these figures are optimistic, as they assume an interest-only loan, which few lenders are willing to make anymore and, in addition, lenders are once again requiring meaningful down payments. 

The massive decline in leverage available to home buyers will likely be permanent and put home prices under pressure for many years to come.

2) As the bubble has burst, existing home sales have tumbled and the inventory of homes to be sold has reached an all-time high of nearly one year.  Econ 101 will tell you that prices cannot stabilize until excess inventory is sold off.  It took three years for the excess inventory to accumulate and we wouldn’t be surprised if it took three years to work it off.

3) Not only are many homes and condos for sale, but even worse is the fact that many are vacant, which can result in distressed sale prices, homes falling into disrepair and depressing the prices of nearby homes, etc.  This chart shows that 2.9% of all American homes and condos were vacant as of the end of Q1, more than 50% above historical levels (and the number is surely higher today).  The most shocking statistic on the page is the fact that of all homes and condos built this decade, 10.2% are vacant.

4) Foreclosures are major drivers of home price declines because they typically result in an auction of the home, often resulting in a highly distressed sale price, whereas someone selling their own home typically won’t accept such a price.  This chart shows that foreclosure filings have skyrocketed over the past two years and there’s no sign of a let-up.  Last month, foreclosure-related sales accounted for 42% of home sold in California and here’s what an article in the New York Times article said today about what the nation’s two largest home mortgage players are doing:

Daniel H. Mudd, Fannie’s chief executive, told investors that Fannie was “using a lot of innovative ways to get the property out the door.” This is not, he said, a good time to be holding on to foreclosed properties “and hoping for a better day.”…

Foreclosures are soaring. In 2006, Fannie and Freddie between them acquired 52,967 properties, a figure that leaped 36 percent, to 71,961, in 2007. During the first half of this year, there were 66,420 foreclosures by Fannie and Freddie.

Not only are there more foreclosures, the losses are much larger. In 2005, Fannie lost an average of 7 percent of the unpaid principal when it sold a foreclosed property. So far this year, the figure is 26 percent, and in California it is up to 40 percent. In all of 2006, Fannie foreclosed on 93 California homes. The current rate is almost 1,000 a month.

Here are some additional statistics:
 
•    At the end of Q1, 2.47% of mortgage loans were in foreclosure, equal to 1.3 million homes or 2% of U.S. households
•    1/3 are in California and Florida
•    Nearly three million homeowners were behind on their mortgages at the end of 2007 and 1-2 million are at risk of foreclosure in 2008
•    8.8 million homeowners were underwater on their mortgages (balances equal to or greater than the value of their homes) as of the end of March according to Moody’s Economy.com
•    30% of subprime loans written in 2005 and 2006 are already underwater

5) Fueled by loose lending standards and a bubble mentality by all market participants, home prices nationwide from 2000-2006 rose more than 50% – and now need to fall approximately 34% from their peak to return to trend line.

6) In the top 20 metropolitan areas tracked by the S&P Case Shiller Index, home prices more than doubled – and, through May, had only fallen 18.4% from their peak.

7) This chart that appeared in the Wall Street Journal last month shows that home prices in the 20 metropolitan areas tracked by the S&P Case Shiller Index, having declined 17.8% from their peak through April, need to fall an additional 29.0% (41.6% total) to reach the level they were at in January 2002.

8) These two charts measure home prices relative to rent and income levels.  The former shows that, assuming steady rent levels, home prices need to fall about twice what they have fallen so far to reach the historical average.  The latter shows that home prices have already fallen back to the long-term price-to-income ratio.  This is the only data point we’ve been able to find that shows home prices have already fallen back to normal levels, and it doesn’t make any sense to us, as income levels for average Americans have been stagnant.

9) This page shows the month-to-month (sequential) changes in U.S. home prices from March 2005 to May of this year.  In the first 17 months of this chart, home prices continued to rise, albeit at a slower and slower rate, until July 2006, when home prices peaked.  At that point, the line on the chart goes negative, where it has remained, meaning the home prices have fallen in every month since their peak.

The most interesting and relevant part of the chart is the line in the last three months, in which the rate of decline slows sharply: from January to February 2008, home prices fell an unprecedented 2.6%, but then "only" fell 2.2% in March, 1.3% in April and a mere 0.8% in May.  Looking at this data, one might be tempted to extrapolate the recent trend and conclude that home prices might stabilize in the new few months – and if that's true, then many financial stocks will likely be great investments from here.  We don’t think this trend will continue, however, as the next two slides make clear.
 
10) This graph shows month-to-month home price data since the inception of the S&P Case Shiller 20-city index at the beginning of 2000.  It makes clear the enormously seasonality in the month-to-month numbers – and that in the eight previous years going back to 2000, home price changes in April, May and June of each year (highlighted by the red circles) are much higher than the rest of the year.

11) This is the same graph, using the S&P Case Shiller 10-city index, which goes back to January 1987.  Again, in virtually every year, one can see the better performance in April-June.  Mathematically, the simple average monthly increase in April-June of each year since 1987 is 0.76% (9.6% annualized) vs. only 0.29% in the other 9 months (3.5% annualized).
 
So does this mean that home prices are likely to return back to falling 2%+ per month later this year once this seasonal effect wears off?  Probably not – 2% per month is a very high number.  But we'd guess – and it’s only a guess – that the average monthly decline will average at least 1% for at least another year and then another year in the zero to -1% range on average for before home prices finally bottom in mid-2010.

12) Many mortgages written at the peak of the bubble (from early 2005 through the middle of 2007) had low “teaser” interest rates that reset after two years, which triggers payment shock and, in many cases, default.  It’s not a coincidence that the mortgage crisis began in early 2007 which, as you can see in the chart, is when the first wave of resets hit, from (mostly subprime) mortgages written in early 2005. 

This chart shows that the resets taper off by the end of the first quarter of 2009, which is leading many to predict that home prices will bottom shortly thereafter.  There are two reasons why we believe this prediction is incorrect.  First, it takes an average of 15 months from the date of the first missed payment for a home to go through the process of going into default, being foreclosed upon, the lender taking possession and, finally, liquidating the asset.  It is primarily in the last phase, typically when the home is auctioned off, that home prices are pressured.  So, to determine the timing of when home prices might bottom, one shouldn’t look at when the resets taper off, but rather when the wave of foreclosures and auctions do.  Thus, add 15 months to the end of Q1 2009 and that’s mid-2010.  But the story is even more grim…

13) This chart picks up what the other chart misses: that a huge wave of Option ARMs and, to a lesser extent, Alt-A mortgages will reset (or “recast”) in 2010 and 2011 – a wave as big as the one in 2007 and 2008 that has caused so much pain to date.

14) This slides describes what an Option ARM is.  In short, an Option ARM is an adjustable-rate mortgage that was given to a prime borrower, usually based on the borrower’s FICO score and appraised value of the home, with little concern for the borrower’s income or assets – hence, more than 70% of Option ARMs were low/no-doc.  The key benefit to the borrower was that, until the loan resets (the technical terms is “recasts”), the borrower only had to pay a small fraction of the interest owned on the loan, with the difference being added to the principal balance of the loan. 

So, for example, the Option ARM might have an interest rate of 7%, fixed at this level for the first five years, but the borrower would only have to pay interest only at, say, a 2% rate (with very small increases each year).  Each month that the borrower chooses to pay the lower rate, the unpaid interest is added to the balance of the loan – this is called negative amortization, and approximately 80% of all Option ARMs have incurred some degree of negative amortization since inception.

A typical Option ARM resets either after five years elapses or – this is key – the loan, due to negative amortization, hits a trigger point, generally at 110%-125% of the original loan balance.  This means that a borrower paying 2% rather than 7% for three years will see the loan balance increase by roughly 15%, which often triggers a reset. 

Slide 13 shows the scheduled five-year Option ARM resets, but because nearly all Option ARMs are negatively amortizing, many are resetting right now, which is triggering a sharp rise in defaults.

15) This slide has quotes from a Wall Street Journal article about rising Option ARM defaults.  Here is the key quote:

’My sense is that many option ARM borrowers are in a worse position than subprime borrowers,’ says Kevin Stein, associate director of the California Reinvestment Coaliton, which combats predatory lending. ‘They wind up owing more and the resets are more significant.’

16) This slide shows that until March 2005, the interest rate on an Option ARM was lower than that of a fixed-rate 30-year mortgage, which attracted rational borrowers to Option ARMs and deterred those already holding Option ARMs from refinancing. 

But after March 2005, rising short-term interest rates pushed the Option ARM interest rate above the rate of a 30-year fixed-rate mortgage – at one point, nearly 200 basis points higher.  This should have dampened demand for Option ARMs and led to a surge of refinancings into the fixed-rate mortgages, but this didn’t happen – in fact, demand for Option ARMs surged.

How could this be?  What could account for such unprecedented, irrational behavior?  There are two likely explanations:

A)    The borrowers had high FICO scores, but weren’t really prime borrowers (one of the major lessons from the mortgage bubble is that FICO scores have proven to be very poor predictors of whether someone would default on a loan).  Recall that most Option ARMs didn’t require any documentation of income or assets (unlike most traditional fixed-rate loans), so if someone had, for example, recently lost his job, an Option ARM would be the product of choice.  Of course, such borrowers are likely to have subprime-level default rates…

B)    The borrowers were prime, but were buying their dream home at a peak-of-the-bubble price, were stretched to the limit, and simply couldn’t afford the full-interest-plus-amortization payments that traditional fixed-rate loans require.  What do you think will happen to these borrowers when the Option ARM resets, the interest rate jumps (to a level far higher than what it would have been under a fixed-rate loan), and not only must all of the interest be paid each month, but the loan also becomes fully amortizing? 

Even if the homeowners can afford the new, dramatically higher payments, will they be willing to make them?  As the next slide shows, the majority Option ARMs were written in bubble states in which home prices have already fallen by 25% or more, meaning a huge number of Option ARM loans are far, far underwater. 

Consider this example: Imagine a $600,000 mortgage that negatively amortizes to $690,000, which triggers a reset (assuming a 15% trigger).  At the same time, the value of the home has fallen 25% to $450,000.  How many homeowners will simply walk away from their homes (or demand that the lender write down the loan to market value) rather than make full interest and amortization payments on a mortgage that’s 53% above the value of the home?

17) This slide shows that Option ARMs were concentrated in the states that had the biggest housing bubbles – and are suffering the worst consequences.

18) This is an email from a Federal Senior Bank Examiner about Option ARMs, which he predicts will be “the next tsunami to hit the housing market”.

Disclosure: The author manages funds that are short Fannie Mae, Freddie Mac, Ambac, MBIA, General Growth Properties, PMI Group, and Radian.
 

Comments

[papita:]

excellent article. there are many people in my old home town of Boca Raton trying to sell their homes while at the same time trying to get peak prices. the result is nearly every other home is for sale and has been that way since 2005. many houses are sitting vacant and this is in one of the best neighborhoods in south florida. that can not be good news. part of the problem and a big part are the brokers who tell the sellers what they want to hear and are keeping the prices artificially high. it's not working.

2008 Aug 20 05:16 AM

[fxtrader07:]

your abk, mbi and rdn shorts are mispülaced and will blow up in your face. you may well be correct on the housing market but that doesn't mean your bond insurance shorts will pay off. I am siding with marty whitman in this case who has a decades long proven track record and knows A LOT about insurers, distressed investing and financial stocks.
and no, i am not surprised that you are now short fannie and freddie. after all bill ackman also went short them - and he seemingly can't make ANY move without Tilson following suit, no?

2008 Aug 20 05:51 AM

[Ishortyou:]

Many of those bonds wraped in RMBS and CDOs are from NINJA loans or credits-No Income, No Job or Assests- originated by banks and broker firms. Many of those bonds were tripla A rated by Moody's. Bond insurers believing they were high quality bonds decided to insure them, but surprise, surprise they contained JUNK, this cost a lot of write downs. Eventually Moody's dowgrades the bond insurers based more on speculation rather than facts and causes a massive sell off of municipal bonds, a flood in the auction rate securities market, massive write downs in banks and broker firms, collapse of several regional banks, Fannie and Freddie, etc., bond insurers are now doing their homework and remediating their books from toxic waste. On the other side the housing market is correcting itself, it will take sometime, but like any other economic bubble is correcting itself, so remediation is on the way.

2008 Aug 20 06:08 AM

[Frank Rong1:]

Nothing new from this article. Yes, many lenders will disappear from this mess, but overall, american consumers will benefit from this mess as home prices finally coming down.

Just like any industry, when prices of a commidity goods(housing this case)move up, more competition come in, thus more of the commodity being produced, eventually prices felt back.

American consumers go best of the deal, since many of them bought prices high with no money down, how much will they lose? Nothing

2008 Aug 20 07:00 AM

[Ishortyou:]

doesn't look that lenders are going to wait for the ARMs ninja loans to reset, knowing that they are already in trouble, they probably are working on how to minimize risk when ARMs loans reset.

2008 Aug 20 07:14 AM

[chtrplyr:]

Doesn't seem like a complete analysis i doubt we will see a full 1% drop for another 12 months at the rate that that S&P index went parabolic down and now has steadied out at 2003/2004 levels - many factors to consider including the amenities and quality added to the homes over time as well as zoning and other water resource issues as well a replacement costs.

Also painting all 'financials' with the same brush is a mistake some modeled and provisioned for much higher peak to trough housing value declines and over all economic conditions.

Without going through loss severity impacts and doing so without being biased and over emphasizing all negative impacts and ignoring positive impacts (housing bill, credits etc.) like this article did a very distorted 'gloom and doom' picture arrived however it might just be all smoke and mirrors of the negativity crowd as their negativity bubble collapses.

2008 Aug 20 07:17 AM

[apppro:]

The only thing that 'remains ugly' here is your narcissistic, Generation Me’er compulsion to prove yourself right no matter who or what you destroy.
Have you ever thought maybe, just maybe that the constant water-boarding of our banks and other financials institutions has perpetuated a major part of this mess. If they treated prisoners at Guantanamo like you treat our financial system, people would be screaming bloody murder.

Ok, you were right BUT:
STOP IT ALREADY! ENOUGH! BASTA! NO MAS!

2008 Aug 20 07:38 AM

[fatcat:]

It seems Mr. Tilson has a lot of critics here....more suckers who can't face reality.Anyone with any financial sense could see this coming for years.

2008 Aug 20 08:20 AM

[OD:]

Very selective in the data you use, but only time will tell.

What I will say, is that econ 101 is an introductory class for a reason. Try and think past the whole idea of "when there's excess supply prices can't stabilize". Think of it this way: if you can buy a house with a 6.5% mortgage and rent it out at a 10% yield would you buy it?

Ok Ok you say, so maybe the buyers should ask for an even higher yield because the sellers are hamstrung and have a lot of supply to get rid of. This is only true if you there are a few big buyers and isn't true when you have individual investors running around all trying to get a sweet deal for themselves. There is no cooperation at these auctions you really need to go to ground zero and take a look at what's happening. Game theory... I think that was a few steps above econ 101.

2008 Aug 20 08:21 AM

[jackeast:]

Solving the Housing “crisis”.

A. In order to solve the crisis a quick look at the underlying issues of the crisis are important.

1. The rate of increase in housing prices was artificially accelerated by the availability of high risk loans. The loans were high risk in that people could not afford to pay the principle and interest while maintaining a quality of lifestyle commensurate with the property they were purchasing. Risk increased as the available cash flow of home owners was not enough to create capital reserves to offset future risk. The loan types were generally variable rate mortgages that even financially savvy borrowers could not adequately assess risk.

2. Supply over the last few years was increased in response to the artificially accelerated rate of home price increases. While the rate of home prices increases was high and capital was easy to come by a large portion of the pool of potential buyers entered the pool of buyers. Those “potential buyers” who transitioned into the “buyers” pool were forced to purchase homes that would normally have stayed out off the market or been eliminated from the market due to development, nature, or disaster for inflated prices. So while these homes in “normal” markets would not have been marketable or tradable in a period of “abnormal” markets they became commodities that were prized by two classes of buyers. The first were marginal buyers who generally would have stayed in the “potential pool” of buyers and “investors” who desired to purchase and “flip” with marginal and minimal “upgrades” to the properties. Further, the accelerating pool of “new” homes added to available supply making the calculus for home buyers more complicated. i.e. Pay slightly more for a new home or slightly less for an existing home. More and more buyers were choosing the former over the latter. This increased risk and resulted in builders having competitive advantages over existing homes. The competitive advantage resulted in more new home construction. At the same time the dynamic of the marginal buyer and investor and now exacerbated by those seeking to “trade up” increased the supply of existing homes. A general but not unreasonable increase in basic commodities created situations in which marginal buyers (i.e. those that recently transitioned into the buyer pool because of the previous dynamics) became unable to service their mortgage debt. As these properties entered the market as sell before foreclosure the supply increased even more. This portion of the supply was marked at very close to cost causing a DECELERATION in the median price of homes in at risk markets.

3. The availability of rental properties became reduced as they became converted to finance and buy properties. This began to drive up the cost of renting. As the cost of renting increased, the calculus of buy versus rent increased the number of those transitioning from “potential buyers” to “buyers”.

4. Eventually the pool of available buyers became maximized to the market conditions and there were no new entries into the demand market. At this point demand began to decelerate. All those who could trade up had done so. All those who could buy a house to live in had done so. The available leverage and capital of “flippers” was maximized.

5. As demand decelerated, the time it took to sell properties increased. Loan brokers and financial institutions as well as construction firms and sellers attempted to reduce this time to sell through special “fast track” loan programs and incentives. Eventually the only way to reduce the time to sell was to reduce prices. This reversed home price increases and began the process of accelerating decreases in home values in the system. As comparable homes were sold for less and less month over month investors began to question the actual value of the collateral behind financial instruments.

6. As interest rates reset on homes and the true cost of ownership began to affect marginal buyers a new class of supply entered the market; the foreclosure. While this class of supply had generally been available to the market they had generally been in demand by the investor and developer. The market could not absorb this extra supply and as housing prices had entered the phase of declining values already, these new entries resulted in drastic rates of declines in “key” markets.

7. Declining values of collateral and leveraging strategies by financial institutions resulted in decelerating returns on loan portfolios and even losses. These losses were identified rightly as due to the decrease in value of properties, which erased the value of collateral, the increasing costs of foreclosure, the decreasing revenue for loan generation, the decreasing interest payments from the pool of home owners, and the increasing cost of refinancing debt as the capital markets began to doubt the value of financial instruments in a new wave of analysis.

8. Risk insurance and cost of capital increased as the traditional backstop of losses, the insurers exited the market place. The scope and depth of losses in the insurance sector locked up the entire market place and made the cost of refinancing and capitalization such that losses mounted. The result was two-fold: 1) increased capitalization that reduced the amount of liquidity in the market and 2) increased cost of gaining capital at the retail level. The result was pushing a large portion of those in the “buyer pool” back to the “pool of potential buyers” and drying up demand.

9. With even less demand and an over abundance of supply prices fell at an even accelerated rate.

10. Psychology of the market place now dictated that the entire pool of buyers analyze the risk of entering a falling market. At this point the cost of moving first may be the further erosion of the value of one’s home and missed opportunity to purchase higher quality at equal or less cost. The buyer market then became limited to those who “HAD” to purchase as a result of market conditions.

11. Interest rates for those financing and the information requirements (i.e. total cost) increased dramatically further eroding demand for properties.

12. The end result is a stagnant market of buyers and sellers and financial institutions with an increasing portfolio of under or non performing loans making all the financial instruments that are supported by the market of an uncertain value. This has further eroded both availability of capital to fund purchases and the ability of financial institutions to finance its debt increasing threats of insolvency. As certainty and confidence is eroded the problems become worse and a feed-back-loop results.


Now that the underlying process leading to the current “crisis” is understood some solutions can be formulated.

B. Reduce supply.

Stabilizing the values of homes is essential to create certainty as to the value of securities and collateral. It will also change the calculus of buyers who are staying out the market because of hopes that they will be able to buy more for less. Reducing supply would also decrease the time that homes are on the market creating conditions that will decelerate the rate of foreclosure. This too will create conditions of certainty and solve the under-and non-performing loan problem.

There are several possibilities for reducing supply and they include:

1. Offering grants to localities to purchase properties to turn into green-space or to place in land/property trusts for later development.
2. Offer terms that would allow the refinance of properties to reduce the foreclosure of homes. Terms such as 40 year or 50 year mortgages at increased interest rates with provisions that state that the property cannot be sold or transferred for 2, 3, or 5 years. The lender can force refinance instead of foreclosure.
3. Market clearing houses can be established where people in foreclosure can have the option of “trading down”. Financial institutions can offer homeowners the ability to refinance into a lower cost home removing it from supply, keeping a marginal home-owner in the home owner pool and maintaining the very highest valued properties in the supply system. These properties would be the most likely ones to benefit from the “trust” green-space programs mentioned above. They are also the most likely to be successfully managed in foreclosure.
4. Financial institutions should enter into property management agreements utilizing programs such as the Defense National Relocation Program that offers property management services for relocating home owners. Properties are rented. By transiting homes from the sale/finance pool to the rental pool two things are accomplished. 1) Those entering the rental pool may be able to remain in their homes as renters paying less cost such as insurance and local property taxes. These costs are transferred to the lender. However, with rental rates as they are, it is possible that even with decreased rates due to increased supply that the lender will be able to cover the costs with rents. 2) Financial institutions are able to maintain the book value of their collateral (real property does not suffer from mark-to-market issues) and still maintain a revenue stream. A provision for refinance and repurchase may be included in the lease/rental agreement offering the potential for future revenue and a ready market of borrowers when future conditions improve.
5. Increase the costs associated with selling a home. For those home owners who cannot show cause for sale( i.e. not in threat of foreclosure as certified by their financial institutions) will pay a tax penalty on the sale of their home regardless of whether they make a profit or not. Something like a .005 tax on the total proceeds of the sale payable into a “Green Space and Trust” account for giving block grants to localities for purchase and clearing homes. This could be in effect for 2 or three years while the market cleans itself up.
6. Decrease the costs of home purchase if one is not also selling a home. Offer a tax rebate equal to the total costs of closing (minus down payments and points) payable in 5 years if the home is owned as a primary or secondary residence for 3, 4, or 5 years. The payment can be prorated based on the length of ownership. The payment can also be divided into two segments, one payable to the lender as a principle payment and one payable to the owner. The rebate could be recouped by the federal government at a rate equal to 10% or 20% a year from the mortgage tax deduction in the years following the payout.
7. Increase the regulatory requirements to offer adjustable rate mortgages. For instance, increased equity in the home through higher down-payments, or increased monthly payments into an “Interest rate adjustment account” to offset the affects of interest rate increases.
8. Allow new home construction companies to purchase their own inventory at reduced prices to claim the loss on their taxes and to not pay sales tax on the properties if held for 2 or 3 years.
9. Allow construction companies and owners of residentially zoned lots to “charge off” or deduct an “opportunity cost” equal to some percentage of the assessed value of the land if the land is undeveloped for 2 years after the deduction. If developed then the individual or company has to pay back the savings resulted from the deduction + 20%.

C. Close the gap between cost of capital for the financial institution and the return on loans given.

1. Embrace the fractured pricing of the housing market by creating new loan segments. Break the housing price market into segments of 100K each in which each higher segment has higher real interest requirements. For instance on a 30 year fixed, the “base” bracket may be between 0 and 100K and equate to the 5 and 6 % range. From 100 – 200K the interest may be between 6 and 6.5% range. Between 200K and 300K the rate may be between 6.5 and 7%. Over 300K the rate may come back to between 6 and 6.5%.
2. Restructure equity requirements based on tiers or categories of loans. For under 100K the equity requirement may be 0%. From 100K to 200K the equity requirement may be between 5% and 10%. Between 200K and 300K the requirement may be between 10% and 15%. From 300K to 400K the requirement may be 20%. Over 400K the requirement may be 10-15% again.
3. Extend the period of repayment to reduce monthly payments on existing loans without refinancing, sort of an automatic renegotiating of terms. By extending the period of the loans and reducing principle payments it decreases the likelihood of default but increases the total expected interest payments to the loan. A 200K loan at 7% moved from 30 to 40 years would reduce the interest and principle payment from $1330 to $1242 a month.
4. Use savings from Dividend Cuts and equity offerings to reduce debt through retirement and repurchase. Repurchase of low quality debt at prices lower than issued with higher quality debt issues and cash would reduce borrowing costs for institutions.
5. Reduce leverage from the current 3:1 (for FRE) to 2.5:1 or less through the process of retiring debt and building cash reserves.
6. Increase cash flow to reduce borrowing requirements. Renegotiate mortgage terms to allow interest reductions, special incentives, and benefits for increasing principal payments.
7. Increase and capital cash flow to reduce borrowing requirements. Encourage voluntary increases to ESCROW and manage ESCROW accounts like Debit Card accounts. Pay interest on excess escrow balances and charge fees for the use of the account. Fence ESCROW DEBIT Accounts as capital reserves not to count in leverage decisions so that a “cushion” or “emergency reserve” of capital exists.

D. Increase Demand

1. Allowing the cashing out of 401K and IRAs for the purchase of homes if the family is “trading down”, the refinance of a home if lived in for more than 1 year and will live in for the next 5 without penalty, or the making of mortgage payments if in foreclosure and have lived in the property for more than a year and will live in it for more than 3 without penalty. If a family uses these funds then the financial institution has to forgive all interest and fees related to the foreclosure proceedings.
2. Stabilize the value of homes through the previously mentioned actions in order to eliminate the tendency of current buyers to wait for a better or lower price.
3. Provide grants and tax incentives for investors to purchase “distressed” properties and to transform them into green spaces.
4. Provide tax incentives for investors to purchase properties in foreclosure, to hold them for 2 or 3 years and then to redevelop or sell them. The incentive could be NO tax on the profit, a tax loss on the purchase that is then offset by a gain when and if sold, or any other program.
5. Allow the purchase of lots zoned for residential single home construction to be held for 3 years. At the end of three years the lots may be developed and no federal taxes paid on the assessed value of the land when sold, only on the property built on it.
6. Allow companies and individuals to purchase residential lots from themselves and to not pay federal taxes on the profits from the assessed value of the land if held for 3 years, only on the value of the property built on it.


E. Accept Losses to reduce Losses

1. Allow the “forgiving” of a % of an outstanding mortgage coupled with rate and term adjustments in order to reduce monthly payments and bring mortgage rates in line with actual values. The owner will pay taxes on the forgiven amount as income, the financial institution accepts a “loss” less than foreclosure, and the terms of the financing are transformed to create a new lower risk asset. For instance: 200K at 8% on a property worth 170K (for whatever the reason for drop in value) with 27 years left, turns into a Mortgage for 180K at 8.5% for 40 years saves over $200 a month when reduced payments and re-assessment of the property and the corresponding tax savings are taken into account. The government collects income taxes on the $20,000.00, the financial institution takes a tax loss on the $20,000.00, and instead of losing 1/3 or more by Foreclosing the financial institution only losses 10% on the revaluation and increases by .5%.
2. “Donate” distressed properties to localities for them to turn into green spaces or rental properties for low income persons. These properties can be “written off” at a value equal to the foreclosure costs and balance of the mortgage.
3. Offer programs by which local communities can purchase/finance distressed properties for destruction/rental/gre... space initiative/business development. For instance, a distressed property in a community could be refinanced under a special community works program at a low interest rate to be paid for by a locality such as a city or even a neighborhood corporation. A group of 25 home owners take partial (4%) ownership of a property that is foreclosed in their neighborhood that is then rented to own to a child care provider at a cost per month equal to the mortgage. While the child care provider may not have the capital to purchase the property the community does. The child care provider then provides care for the community and locality at market rates. This could be the same for any type of community home based business, a medical clinic, or even a library or dentist.
4. The property could be financed by a community and be torn down at cost to the lender in exchange for the community taking a refinanced stake to turn the lot into a neighborhood playground, green space, or held in common for later sale. On a 200K home each resident of the community (if 25 were included) would finance $8,000.00 over 30 years at 5%, or less than $50.00 a month. This may be added to a community association dues and the federal government may grant tax deduction status to the interest and any profit from the use or sale of the lot/property. The amount may be managed on an individual basis by the loan provider. 25 low risk loans at the price of 1 HIGH RISK loan. $50.00 is a small price to pay to maintain the value of homes in a community. And the cost is borne by the community that benefit from a maintenance of value. This also reduces supply and increases demand.

2008 Aug 20 08:35 AM

[Ishortyou:]

lets put solutions to work!

2008 Aug 20 09:08 AM

[neeb??:]

Jackeast makes good sense in this case. The only problem is that we also need to instill a healthy level of fiscal responsibility in the borrower.
All financial agencies, including the alledgedly more objective rating agencies fell over themselves hence proving---Human, all too Human.

2008 Aug 20 09:11 AM

[econ101:]

With all of the rhetoric surrounding housing everyone has forgotten the basics. At the end of the game there are only two stats that are meaningful- median income for a family of 4 (about $49k) and median home prices (about $231K pre-correction).

At today’s levels the two numbers don’t work regardless of how the financing is structured. Period. And also you may want to apply an income approach to valuation instead of comp sales. Duh…

2008 Aug 20 09:30 AM

[prescient11:]

$600B in losses have already been recognized, at least. Let's keep the numbers right.

2008 Aug 20 10:14 AM

[Rhett:]

None of the comments equal Tilson's insightful analysis. Great job, Whitney!

2008 Aug 20 10:51 AM

[TrueCasey.com:]

Thank you for bringing us this timely news and not sugar coating things. Those realtors are still calling this a soft landing or "we're hitting bottom" or other crap. (Nothing against realtors BTW, I would be saying the same thing if I was one, its human nature).

We need to be realistic and understand a lot of people are in trouble right now.

2008 Aug 20 01:23 PM

[TrueCasey.com:]

Shouldn't have said anything about the realtors... i'm sorry... wasn't thinking straight.

REally what we need I think is for the government to STOP BAILING OUT BANKS... because our own taxes are going to pay for all that stuff and we're going to have some MASSIVE INFLATION.

It's already happening.

Thanks to the federal reserve and the fiat monetary system we're going to keep having problems.

Instead of bailing out banks with more fake money lets get some REAL MONEY.

Like going back to the gold standard!

2008 Aug 20 01:27 PM

[Big Al45:]

This writer of this article seems to forget that all real estate is local. His conclusions regarding Alt A defaults is probably on point for banks that have a high exposure to mortgage loans made in Southern and Central California, Nevada, Florida, Michigan, Ohio, and the Atlanta metroplex.

But, there are a lot of other areas in the US where housing prices did not rise much during the housing bubble and prices in those areas probably will not fall more than 15% peak to trough. As long as the government bails out Fannie and Freddie (which seems certain), banks that don't have significant exposure to California, Florida, etc. should return to profitability by the end of 2009.

For the record, I do not own any bank stocks, and expect the market to retest and probably exceed the July lows. However, the level of pessimism in this article is excessive.

2008 Aug 20 01:32 PM

[mbacapitalist:]

Some interesting and useful solutions have been presented. Reducing the supply is the only sure way that the housing market will be stabilized. Changing the rules, adding incentives, etc, will not ease the amount of supply that is flooding the market. The builders are somewhat growing a brain in this area. They've sort of slowed down production of new constructs pending the approval of the financing. If the current president can get it right by commenting that if you build too much, you'll have an excess supply (obviously not in such sofisticated words), I'm sure the issuers of housing permits and builders can slow down the dumping of new supply on the market. There's just too much housing available out there.

The DC metro market is a great example. The builders continued to flood the market with excess inventory over the past several years, even post-2005 which is when the market started to dramatically cool in this area. As a result, builders have given out massive incentives, propelled the rapid cooling of housing prices, and still continue to deliver more homes. Until these units are absorbed, home prices will not even begin to stabalize. I do not see the number of people (absorbers) moving into this area exeeding the number of available housing units; its more likely the other way around. The DC market is certainly a buyers market, and if I were a buyer in this area, I would take my time.

2008 Aug 20 01:48 PM

[ain't no fo...:]

Great article!

denial ain't just a river in Egypt...

2008 Aug 20 01:52 PM

[Tom Armistead:]

Whitney, S&P Case Shiller is a flawed index - it doesn't cover the whole country, it ignores refinancing, it overweights higher value homes and it overweights transactions that are closer together in time.

The transactions that carry the most weight would be paying 20% too much for a house in California, not making the payments, and then in a matter of months being foreclosed and selling for 20% too little.

Take a look at the OFHEO indexes, specifically the one that includes refinancing. What Case Shiller shows is relevant to the worst of the subprime, Alt A etc. in the former hottest areas, but distorts reality for the rest of the market.

You are always doing your homework, it seems - here's something else you could check out. 1) how big is MBI's repurchase authorizatoin? 2) how many shares could they have bought starting 7/1/08? 3) After counting treasury shares, Warburg Pincus, management and institutional investors, how many shares remain? 4) how many shares are shorted?

The answers might prove disconcerting.

2008 Aug 20 03:14 PM

[1worldcurrency:]

Ok there's one more econ 101 basic number being ignored: 9.6 trillion, trending up. That national debt is so big no one can grasp it, so we let it get bigger, and no, we don't "owe it to ourselves". What's another zero, coming soon when they bail out fat Fannie and Freddie.

That number represents wealth that must be transferred to places like China where they have been working and saving to feed our fat consumer. Much of our paper wealth is in our homes. We are spending huge amounts of our wealth in Iraq.
We must cut fat, either with a steady diet, slow starvation, or liposuction. Ice cream rebate checks just delay the inevitable.

2008 Aug 20 04:29 PM

[Ishortyou:]

Lets assume the worst and that is the Fannie and Freddie stock go bust to zero, the government take the GSE's, so what? are we going to h*** for that? are the mortgages in their books go bust? are we going to crush? the answer is no! all those mortgages in their books will automatically be backed up by the government and even be rated as triple A, that will upgrade the books of all of those holding them into CDOs, MBS, SIVs and cause massive write ups! so what is the nonsense in here? that would be the best case scenario for bond and mortgages insurers, I am sure there are many of them praying for the government to take over the books of Freddie and Fannie.

2008 Aug 20 08:01 PM

[Akhenaten:]

All the data to this new "updated 8/20/08" is "OLD" data From their one and only never been updated since 12/2007 Investing Congress very impressive.

I like the strokes they give themselves " See how many Television programs we have been on" sites.

What happened to MBIA /AMBAC demise

Anything to do with the CDO buy backs by the Brokers slipping in Subprime morgages and calling them "AAA" bonds

And Now having to buy them back!

2008 Aug 20 09:26 PM

[Ishortyou:]

Those bonds that had wraps of NINJA loans (no income, no job-assets) were rated triple AAA rated by Moody's, so if you think you were insuring low risk bonds you were mistaken, so no fair game here really.

2008 Aug 21 07:31 AM

[bearfund:]

TomArmistead writes "The transactions that carry the most weight would be paying 20% too much for a house in California, not making the payments, and then in a matter of months being foreclosed and selling for 20% too little."

A superb synopsis of leverage-driven bubbles if ever I've heard one.

2008 Aug 23 04:56 PM

[WEBISKING:]

Buffett said yesterday on cnbc we arent close to a bottom and we havetoo many houses for the amount of people that can afford them.The bear market for stocks tat got overpriced in 1972 lasted for 10 years.The housing bubble was abigger bubble and should last as long IMO

2008 Aug 23 10:56 PM

[Premie:]

Anyone see Radian increasing sales force- 30% to date. "We are seeing increased demand at the local level in many of our markets..." And here I thought you rocket scientists had it figured out. We're talking about mortgages right? Supply and demand business cyle righthome prices fall 30%...40%...50%...60%.... What happens to demand? Oh, maybe like at the top... it's different this time.... remember- "there not making any more land!"

Hmmm... I guess everyones going to short on the spike up tomorrow...

2008 Aug 25 08:03 PM

[rgp44:]

How tiresome, how many times can you beat the same dead horse. We all know the housing sector is a disaster, that lending standards went to pot and that financial institutions have piles of bad debt. This is all true and obvious, but at current prices shorting FRE and FNM is probably one of the stupidest ideas ever. If you've shorted these stocks from 30, 40, 50 down any sensible person would declare victory and move on. The govt isn't going to let these institutions fail which means the only way you win is through nationalization or a super-dilutive capital addition. Any scenario that is only mildly dilutive, a convertible pfd or some sort of warrant-type Chrysler bailout or God forbid they muddle through with no bailout and you're toast. Yes, the news flow is horrible but the political realities and risk/reward balance weigh heavily against you. To make this bet you have to have a level of certainty that just can't exist where the government is involved. As smart as Tilson is I can't believe he's doing something this dumb.

2008 Aug 27 02:06 PM

[Value Dope:]

Did Bill Ackman tell Whitney to write this? Tilson is a genius, how he gets investors into T2 when this guy just copies the work of his buddies is amazing. His "research" is lifting work from Amherst Sec or just echoing what Ackman, Einhorn, and his other real investor friends say and tries to get into that circle...

2008 Aug 27 08:19 PM

[Premie:]

Have to be more than a couple of nervous shorts out there tonight! These next few day should be interesting. Enough said...

2008 Aug 28 06:20 PM