Ponzi Scheme Definition, from Wikipedia:

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

Knowingly entering a Ponzi scheme, even at the last round of the scheme, can be rational economically if government bails out those participating in the Ponzi scheme. If governments use newly created currency to bail out the scheme victims, the newly printed currency will devalue the rest of the currency in circulation, meaning all holders of that currency will suffer price inflation. However, Ponzi schemes cannot last forever.

Who was Ponzi and what did he do?

Charles Ponzi (March 3, 1882 – January 18, 1949) was an Italian swindler, who is considered one of the greatest swindlers in American history. He was born Carlo Pietro Giovanni Guglielmo Tebaldo Ponzi in Lugo, Italy in 1882.

When Ponzi was released from prison, he eventually made his way back to Boston. A few weeks later, Ponzi received a letter in the mail from a company in Spain. Inside the envelope was an International reply coupon (IRC), something which he had never seen before. He asked about it and found a weakness in the system which would, in theory, allow him to make money.

The purpose of the postal reply coupon was to allow someone in one country to send it to a correspondent in another country, who could use it to pay the postage of a reply. IRCs were priced at the cost of postage in the country of purchase, but could be exchanged for stamps to cover the cost of postage in the country where redeemed; if these values were different, there was a potential profit. Inflation after World War I had greatly decreased the cost of postage in Italy expressed in U.S. dollars, so that an IRC could be bought cheaply in Italy and exchanged for U.S. stamps of higher value, which could then be sold. Ponzi claimed that the net profit on these transactions, after expenses and exchange rates, was in excess of 400%. This was a form of arbitrage, or profiting by buying an asset at a lower price in one market and immediately selling it in a market where the price is higher, which is not illegal.

Ponzi started his own company, the “Old Colony Foreign Exchange Company,” to promote the scheme. He set up shop in a building on School Street. Word spread, and investments came in at an ever-increasing rate. Ponzi hired agents and paid them generous commissions for every dollar they brought in. By February 1920, Ponzi’s total take was $5,000, (approximately $54,000 in 2008 dollars). By March, he had made $30,000 ($328,000 in 2008 terms). A frenzy was building, and Ponzi began to hire agents to take in money from all over New England and New Jersey. At that time, investors were being paid impressive rates, encouraging yet others to invest. By May 1920, he had made $420,000 ($4.59 million in 2008 terms).

Ponzi was bringing in cash at a fantastic rate, but the simplest financial analysis would have shown that the operation was running at a large loss. As long as money kept flowing in, existing investors could be paid with the new money. In fact, new money was the only way Ponzi had to pay off those investors, as he made no effort to generate legitimate profits.  (Sound Familiar?)

Social Security System Ponzi

Found this on HowStuffWorks.com – I’m laughing right now because of how ludicrous this sounds.  This was our governments idea:

In 1935, when Roosevelt signed the Social Security Act into law, there were a lot of people who needed benefits (because of the Great Depression), but there was no money to pay those benefits with. The idea at the time was that people currently working would pay into the system, and their money would immediately go back out in the form of benefit checks. Each generation of retiring workers would get paid by the people currently working, and therefore the system would fund itself forever despite the fact that the system had no money to start with. Read more

So we all know this is a game of musical chairs.  WOW.  My kids and grandkids probably will be the ones without a chair.

Our Present Doomsday Cycle

In a report just released by a non-pastisan panel which includes Rob Johnson of the United Nations Commission of Experts on Finance and bailout watchdog Elizabeth Warren, we’ve officially been warned that:

The country is now immersed in a “doomsday cycle” wherein banks use borrowed money to take massive risks in an attempt to pay big dividends to shareholders and big bonuses to management – and when the risks go wrong, the banks receive taxpayer bailouts from the government.”

Do these two descriptions sounds frighteningly similar to one another to anyone but me?

Could it be that the US banking system and government, not Bernie Madoff, are in fact perpetrators of the biggest Ponzi Scheme in the history of the world? After all, Madoff’s $65 Million heist is absolute peanuts compared to the bailout funds… and profits, that have been realized by the banking system in the last year or so.

By definition, what the government and banks are doing is actually worse than what Madoff did. At least Bernie’s victims made the conscious decision to invest their money in his funds, and most of them were high net worth individuals, ability to withstand a hit to their bank accounts… the US taxpayer has no choice in the matter, and will suffer far worse consequences if in fact the house of cards all comes crumbling down here.

According to that report, we may not be far away…

“In 2008-09, we came remarkably close to another Great Depression. Next time we may not be so ‘lucky.’ The threat of the doomsday cycle remains strong and growing. What will happen when the next shock hits? We may be nearing the stage where the answer will be – just as it was in the Great Depression – a calamitous global collapse.”

Yet despite all the warning signs, and all the hard lessons learned from the 2008-2009 downturn, instead of trying to change course and right the ship, the powers that be simply seized the opportunity to further line their pockets, taking on more risk and making bigger bets in the form of “new investment” from the US taxpayers.

“The balance sheets of most Wall Street banks are fiction.” – States Frank Partnoy, a panelist from the University of San Diego.

Faulty balance sheets, risky short term investments, paying off bad bets off with new investor’s capital, huge dividends and giant paydays for management…. You decide.

Jon Maddux, CEO

www.YouWalkAway.com

Related posts:

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2. Shadow inventory and price declines The reality is that there is a bottom to housing prices. People need a place to live and are willing...
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A Forcible Entry and Detainer is an action that a new property owner (the foreclosing bank) can take if the existing occupant refuses to leave after appropriate notice (90 day notice of Trustee Sale)in Metro Phoenix. Foreclosure occupants could be either a tenant or original owner of property that was sold at a Phoenix foreclosure or trustee’s sale. Foreclosure eviction laws are subject to change, but this article is current In Arizona as of March 2010. This article was prepared with the help of a good friend, Georgi Stratton. Her contact info is on the bottom of the post.

The tenant/occupant receives a written demand to vacate the property. The term of the period to vacate is dictated by the type of occupancy – whether commercial or residential and whether a tenant or an owner that was foreclosed on. This term normally is either 5 or 7 days, unless the contract states otherwise. After the 5-7 days expire and the tenant/occupant still refuse to leave then a complaint for a forcible detainer action can be filed. The statutes provide for a very short notice period before a
court hearing.

The sole issue at the court hearing is whether or not the tenant/occupant has the right to possession. If they do not then they will be found guilty of a forcible entry and detainer. The court will enter an order directing the tenant/occupant to vacate within 5 judicial days. After that period has expired the Sheriff’s office can then evict the tenants/occupants, remove their personal property and give the rightful owner possession and control of the property.

It would be wise for the rightful owner to change the locks and take steps to protect the property.

Typically the seller must vacate the home within 7 to 14 days after a Trustee Sale (auction). Often the bank will offer the homeowner a $1,000 – $2,000 relocation fee if the homeowner moves within several days and leaves the home is good condition. If a foreclosed homeowner in the Phoenix area is being forced out without a moving fee or several days to move, the homeowner has rights. Inform the lender’s representative that you request a moving fee or are requiring them to file a Forcible Entry and Detainer Action. If they refuse to comply with either of these or if you feel your rights are being infringed upon, contact the local Sheriff for enforcement of current metropolitan Phoenix foreclosure eviction aws.

If the lender has to file a Forcible Entry and Detainer Action, you will not be able to get any cash for moving expenses.

Georgi Stratton
,Paralegal – Director of Short Sales, 
Winsor & Coleman, PLC
Direct: 480.695.6565
Fax: 480.699.8853
Email: georgistratton@yahoo.com

Phoenix Foreclosures 41% of Active Market

Phoenix Real Estate

Arizona Mortgage Lenders

Phoenix Foreclosures

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One of the things that I love about my job is when I get to talk to people that are on the “inside”.  What I mean by the “inside” is someone that is working for the banks.  A disgruntled bank employee. A pissed off loss mitigator.  Someone who decides whether or not to pursue you for a deficiency judgment.  Each of my conversations have many commonalities.  Some are upset that the government is over promising and obviously… under delivering.  Others are happy to have a job, however are quite sick of feeling like they can’t get anything done because of the basic lack of resources.  I mean come on? Mr. CEO of XYZ Lender… after all that government bailout money…can’t you afford to get a new fax machine or use efax so you stop losing all our faxes?

After a long conversation with this particular head of loss mitigation for …………. Mortgage lender, I asked him to email me his thoughts on what he has been seeing and feeling.  Enjoy.

DUMP The HAMP

President Obama had big aspirations on bringing America a much needed change, yet “change” seems to be all that’s left in our bank accounts each month. We were promised a new modification program that would help between 3 to 4 million at-risk homeowners – both those who are in default and those who are at risk of imminent default – by reducing their mortgage payments to a more affordable rate. It sounded pretty good to me, until I found out how everything works.

First of all, there are 4 different versions of the Home Affordable Modification Program;

Non-GSE (loans owned by your lender)

The Treasury wrote this version in 3 weeks after Obama introduced his financial stability plan and has been continually revised since.

Fannie Mae

They took the Treasury’s version, rewrote it and took many things out of its original context (such as defining common definitions differently, thus causing massive confusion and ultimately making your lender’s job a heck of a lot harder…)

Freddie Mac

They say you have to be more than 60 days behind on your mortgage payment or you are considered current… and ineligible for this program…thanks! Fannie Mae will be implementing this by June 1st as well.

FHA

They will deny you if you have non-mortgage expenses that are over 24% of your total gross income, lame.

You can find out if your lender is participating by calling, or by visiting the Making Home Affordable website.

The one major pet peeve I have about this program is how it doesn’t help the average family man as mush as it helps a bachelor or someone who is single. Shouldn’t it be the other way around??  Let’s say you have a family of 4, a mortgage payment of $2,000, average monthly expenses around $2,000, and your total gross income has been dropped from $6,500 per month to $4,000. Will this program help you? The answer is NO! This is because the program multiplies your current monthly gross income by 31% to achieve your target monthly mortgage payment. In this case, $4,000 x 31% = $1,240. This would save you $760 per month. However, when you factor in the car payment, the kid’s clothes, food, insurance, utility bills, etc., you are left sailing toward the same iceberg you feared from the beginning ($1,240 + $2,000 = $3,240 subtracted from a net income of $3,200 = -$40/month). All it would take is one unexpected event to cause you to fall behind and be right back where you started. This brings me to my next point. If you happen to be lucky enough to receive this modification and face a new hardship 1 year later and you to fall behind, forget about asking for this HAMP again. You only get one shot.

I could go on and on about how terrible this program is, but I want to tell you about what is going on inside of your lender’s Loss Mitigation Department.

In the early 2000’s a typical lenders had about a 1% delinquency ratio. In 2007, after investors on Wall Street quit backing high-risk mortgage loans, your lender’s delinquency ratio’s began skyrocketing from 3 to 4% to up to 8% or more in other cases, and foreclosure ratios have jumped up to around 3 to 4% for stable lenders who never even originated high risk ARM loans! For your lender to keep up with the amount modification requests they receive, they would need to quadruple or even occtiply (yes, an octomom reference…) their Loss Mitigation Department to keep up and comply with investor modification guidelines. There lies the problem.   How do you fund your loss prevention department if your sales department isn’t making as much money? The answer is they have to convert the HAMP trial plans into actual modifications, so they can receive their pay for performance incentives from the government.  But they can’t…  The problem is the underwriting requirements.

Completing a HAMP modification is like originating a brand new loan, except your loan officer is unable to contact you by any other means than mail, and his/her processors are quickly (or inadequately) trained, robotic associates who have to keep up with rapidly changing, loosely defined guidelines from Fannie Mae, Freddie Mac, and FHA. It is almost impossible to ever finish one of these things correctly! Not to mention, loan modifications are so much like a originating a brand new mortgage loan that the government wants all Loss Mitigation employees to be licensed.   This is a good idea for training, but a bad idea for lenders because this will be very costly and time consuming to complete (this will ultimately have to happen though…). It’s just another daunting task for your lender’s loss mit department, which will ultimately slow down your modification.

Probably the most difficult thing your lender has to do is build calculators, use cumbersome excel documents, and report to numerous sources to correctly implement this modification. The HAMP is such a hassle, people who work at Fannie Mae don’t even like it and are praying it ends in 2012 like it’s suppose to. We need a better solution. DUMP the HAMP already, and give us something that works NOW!

——————————–

Conclusion

We have been getting calls non-stop from homeowners who are DONE.  If you are DONE, you know what I mean.  Tired of spending countless hours trying to save your home, when quite frankly it doesn’t seem like it’s worth it anyways.  You feel like your lender doesn’t give a crap.  Even if you get a modification, they won’t reduce your principle so… you’re still stuck with a home that’s not worth anywhere near what you owe on it.  Values are stagnant or dropping.  Credit is still contracting.  Banks like Citi and Wells have new incentive programs designed to lower your credit card limits and get you to pay down your principle.  It’s clear to me that lenders don’t want to lend and won’t resume common sense lending anytime soon.  Ask a local loan officer.  They are still having trouble getting great credit loans done.  I agree.  Dump the Hamp and start re-appraising homes, cut the principle balance down to 94% of the value (so people can sell their home if they’d like without being punished), give the same rate to anyone who accepts the program, whatever the 30 year fixed rate is at the time and revenue share on the upside 10-20% of the equity when they sell the house.  Another idea would be allow short refinancing.  This will not happen because the banks don’t have to “mark to market” their loans.  They are better off just leaving them delinquent.  Which is what we are seeing.  Lenders continuing to postpone auction dates.  14-18 month foreclosure timelines, where the lender should take only 8 months to foreclose.

Wait a minute here.  If bankers got to “mark to market” when values were going up… thus taking HUGE bonuses based on those profits, and now they don’t have to “mark to market” when values are plummeting, so they can still take big bonuses…isn’t that called CHEATING? Uh let’s see… Isn’t that is exactly like heads I win, tails I win?  Hmm… So wouldn’t that be similar to a homeowner buying a house, value goes up, they take out all the cash, then when the value goes down, they walk away without recourse? Government, can you please change the recourse laws in all the other 40 or so states to make it fair?  Since you are taking care of your banking buddies, don’t forget about the people who pay taxes that you’re supposed to be WORKING FOR.  We want the same rules for us.  Please share your thoughts below…

Jon Maddux, CEO

www.YouWalkAway.com

Related posts:

1. Obama’s Micro-Mismanagement of HAMP Equates to “Can-Kicking Stupidity” When a program is badly flawed and not working, the rational thing to do is scrap it. Given that HAMP...
2. Fannie Mae Posts a $15.2 Billion Loss Yikes. From the Fannie Mae Press Release: Fannie Mae (FNM/NYSE) reported a net loss of $15.2 billion in the fourth...
3. Is HAMP a Wolf in Sheep’s Clothing? HousingStorm contributors have already described HAMP loan modifications as potentially criminal and the most exotic mortgage yet, but they could...

They estimate that the current backlog of distressed mortgages will take just under 3 years to clear. They call that estimate conservative… I think it is likely optimistic given that delinquency rates are still climbing. Still it is a reasonable guess. Here in CA we have one million homeowners who are already delinquent, and we seem to be clearing about 25-30k a month based on foreclosures and short sales (which are the only “solutions” that are actually clearing the distress by eliminating negative equity). Divide one million by 30k, and you come to the same 33 month conclusion they reach.

Another interesting part of the report deals with recently cured loans… those no longer delinquent, primarily due to loan modifications. They suggest that these should be included in calculations of shadow inventory, as they have had a nearly 70 percent rate of recidivism – in other words, most become delinquent again because the loan mod failed to address the core problem of negative equity. Seems like a reasonable conclusion to me.

Where I take some issue with Standard & Poors assessment is there conclusion that liquidation will lead to lower housing prices. They come to this conclusion based on the simple idea that an increase in supply will lower prices. There is some truth in that notion. For example we certainly have seen some pricing strength recently due to efforts to slow foreclosures which have clearly constrained supply, while at the same time demand has been stimulated with low interest rates and tax credits.

But this simple supply/demand theory of housing prices fails to adequately consider the fact that housing is highly leveraged, and that price is primarily a function of income and loan terms, and only secondarily supply and demand. Worse, this over-simplistic supply/demand model has led many to believe that foreclosures cause price declines, when in fact it is exactly the opposite… price declines cause foreclosure.

Note that the foreclosure crisis started in earnest in late 2006, however, price declines did not start until lenders removed the ridiculous loan products that enabled people to over pay in August of 2007. At that point we had a precipitous drop in price… not due to foreclosures, but instead due to the fact that people simply couldn’t afford the prices reached during the bubble without those loan products.

Foreclosures and housing supply grew rapidly during the price correction, but those who think the correction was due to either these foreclosures or the growing supply are terribly mistaken. Instead it was simply a correction back to reasonable prices, that buyers could afford based on their incomes and the more traditional loan products that remained available.

Unfortunately the belief that foreclosures and supply caused those declines remains all too common as yet again evidenced by the conclusion of this report. It is a belief that is delaying our recovery as government works to artificially constrain supply by slowing foreclosures, leaving homeowners stranded in prisons of debt, and buyers with little available inventory to choose from.

The reality is that there is a bottom to housing prices. People need a place to live and are willing to spend a certain portion of their income on housing to do so. Investors need to find returns, and there is a point where buying homes as an investment make sense. In many parts of California we’ve returned to those prices levels. And in those areas that have already corrected withholding supply won’t return prices to prior levels… people simply can’t afford it. And contrary to Standard & Poors’ analysis increasing supply is just as unlikely to cause further price declines… people need a place to live, and investors are too desperate for reasonable returns.

This post originally appeared on Sean’s blog http://www.foreclosuretruth.com/

Related posts:

1. Everything starts West and Heads East: inventory is going down for the country. Total housing inventory at the end of October fell 3.7 percent to 3.57 million existing homes available for sale, which...
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But before we jump into that, I want to let my Conversations subscribers know that we have posted a recent conversation with two hedge-fund managers, Kyle Bass of Hayman Advisors [and his staff] here in Dallas and Hugh Hendry of the Eclectica Fund in London. Our discussions centered on what we all think has the potential to be the next Greece, but on a far more serious level. It was a fascinating time.

Then next Wednesday we will post a Conversation I had with George Friedman of Stratfor fame, and then the following Wednesday a Conversation that I just completed with Dr. Ken Rogoff and Dr. Carmen Reinhart, the authors of This Time Is Different.

For new readers, Conversations with John Mauldin is my one subscription service. While this letter will always be free, we have created a way for you to “listen in” on my conversations with some of my friends, many of whom you will recognize and some whom you will want to know after you hear our conversations. Basically, I will call one or two friends each month and, just as we do at dinner or at meetings, we will talk about the issues of the day, with back and forth, give and take, and friendly debate. I think you will find it very enlightening and thought-provoking and a real contribution to your education as an investor.

And as you can see, I can get some rather interesting people to come to the table. Current subscribers can renew for a deeply discounted $129, and we will extend that price to new subscribers as well. To learn more, go to http://www.johnmauldin.com/newsletters2.html. Click on the Subscribe button, and join me and my friends for some very interesting Conversations.

The Velocity of Money

The Federal Reserve and central banks in general are running a grand experiment on the economic body, without the benefit of anesthesia. They are testing the theories of Irving Fisher (representing the classical economists), John Keynes (the Keynesian school) Ludwig von Mises (the Austrian school), and Milton Friedman (the monetarist school). For the most part, the central banks are Keynesian, with a dollop of monetarist thrown in here and there.

Over the next few years, we will get to see who is right about debt and stimulus, the velocity of money, and other arcane topics, as we come to the End Game of the Debt Super Cycle, the decades-long cycle during which debt has grown. I have very smart friends who argue that the cycle is nowhere near an end, as governments are clearly increasing debt. My rejoinder is that it is nearing an end, and we need to think hard about what that end will look like. It will not be pretty for a period of time. The chart below shows the growth in debt, both public and private.

But the end of this debt cycle involves more than just debt reduction. There are a number of ideas we have to get our heads around, including the velocity of money. Basically, when we talk about the velocity of money, we are speaking of the average frequency with which a unit of money is spent. To give you a very rough understanding, let’s assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 of flowers from you. You in turn spend $100 to buy books from me. We have created $200 of our “gross domestic product” from a money supply of just $100. If we do that transaction every month, we will have $2400 of annual “GDP” from our $100 monetary base.

So, what that means is that gross domestic product is a function of not just the money supply but how fast that money moves through the economy. Stated as an equation, it is P=MV, where P is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing P by M. By the way, this is known as an identity equation. It is true at all times and all places, whether in Greece or the US.

Our Little Island World

Now, let’s complicate our illustration a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few pages, please. Let’s assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island is $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses get more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc., and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers yet.

Now let’s complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP rises to $14,000,000. In order for everyone to stay at the same level of gross income, though, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does not increase, that means that (in our simple island world) on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase, GDP will stay the same. The average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000. The prices of products fall.

Each business now is doing around $80,000 per month. Overall production is the same, but divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money “neutral.”

It’s basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If Island Central Bank increases the money supply too much, you will have too much money chasing too few goods and inflation will rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let’s say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP will grow to $24,000,000. That will be a good thing, won’t it?

No, because with the two new businesses only 20% more goods are produced. There is a relationship between production and price. Each business will now sell $200,000 per month, or double their previous sales, which they will spend on goods and services, which only grew by 20%. They will start to bid up the price of the goods they want, and inflation sets in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let’s assume 10 million businesses, from the size of Exxon down to the local dry cleaners, and a population that grows by 1% a year. Hundreds of thousands of new businesses are being started every month and another hundred thousand fail. Productivity over time increases, so that we are producing more “stuff” with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, the population, and productivity, or deflation will appear. But if money supply grows too much then you have inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant, and therefore he stated that inflation is always and everywhere a function of the supply of money. And it was, from about 1950 until 1978 when he was doing his seminal work. But then things changed.

Note that nothing Friedman says contradicts the equation MV=PT, if you assume constant velocity. Almost by definition you get inflation if the money supply grows too fast.

Let’s look at two charts sent to me by Dr. Lacy Hunt of Hoisington Investment Management in Austin (and one of my favorite economists). First, let’s look at the velocity of money for the last 108 years.

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average of the last 100 years. Also, Lacy pointed out in a conversation that helped me immensely in writing this letter, that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times, since World War II; but even then, mean reversion would result in a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let’s look at the first chart.

Now, let’s look at the same chart since 1959 but with shaded gray areas that show us the times the economy was in recession. Note that (with one exception in the 1970s) velocity drops during a recession. What is the Fed response? An offsetting increase in the money supply to try and overcome the effects of the business cycle and the recession. P=MV. If velocity falls then money supply must rise for nominal GDP to grow. The Fed attempts to jump-start the economy back into growth by increasing the money supply.

In this chart from Hoisington, the recessions are in gray. If you can’t read the print at the bottom of the chart, he assumes that GDP is $14.5 trillion, M2 is $8.2 trillion, and therefore velocity is 1.7, down from almost 1.97 just a few years ago. If velocity is to revert to or below the mean, it could easily drop 10% from here. We will explore why this could happen in a minute.

P=MV

But let’s go back to our equation, P=MV. If velocity does slow by another 10%, then money supply (M) would have to rise by 10% just to maintain a static economy. But if we assume 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, then M (money supply) actually needs to grow about 5% a year, even if V is constant. And that is not particularly stimulative, given that we are in recession.

Bottom line? Expect money-supply growth well north of 7% annually for the next few years, or at least the attempt. Is that enough? Too much? About right? We won’t know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday-morning quarterback for many years.

A Slowdown in Velocity

Now, why is the velocity of money slowing down? Notice the real rise in V from 1990 through about 1997. Growth in M2 (see the above chart) was falling during most of that period, yet the economy was growing. That means that velocity had to rise faster than normal. Why? Primarily because of the financial innovations introduced in the early ’90s, like securitizations, CDOs, etc. It is financial innovation that spurs above-trend growth in velocity.

And now we are watching the Great Unwind of financial innovations, as they were pursued to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

The financial innovation that drove velocity to new highs is no longer part of the equation. Its absence is slowing things down. If the money supply hadn’t risen significantly to offset that slowdown in velocity, the economy would have been in a much deeper recession, if not a depression. While the Fed does not have control over M2, when they lower interest rates it is supposed to make us want to take on more risk, borrow money, and boost the economy. So they have an indirect influence.

And now we come to the policy conundrum for the Fed. They have pumped a great deal of money (liquidity) into the economy. Normally, banks would take that money and multiply it by lending it out (through fractional reserve banking at a potential 9-times factor), increasing velocity and the overall money supply. In the past, the more the Fed increased the money supply, the more banks lent.

But today bank lending is still falling at an average of 15% annually, so far this year. But what if that trend stops?

Corporations in the US have more money on hand than ever in the last 54 years. They are more productive. Their debt-to-equity ratio has been dropping by about 25% for the last 3 quarters, as they repair balance sheets. Capital spending jumped 18% annually in the last quarter. If we are not at an inflection point of rising employment, we are close to it (although we do need at least 100,000 new jobs a month to make up for increased population). And thus are the stock market bulls inspired, and we hit new trend highs weekly.

While growth this quarter will not be as robust as last, it will be fairly good for an economy with 10% unemployment. If you are a Fed governor, you have to be worried that things could turn around quicker than now seems plausible. What if corporations decided to take their cash and start investing in growth?

The last chart showed a small uptick in velocity at the end of last year. What if that is for real? What if we have turned the corner? Then the Fed will have to start taking back the money they have put into the economy, unless they want to see inflation. And indeed, that is what some Fed governors are arguing. They want to raise rates now, or at least signal that they will begin to do so soon. Note there have been a number of speeches by Fed officials of late assuring the bond market that they are aware of the problem, and that they have all the tools they need to keep inflation (and higher interest rates) at bay.

But then again, while there are signs that the economy may be picking up, it is a strange type of recovery. It is what I call a statistical recovery. Let’s look at this litany from my friend David Rosenberg of Gluskin Sheff. He notes that there are measures of economic health other than the stock market and GDP. To wit:

• More than five million homeowners are behind on their mortgages.
• There are over six million Americans who have been unemployed for at least six months, a record 40% of the ranks of the jobless.
• The private capital stock is growing at its slowest rate in nearly two decades.
• Roughly 30% of manufacturing capacity is sitting idle.
• Nearly 19 million residential housing units, or about 15% of the stock, is vacant.
• One in six Americans is either unemployed or underemployed.
• Commercial real estate values are down 30% over the past year.
• The average American worker has seen his/her level of wealth plunge $100,000 over the last two years, even with the recovery in equity markets this past year.
• Bank credit is contracting at an unprecedented 15% annual rate so far this year as lenders sit on a record $1.3 trillion of cash.
• Unit labor costs are down an unprecedented 4.7% over the past year, and what has replenished household coffers has been the federal government, as transfer payments from Uncle Sam now make up a record 18% of personal income (and the Senate just passed yet another jobless benefit extension bill!).”

Wow. 18% of personal income in the US is now from the US government (also known as taxpayers, current and future).

If you take away the punchbowl too soon, you risk strangling a very shaky recovery that is significantly dependent on stimulus spending, which is going to rapidly go away the second half of this year. Further, the Fed situation is complicated by the fact that taxes are highly likely to go up in 2011 (maybe the largest tax increase ever), which will put a serious strain on the economy.

I think the Fed is on hold throughout 2010 and well into 2011, as they see what effect the tax hikes, coupled with decreased stimulus, bring. Next week we will explore the potential effects of the tax hike on the 2011 economy. Stay tuned.

Let me ask for a little bit of help. I am trying to find data on the potential tax increases, and what I am finding is all over the board. In fact, I had intended to write about that topic this week, but simply don’t trust the numbers I am reading. If you have a source or RECENT paper, I would love to see it. Thanks.

Dallas, and Thoughts on the Economy

What started me thinking about tax increases was the problems that so many people I know personally are having, including my kids. It is difficult watching your kids struggle with fewer work hours, the need to make car payments and buy diapers. For many, it’s cuts in pay, lost jobs, and more. Lack of health insurance is often a worry, too.

And knowing it could get worse is rather sobering. Trust me, I see the human side of the need for health-care reform, but also balance it with the need for some fiscal responsibility. We have $38 trillion in unfunded Medicare liabilities. How can we add more? Does anyone really believe that this bill being offered will actually cut spending? How do you cut Medicare by $500 billion when it is already so underfunded? Really? But what about kids and families with no insurance? Something better than what we are seeing is needed to get the problem solved. More on this next week.

I will be a panelist in the inaugural “America: Boom or Bankruptcy?” summit to be held in Dallas on March 26. There will be five of us, presenting problems (plenty of those!) and possible solutions. This promises to be a no-holds-barred, full-throttle event. It should be a lot of fun. Details at www.fedfriday.com.

It’s time to hit the send button. I have kids coming to the airport, and I want to be there. Spring break and all, and I look forward to it. Have a great week.

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Other governments around the world take steps to curb lending and warn citizens of the perils of excessive mortgage debt. Why don’t we?

My friends feel it’s their appointed duty
They keep trying to tell me all you want to do is use me
But my answer yeah to all that use me stuff
Is I wanna spread the news that if it feels this good getting used
Oh you just keep on using me until you use me up

Bill Withers — Use Me

Lenders with encouragement from the US Government want to use you to pay for their mistakes; they want to use you, and they want you to feel good about it. Buy now, it doesn’t matter if you go underwater; lenders don’t care as long as you make your rent payments on the money.

Recently, I wrote about Canadian finance minister Jim Flaherty preventing further inflation of Canadian housing bubble.

Allow me to recap and interpret:

(1) He is forcing qualification at a higher payment rate. If he had stated 30-year fixed rather than a 5-year fixed, It would be better, but it is a step toward stable financing. I wish the statement clarified whether or not interest-only ARMs are permitted there. I believe the qualification standard he is imposing is based on a 30-year amortizing mortgage with only a 5 year fixed rate.

(2) Twenty percent down payments? I would like to see this on all property, but common sense says investment properties and second homes should require a significant down payment — people don’t hesitate to walk away from investment properties.

(3) And limiting cash-out refinancing to 90% LTV is identical to the proposal I made. I like this requirement because it provides an equity cushion that stabilizes markets and prevents walkaways.

“We do want to discourage the tendency by some to use their home as an ATM machine, the tendency by some to buy three or four condominiums by way of speculation,” Flaherty said. “This will discourage the kind of mortgage refinancing that can create unsustainable debt levels as interest rates go up.”

Our government actively encouraged us to borrow, spend and be happy while Canadians are being warned about excessive debt and spending their equity foolishly. The contrast is conspicuous.

It isn’t just the Canadians who exercise better control over lending and warn their citizens of the perils of buying and borrowing today. The Swiss, long known for their banking prowess, do not cave in to banking interests.

The Swiss Central Bank sends warning on excessive mortgage borrowing

By Catherine Bosley

The Swiss National Bank warned banks and borrowers on Thursday about taking on too much debt while interest rates were still very low, indicating it is concerned about a possible housing bubble.

…”The SNB is warning banks and borrowers to be extremely cautious,” the central bank said in its quarterly policy statement. “The fact that interest rates are exceptionally low by historical standards must be taken into account.”

…”What they wanted to avoid is house prices going up too much in response to a slightly brighter economic outlook. That would mean another bubble,” said Henrik Gullberg of Deutsche Bank. “One way of doing that is to keep sending these verbal warning shots while policy is still very expansive.”

The Swiss government is openly concerned about its citizens financial well being, and they post warnings about mortgage borrowing to help people. Why is it only bloggers like me who issue these warnings here in the US?

The US Government wants its citizens to borrow as much as possible to help out ailing banks even if that destroys the borrower. Shameful.

Some analysts have argued that the central bank may raise borrowing costs earlier than the market currently predicts, and despite the strong Swiss franc, due to the housing concerns.

The SNB said it was conducting an in-depth investigation into banks’ mortgage-granting practices and that it would work with regulators to see if any corrective steps were needed.

SNB statistics show that prices for single family homes in Switzerland rose by some 4 percent last year.

SNB vice-chairman Thomas Jordan warned as early as autumn last year of a possible bubble in the private housing market.

Why is the US Government out to screw us?

Hasn’t it become obvious that our government does not care about the people? As a citizen of this country, you should be outraged by the way your government puts your interests last. Our government openly advocates destructive policies that transfer wealth from you to the lenders.  The US Government as ruled today is completely captured by money interests; they feed us a steady stream of bullshit bailouts and false hopes to convince us to take on more debt and keep the Ponzi Scheme alive.

It wasn’t always that way.

Andrew Jackson and the Second Bank of the United States

AIG was not the first institution that was too big to fail. Andrew Jackson waged a personal war against the banking behemoth of his era, and as a former general, he knew how to win a battle. From Wikipedia:

The Second Bank of the United States was authorized for a twenty year period during James Madison’s tenure in 1816. As President, Jackson worked to rescind the bank’s federal charter. In Jackson’s veto message (written by George Bancroft), the bank needed to be abolished because:

• It concentrated the nation’s financial strength in a single institution.
• It exposed the government to control by foreign interests.
• It served mainly to make the rich richer.
• It exercised too much control over members of Congress.
• It favored northeastern states over southern and western states.

Following Jefferson, Jackson supported an “agricultural republic” and felt the Bank improved the fortunes of an “elite circle” of commercial and industrial entrepreneurs at the expense of farmers and laborers. After a titanic struggle, Jackson succeeded in destroying the Bank by vetoing its 1832 re-charter by Congress and by withdrawing U.S. funds in 1833.

Does Jackson’s reasoning sound familiar to you? Isn’t most of what he identified as problems exactly what we have with too-big-to-fail institutions? Who will be our modern Andrew Jackson who will crush our banking cartel? Our current crop of politicians are hopeless or worthless completely captured by banking interests and too fearful to do anything to help the people. We are lost, and we need a real leader like Andrew Jackson to help us find our way.

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Please consider: Snow Job: Strategic Defaults in an Era of Negative Equity

As more than a million people filing bankruptcy every year learn, life continues even after their credit scores are trashed. They can still buy cars on credit. They still have credit cards (secured) and debit cards. They can still rent apartments and houses.

Bankruptcy is a nuclear strike on a consumer’s credit score. Filing alone delivers a 355-365 point hit (out of top scores of around 800) and outright disqualification from obtaining any extension of credit from many lenders. The black mark follows the borrower for 10 years.

Short sales can trigger drops of 100-130 points; strategic defaults bring slightly heavier penalties, 100-150 points. The negative mark attaches to a credit record for seven years (but diminishes over time).

However, it’s possible to get a government loan only 3 years after foreclosure.

Ironically, late mortgage payments can have a bigger impact than outright default. FICO scores can easily plunge 200 points merely through nonpayment of a mortgage for a period of 60 to 90 days—something that lenders generally require of borrowers seeking loan modifications.

Credit recovery takes place remarkably quickly. Faced with the choice of foregoing credit card payments and incurring stress-related expenses stemming from high debt levels, the temporary black eye could be well worth it. Walkaways also join the crowd: Credit scores have been dropping steadily throughout the recession, especially for those with higher ratings.

Although for some people bankruptcy may be the best option, for most people facing mortgage problems, there is no reason to file bankruptcy.  If you isolate the foreclosure and keep everything else good on your credit, you will be on your way to financial recovery much quicker than one would expect.  Typically after 2 years things will start looking a lot better… credit score wise.  If you are considering bankruptcy, you may wanna re-think it and make sure that your problem doesn’t only revolve around the underwater mortgage.  You may be able to stay free in your home for 12 months and pay off all your other unsecured debt.  You definitely don’t need to nuke a problem that may only need a sniper.

Related posts:

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Like the federal loan modification program that was put into effect just over a year ago, the federally subsidized short sale program, set to take effect April 5^th, is now being touted as the next great hope for homeowners who either can’t afford to, or are choosing not to, pay their mortgages.

But, just like the Making Home Affordable program that released last year with the promise of saving millions of homes, the federal short sale program is drastically flawed, and if enacted, will more than likely end up with the same exact outcome… after many months and billions of wasted taxpayer dollars, the “experts” will be that it isn’t working for a variety of reasons.

In this Nostradamus like post, we’re going to examine why this new program is doomed to fail… do us a favor – bookmark it, and in a year come back and revisit it, and see how many of these predictions come true. Without further adieu, here are 5 reasons why a federal short sale program won’t work:

1. Second (and third) mortgage holders

Here’s a potential scenario: You owe $500,000 on your home, which was purchased in 2005 with an 80/20 loan, meaning your first loan was for $400,000 (80%) and the second loan is for $100,000 (20%). Due to the collapse of the housing market, the home is now worth $300,000. You put it on the market for $300,000 and get an offer for $250,000, which you take to your first lender. Even if you jump through all their hoops, have a valid hardship, and get your short sale approved, that still leaves the second lender out in the cold, holding the bag to the tune of $100,000. The logical, and typical response from the second lender, will be to block the short sale any way they can.

2. Lack of buyers

Even in a perfect world where every lender agreed to take a loss and accept a short sale, there’s still one major flaw – we’re still in a recession, unemployment is at a multi-decade high and still rising, and consumer confidence is at an all time low. Add to that the fact that due to lack of liquidity and tightening of lending standards, many would be homebuyers are now ineligible for a mortgage anyway. Not exactly a formula for people rushing out to buy all these short sale properties, or to secure the funding to do so even if there were.

3. Bureaucracy & red tape by the banks

Have you ever tried to contact your bank for anything? Loan modification, find about or try to reverse a credit card fee, anything?

If so, you certainly know that it’s not the easiest task in the world. One department sends you over to another, who makes you repeat your info and your story. They tell you to fax in documents, then claim to never receive them. They say you’ll get a call back and you never do.

The point is that if the lender needs an excuse to postpone or make it  difficult for you to do anything, they have it… even if they have the best of intentions, the sheer volume of the requests for modifications, short sales, etc, has most lenders scrambling to play catch up.

Then there’s the fact that has squashed the hopes of so many short sellers in the past – even if you can get all the lenders and investors to agree on the short sale, that usually takes 3-6 months! By that time most qualified buyers have either found another home and lost interest in the current deal.

4. Lack of incentive & penalties

Just like the Federal Loan Modification program, this plan is lacking a huge ingredient… namely the lack of incentive for banks to take less than what they’re owed, and the lack of penalties for delaying or not complying with the rules of the program.

According to a NY Times article on Sunday, the program will offer $1000 apiece for 1^st and 2^nd mortgage holders, and $1500 for the seller.

Sure, there’s a $1,000 incentive payout for a bank to accept a short sale, that’s almost more of a slap in the face than anything. Actually, I’m kind of laughing out loud right now at the absurdity of this.  If someone owed you $100,000, and they came to you and said… “well I can only pay you $25,000, but  don’t worry, because my buddy here has another $1,000 for you…cool?” Haha… Does that really make anything better – it’s still only $26,000!!!

Or it looks more like this…

Borrower:  I know I owe you $100,000, but I can pay you $25,000… Is that ok?

Lender: No

Borrower: Ok, ok… well what if my friend uncle sam gives you $1,000 will that help?

Lender: Sure

I mean come on! Where do these smart people come up with these programs?

You really don’t need to incentivize the seller to sell – the fact that they are out of an underwater mortgage is incentive enough in most cases. The problem is, how can it possibly seem like a good idea for banks to take a $1000 consolation prize to take a loss of 5 or 6 figures on a deal?

Without a real, valuable incentive to accept short sale offers, and without a real penalty to lenders who don’t try to make things happen, there will be no real reason for lenders to go the extra mile to accept the short sales.

5. Lack of clear cut, uniform guidelines

Again, there is another huge comparison to be drawn with the federal loan modification program… the final decision is to be made at the sole discretion of the lender. One of the main reasons that the modification program failed is because you could submit the same application to 2 different lenders, or in some cases to 2 different people at the same lender, and receive 2 completely different answers.

Unless there is a uniform set of guidelines for acceptance, there is no way this will work.

Conclusion:

As with the loan modification program of a year ago, this program is destined for failure unless drastic changes are made to it by the government. By enacting these programs that are meant to be a show of the governments dedication to fixing the economy, but not including any real rules for banks to follow, they are delaying the inevitable, costing taxpayers billions more dollars, and making themselves look foolish and corrupt. Now is no time for token gestures, the economy is at the brink of collapse.

Either make changes that have some teeth and force the banks to start playing by some logical rules again, or do nothing, step back and let free market capitalism run its course. Let the market decide what the prices of homes should be, and who can qualify for them.

Sure there will be bank failures, foreclosures, and more pain, but most people who have an understanding of the economy, a few ounces of logic in their head, and don’t have a bank lobbyist at their doorstep daily, will tell you that this is bound to happen anyway. So isn’t it better to “rip the band aid off quickly”? Either let things take their course naturally, or to really take some action to change that course, instead of doing everything and anything, at all costs (literally) to keep playing by the bank’s rules, and stay on the same crash course that we’re currently on?

And then there’s the issue of the millions of people who are facing foreclosure. If they have tried everything possible to get a short sale done – jumped through all their banks hoops, found a buyer, did all the proper negotiation with all involved parties, and the banks still said no… then shouldn’t those people have the right to give the bank their home back with the same ramifications as if they did a short sale? It just seems very illogical to penalize a seller for circumstances that are far beyond their control, and very unproductive… why not penalize the banks who drag their feet and lose deals instead? You’d at least get some more short sales closed.

New York Times Reported on March 7, 2010:

But at the end of the day, the banks would rather make things difficult. According to J. K. Huey, a Wells Fargo vice president, said a short sale, like a loan modification, would have to meet the requirements of the investor who owns the loan.

“This is not an opportunity for the customer to just walk away,” Ms. Huey said. “If someone doesn’t come to us saying, ‘I’ve done everything I can, I used all my savings, I borrowed money and, by the way, I’m losing my job and moving to another city, and have all the documentation,’ we’re not going to do a short sale.”

Please comment below and let us know why you think this new program either will or won’t work. Thanks!

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In a phone interview yesterday with a writer from the New York Daily News, I was asked…”Jon, where exactly is the tipping point? When do people realize it may be better to just walk away?”  This is a difficult question, I said, because it’s not so clear cut.  It depends on many factors.  However, when it comes to specifically a “strategic defaut”, it may be a little more cut and dry.  At what point does one decide to face the consequences of a foreclosure over pumping more & more money into a home with negative equity every month? Strategic Default can be defined as the growing trend of people who can afford to make their monthly mortgage payment, but due to the fact that they’re upside down on the mortgage or think they can get a better deal elsewhere,  they voluntarily default on the mortgage.  Often times they live in the home for a year or more, using that time to pay down other debts or save up money.  Time will ultimately tell the real answer to this question, but I predict that this year we will see more and more homeowners tipping.

Homeowners Are Technically Renting

An article yesterday in the San Francisco Chronicle said

“The reality is, if you’re 30 percent underwater, you’re effectively going to be a renter in that home while paying your mortgage for the next 10 to 15 years before you get back to break-even with your equity,” said Paul Leonard, director of the California office for the Center for Responsible Lending.

“It’s not enough to have affordable monthly payments, if a borrower can walk across the street and rent some place for less, save money and have a little nest egg by the time their credit score recovers to be able to buy a home.”

And it’s not just a numbers game… in many cases it’s outside factors that cause someone people who have the means to pay to default – changes in jobs, suburban neighborhoods deteriorating as housing values plummet and changes in family life can all act as a catalyst for  a financially stable person to voluntarily choose default.

“We could make our payment every month by doing a little bit of overtime,” said Jose Tolentino of the Bay Area of California. “But we want to start a family. We could rent for half what we’re paying and afford to have kids.”

In many cases, making this choice without needing a catalyst is the best financial decision an individual or a family can make. In a housing market where the majority of signs point to another decline in housing prices, and even the most optimistic of economists and analysts don’t expect any price increases like what we saw during the boom years, it can take years, in many cases decades to recover the equity that’s already been lost.

Brent White, a law professor at the University of Arizona, says that the number of true strategic defaults – people walking away from underwater homes in the absence of other problems such as job loss – seems lower than common sense would dictate.

“People are acting against their own economic self-interest by continuing to pay off houses where they may not have any equity for decades,” he said. “They’re throwing away good money after bad.”

Shame, guilt and fear stop many homeowners from reneging on their mortgages, he said. The government and big banks actively cultivate those emotional constraints because the economic consequences of a large-scale walkaway phenomenon could be dire, he said.

Sure, there’s a credit hit to be considered, and in certain states there may be legal ramifications that a lender can take to try and pursue a deficiency judgment, and then there’s the ever popular “social stigma” attached to walking away, but at the end of the day, when painted in comparison with burdening yourself and future generations with the debt of one bad investment, the consequences start to pale quite a bit. Obviously every situation varies, but when looked at from a purely business standpoint, the Strategic Default option is starting to look better and better to the millions of underwater homeowners out there.

Please let us know what your thoughts are on the Strategic Default debate… at what point does it make sense? Or should one be obliged to pay the monthly mortgage at all costs?

Jon Maddux

CEO

www.YouWalkAway.com

Email me at:  jon@youwalkaway.com

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In an effort to end the foreclosure crisis, the Obama administration has been trying to keep defaulting owners in their homes. Now it will take a new approach: paying some of them to leave.

This latest program, which will allow owners to sell for less than they owe and will give them a little cash to speed them on their way, is one of the administration’s most aggressive attempts to grapple with a problem that has defied solutions.

Under the new program, the servicing bank, as with all modifications, will get $1,000. Another $1,000 can go toward a second loan, if there is one. And for the first time the government would give money to the distressed homeowners themselves. They will get $1,500 in “relocation assistance.”

Short sales are “tailor-made for fraud,” said Mr. Lawler, a former executive at the mortgage finance company Fannie Mae.

Under the new federal program, a lender will use real estate agents to determine the value of a home and thus the minimum to accept. This figure will not be shared with the owner, but if an offer comes in that is equal to or higher than this amount, the lender must take it.

Big Shell Game

Diana Olick describes the situation perfectly in Mortgage Principal Writedown Won’t Save Housing.

And so it begins. Big gun lawmakers are making the move toward principal writedowns as the last resort to save the housing market.

The problem is prices. Home prices have fallen so far in the hardest hit areas, the areas where the bulk of the troubled loans are, that banks would have to write down principal 30 to 50 percent to put borrowers back in the green. Accounting rules require that banks write down the value of those loans on their books, and experts tell me that if banks really accounted for all the losses in the home loan market, they’d all be insolvent.

That’s why the Obama Administration has created this kind of shell game in the first place.

I stole that shell game idea from housing consultant Howard Glaser: “We’re spending tens of billions of dollars on a tax credit to get people to purchase homes, we’re spending federal money to keep them in their homes through the modification program, and now we’re going to pay them to move out of their homes. This is not a sustainable system for the housing market. It’s a shell game. Bernie Madoff could have created this system,” Glaser told me today.

F.R.A.U.D.

Let’s take real estate agents who might not have had any sales for 6 months or even a year, and agents who have a vested interest (a commission) in selling a home, and let’s put them in charge of figuring out what a home is worth. Good idea.

Oh…there’s no chance real estate agents will sell homes to their friends for cheap or to total strangers for that matter, just to get a commission. Indeed, real estate agents have been the paragon of virtue throughout the crisis so this is the culmination of a perfect idea.

Even appraisers working directly for the bank might be tempted to make special arrangements with favored real estate agents. A final approval process at the bank would make fraud harder, but that is contrary the idea the lender must take an offer if it hits the established minimum bid. A secondary review would also slow things down.

That aside, even with the chance for fraud, lenders are losing money by doing nothing, and in many cases by letting people live in homes rent free for 18 months or longer. Perhaps dealing with fraud issues is the lesser of two evils, assuming of course the banks can afford the loan losses. Then again, what alternative is there besides pretending loans on the books are worth full value?

This is what our affordable housing program has become: Giving tax credits to new home buyers, spending taxpayer money to keep people in their homes, paying people to move out of their homes, and bankrolling Fannie Mae and Freddie Mac with tax dollars for unlimited losses.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

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Government programs like FHA, Fannie Mae, Freddie Mac, HAMP, Tax-Credits, etc, were all designed with the goal of making homeownership more attainable…meaning that more people can now attain a limited supply of homes.  Increased demand leads to higher prices…meaning these programs just made housing less attainable. Economically-speaking, we’d be better off if they never existed in the first place.

It sounds almost un-American to say such things…and that’s a big part of the problem.

Even while acknowledging that high home prices actually harm the economy, Yale economics professor Robert Shiller wrote a piece in The New York Times, making a case that the Government should continue supporting the programs that cause them.  He specifically mentions the F.H.A., Fannie Mae, and Freddie Mac, but all supporting programs were implied.

His reasons for supporting Government actions were basically:

1. Home prices would fall more if the programs ended
2. “The American Dream” is essential to our “sense of national identity”

The Emperor’s clothes are beautiful indeed.

From the article:

…But what is the long-term justification for putting taxpayers on the line to subsidize homeownership? Is this nothing more than a sacred cow in American society — a political necessity because so many voters own homes and are mindful of their resale value?

In fact, there is much more to the history of subsidizing housing. While the crisis in the housing market shows that our current approach is far from perfect, there is a certain wisdom behind it, related not only to economic stimulus but also to the preservation of a sense of national identity. It’s important to remember this as we consider re-engineering our institutions as the crisis ebbs.

…

This time, the best answer isn’t found in traditional economics but rather in American culture: a long-standing feeling that owning homes in healthy communities is connected to individual liberties that embody our national identity. Historically, homeownership has been associated with freedom, while renting — often in tenements or mill villages — has been linked to the oppression of a landlord.

In his classic 1985 book, “Crabgrass Frontier,” Kenneth T. Jackson of Columbia University delineated the complex train of thought that over the last two centuries has produced the American belief that homeownership encourages pride and good citizenship and, ultimately, preservation of liberty. These attitudes are enduring.

Back in 1899, in “The Theory of the Leisure Class,” Thorstein Veblen described homeownership, particularly of large and expensive dwellings, as “conspicuous consumption.” By that, he meant that it was undertaken substantially for the purpose of impressing others by showing the amount of money one can afford to waste on space one doesn’t need.

What is specifically American here — though it’s increasingly seen in other countries, too — may be the modern sense of equal citizenship, engendered by the illusion that we can sustain conspicuous housing consumption even among a majority of the people.

In short, this all has a great deal to do with culture, and little to do with financial wisdom.

On home prices, Shiller writes:

If many of these homes needed to be converted to rental units, home prices might well drop.

Though the policies are economically insane, they are worth the cost in order to perpetuate “a long-standing feeling that owning homes in healthy communities is connected to individual liberties that embody our national identity.”

In other words, the concept of “The American Dream of Homeownership” is worth defending at any cost because it is a central to our culture.

Really?  Is our National Identity really defined by lust for a material good?

Consider the alternatives…

Americans: Smart and Hard-Working

Americans: Gracious and Strong

Americans: Helping Each Other

Americans: Character and Perserverance

No, we’re Americans: People who want to Buy Houses

How twisted and materialistic have we become as a culture to openly define ourselves by something we own?

As a renter, I am offended.  As a citizen and a taxpayer, I am outraged.

Shiller suggests that The American Dream is too sacred…that our fragile national ego would collapse if its credibility were threatened.  But, he’s wrong.  The jig is up and the public knows it.  In fact, they are asking for it, desperately wanting to find some spiritual purity after a decade of decadence. Social mood is shifting.

Shiller mistakenly suggests that home prices are worth propping up.  But the problem isn’t that home prices are falling, it’s that home prices are still too high. Falling prices and foreclosures aren’t the problems, but the solutions, not the illness, but the cure.

The time has come to shout out that the Emperor has no clothes: The American Dream is simply a marketing campaign, a gimmick, perpetuated by industry groups and their lobbyists.  That a home can define one’s success or national identity is simply a symbollic, mutually-shared illusion.

Consider the actual, original American Dream by James Truslow Adams:

“that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement. It is a difficult dream for the European upper classes to interpret adequately, and too many of us ourselves have grown weary and mistrustful of it. It is not a dream of motor cars and high wages merely, but a dream of social order in which each man and each woman shall be able to attain to the fullest stature of which they are innately capable, and be recognized by others for what they are, regardless of the fortuitous circumstances of birth or position.”

Somewhere along the line, corporate marketing departments changed The American Dream to exactly “high wages and motor cars (houses)”.

Somewhere, our heros changed from men-of-character to men-with-credit-cards.

Now, the false American Dream is becoming an American Nightmare.  Many of our friends, neighbors, and family members are in their darkest hours and being forced to re-examine their paths and priorities.  One-by-one, they are emerging from the darkness and rebuilding lives to be recognized by what they are, not what they have.  Their stories are spreading, giving hope and courage to others who are struggling financially.

Social movements are born from crisis such as this. The opportunity is here to redefine American Culture.

It’s time to take back The American Dream.

Related posts:

1. Housing Subsidies, Debt Expansion, and the Death of American Liberty This post originally appeared on the Irvine Housing Blog. Today we examine housing subsidies and how they contribute to the growth...
2. Sham Survey Proves People Have No Economic Clue It is mind-blowing that 78-81% of potential homebuyers would be in favor of Government support. Do they not understand that...
3. Fannie Mae Posts a $15.2 Billion Loss Yikes. From the Fannie Mae Press Release: Fannie Mae (FNM/NYSE) reported a net loss of $15.2 billion in the fourth...

The ARM Problem has not gone away. Today we examine an updated ARM reset schedule and consider its impact on our local housing market.

it’s time for me to get away from here
just thought you oughta know the end is near
did you honestly think it would’ve worked at all
cuz evrything i’ve seen has only made me fall
there ain’t much i can do now that i’ve seen the truth
there ain’t much i can do now they’ve made me into
one of you

REPENT
for the kingdom of oblivion is at hand
REGRET
not a thing for all’s as it was planned
REJECT
false gods false hopes and false ideals
RESET
push the button game over no more time to steal

Left Spine Down — Reset

Wouldn’t life be much easier if we could hit a reset button and wipe away the excesses of the housing bubble? In the housing bubble era, reset is associated with a bad thing that happens to adjustable rate mortgages. I remember last year a few astute observers much wiser than me chastised me for worrying about adjustable rate mortgages because they were all resetting to lower rates — problem solved. Foolish me. I must be a Chicken Little sounding a false alarm, right?

I wrote most recently about The ARM Problem in the summary post Option ARM story. The problem with adjustable rate mortgages resetting and recasting to higher payments has diminished in importance because many of the loans have defaulted early, so now the major problem is shadow inventory. The ARM problem is still with us, and much of our shadow inventory — and ultimately foreclosure and resale inventory — is spawned from this lending monster.

$1 trillion worth of ARMs still face resets

By Zach Fox

While several industry observers worry about negative equity and unemployment driving foreclosures, a couple of experts point out that interest rates on mortgages remain a cause for concern.

Credit Suisse made waves in 2007 among housing bears with a chart that estimates the volume of adjustable-rate mortgages to face a reset each month. An updated version of the chart, which was provided to SNL, shows resets remain a worrying force over the next few years.

Most of the resets are expected to occur through 2012. Between 2010 and 2012, the chart indicates that $253.25 billion of option ARMs will adjust, while Alt-A loans totaling $163.71 billion will reset over that time. Altogether, $1.010 trillion worth of ARMs will reset or recast during the three-year period.

“Option ARM resets are still pending. … Nothing much has happened yet because rates were so low that resets were pushed back,” Chandrajit Bhattacharya, head of non-agency RMBS and ABS strategy at Credit Suisse, told SNL.

That is not entirely true. Many of these loans are still pending, but the borrowers are not paying. The reset chart is not adjusted for shadow inventory. Many of the loans facing reset are already in default. Numerous of the light blue (Option ARMs) have already defaulted as have many of the light green (Alt-A loans).

Borrowers who already have seen their ARMs reset might be sitting on their hands and not refinancing into fixed-rate products, McBride said. Because mortgage rates have been so low recently, resets can actually lower, not raise, monthly payments. When that happens, borrowers might feel little urge to refinance into a fixed-rate product that would cost more per month.

This is the real problem; people will do anything, no matter how foolish, to lower their monthly payment because they believe the government will bail them out if interest rates move against them. Why wouldn’t they? Moral hazard caused by lending bailouts emboldens both lenders and borrowers and ultimately increases the cost of the bailouts demanded.

“The avoidable scenario is interest rates start to go up over the next couple of years, and all of a sudden, millions of homeowners who are stuck in adjustable rate mortgages and haven’t been able to refinance out of them become sitting ducks for big payment increases,” McBride said. “And then here we go again. It’s like 2007 all over again. And again, the HARP program is key to avoiding that iceberg, and we’re headed right for that iceberg, and no one’s turning the wheel because everyone’s focused on mortgage modifications.”

“If you look at it, there’s almost probably 5 million borrowers sitting there in some sort of delinquency right now who have yet to be foreclosed upon. So if you say [the Home Affordable Modification Program] is going to save only a small fraction of that, the rest of them have to go through in some form of foreclosure or distressed sale,” Bhattacharya said. “So it’s definitely not over by any means.”

Credit Suisse projects 10 million foreclosures over a five-year period starting in 2008.

To put the ARM resets schedule in context, these timelines represent the totality of the carnage the markets face from ARMs, but the actual foreclosures related to these loans may occur early due to unemployment, negative equity or a number of other reasons. Shadow inventory emerges from this schedule and pulls destruction forward. Loan modifications, which are supposed to be the market savior, increase the problem with terms that have escalating interest rates and increasing payments. So why is this a big deal here in California?

… option ARMs are concentrated in just a few states. A Fitch Ratings study from Sept. 8, 2009, The Building Block: Bringing \’cram-down\’ back’,PU_STATUS,’9/14/2009 The Building Block: Bringing \’cram-down\’ back’,PU_CAPTION,’Article’,PU_POPOFF,0));”>reported that three-quarters of all option ARMs were in California, Florida, Nevada and Arizona.

Don’t worry; Irvine has none of those problems, right?

More Foreclosures are Coming

From the OC Register: Foreclosures now are just ‘tip of the iceberg’:

[Bruce] Norris told hundreds of investors attending a seminar he held in Costa Mesa this past weekend that numbers indicating the appearance of  firming home prices and fewer foreclosure auctions are “illusions.”

Government repayment and loan modification programs make foreclosure numbers appear lower for now, but are delaying the inevitable inability or disinclination of homeowners in trouble to hang on to property that has dropped in value by hundreds of thousands of dollars, he says.

Meanwhile, he says,  redefaults on loan modifications are “sabotaging” government efforts.

Mortgage delinquencies will continue “skyrocketing,” he says, because:

• “The resets of the Option-Arm loans will cause a larger number of foreclosures than the subprime loans.
• “Resets are part of the problem, but a bigger concern is the owners who owe more on their home than it’s worth.
• “Commercial loans and credit card losses will soon add to the problem.”
• Unemployment is a signifcant factor. He says: “I think we will fall back into recession by the end of 2010, and the unemployment rate and underemployment rate will be about 20% in 2011.”
• Owners are finding it more and more acceptable not to make their house payments. The mindset, according to Norris: ” ‘I see my next door neighbor has stopped making his payment, and he just bought a camper.’ You can see that coming. We haven’t really been through the biggest part of the problem.”

Updated ARM Reset Schedules

For historical reference, I superimposed the new reset chart onto the old one to see how the original projections have changed.

In the cleaned up graphic below shows the next four years of adjustable rate mortgage resets.

More reason to believe the Bernanke Put, the implied protection of mortgage interest rates, is going to be kept in place.

The results of amend-pretend-extend are apparent, and in case the obvious is overlooked, restructured loans only postpone bank losses.

The amend-pretend-extend policy is like shovelling snow; the more you push the snow, the larger the build-up on the front of the shovel. Eventually, you will need to stop and remove the snow or you get stuck. Similarly, pushing ARMs out further simply adds to the problem and makes correcting the problem costier.

Lenders believe that a rolling loan gathers no loss, so they would push the problem back endlessly if they could. Eventually, appreciation may bail them out, but the existence of these loans and the inevitability of higher interest rates will weaken appreciation or kill it entirely. Also, despite the foolishness of it, many of these loans are being underwritten today as affordability products. Rather than eliminating ARMs at the bottom of the interest rate cycle, we are expanding their use.

If the ARM problem becomes large enough, politicians will deem it too-big-to-fail and engineer another bailout. At this point it is difficult to advise people to take on conservative financing and do the right thing. So much moral hazard exists that I can not persuasively argue with someone considering an ARM loan. The system is there to be gamed, and everyone seems OK with that. Personally, I find it appalling.

Related posts:

1. New Credit Suisse Recast Chart Credit Suisse has released an updated version of their popular Mortgage Reset & Recast Chart. Here is the new one:...
2. Wednesday Links Look into the Shadows Moody’s Expects HAMP Missteps to Prolong Home Price Declines – DSNews “It is looking likely that foreclosures will hit the...
3. Mortgage Rates Hold Steady This Week Mortgage interest for the week held fairly close to the previous week’s rates, reports Freddie Mac. Average interest on 30-year...

The Housing Bubble

Prices went up a large amount during the Great Housing Bubble, but what makes this price increase a bubble? To answer this question it is necessary to accurately measure price levels and review historic measures of affordability to establish these price levels are not sustainable. [1] Measuring house prices is not a simple task, and there are many methods market watchers use to evaluate market prices. These include the median, the average cost per square foot, and the S&P/Case-Shiller indices. Price levels in financial markets represent the collective result of individual actions. There are techniques to measure the actions of the individual market participants and their impact on house prices. These measures are debt-to-income ratios and price-to-income ratios.  The amount of debt people are willing to take on compared to the income they have available is their debt-to-income ratio. The amount of money people are able to put toward the purchase of residential real estate compared to their income is their price-to-income ratio. These ratios are important because they show how much people are borrowing and spending from their earnings to acquire real estate. When these ratios break with historic patterns, they signify a housing bubble.

There is a point where people are not able to bid up prices any higher because they do not have the savings or the borrowing power to pay more. This affordability limit determines where bubble rallies end; however, this limit is not predetermined or in a fixed location. The purpose of exotic financing programs is to expand this limit and bring more customers to the market and generate fees for the lenders. Unfortunately, these products have continually proven to be unstable, and the high default rates and lender losses inevitably lead to a contraction of credit known as a credit crunch. Interest-only and negative amortization loans created the housing rally and their elimination due to borrower default created the housing crash.  As mentioned previously, the housing bubble was a credit bubble.

Price Measurements

There is no perfect measure for any broad financial market activity. Markets for stocks, bonds and other securities are the most widely reported and measured financial markets. It is relatively easy to measure activity in these markets because all sales are recorded at a few central exchanges and the “products” are uniform (one share of stock is equal to another). In contrast, real estate markets are much more difficult to evaluate. [ii] Real estate transactions are recorded into the public record in thousands of locations across the country. Keeping an organized database of these records is such a daunting task that the title insurance industry has taken this responsibility as part of its business model, and many people are devoted to the arduous task of obtaining and organizing these records on a daily basis. Real estate does not have the uniformity of stocks or other financial instruments. Each property has unique qualities that differentiate it from all other properties making like-kind comparisons very difficult. Geographical location is a major influence on the value of real estate. Even if two properties could be found with identical physical characteristics, the values of these properties could vary considerably based on where they are located. Ideally, a market measure would record the changes in sales prices of identical assets or in the case of an index, a group of similar assets. The unique nature of real estate assets makes it difficult to use standard measures of reporting utilized in other financial markets.

Due to the problems of asset uniformity and variability based on location, real estate markets are typically measured using some form of median pricing over a specified geographic area. The median is a statistical measure of central tendency where half the data points are above and half the data points are below. For instance, in a list of 5 numbers sorted by size ($100,000, $200,000, $300,000, $500,000, $900,000,) the third number in the list ($300,000) would be the median because it has two numbers that are larger and two numbers that are smaller. The median ($300,000) is used rather than an average ($400,000) because a few very expensive properties can increase the average significantly, and the resulting number does not represent the bulk of the price activity in the market.

One of the problems with a median as a measure of house prices is a lag between when a top or a bottom actually occurs and when this top or bottom is reflected in the index. During the beginning of a market decline, the lower end of the market has a more dramatic drop in volume than the top of the market. This causes the median to stay at artificially high levels not reflective of pricing of individual properties in the market. In other words, for a time things look better than they are. At the beginning of a market rally, transaction volume picks up at the bottom of the market at first restarting the chain of move ups. During this time, the prices of individual properties can be moving higher, but since the heavy transaction volume is at the low end, the median will actually move lower.

The median is a good measure of general price activity in the market, but it does have a significant weakness: it does not indicate the value buyers are obtaining in the market. The houses or structures built on the land compose the most significant portion of real estate value in most markets. These structures deteriorate over time and require routine maintenance that is often deferred. During times of prosperity, many people renovate homes to add value and improve their living conditions. The impact of deterioration and renovation of individual properties is not reflected in the median resale value. Also, at the time of sale, there are often buyer incentives which inflate the recorded sales price relative to the actual cost to the buyer. These buyer incentives also distort the median sales price as a measure of value.

Many data reporting services measure, record, and report the average sales cost on a per-square-foot basis to address the problem of evaluating what buyers are getting for their money. For instance, in a declining market if people start buying much larger homes at the limit of affordability, the generic median sales price would remain unchanged, but since buyers are getting much larger homes for the same money, the average cost per-square-foot would decline accordingly. This makes the average cost per-square-foot a superior measure for capturing qualitative changes in house prices; however, this method of measurement does not capture the relative quality of the square footage purchased, only the price paid for it. High quality finishes may justify a higher price per square foot. There is no way to objectively evaluate the impact finish quality has on home prices. The main problems with using the average cost per-square-foot to measure price is that it does not provide a number comparable to sales prices since it has been divided by square feet, and it is not widely measured and reported.

Figure 15: National S&P/Case-Shiller Home Price Index, 1987-2007

To address some of the weaknesses of the generic median sales price as a measure of market value, Karl Case and Robert Shiller developed the Case-Shiller indices for measuring market trends. [iii] This index measures the change in price of repeat sales. It solves the dilemma of pricing like-kind properties–almost. Although these indices capture the price movements of individual properties far better than the generic median sales price, it does not take into account value added through renovation and improvement. To address this issue, the index gives less weight to extreme price changes assuming the outlier is a significant renovation. However, if there is a market-wide renovation of properties, as was the case in many markets during the Great Housing Bubble; this will cause a distortion in the index. The other weaknesses of the Case Shiller indices concern how and where it is reported. Since it is an index of relative price change rather than a direct measure of price, the index is reported as an arbitrary number based on a baseline date; therefore, the numbers are not useful for evaluating current pricing. The index is also confined to 20 large metropolitan areas around the United States. The large geographical coverage areas are required to obtain enough repeat sales to construct a smooth index. The broad yet limited geographical coverage fails to capture price changes in smaller markets. Also, since the Case-Shiller index is a measure of changes in prices of sales of the same home, it does not include any newly constructed homes. No measure is perfect, but the Case-Shiller index is the best at measuring historic movements in pricing because its methodology is focused on repeat sales of the same property.

Figure 16: Los Angeles S&P/Case-Shiller Index, 1987-2007

The examples from this work will use the median sales price, not because it is the best method, but because it is the most widely used and best understood of the common measures. Also, since it gives a number reflective of sales values in the marketplace, it is the easiest to understand and interpret. This measure has weaknesses, but over time it does a reasonable job of documenting overall prices and trends in the marketplace.

Figure 17: Median Home Prices, 1968-2006

The Great Housing Bubble was an asset bubble of unprecedented proportions. Between 2000 and 2006, home prices increased 45% nationally, and in California home prices increased 135%. [iv] Had this amazing price increase coincided with a period of high inflation, it may not have been indicative of a price bubble, merely the general increase in prices of all goods and services; however, inflation was low during this period. The inflation adjusted price increases nationwide were 23% and in California it was 100%. There was no great improvement in the quality of houses justifying the higher prices. Although some homeowners made cosmetic improvements, the vast majority of homes were unchanged during this period, and many deteriorated with age. Resale homes did not undergo any form of manufacturing process where value was added to the final product. There was little real wealth created during the bubble, just a temporary exaggeration of value.

Price-To-Income Ratios

Price-to-income ratios represent the amount borrowed relative to the incomes of the borrower. There are many variables that impact house prices, and some of the variability in prices over time can be attributed to changes in these variables; however, since most houses are purchased with lender financing, and since lender financing is linked to income, the price-to-income ratio is the best metric for evaluating long-term housing price trends. The price-to-income ratio does not need to be adjusted for inflation as both prices and income will rise with the general level of inflation. Most of the fluctuations in the ratio are based on changes in financing terms, in particular interest rates, and of course, irrational exuberance.

The Great Housing Bubble saw unprecedented price-to-income ratios because interest rates were at historic lows and the use of exotic financing including negative amortization loans were at historic highs. When measured against historic norms of house price to income, the degree of price inflation was staggering. [v] In markets where bubble behavior is not prevalent, price to income ratios hover between 2.3 and 2.8. In bubble markets there is a tendency to maintain higher ratios, and the range over time is much greater. Any ratio less than 3 is generally considered affordable.

Figure 18: National Ratio of House Price to Income, 1986-2006

In bubble markets ratios of 3 to 4 are as affordable as they get. Anything greater than 4 is a strain on family budgets and generally a sign of an inflated market. Ratios greater than 5 are considered very unaffordable and prone to high rates of default because they tend to be characterized by exotic financing. Price-to-income ratios in the bubble of the early 90s in California did not exceed 6 because interest rates were higher and because negative amortization loans were not widely available. During the Great Housing Bubble, the national ratio of house price to income increased 30% from 4.0 to 5.2. This means 30% more debt is serviced by the same income. Some of this increased ability to service debt is explained by lower interest rates and exotic loan terms, and some of this increase came from people choosing to take on larger debt loads due to the irrational expectation of ever increasing house prices coupled with loose lending standards which enabled the populace to take on these debts. The national trends were small compared to the frenzied activities of bubble markets in California where most markets saw their house price to income ratio double.

Figure 19: Price-To-Income Ratio in California, OC and Irvine, 1986-2006

Buyers were never forced to buy; it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. The exotic financing was not a result of high prices; it was the cause of high prices. Lenders were keen to offer these products because they were not taking on the risk, and it allowed them to keep transaction volumes high. The lenders profits came from transaction volume. By late 2007, the market balance had shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers: their dreams of riches from perpetual appreciation were in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homeowners with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.

Price-To-Rent Ratios

Price-to-rent ratios represent the cost of a dwelling unit relative to the cost of a comparable dwelling unit. This ratio is also subject to the same variability exhibited by the price to income ratio. [vi] This is not surprising considering rent is generally paid out of current income, so incomes and rents tend to track one another fairly closely. The ratio of rent to income has stayed within a range from 13.6% to 16.5% from 1988 to 2006. This demonstrates renters have been putting roughly the same percentage of their incomes toward housing for the 18 years period of data examined. The evidence from the sudden and dramatic changes in the price-to-income ratio and the price-to-rent ratio points to a housing bubble. [vii] If these two measures of value had been supported by a rise in the rent-to-income ratio, the increase in prices might have been explainable by a shortage in dwelling units causing all consumers of housing to see an increase in the percentage of their income going toward housing. Evidence from the rent-to-income ratio is to the contrary.

Figure 20: National Price-to-Rent Ratio, 1988-2007

Debt-To-Income Ratios

There was a significant price bubble in residential real estate in the late 1980s crashing in the early 1990s. This coastal bubble was concentrated in California and in some major metropolitan areas in other states, and it did not spread to housing markets nationwide. When comparing this previous bubble to the Great Housing Bubble, the macroeconomic circumstances were different: prices and wages were lower in the last bubble, interest rates were higher, the economies were different, and other factors were also unique; however,  the evaluation of personal circumstances each buyer goes through when contemplating a purchase is constant. The cumulative impact of the decisions of buyers is represented in the debt-to-income ratios–how much each household pays to borrow versus how much they make. Comparing the trends in debt-to-income ratios provides a great tool for elucidating the behavior of buyers.

Typically debt-to-income ratios track interest rates. As interest rates decline, it becomes less expensive to borrow money so borrowers have to put less of their income toward debt service. The inverse is also true. On a national level from 1997 to 2006 interest rates trended lower due to low inflation and a low federal funds rate. During this same period people were increasing the amount of money they were putting toward home mortgage debt service. If the cost of money is declining and the amount of money people are putting toward debt service is increasing, the total amount borrowed increases dramatically. Since most residential real estate is financed, this increased borrowing drove prices up and helped inflate the Great Housing Bubble.

Figure 21: Debt-To-Income Ratio and Mortgage Interest Rates, 1997-2006

The figure on the following page shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006. It is calculated based on historic interest rates, median home prices and median incomes. Lenders have traditionally limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels. During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards are prone to high default rates once prices stop increasing. In 1987, 1988 and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.

Figure 22: Debt-To-Income Ratio, California 1986-2006

Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. The psychology of buyers reflected in debt-to-income ratio is the facilitator of price action. In market rallies people put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. People are not passively responding to market prices, they are actively choosing to bid prices higher out of greed and the desire to capture the appreciation their buying activity is creating. This will go on as long as there are sufficient buyers to push prices higher. The Great Housing Bubble proved that as long as credit is available there is no rational price level where people choose not to buy due to prices that are perceived to be expensive. No price is too high as long as they are ever increasing.

In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining. In fact, it is possible for house prices to decline so quickly that no mortgage program can reduce the cost of ownership to be less than renting. The only thing justifying a DTI greater than 50% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even beginning to decrease, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. In a bubble market when the market debt-to-income ratio falls below 30%, the bottom is near.

[ii] Jordan Rappaport provides an overview of the various methods of house price measurement in A Guide to Aggregate House Price Measures (Rappaport, 2006).

[iii]  In the paper A Note on the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes by Andrew Leventis (Leventis, 2007), the author makes the following observation: “OFHEO’s House Price Indexes (the “HPI”) and home price indexes produced by S&P/Case-Shiller are constructed using the same basic methodology. Both use the repeat-valuations framework initially proposed in the 1960s and later enhanced by Karl Case and Robert Shiller. Important differences between the indexes remain, however. The two models use different data sources and implement the mechanics of the basic algorithm in distinct ways.”

[iv] Praveen Kujal and Vernon L. Smith noticed an interesting phenomenon in the studies of perceptions of fairness in their paper (Kujal & Smith, Fairness and Short Run Price Adjustment in Posted Offer Markets, 2003), “perceptions of fairness cause people to resist price increases following abrupt changes in conditions with no cost justification. Fairness is thus interpreted as being a result of expectations that are not sustainable.” This implies that people have an intuitive sense that nothing is justifying the dramatic increase in prices during a bubble rally. There is no perception of fairness because houses are not any better, nor are houses any more expensive to build. The increase in prices has no justification in cost. Carl Case and Robert Shiller also noticed the same behavior among sellers in financial manias who felt guilty that the buyer paid so much (Case & Shiller, The Behavior of Home Buyers in Boom and Post-Boom Markets, 1988).

[v]  In the paper Are House Prices the Next “Bubble?” (McCarthy & Peach, 2004) the authors completely missed the implications of the rising price-to-income ratio. Some amount of the increase in price (less than 50%) nationally can be attributed to lower interest rates. The authors make the statement, “The marked upturn in home prices is largely attributable to strong market fundamentals: Home prices have essentially moved in line with increases in family income and declines in nominal mortgage interest rates.” An analysis of the impact on lower interest rates on actual payments and debt-to-income ratios would have revealed their conclusion erroneous, but no such analysis was undertaken. In the paper (Gallin, The Long-Run Relationship between House Prices and Income: Evidence from Local Housing Markets, 2003) Joshua Gallin reaches the following, completely erroneous conclusion, “More formally, many in the housing literature argue that house prices and income are cointegrated. In this paper, I show that the data do not support this view. Standard tests using 27 years of national-level data do not find evidence of cointegration.”

[vi] The paper for the Federal Reserve Board by Joshua Gallin, (Gallin, The Long-Run Relationship between House Prices and Rents, 2004) demonstrates there is a relationship between these variables long term. What is interesting is the Mr. Gallin did not reach the same conclusion with respects to the relationship between house prices and income (Gallin, The Long-Run Relationship between House Prices and Income: Evidence from Local Housing Markets., 2006) despite the fact that rents and income track each other very closely.

[vii] In the paper Housing: Boom or Bubble (Schiller, 2007), author Tim Schiller shows a chart on page 17 that looks very similar to the one in this work (He used a different data source, but the results were almost the same.) The chart shows the obvious sign of a massive housing bubble with prices showing a deviation in the price-to-rent relationship 5 times the previous high of the coastal bubble of the early 1990s. Despite the visual appearance of the chart, he goes on to say the rally in prices was supported by fundamentals. Obviously, he was proven wrong. There is a history of scholarly papers on the price-to-income ratio that completely missed the housing bubble.

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As the infamous “Summer Buying Season” looms a few months out, it remains to be seen whether or not recent market strength can continue. In a way, the housing market has been turned on its head in the past year: The weakest markets are now the strongest, while some of the most well-to-do areas remain shaky and illiquid. The bifurcation in today’s housing market is persistent, and we believe will continue to be the dominant trend in 2010. Taking a look around the Bay Area, data support this theory, as can be seen the charts on the following pages.

Alameda is truly an island unto itself. It is after all, an island. And in some ways a whole different world. The western half of the island is dominated by the quasi-vacant Alameda Naval Complex, which is part maritime ghost-town, part industrial development opportunity in the making: Years of potential development deals have hung over the area, which remains one of the choicest pieces of undeveloped land in the Bay Area. Meanwhile, strong schools, a bustling downtown and a unique sense of community draw middle class families from around the Bay to call Alameda home. As the chart above illustrates, Alameda has seen its share of price declines, but this decidedly middle class town has experienced decidedly middle of the road housing troubles. With prices off “just” 24% from the peak and stabilizing of late, homeowners couldn’t have asked for a much better outcome from the worst housing slump since the Great Depression.

———————————————————————————————————————-

We at Cirios have shown chart upon chart, graph upon graph, data upon data to illustrate that low end housing markets have been the first to recover, while high end markets have remained troubled. At first, we were called loony, since conventional wisdom knows that when housing starts to recover, it’s the strong markets that bounce back first. Not so this time. It has now been well documented that luxury real estate is still under pressure even as distressed markets start to stabilize. In case you weren’t convinced, we offer you yet another fascinating example of why buying in the high end can still be a risky proposition if not done smartly. The graph above shows condo prices in Burlingame, one of the most desirable locales on the Peninsula. There aren’t a ton of condos in the town in the first place, as evidenced by the spotty dots, but the trend is clear: Prices have come down, but not by much, and if the cluster of dots below the trend line in 2009 are any indication, stability isn’t likely in the cards in the immediate future. Flip the page to see the polar opposite situation across the Bay in Concord.

———————————————————————————————————————-

Wow, now that is a chart. (Commodity-watchers of recent years will recognize this pattern, to be sure). The price correction above was nothing short of spectacular. Unless, of course, you owned a condo in Concord. In addition to all the other factors pushing down prices, as condo buildings got into financial trouble, they were crossed off the FHA and Fannie Mae Approved list, effectively locking buyers out of financial options. When your only buyer is an all-cash investor, prices really crater. Dig into the data above at the complex-by-complex level and you can literally identify the point at which the complex got removed from the Approved list. But as rental yields once again started to make sense, investors returned to the market. With prices having tumbled all the way back to 2000 levels, even though Concord doesn’t have the caché of Burlingame (nor the schools, of course), where would you rather put your money?

———————————————————————————————————————-

Just like the statement “the housing market has bottomed” is meaningless to anyone but the most macro-focused economists, trying to look at even city-wide home price trends is often a fruitless endeavor. And while sometimes even zip codes hide the true trends (as we saw last month with Menlo Park, CA), zip codes are the only way to even begin to examine home price trends effectively, especially within large cities. For example, the question “How far off the peak are home prices in San Jose?” is impossible to answer. The chart above shows the zip of 95127, which lies to the east of Highway 680. From the peak, prices are down more than 50%, all the way back to levels not seen since 1999. Note also that there was nary a pop during the dotcom bubble, which means this area isn’t chalk full of technology execs, to say the least. Flip to the next page for a very different perspective from a very different part of town.

———————————————————————————————————————-

The zip code of 95120 is home to the Almaden Valley, one of the most desirable parts of San Jose, and, by extension, Silicon Valley. All one needs to do to is look at the spike in expensive homes sold in this area during the peak of the dotcom craze to get a sense of the area’s demographics. Prices in 95120 are off a mere 20% from the peak, which occurred a full year after that of our previous area of 95127. Interestingly, Almaden has seen a touch of stabilization since the beginning of last year, and even a small rise in prices. But, with prices only back to 2004 levels, during the height of the housing boom, we would caution that it’s more than likely that 2010 could bring some pricing pressure, as a weak job market begin to stress Silicon Valley’s more well-to-do residents.

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Opportunity Overview:2730 Sherwood Dr., San Bruno, CA 94066
For many people familiar with the Bay Area, the Peninsula is a place where only the wealthy can afford to live. And while this holds true for most areas, there remain some desirable areas that still afford first-time buyers a place to call home. One of these towns is San Bruno. Known more for its poor weather than affordable homes, San Bruno often gets a bad rap: There are plenty of neighborhoods that aren’t buried within the fog belt. San Francisco International airport is close (although in some cases too close), and job centers are a short drive North or South. Homes frequently sell for less than $600,000 which, on the Peninsula, is downright cheap.

Property Details
Bedrooms: 3
Bathrooms: 2
Living Area: 1,140 square feet
Lot Size: 5,432 square feet
List Price: $549,000
Sale Price: IN ESCROW (8 days on market)
List Date: 2/12/2010

This property was purchased at Trustee Sale on January 4, 2010 for $444,000. In just over 30 days, the buyer was able to relist the property for more than $100,000 above acquisition cost. The quick turnaround indicates that improvements were more than likely cosmetic in nature. Given the lack of equivalent homes on the market, it ‘s safe to assume this property will sell at or above its asking price.

Here is one potential scenario of how an investor would make out:

(Note that the cost figures below are estimates)

$444,000: Purchase price
$30,000: Repairs and remodel
$1,520: Taxes
$3,500: Insurance
$5,000: Escrow costs
$484,020 Total Investment

Although a $30,000 budget is not especially large, given the small size of the home, many high quality improvements could have been made. The final numbers in our scenario look like this:

$570,000: Sale price (estimated)
$28,500: Less Real Estate Commissions
$484,020: Less Total Investment
$57,480: Profit
11.9% ROI

A return of 11.9% is not as high as other deals we have seen come across the steps, but escrow is scheduled to close on March 11th, so the deal took just under 70 days from purchase to eventual resale. The annualized return on this deal was meaningful, indeed.

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This month’s zip code spotlight moves to what can truly be called the heart of the San Francisco Peninsula. Nestled between South San Francisco and Burlingame, San Bruno is a suburban haven only minutes from the city.

Homes in the area range widely in cost, from $1.3 Million dollar mansions on the hill to affordable, $300,000 row homes closer to the bay. In the midst of all this, a solid core of reasonably priced (by peninsula standards) homes provides an excellent alternative to more expensive south peninsula locales. The median listing price currently rests at around $650,000. For this price, homebuyers can get a reasonably large 3 bedroom home with a good sized lot.

With a housing stock largely consisting of homes built in the 1950’s and 60’s, opportunities abound for rehab investments. Foreclosure activity has been on the rise in the area of late, while prices seem to have leveled off somewhat. As you can see from the graph below, the moving average sale price for homes has actually increased slightly over the last 6 months. During that time, supply has come down from its spike in 2008 but is still slightly elevated from traditional levels, likely due to the increase in foreclosure activity.

What this means is that home values in the area are increasing despite downward pressure from increased supply. This is a good indicator for the medium term prospects of San Bruno real estate, as it indicates that demand is higher (relative to supply) than it has been traditionally in this area. If supply does taper off, prices should go even higher. In the meantime, we feel that price stability for this area is very likely, making rehab investments in the area quite attractive.

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Today we look at one family in San Diego hoping for debt forgiveness that isn’t going to happen.

Love is like oxygen
You get too much you get too high
Not enough and you’re gonna die
Love gets you high

Time on my side
I got it all
I’ve heard that pride
Always comes before a fall

Sweet — Love Is Like Oxygen

Appreciation is like oxygen, you get too much prices get too high, not enough and your gonna die — or at least be forced to pay down debts – a fate antithetical to a borrowing dependant lifestyle.

Recently, I wrote about The Coming Tax Nightmare Over Forgiven Mortgage Debt in California, and recently another story was written about the Hefty tax bill may hit those who lost home.

San Diegans who have lost their homes through foreclosure or short-sales thought they had emerged from the dark times and could start rebuilding their lives.

Then the state tax man came calling.

With less than six weeks before taxes are due, an estimated 16,000 former homeowners statewide will owe $15 million in extra income taxes this year and $29 million through 2012.

Today we look at one family lamenting the $20,000 tax bill they must pay for their failed speculation.

[March 2, 2010 | Photo by Charlie Neuman. Bonnie and Clyde are facing a California tax bill of up to $20,000 because, they have found, the state treats short-sales differently than the IRS.]

Phyllis Roth, 63, a tax preparer, said she did not realize until recently that the state would treat the short-sale differently than the Internal Revenue Service would. She estimates her state taxes at $15,000 to $20,000.

“I didn’t call anybody,” she said. “I was looking online and didn’t see anything. That’s what happens when you rely on yourself.”

Brilliant marketing for her tax preparation business, “Let me help you miss a $20,000 tax obligation. I did.”

For the Roths, who continue to own a previous home and have other assets, their nearly $200,000 in losses does not cancel out their other holdings. The couple said they normally operate conservatively and only bought the home, which they lived in while their son continued to live in their first house, so they could sell it at a profit and pad their retirement accounts.

“If we have to pay it, we’ll pay it,” Phyllis Roth said of the taxes. “It’s less money to retire on, but it’s not the end of the world.”

If we have to pay it? Sure, let’s take our broken State budget and carve out a tax break for HELOC abusers and everyone else who lost money speculating in the housing market. That should provide a great incentive for frugality and curb speculation. Not.

Congress exempted most homeowners from the extra federal tax through 2012, and the state followed suit for 2007 and 2008 but did not extend the provision last year. The state Assembly may vote tomorrow on a bill to repeal the tax, but Gov. Arnold Schwarzenegger vetoed such a bill last year over unrelated provisions.

“The state of California is seriously upside down financially, and I think the governor will probably veto it again,” Nemeth said.

H.D. Palmer, a spokesman for the Department of Finance, said Schwarzenegger remains opposed to the bill in its present form but has not announced whether he will veto it again. Other versions of the tax repeal are in the hopper and could be passed next month, legislators’ analysts said.

Failure to halt the tax could cost Jack and Phyllis Roth of Fletcher Hills as much as $20,000 in state income taxes this year — they paid $781 last year — because of the home they sold short in Flinn Springs in November. They bought it in 2004 for $545,000, invested $50,000 in improvements, and then saw its value fall by one-third before they sold it for $410,000. The result was about $190,000 in net loss that was forgiven by the Roths’ lender.

Notice the words the reporter selected, “They bought … invested.” They did neither of those things; they borrowed. These people put no money down, borrowed another $50,000, sold for a $190,000 loss, and they are complaining because they might lose $20,000 of their money in taxes. We are not saving an already injured party from further pain, we are removing the only real pain these people will feel.

[schadenfreude alert] The state Franchise Tax Board has received an increasing number of calls from former homeowners who are discovering the giant tax bills they face, said spokeswoman Denise Azimi. Azimi said the former homeowners can work out a payment schedule, though the state charges 4 percent interest on such stretched-out payments.

If the tax is repealed eventually, the taxpayers could seek a refund, but for now, they have to pay what is due by April 15 or face a penalty.

Sen. Lois Wolk, D-Davis … who chairs the Senate Revenue and Taxation Committee, said it was appropriate to group all tax conformance measures into one bill. But if her bill is vetoed again, she indicated she would act to get the cancellation of debt tax repealed.

“We’re certainly not going to allow homeowners to have to pay significantly more tax when they’ve had to relinquish their homes through short-sales (and foreclosures),” Wolk said.

Why not? People who have non-recourse purchase money mortgages are not getting a tax bill. It is only investors, speculators, multiple-property owners, HELOC abusers and others with recourse loans who are getting a break. They are not a group who needs subsidies.

Insolvency

Every borrower will try to establish insolvency as defined by the Internal Revenue Service:

Do not include a canceled debt in income to the extent that you were insolvent immediately before the cancellation. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities exceeded the FMV of all of your assets immediately before the cancellation. For purposes of determining insolvency, assets include the value of everything you own (including assets that serve as collateral for debt and exempt assets which are beyond the reach of your creditors under the law, such as your interest in a pension plan and the value of your retirement account). Liabilities include:

• The entire amount of recourse debts, and
• The amount of nonrecourse debt that is not in excess of the FMV of the property that is security for the debt.

As defined by the IRS, insolvency is a condition of negative net worth; in other words, if you have no assets for the IRS to take, they will leave you alone. True or not, the incentive to feign and declare insolvency is huge.

How many people are filling false tax returns claiming insolvency when in reality, they just don’t want to pay, and they hope they can cheat and get away with it?

Related posts:

1. The Coming Tax Nightmare Over Forgiven Mortgage Debt in California Do you think homedebtors are ready for their California tax bill on forgiven debt? That HELOC will get them. ...
2. California Legislature to Vote Monday on Taxing Forgiven Mortgage Debt For thousands of Californians who did a short sale or had mortgage debt forgiven via a modification in 2009, Monday...
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San Francisco Building Owners Sell Winners, Keep Sinners
(San Francisco Business Times)
There’s an old saying on Wall Street that you shouldn’t sell your winners to finance your sinners. Landlords in San Francisco, apparently, didn’t get the message. 303 Second St., just blocks from the freshly constructed One Rincon Tower, was just listed and is expected to fetch north of $200 million. Along with another new listing at 333 Market St., which is a few blocks from the Embarcadero and 100% leased to Wells Fargo, the activity supports the view that building owners are looking to raise capital by selling strong performing assets. SF landlords are likely hoping they don’t end up like former brokerages like Bear Stearns and Lehman Brothers, which shed high quality assets to stave off a cash crunch. Oops.

(Read more here: http://tinyurl.com/ciriostrendsmar1)

Bay Area Home Sales Slip in January
(San Francisco Chronicle)
It’s not unusual for home sales to fall from December to January; the holidays are a notoriously sleepy time in the housing market. But this January was abnormally slow, as transactions in the Bay Area fell 4% from a year ago, marking the first year-over-year drop in sales in 17 months. Some chalked up the slowdown to the dearth of listings on the market, while others raised the possibility of a hiccup in the housing market’s recent strength. At least within the San Francisco city limits, we at Cirios have noticed a meaningful pickup in new listings in the past month (supported by the data presented on the first page). Opportunistic buyers should be licking their chops, but, as always, picking their spots.

(Read more here: http://tinyurl.com/ciriostrendsmar2)

Hotels Slash Prices to Keep Occupancy Up
(San Francisco Business Times)
Sure, you’re broke, but it’s never been a better time to visit San Francisco. Hotels, smarting from an excessively weak tourism market, are slashing rates to keep their rooms full. Northern California as a whole saw room rates slip 13.2% from last year, while San Francisco’s decline approached 16%. Meanwhile, occupancy in San Francisco held relatively steady, off only 4.3% from 2009. Contrast this with apartment buildings, where landlords let units sit vacant rather than dropping rents. This is especially true in San Francisco, where tenant-friendly rent control laws means it can take years for landlords to recoup lost rental income.

(Read more here: http://tinyurl.com/ciriostrendsmar3)

Santa Clara Residents Undecided on 49ers Fate
(San Jose Business Journal)
Less than a month after the Santa Clara city council paved the way for a June vote on a nearly $1 billion stadium for the San Francisco 49ers, voters aren’t so sure. In a recent poll, Santa Clara voters are split right down the middle on the subject, with 45% favoring the plans and an equal portion opposed. This contrasts another poll done last month which shows just 40% of Santa Clara voters in favor of the stadium, with 54% opposed. San Francisco is still holding out hope that they’ll get a shot at keeping the team, but only time, and votes, will tell.

(Read more here: http://tinyurl.com/ciriostrendsmar4 )

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Given the historic home price declines seen in the past four years, few investors have been focused on deferring taxes on real estate gains because, let’s face it, there just haven’t been many gains. However, as investors begin to wade back into the real estate market (cash investors accounted for more than 25% of existing home sales in January), they should be well-versed in State and Federal laws and tax codes that allow investors to minimize the pain of taxes.

One useful tool is the like-kind exchange created by 26 U.S.C. Section 1031 of the United States Internal Revenue Code. Or, as is more commonly known, the 1031 Exchange.

A 1031 Exchange allows an investor to sell an income, investment or business property and soon thereafter purchase, or “replace” it with a like-kind property, ie, another income, investment or business property of equal or greater value. All gains from the resale of the first property are deferred, so long as the IRS rules governing 1031 Exchanges are closely adhered to.

Several types of real estate properties can qualify for a 1031 Exchange. Real estate held for income, business purposes or investment can qualify, whereas personal residences and, for the most part, fix-and-flip properties do not qualify. Vacation homes and second homes that are not held as rentals also do not qualify, unless specific tests for “usage” set out in the IRS Code are met (consult a CPA or other expert before attempting a 1031 Exchange with a vacation home).

Today, most 1031 Exchanges are facilitated by what is known as a “Qualified Intermediary,” or QI. IRS rules are very strict about what can be done with sales proceeds that are to be rolled into another property in order to qualify for the 1031 Exchange, so QIs were designed to ensure all regulations are met for an approved exchange. The QI facilitates the transaction by acting as the investor’s agent when he or she sells the original property and buys the replacment. This is all above board, as regulators created this type of entity to try and standardize the process by which 1031 Exchanges could take place.

Upon the earlier of the deed recording or possession transferring to the new buyer, an investor seeking to do a 1031 Exchange has a non-extendable 45 days to close on or identify in writing a potential “Replacement Property.” After identifying this Replacement Property, the investor has a maximum of 180 days from the date the first property was transferred to the new owner to close the purchase of the Replacement Property. An important caveat: If the due date on the investor’s tax return for the tax year in which the original property was sold is earlier than the 180 day deadline, then the due date for the tax return is the final deadline for the closing of the new property.

If an investor fails to meet either the 45 day identification or 180 day closing deadlines, the 1031 Exchange is disqualified and taxes will be due on the capital gains from the sale of the property.

Once a Replacement Property is identified, the QI – not the investor – acquires the Replacement Property from the seller at closing. Once closed, the QI transfers the Replacement Property to the investor. This is done to ensure that 100% of the sales proceeds are rolled into the new investment and not used for any other purpose, which would disqualify the exchange.

Sound complicated? A bit. But 1031 Exchanges are a critical tool to building wealth in real estate by deferring tax obligations and using the savings to build more wealth. And, as always, investors should consult a CPA, attorney or other tax expert before attempting to perform a 1031 Exchange with your valuable investments.

DISCLAIMER: Cirios Real Estate is not a tax, financial or investment advisor. All investments carry risk. Before considering any investment options, including 1031 Exchanges, consult your investment advisor and tax professional.

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Last month, we discussed the role confidence plays in the housing market. The better Americans feel about the economy (using the stock market as a barometer of the country’s economic fortunes), the more likely they are to go out and buy a house.

Sticking with the theme of market psychology, let’s now examine the other side of the transaction: Sellers.

In today’s market, sellers basically fall into two categories: Those who can, and those who can’t. In other words, if you still have equity, you can sell. If you are underwater on your house, you can’t.

The decision for the latter of whether to sell is, unfortunately, pretty simple. So let’s consider the former, those fortunate homeowners who still have equity left in their homes.

Selling into a weak market is a drag. With so many homes to choose from, buyers can drive a hard bargain. And thanks to unrealistic expectations and bad advice from Realtors trying to win clients with lofty promises, thousands of sellers over-listed their homes and subsequently chased the market down throughout 2007, 2008 and 2009.

Very few voluntary sellers dipped their toes into the market because it was just so bad. The only true sellers were those who had to sell for some reason or another.

So what now? Housing isn’t nearly as bad as it was this time last year, and in many markets the worst of the price declines are likely over. Stocks rallied fiercely last year, rebuilding many damaged nest eggs. And even though there are looming threats out there to our nascent – and very governmentally influenced – economic recovery, things are not nearly as dire as they once were.

We wrote back in May 2009 that “Willing and able buyers are pouring back into the market. And as they do, sellers – buoyed by newfound confidence – are prepping their homes for the market.” Although inventory remained constrained throughout 2009, the percentage of distressed sales relative to regular sales is slowly dropping.

Recent data is seeping out that supports our view, and the trend is picking up steam so far in 2010. The graph below, courtesy of SocketSite, shows active listed inventory in the city of San Francisco. Notably, the black line representing 2010 has reached to the orange 2008 line … and check out that slope!

Anecdotal evidence supports the data. Sellers are trying to get in ahead of the summer buyer season, particularly with the (latest) expiration of the homebuyer tax credit just around the corner in June.

While we at Cirios are constructive about real estate investment opportunities, we remain cautious. A backlog of eager sellers is one of a host of factors that looms on the horizon.

If you were a seller, what would you do?

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