Investors are anticipating the unravelling of the 21 July 2011 “solution” and a breakdown of the interbank-market that would throw the economy into an “immediate recession” like the one experienced after the Lehman bankruptcy. This column argues that this will happen without quick and bold action. The EFSF can’t work as designed but if it were registered as a bank – which would give it access to unlimited ECB re-financing – governments could stop the generalised breakdown of confidence while leaving the management of public debt in the hand of the finance ministers.

Has housing bottomed? Here is the sure-fire way to tell:

Stories titled “Has housing bottomed? Here’s how to tell” have vanished for lack of interest.

The absence of stories about the bottom in housing will mark the final nadir, because the real bottom can only be reached when everyone has abandoned housing as a pathway to easy money. Only when the public and investor class alike have completely lost interest in real estate as a “sure-fire” investment can the real trough be reached.

This destruction of long-held habits and beliefs takes a long time. The closest analogy might be the stock market in the last secular Bear market. Stocks topped out in 1966, though the economy lumbered on until 1969 before faltering. Stocks then meandered for 13 years of stagflation, losing 66% of their inflation adjusted value in 1966 by 1982.

People gave up on stocks. I call this loss of faith “when belief in the system fades:” note how household participation in stocks topped out in 1969, three years after the peak in the market. Participants clung to their belief in stocks for about four years after 1969, at which point participation cratered as they finally abandoned their faith in a “permanent Bull market.”

Household participation fell by two-thirds and remained low for years.

In August 2006, near the top of the housing bubble, I suggested a three-part scenario for the housing bust: it would take eight more years to play out, and the declines would occur in sharp downlegs following a phase-shift model.

Phase Transitions, Symmetry and Post-Bubble Declines (August 2, 2006)

Here is the chart I presented at that time as a possible time model:

Here we see the first phase shift decline and the Central State engineered “recovery,” which has now rolled over.

Here is CoreLogic’s snapshot of housing (via Calculated Risk). There is still a long way to go down before the market retraces the entire bubble.

The Federal Reserve has bet that housing valuations can be propped up by lowering the interest rate on mortgages. To the degree that a few fence-sitters might be tempted to take the plunge, lower rates have a modest follow-through–but the real determinant of housing is employment, which as we all know, has tanked.

Here’s the civilian employment ratio, which reflects the percentage of the labor force that has a job:

Perhaps even more telling is the per capita rate of employment:

By this broad measure, employment has declined to levels last seen thirty years ago.We can also look for clues to housing’s future by looking at wages, which have dropped steeply:

These charts pose a simple yet profound question: how can people buy a still-expensive house if they don’t have a job, or their income is plummeting?

The proximate triggers for the next phase-shift down include a decline in Central State intervention in the housing market and a return to official “recession” as the “soft patch” turns into a quagmire.

In an era where “market sentiment” swings wildly from day to day and the nation awaits every quarterly report from Apple as the “definitive” bellwether not just on stocks but the entire Galactic Mood, then the notion that trends can take years to play out doesn’t sit well with our impatient demands for a “bottom.” But long-term trends take years to play out, whether we like it or not.

Readers forum: DailyJava.net.

Order Survival+: Structuring Prosperity for Yourself and the Nation (free bits) (Mobi ebook) (Kindle) or Survival+ The Primer (Kindle) or Weblogs & New Media: Marketing in Crisis (free bits) (Kindle) or from your local bookseller.

Of Two Minds Kindle edition: Of Two Minds blog-Kindle

Underwater loan owners with payments exceeding rent have a moral imperitive to strategically default to provide deterence for banks to inflate future housing bubbles.

A sacred cash cow with sickly tits
Dripping temptation for hypocrites
to death she’s beaten
The prosperous endlessly stating the obvious

Caught in your words, sever the knot this time
Somebody show me their true face
Face me once as I leave all that I despise
Face me as I unleash this hate refined

Lamb Of God — In Your Words

The fear of strategic default is a necessary deterrent to foolish lending. Without it, lenders are emboldened to make all manner of bad loans because they believe they will get paid back. Lenders will make nearly any loan if they believe they will get their money back with interest. It’s only when they feel they won’t get repaid are they prompted to loan responsibly.

Signatory versus asset-backed debt

Some have questioned how I can be so against debt, yet I am leveraging up to the max to buy cashflow properties in Las Vegas. Isn’t that being hypocritical?

No. Not all debt is created equal. The debt I am taking on is backed by a cashflow-producing asset. The income stream is being used to repay the debt with interest, and if for some reason I am unwilling to pay back the loan, the lender can take back the property and obtain a cashflow equal to or greater than the payment on the debt. That is asset-backed debt.

I had the good fortune to meet a gentlemen who provides asset-backed debt from a major lender. His company provides debt for property, plant, and equipment to other major corporations. When he analyzes the collateral for a loan, he considers it’s useful life, the recovery and resale value, and the cashflow the asset may generate (if any). He assumes the debtor’s word means nothing and any recovery of capital will come solely from the collateral pledged to cover the loan. In his world, there is no signatory assurance of repayment. There is only collateral repossession, cashflow, and resale.

Asset-backed debt is essential to the functioning of our economic system. Many businesses could not raise the equity to obtain the property or equipment necessary to it’s operations. Lenders can loan against working capital at very low rates with little risk. If businesses have their money freed up to grow the business, our economy grows and prospers. In short, asset-backed debt is useful and freeing.

On the other hand, signatory debt is slavery. Signatory debt is money given to a borrower simply based on the borrower’s promise to repay. It has nothing to do with an asset, and if the borrower chooses not to repay, recovering signatory debt can be very difficult because it is not backed by tangible collateral.

Signatory debt provides no useful purpose. It provides a short-term economic boost as demand is pulled forward, but once it is consumed, money that would ordinarily have been spent by the borrower on consumer goods is instead diverted to the lender for debt service. It’s only when signatory debt is expanding that the economy is stimulated. The expansion of signatory debt is a Ponzi scheme.

Signatory debt creates Ponzis

The problem with signatory debt is simple: people don’t want to keep their promise to repay when it is inconvenient. Ponzis live to consume. They will take money under any terms offered, and when it comes time to pay the bills, they will seek more borrowed money to keep the system going. Borrowing money to repay debt is the essence of Ponzi living. Has anyone been watching events in Greece unfold?

Ponzis will inevitably spring from signatory debt. Not everyone who borrows with no collateral is a Ponzi, but Ponzis could not exist without signatory debt. The losses created by Ponzis are the only deterrent from lenders giving out free money. In our current home mortgage lending system backed by the government, without strict controls, Ponzi borrowing with home loans is inevitable.

Conflating asset-backed debt and signatory debt

Lenders are keen to conflate the distinction between asset-backed debt and signatory debt by over-loaning on assets. The housing bubble is a classic example, but lenders do this with car loans, commercial loans, and personal property loans.

A home loan has a component of asset-backed debt. The portion of the cost of ownership (payment, interest, taxes, insurance, HOA) equal to rental is asset-backed. If the loan balance is limited the size supportable at rental parity, the property could be rented for an income stream capable of sustaining the debt service.

However, once the cost of ownership exceeds the cost of a comparable rental, the only assurance the lender has of getting repaid is based on the signatory promise of the borrower. Therefore, the loan is part asset-backed and part signatory. When lenders cross the line from asset-backed to signatory debt, they turn good debt into evil debt and inflate asset bubbles. Lenders did this in both the residential and the commercial real estate markets during the 00s.

Once lenders cross the line from asset-backed debt to signatory debt, they are inflating an unsustainable Ponzi scheme. Inevitably, prices will crash back to asset-backed levels determined by rental parity. it’s not a matter of if, only when. We are seeing this play out across America right now with the deflation of the housing bubble.

Strategic default is moral imperative

Lenders attempted to enslave an entire generation. They issued copious amounts of signatory debt to borrowers who only intended to repay that debt if house prices went up. Lenders created the Ponzis I profile on this blog on a daily basis.

Strategic default has been portrayed as immoral by lenders. This is wrong. Lenders were immoral when they abdicated their responsibility to sound lending practices that ensured their borrowers could remain solvent. It is outrageous after such irresponsible lender behavior that lenders have the nerve to chastise borrowers for being immoral when borrowers fail to repay their debts.

Borrowers have moral responsibility to default on loans where the payment on an amortizing mortgage exceeds the cost of a comparable rental.

If borrowers don’t default, if lenders are given a free pass to make another generation insolvent, then we have failed our children. We are sentencing them to live in a world where lenders enslave them through excessive mortgage payments to afford properties comparable to rentals.

Without the fear of strategic default, lenders will conflate asset-backed debt and signatory debt again. Lenders will inflate future housing bubbles, and our children will be faced with the decision to own something far less desirable than what they can rent or sentence themselves to a lifetime of debt servitude.

The next time you read or hear that borrowers who default are being immoral, ask yourself who is really being immoral, the lender or the borrower. In my opinion, it is the lenders who were immoral when they inflated the housing bubble and over-burdened borrowers. The borrower who strategically defaults is behaving morally by doing what’s best for their family.

Conforming Loan Limit Decrease Will Increase Strategic Default

Gary Anderson — Jun. 27, 2011, 1:31 PM

The conforming loan limit will be decreased by varying amounts in high end markets throughout the nation, according to the New York Times.

If congress does not take action, and I hope they don’t, September 30th is the date these homes will be governed by the private market, with interest rates likely being higher.

The FHA, Fannie Mae, and Freddie Mac will pull out of these markets, as these loans are perceived by both political parties as being a burden on taxpayers. Potentially, less demand will cause the values of these homes to go down.

Yes, Pending conforming loan limit decrease will make California houses more affordable.

Of course, this deflation of housing brought on by less demand is necessary to forge another housing bubble down the road whichbankers apparently want. I think government believes, however, that strategic default will not be an overwhelming issue, since polling seems to back the view that only 39 percent of eligible defaulters would consider defaulting. This actually emboldens banks to want more easy money loans because they know that everyone will not default. If everyone did default, banks would reconsider easy money lending, which would be a good thing.  But there could be a change coming regarding views on the morality of the practice.

The change in morality has already occurred: Strategic mortgage default has become common and accepted in 2011.

It is this change of view regarding the morality of the practice that has banks worried. They are so worried that they are instituting tough measures to scare the potential defaulter into obedience.

While I don’t like to see housing values decline, because it hurts people who have worked hard to attain their status, housing should not be inflated artificially. Housing should be shelter first, and an inflation hedge second. It should never be a speculative commodity, rising faster than inflation, because it is too important to the nation. If the decline in price for these houses becomes a long term reality, then many more people could afford to buy these houses for a long time into the future, and they would have more discretionary income than some owners have now. Their wealth would be founded upon a sound market and not on the shifting sands of speculation.

It’s simple math. If a smaller portion of a wage earner’s salary is diverted to housing costs, particularly interest, then money is freed up to be saved or spent on other things. Mortgage debt is a drain on the economy.

People in New York, Massachusetts,California and other high end regions should brace for less demand and higher interest rates for mortgages above the conforming limit. This is the jumbo mortgage arena where less demand has already caused a decline in house prices. But perhaps we haven’t seen anything yet, as people will flee the higher rates until the prices themselves bottom out.

And owners should beware, because in the highest of high end areas, conforming loan limits could drop by the hundreds of thousands of dollars. This is something for even the most affluent members of our nation to think about. But knowing that most of them are staunch free market zealots should make the decline of their house values more palatable. Or maybe not.

The Irvine Company has already been plagued by flagging sales. What is going to happen when borrowers find it tougher to get loans at the price points they want to sell?

But since Fannie and Freddie are pulling out of this high end arena, they will have no influence on the defaulter like they did. As of last year, they were scaring defaulters with the threat of a 7 year ban on their mortgages. Now there is little to scare the strategic defaulter other than a credit score decline.

And, it has been shown that defaulters have a shorter window of risk in recourse states to lawsuit than do short sellers. And we know that California is a non recourse state. If a borrower does not have a recourse HELOC, or a refinance into a recourse loan, that borrower is really free to walk away in a non recourse state. So, potential strategic defaulters, what are you waiting for?

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I predict a wave of strategic default at the $750,000+ price ranges. Many of these borrowers were Ponzis who were only holding on because they believed prices were coming back. Once they realize the demand is gone, and it may not come back in the next decade, why would they keep making the oversized payments? After all, the plan was to live off the HELOC booty and appreciation, and that isn’t going to happen. I expect Orange County delinquency rates to rise along with the rest of Coastal California.

No appreciation eight and a half years later

Back in 2007 and 2008, we would marvel at 2004 rollbacks. Those only represented about four years of zero appreciation. However, as the housing bust has dragged on, prices keep rolling back, and the dead time of zero appreciation has not extended to over eight years — and it will get worse.

Buyers from 2002 and 2003 are facing resale prices that often barely cover their sales commissions. There certainly isn’t enough gain to compensate them for the additional cost of ownership they paid during the years of bloated mortgage payments. Also, inflation has eroded the value of money over the last eight years, so on an inflation adjusted basis, they are certainly behind those who rented instead.

Appreciation is supposed to justify making excessive payments. When it doesn’t materialize, the people who opted for oversized loans played the fool. Banks are the beneficiaries along with realtors, mortgage brokers, and the former owners who obtained a windfall.

Slow steady gains in the housing market are much preferable to periods of boom and bust. If home prices were tethered to incomes through sane debt-to-income ratios and stable interest rates, homeowners would steadily gain equity, and none would be facing the terrible problems they are today. The goal of government policy should not be to maximize borrowing to save the banks and preserve loan owners illusions of wealth. The goal should be stable home prices and sound lending practices to sustain home ownership and preserve disposable income to sustain a consumer economy.

Low home prices are a good thing, but falling prices, in the short-term, are a tough pill to swallow. Money and confidence are lost and consumer spending dries up. Moreover, given the backdrop of the enormous bubble and all of the outstanding loans, falling prices mean more strategic defaults, even more foreclosures, and more losses for our already undercapitalized banks.

There are literally millions of foreclosures in that will be coming to market over the next few years. Add to that a few million short sales and the rest of our shadow inventory, and we’re looking at a big heap of distressed property that will put immense downward pressure on home prices. The supply of homes for sale will be large.

Home prices are simply a function of supply and demand. Facing this coming large supply, the government either needs to increase demand or find a way to reduce that supply to achieve price balance. Since 2008, there have been a host of “extend and pretend” programs aimed at these two things: HAMP, Homebuyer Tax Credits, QE2, Foreclosure Moratoriums, etc.

While these programs have bought us time, they haven’t solved the fundamental problem: home prices are still too high. And without continued intervention, they will continue to fall – perhaps back to their historical trend-line, or perhaps even overshoot it.

Here are 4 ways the government might try to stabilize the housing market before the election:

1. Fannie Mae, Freddie Mac, and the FHA could rent out their foreclosures instead of selling them.

Pros: This would certainly reduce the supply of homes that come up for sale over the next few years.

Cons: But then what? Assuming they would sell them eventually we are just kicking the can down the road again. Besides, the GSEs don’t like this idea.

2. A Massive Principal-Reduction Campaign. This could either be up front, as banks are doing with option-arm loans, or after time as an incentive.

Pros: This would entice some would-be-strategic-defaulters to stay in their homes. But, are there really that many would-be-strategic-defaulters? If so, the housing market is much more bleak than we realize.

Cons: Moral hazard. How can you reduce some and not others? What about the guy who just paid his mortgage off? Voters won’t like this unless everyone gets free money.

3. Investor incentives. They already got what they could out of first-time homebuyers, but maybe they could stoke housing demand by giving investors reasons to buy lots of homes. They could offer special financing, free rehab money, and tax credits. How about “Buy Two, Get One Free”?

Pros: Especially at the low-end, this could spark demand and soak up excess inventory.

Cons: Now lower-end or first-time homebuyers will have a tough time competing with these investors. Besides, wouldn’t those investors rather simply buy the same house for less, without all of those gimmicks?

NOTE: This seems to be the least-horrible solution.

4. A National Foreclosure Moratorium. No foreclosing, no extra supply.

Pros: In the short-term, prices would hold and voters would probably approve.

Cons: Free rent = more strategic defaulters. And, in the long-run, this only makes things worse. And, U.S.S.A.?

Why Housing Gimmicks Are Needed

The only reason why all of these “extend and pretend” gimmicks are needed is that, with home prices at their current levels, there simply isn’t enough demand. If Uncle Sam would get out of the way and let prices find their bottom, then, by definition, there would be appropriate demand and the housing market would be in harmony.

The Obama Administration has to find a way to get us to happily pay $3 for widgets, when they are probably only worth $2, and five more widget factories just came on-line. And then re-elect them for their brilliant plan.

Such a theory is presented in the Herald Sun although one might not quickly spot it because of the headline Decade of pain for Melbourne’s property market

The good news for homeowners is that AMP Capital chief economist Shane Oliver and Grattan Institute program director Saul Eslake – the ANZ’s chief number cruncher for close to 14 years – say Victoria will avoid a US-style property crash which saw prices plunge by 30 per cent.

Instead, house prices will continue their single-digit slide into 2012 before stagnating for five to 10 years as wages catch up with a median house price which has climbed 133 per cent since 2000.

“We are facing a situation where we are just spinning the wheels for up to 10 years until incomes catch up with property prices,” Mr Oliver said. “You could have a five to 10-year period where you have prices rise before they come off again and basically track sideways within a range.”

Totally New Paradigm, Permanently High Plateau

That does not sound like a decade of pain, nor is it a “bleak” outlook. Rather, it’s none other than the entirely laughable “Totally New Paradigm, Permanently High Plateau” theory.

Flashback March 26 ,2005: It’s a Totally New Paradigm

Ron Shuffield, president of Esslinger-Wooten-Maxwell Realtors says that ”South Florida is working off of a totally new economic model than any of us have ever experienced in the past.” He predicts that a limited supply of land coupled with demand from baby boomers and foreigners will prolong the boom indefinitely.

“I just don’t think we have what it takes to prick the bubble,” said Diane C. Swonk, chief economist at Mesirow Financial in Chicago, who was an optimist during the 90′s. “I don’t think prices are going to fall, and I don’t think they’re even going to be flat.”

“I look at this as a short-term investment,” said Mr. Farquharson, 36, who works for a venture capital firm, “and plan to unload it as soon as things look dangerous.”

Now there’s a laugh. By the time it looks dangerous will there be anyone looking to buy?

Talk of “new paradigms” or “new economic models” has been associated with every major bubble in history, typically near the peak. Wasn’t it just 5 short years ago that Greenspan proclaimed the “productivity miracle” and everyone was counting “clicks” on dot coms as the “new economic model”?

Just as soon as I finished writing this post, I found a new quotation to add.
It’s perfect.

Gregory J. Heym, the chief economist at Brown Harris Stevens, is not sold on the inevitability of a downturn. He bases his confidence in the market on things like continuing low mortgage rates, high Wall Street bonuses and the tax benefits of home ownership.

“It is a new paradigm” he said.

Scroll back up and take a look at that first chart again. Current talk of “New Paradigms” and “New Economic Models” should tell you exactly where we are and where we are ultimately headed.

Flashback June 7, 2005: It’s time to shift the arrow

Yes, Mish readers I am pleased to announce that housing has now reached “A permanently high plateau”. I offer the following quotes from a New York Times article as evidence:

“I think we don’t expect prices to continue to rise at this pace, however, we don’t see a bubble bursting either,”he said. “I don’t recall a real estate bubble ever bursting that wasn’t preceded by bad economic conditions or some dramatic shock, and nobody is predicting any of that right now.”

“The interesting thing we’re seeing is, it’s a very stable, brisk market,” said Steven B. Schnall, the president of the New York Mortgage Company, a mortgage lender. Mr. Schnall pointed to continued low interest rates as the most important factor in the market. ”I don’t see prices continuing to skyrocket,” he said. “They’ve reached a very high level and this almost appears to be a new normal, and interest rates are helping that.”

Flashback …
“Stock prices have reached what looks like a permanently high plateau.”–Irving Fisher, esteemed economist, October 1929

Flashback November 01, 2005: Thoughts on Housing Construction

Many seem to thing that housing will plateau and there is no fear of a real slump. At the top of the list in believing the “permanently high plateau” theory is David Seiders, the chief economist for the National Association of Home Builders. According to Seiders, single-family starts numbered about 1.6 million, in 2004. He expects another record this year, even as the industry begins to hit ”the plateau we’ve been watching and waiting for.”

Also chiming in on the permanently high plateau theory is Erik Bruvold of the San Diego Regional Economic Development Corp. in the San Diego News article Housing economists raise yellow flag over San Diego.

Mr. Bruvold predicted a flattening in prices rather than a dramatic falloff. Already, the inventory of homes on the market is growing and sales prices are lower than asking prices. “I think we’ve hit a plateau,” Bruvold said. “I would not refer to it as a turning point.”

David Berson chief economist of Fannie Mae and David Seiders, chief economist for the National Association of Home Builders also seem to be giving some credence to the “plateau theory”. “Prices are so high that at some point there is the possibility people may simply decide it’s too expensive to move there,” Berson said. “Alternatively, prices may simply slow for a period of slow or no price gains.”

No one seems to be as optimistic as the Toll Brothers according to the New York Times article Closing Ground.

At the moment, Toll controls enough land for nearly 80,000 houses. Its competitors, which tend to build lower-priced houses on smaller lots, have even larger accumulations. K. Hovnanian has land for more than 100,000 houses. Pulte Homes holds 350,000 sites. Still others – Lennar, Centex Homes, D. R. Horton, KB Home – control hundreds of thousands as well. And all of them are in ferocious pursuit of more.

The company expects to grow by 20 percent for the next two years and then will strive for 15 percent annually after that. Those estimates suggest that the company’s expected production of around 8,600 houses this year will expand to at least 15,000 houses by 2010. Individual Toll developments now range in size from a few dozen to 3,000 houses.

“Why can’t real estate just have a boom like every other industry? Why do we have to have a bubble and then a pop?”asked Toll.

….

This cycle will not be any different. I do expect some home builder bankruptcies out of this mess but it is not easy to predict which ones.

Here is what the housing evidence suggests:

1. Homebuilders are clearly ignoring business cycles, affordability issues, tightening credit, and liquidity concerns. Money has been too easy for too long for anyone to understand what might happen in a liquidity crunch.
2. Homebuilders will keep buying more and more land and adding more and more to housing inventory in a foolish attempt to grow 20% every year fighting for “market share” right at the peak of the boom.
3. No one seems to see or believe the devastating consumer led recession that is staring them in the face. It’s simply “build or die”.
4. People will likely borrow to buy this housing bubble until lending literally seizes up.

I believe we can now answer Toll’s question: ”Why can’t real estate just have a boom like every other industry?”

My answer is “Patience Mr. Toll, you will, and it will end up looking a lot like the telecom bust of 2000 as well.”

We are now hearing exactly the same nonsense out of Australia.

Agents Withhold House Price Data

Please consider Agents Withhold House Price Data

MELBOURNE real estate agents and vendors are increasingly withholding or manipulating data provided to the Real Estate Institute of Victoria, prompting calls for the mandatory reporting of all property sales to protect consumers.

A Sunday Age investigation has found that 27 per cent of all auction results published by the industry body in June were missing critical information – including the sale price, passed-in price or the reserve. Many auctions were not reported at all, distorting clearance rates that are used by buyers and sellers to gauge market strength.

Nearly one in five properties sold at auction are now reported to the REIV with the price marked ”undisclosed” – a significant increase from last year’s property boom, up from 11 per cent then to 18 per cent now.

The investigation also revealed that 43 per cent of properties scheduled for auction in June had no published quote range, further frustrating buyers’ attempts to obtain basic information.

Last month, agency RT Edgar sent a newsletter to clients warning there was a ”serious question mark” over media reporting on the market because many agents were withholding sale prices and passed-in results.

REIV head Enzo Raimondo defended the institute’s voluntary reporting methodology, saying the ”small increase” in the number of undisclosed results did not affect the integrity of the system.

”It is not the role of the REIV to force home owners to publicly declare the amount for which their homes sell. If a person really wants to know the price for which a home sells, they can attend the auction,” Mr Raimondo said.

Favorite Comments From the Article

• Moral of the story? Don’t buy now. Wait. And with every day that passes take comfort in knowing that property investors and RE agents are dying the death of a million cuts (with every month, comes more news of further price falls)
• “If a person really wants to know the price for which a home sells, they can attend the auction,” Mr Raimondo said.” Bit of a childish, simpleton’s response there, Mr Raimondo. As head of the REIV your attitude only serves to underscore your industry’s dodgy reputation.

Dear Real Estate Buffoons

1. Prices are falling whether you disclose them or not
2. Not disclosing prices makes people mistrustful and rightfully so. That will hurt, not help sales

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

Here are 5 things you need to know about Option-Arm debt forgiveness…

1. Option-Arm Loans Explained

Option-Arm loans were a creative way to help people buy a home that they probably couldn’t really afford. Each month, the buyer gets 4 payment options:

1. 30-year principal & interest (normal)
2. 15-year principal & interest (I wonder if any of these payments were ever made…)
3. Interest-only payments
4. A Minimum payment

Option-Arm loans were commonly referred to as “Pick-a-Payment” loans.

With “minimum” payment, borrowers pay less then even the interest-only amount. That difference, then, is added back on to the total amount of principal-owed. This is referred to as “negative amortization.”  In short, a $700,000 loan could balloon to $750,000 in a few years.

The interest rates were adjustable. Each year, the interest payments would “reset”, changing the amount of the monthly payment – but that wasn’t the real problem.

The real problem was that, if you only made the Minimum Payment, your loan would eventually “recast” – meaning that your payment options would disappear, leaving you with only a 30-year fixed payment. Recasting generally happened when the total amount owed reached 110% – 115% of the original loan balance, typically within 2-5 years.

So, a borrower with a Minimum Payment of $3,000 per month could easily be facing payment of $5,000 or more when their loan was recast.

2. How Option-Arm Loans Were Used

At the time, Option-Arm loans were defended by the mortgage industry, suggesting that most borrowers would make the interest-only or 30-year fixed payments, using the Minimum Payment only occasionally, if they needed to free up some cash.

But this was impossible for most Option-Arm borrowers because they could never afford any amortized payments – they didn’t have to! Borrowers only needed to qualify for the Minimum Payment, to qualify for the loan. Instantly, borrowers who might have otherwise only qualified for a $500,000 mortgage, could now get an $800,000 one.

Option-Arm loans were most popular in high-priced areas like the San Francisco Bay Area and Manhattan. Back in 2009, I wrote: Time Bomb Loans Used Heavily In The Bay Area

From 2004 to 2008, “one in five people who took out a mortgage loan (for both purchases and refinancing) in the San Francisco metropolitan region (San Francisco, Alameda, Contra Costa, Marin and San Mateo counties) got an option ARM,” said Bob Visini, senior director of marketing in San Francisco at First American CoreLogic, a mortgage research firm. “That’s more than twice the national average.

Of the 10 metro areas nationwide with the most option ARMs, three are in the Bay Area, according to Fitch Ratings, a New York research firm. They are the East Bay counties of Alameda and Contra Costa, the South Bay area of Santa Clara and San Benito counties, and the counties of San Francisco, Marin and San Mateo.

…

Fitch said 94 percent of borrowers elected to make minimum payments only. The shortfall gets added to their loan balance, which is called negative amortization. The amount they owe can grow substantially.

…

After five years, or once the loan balance reaches a certain threshold above the original balance, the mortgages “recast” and borrowers must make full principal and interest payments spread over the loan’s remaining life. Fitch said that new payments average 63 percent higher than the minimum payments, but could be more than double in some cases.

3. Getting Graphic

Option-Arm loans rightly disappeared with the collapse of the private mortgage market in late Summer, 2008. As home prices tumbled, it was easy to see that Option-Arm foreclosures were a train-wreck waiting to happen.

It’s compelling to continue paying $3,000 each month for an $800,000 mortgage. But when the mortgage becomes $900,000, the payments jump to $5,000, and the house is only worth $600,000 – huge numbers of borrowers will walk away from their homes.

Here is the original, famous loan reset/recast chart from Credit Suisse:

And here is a better one:

Currently, in the Summer of 2011, we are approaching the estimated peak of Option-Arm recasting. However we may not know the extent of the damage for some time.

In March, 2010, I wrote:

Because the foreclosure pipeline is already so backlogged, people who stop making payments during this stretch could easily end up waiting another 1-2 years before their homes are actually foreclosed upon.  Even without all of the foreclosures still to come from unemployment, it is easy to see this foreclosure crisis being with us well into 2014-2015.

Since then, foreclosure backlogs are even worse. Many of the Option-Arm borrowers to decide to stop making payments in 2011, won’t even get foreclosed on until 2013.

4. Why Banks Are Writing Down Principal

Banks are semi-secretly writing-down principal (reducing the loan amounts) for thousands of Option-Arm borrowers, and they have two very good reasons for doing so.

1. They can afford it. JP Morgan, BofA, and Wells Fargo bought these loans from Wachovia, Morgan Stanley, Countrywide, and others for mere pennies on the dollar. They can afford to cut the principal in half and still make enormous profits.
2. By reducing principal, they will reduce the number of strategic defaults. If the trend walking away from mortgages continues to grow in popularity, home prices will fall more quickly.

The New York Times reports:

As millions of Americans struggle in foreclosure with little hope of relief, big banks are going to borrowers who are not even in default and cutting their debt or easing the mortgage terms, sometimes with no questions asked.

Two of the nation’s biggest lenders,JPMorgan Chase and Bank of America, are quietly modifying loansfor tens of thousands of borrowers who have not asked for help but whom the banks deem to be at special risk.

…

Bank of America and Chase inherited their portfolios of option ARMs when they bought troubled lenders during the housing crash.

Chase, which declined to comment on its program, got $50 billion in option ARM loans when it bought Washington Mutual in 2008. The lender, which said last fall that it had dealt with 22,000 option ARM loans with an unpaid principal balance of $8 billion, still has $33 billion of them in its portfolio.

Bank of America acquired a portfolio of 550,000 option ARMs from its purchase of Countrywide Financial in 2008. The lender said more than 200,000 had been converted to more stable mortgages.

Dan B. Frahm, a spokesman for Bank of America, said it was using every technique short of principal reduction to remake its loans, including waiving prepayment penalties, refinancing, lowering the interest rate, postponing some of the balance and extending the term.

“By proactively contacting pay option ARM customers and discussing other products with better options for long-term, affordable payments, we hope to prevent customers from reaching a point where they struggle to make their payments,” Mr. Frahm said.

5. What This Means For The Rest Of Us

All of this is going to have a limited impact on our own home prices. For those of us in high-priced communities, there will be a few fewer foreclosures over the next 2-3 years.

The issue at play for most of us is one of fairness. Moral Hazard. The most reckless and speculative borrowers are getting rewarded, while many others are getting foreclosed upon. Ironically, it was the severity of the recklessness that lead to the big banks buying these loans so cheaply, enabling the principal reductions.

The Times continues:

Adam J. Levitin, a Georgetown University law professor, said these little-publicized programs were more evidence that the banks were behaving in contradictory and often maddening ways.

“Loan modifications that should be happening aren’t, while loan modifications that shouldn’t be happening are,” he said. “Homeowners of any sort, whether current or in default, would rightly be confused and angry by this.”

There is nothing fair or moral about it. But, let’s be honest, the fairness train left the station a long time ago.

The California Association of realtors acknowledges that a lower conforming loan limit will further damage our already weakened housing market.

We’re not scared to lose it all
Security throw through the wall
Future dreams we have to realize
A thousand sceptic hands
Won’t keep us from the things we plan
Unless we’re clinging to the things we prize

Howard Jones — Things Can Only Get Better

Are falling house prices good or bad? I suppose it depends on who you ask. According to homeowners and realtors, falling house prices are the end of the world (see below). For those who want to buy a house, falling house prices means things can only get better.

House prices are currently falling, and they are expected to do so for the foreseeable future. Despite the whining by realtors that lending standards are too tight, these standards will continue to tighten as the market is weaned off government supports.

In 2008, the conforming limit was raised from $417,000 to $729,750 in high priced markets like Irvine. Apparently, bureaucrats felt high wage earners needed government subsidies to afford the ridiculously priced housing in places like Irvine. The real motivation was to prop up prices and shift the losses from private lenders to the government-backed GSEs. To some degree, they were successful.

I have made the case on two separate occasions that lowering the conforming limit will lower house prices in Irvine, particularly on those properties that required conforming loans in the $625,000 to $729,750 range. This argument has been dismissed by some in the astute observations.

In February, I reported that Lowering GSE and FHA loan limits will lower house prices.

However, if they do lower the jumbo conforming limit from $729,750 to $417,000 or below, the meat of the Irvine market would suddenly have to pay jumbo rates. We would be among the first markets in the country to experience the transition from public to private financing. Jumbo rates are somewhere between half-a-point and one point higher than conforming rates. If future buyers are facing higher interest rates, their hopefully higher incomes will not be leveraged as much, and the loan balance will not be larger.

Markets where jumbo conforming loans ($417,000 to $729,750) are prevalent, the market impact will be the most noticeable. If you combine that with the possibility that loans that large will no longer be tax deductible, and borrowing huge sums to take a position in real estate doesn’t seem quite so appealing. Future take-out buyers will not be so leveraged.

I followed up with the post Conforming mortgage limit falls to $625,500 October 1, prices to follow.

This change strikes at the heart of the Irvine single-family detached market. Many Irvine properties have loans between $729,750 and $625,500. Every buyer contemplating a loan in that range will face an interest rate half a percent higher. As a result, buyers will either need to come up with 10% more income to afford the same mortgage, or the loan they will qualify for will be 10% smaller. Since most Irvine borrowers are maxed out, loan balances in this price range will likely decline by 10%, and the houses they were intended to finance will similarly drop in price.

Market prices are set on the margins, and if the current balance of supply and demand is not sustaining prices, what happens when demand is curtailed even a little bit? Obviously, the market will find a new equilibrium, most likely at a lower price.

For those that dismiss this upcoming drop in the conforming limit as meaningless, why has the California Association of realtors raised the alarms and come out opposing this change? i think we all know the answer to that one.

Pending conforming loan limit decrease puts California on edge

by JON PRIOR — Thursday, June 23rd, 2011, 1:04 pm

With the conforming loan limits expected to drop in October, the California Association of Realtors warned of the impending harm to homeowners, while the only private-label securitizer left notified investors of more opportunities.

Have you ever noticed that realtors only defend the interests of homeowners? Aren’t buyers half of their income and market? Why do realtors consistently want to screw buyers in favor of sellers?

The conforming loan limit determines the maximum mortgage amount the Federal Housing Administration, Fannie Mae and Freddie Mac can buy or guarantee. Without congressional action, the limit will drop to $625,500 from $729,950 for the majority of counties nationwide on Oct. 1.

These three agencies currently fund 95% of the mortgage market, and housing finance reformers point to lowering this limit as a first step to usher in private capital.

The lowering of the conforming limit back to $417,000 is the first step toward returning to a private market. Private loans without government backing will have risk, and providers of the capital for these loans will want to be compensated appropriately for the risk they are taking on. This will increase borrowing costs and thereby reduce loan balances which will in turn lower prices.

However, according to CAR, more than 30,000 Californian homeowners will face higher down payments, higher mortgage rates and stricter loan qualification requirements when the limits drop.

Notice the choice of words above. It isn’t California homeowners who will face those problems, it is California home buyers. This will hurt current homeowners trying to get their inflated prices, so CAr has conflated homebuyers with homeowners and chosen sides to favor owners over buyers.

Further, CAr is acknowledging that the new lower conforming limit will dampen demand. Of course, they portray that as a bad thing because it doesn’t benefit homeowners. However, it’s great for homebuyers, and I think it’s fantastic.

The $104,450 decrease in most counties will not be felt in some California counties. In fact, it will be steeper.

CAR analyzed the effect of dropping the limit across several specific counties in California. In Monterey County, for instance, the government-sponsored enterprise limit will drop a total of $246,750, followed by a $151,250 drop in San Diego, and $141,550 in Sonoma County.

The FHA conforming loan limit will fall $201,450 in Merced County and $164,650 in Riverside.

“By reducing the conforming loan limit, thousands of California homebuyers will be shut out of homeownership,” CAR President Beth Peerce said.

Bullshit. It really annoys me when I read that nonsense. Nobody will be shut out of ownership. Sellers will have to lower their prices in order to sell. Period. If sellers chose not to lower prices, they won’t sell. Since so much of the market is must-sell distressed inventory, sellers will lower their prices, and properties will become more affordable.

“The higher mortgage loan limits are critical to providing liquidity in today’s housing market and are essential to our housing recovery.

More bullshit. A higher conforming limit is essential for prices to stabilize at higher levels, but no government guarantees are required to stabilize pricing or for housing to recover.

We urge Congress to maintain the current limits and make them permanent to provide homeowners and homebuyers with affordable financing and help stabilize local housing markets.”

She forgot to add the words “at inflated price levels” to the end of her statement.

Redwood Trust, a real estate investment trust based in California and the only firm to issue a residential mortgage-backed security since the financial collapse in 2008, said the conforming loan limit decrease could drop more loans into its grasp. Redwood already plans to issue two more RMBS by the end of the year.

If risk is properly priced, and if the buyer pool meets the qualification standards, the private market will pick up the slack. It will just do it at a lower price point. The return of the private market is what we want.

If annual residential mortgage originations return to $1.5 trillion and jumbo loans — which served as the collateral in its RMBS deals — account for 20% of that, originations of jumbo loans could reach $300 billion, Redwood said in its first quarter report to investors.

“With GSE reform, the portion of the mortgage market that could potentially be available to Redwood could be substantially larger if the conforming loan limits are reduced (as the Obama administration has indicated it intended to do) during the reform transition period, and perhaps still larger if, as part of GSE reform, the concept of conforming limits is eliminated,” Redwood said.

Write to Jon Prior.

Follow him on Twitter @JonAPrior.

There is no question in my mind that a lower conforming limit will lower prices on desirable single-family detached homes in Irvine. It’s only a matter of how much and how soon the impact is felt. With the other market headwinds, during the fourth quarter of 2011 when the new standards will be in effect could be pretty ugly.

As you know, I am a firm believer that the state of the global economy is such that we as investors have to be especially agile and focused today. Consequently I spend a great deal of time and effort looking into alternative investment strategies and managers. I’m very pleased to announce that I am relaunching my special newsletter for accredited investors, to share the latest opportunities and pitfalls in alternative assets.

The good news is that this Accredited Investor Letter is completely free. The only restriction is that, because of securities regulations, you have to register and be vetted by one of my trusted partners before you can be added to the subscriber roster. They include Altegris Investments in the US, Absolute Return Partners in Europe, Nicola Wealth Management in Canada, and Fynn Capital in Latin America. This is a painless process (I promise!), and just to sweeten the pot, after you register my partner will provide you access to the video of Gary Shilling’s speech from my Strategic Investor Conference in La Jolla, as well as those of Martin Barnes and David Rosenberg; and we have just added Louis-Vincent Gave, who focused on China. These guys are all great speakers with absolutely compelling presentations.

[[ Click here now to register]] and you’ll be part of the summer relaunch of my letter exclusively for accredited investors. In the meantime, enjoy the video presentations and benefit from their wisdom as you plot your investment course. Over time, we will make all the conference videos available to the subscribers of the free Accredited Investor E-letter. Those who attended the conference, or have spoken with an Altegris professional, already have access to all the speeches and panels.

I do not like limiting the letter to accredited investors, but those are the rules under which I work. This is not of my choosing, and I have worked in front of and behind the scenes to try to change what I think is a very unfair rule. (See important risk disclosures below. In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

The Contagion Risk of Europe

Bernanke gave another press conference after the FOMC meeting this week. Taking his time to address the situation in Europe, and the increased urgency of the crisis in Greece, Bernanke said US bank exposure to Greece was minimal and only indirect, via positions in large, core-nation banks in Germany and France. Raising a red flag, the bearded academic said that money-market mutual funds had substantial exposure to those same banks and could take a big hit if push came to shove in Europe. “A disorderly Greek default would have significant effects on the US” economy, he added.

About the only thing there was seeming consensus on in Europe was that Greece will eventually default. The question is when. European leaders, along with the IMF, have caved and will give Greece €12 billion to tide them over while they debate on finding €70-100 sometime late next month. By some accounts that amount will have to be a lot more. Meanwhile, the ECB is adamant that Greece cannot be allowed to default.

The whole process is somewhat akin to trying to help someone who is drunk by giving them another bottle of whiskey. Trying to cure a problem of too much debt with even more debt is simply irrational, and everyone but Europe’s leaders can see that. So why are they doing it?

Because if Greece is allowed to go, there is real reason to believe that the problems will spread rather quickly to the rest of peripheral Europe. By the way, it is not just French and German banks that US money markets have exposure to; there are a lot of Spanish banks that have issued commercial paper as well. And my sources told me that many of the state-owned German Landesbanks are essentially insolvent, with massive amounts of sovereign debt. By the way, another source notes that US money-market funds are not rolling over the commercial paper to some of the banks (like Spanish ones), so there is a liquidity squeeze coming to European banks in peripheral countries.

The ECB has taken on some €100 billion of Greek, Irish, and Portuguese debt, if I remember the number right. They have capital of only about €10 billion. They want to take on even more debt from the banks, as the banks are using sovereign debt as collateral. The whole process is a way to paper over the fact that many European banks are essentially insolvent if they have to mark to market their Greek debt.

I think it is a given that in the near future Ireland is going to tell the ECB that the line item on their balance sheet for €60 billion that says “Loans to Ireland to bail out their banks” should be moved from the line that says loans to the line that says capital. They will simply walk away from the debt. “Here are the keys to your banks. What are you going to do with your banks?”

Let’s assume (generously) that there is only a 50% haircut on Greek debt. Add in the Irish debt, assume a smaller haircut on Portugal, at least initially, and you can easily get to €100 billion in losses for the ECB. That makes Lehman look like small potatoes.

The ECB would either be forced to print money to cover the losses or have a massive capital call to ECB members. Germany is 27% (again, from jet-lagged memory), so their portion would be a mere €27 billion. How do you think that will play with the voters in Bavaria? The ECB was not supposed to take on bad debt, according to its original charter. More than one person speculated to me that Germany might simply use that as an excuse to leave the euro. Not by the current set of politicians running the place but the new set that will be elected when things go bad.

And printing? Not all that good for the value of the euro.

Will the Euro Survive?

We had dinner on Monday night at the home of Hervig von Hove of Notz-Stucki Bank, where I was speaking the next morning. There were 16 of us at the table, and these people represented a great deal of money as managers and investors. All very well-informed. We sat outside in perfect weather in the Swiss countryside. Charles Gave sat across from me at the middle of the table, and we talked and debated as the rest asked questions and offered opinions for 3-4 hours. The wine was flowing, and it was a most interesting evening. Now, with that set-up…

I was asked if I still thought the euro was going to parity with the dollar, and I said I did, although I was not sure what the euro would look like in three years, or who would be in it. There was some pushback from people who thought the dollar would be the weaker currency. So I asked for a show of hands as to how many people thought the euro would be higher in one year’s time. There were 6 hands raised, but one gentleman said he was actually abstaining. So I asked how many thought the euro would fall, and we got 12 hands. Yes, that is 19 votes for 16 people. Clearly there were at least three economists in the group who voted both ways!

Then someone asked Charles about the issue. Now, for those who have never had the extreme pleasure of time with Charles, he is a powerful, white-haired French patrician, and one of the better economists I know. Quite a brilliant thinker and not afraid to express his mind forcefully with a voice that sounds like God talking, with about the same assurance (note to self: never again follow Charles on a speaking stage).

“The question is entirely irrelevant” – punctuating the air for added emphasis. “The euro will not exist in a year. The whole thing was dysfunctional from the beginning.”

I suggested that was a tad bearish.

“Not at all. I think it is extremely bullish. The demise of the euro and the return of national currencies will allow for proper allocation of investments and resources. It is the best thing that could happen for the markets.”

I could not get him to commit to exactly how that process of dissolution would look.

“I didn’t create the euro so it is not my responsibility to solve the problem for them.”

But I cannot help but think that any exit by anyone from the euro will be disorderly, giving rise to Bernanke’s “significant effects.” Many European banks are simply not solvent if there are major sovereign defaults. The US banks have sold some $90 billion in credit default swaps on Greek, Irish, and Portuguese debt to European banks. That is supposedly balanced with other purchases of CDS, but my sources say that much of that insurance is from German Landesbanks. Yes, the same ones I mentioned above that are basically insolvent. We are joined at the hip to Europe. A European recession would certainly be felt here. And a credit event could cause the same problem as in 2008, as banks start to refuse to lend to each other again. Ugh.

The potential for a real crisis is far too high for comfort. It would mean another recession for sure, with the US already close to stall speed and global growth slowing. I hate to sound alarmist, but I am worried. Absent a problem in Europe, the US should be fine, if slow. And maybe European leaders can stall the crisis off longer, buying time for banks to move their debt to the ECB and raise capital. We have to really keep our eyes on this.

At some point, Europe needs to realize that the problem with Greece, Portugal, et al. is not illiquidity, but that they are insolvent and have few prospects for economic growth anywhere close to what is needed to solve their problems.

Europe would be better off just taking the money they are giving to Greece and using it to recapitalize their banks. Let Greece go. Give it up. Let them enter a 12-step program or whatever it is that insolvent nations do. That is harsh, but it is also the truth.

But there are very sad things going on. It is not just banks that are losers here. Pharmaceutical companies are starting to refuse to deliver to Greek hospitals, as they are up to two years behind on their payments. It turns out that Greece owes some €6 billion to private businesses like hospitals and simply cannot pay. Those costs are rising, and much of it is to hospitals for medical care supported by the government. They are issuing bonds (shades of California) for the debt in some cases, which sell for a discount of 50%, if they can be sold. And we thought finding €12 billion was a hard thing.

This is not just a Greek problem, it is a concern in many countries that are having financial difficulties.

A Greek Coup?

Now, time for some speculation on my part. For Greece to leave the euro, the politicians would have to make a rather serious decision. That will not happen overnight. The minute there was any speculation or a “secret” meeting of Greek leaders to discuss leaving the euro, the run on the banks would be massive and fast. It would all come down quickly.

To go back to the drachma would require a bank holiday for a week, and it would have to be a surprise move. About the only way for that to happen would be a military coup coupled with a bank holiday and promises to return to elections after the currency issue was solved. The current government does not have the votes or the power to declare a holiday and move to the drachma, or at least they don’t as I read it. Just a thought.

No Good Deed Goes Unpunished

Switzerland was irrationally expensive. Small Diet Cokes at the Mandarin Hotel were $12. That is not a typo. I get a full 12-ounce can on sale here for about $.25. A casual meal, not particularly outstanding, was easily $100. Taxis are outrageous, with a one-mile trip costing up to $70.

In the category of no good deed goes unpunished, the Swiss are suffering such high prices due to managing their country responsibly. Everyone wants the Swiss franc. It was about $1.20 for one franc. I remember when it was $.25. Then again, so was the German mark.

In the Biggest Loser category, the award for the central bank that made the worst trade in history goes to Switzerland, with losses of 21 billion francs in 2010, trying to keep the value of the franc down against the euro. That’s about $25 billion at today’s valuation.

Home Again, Home Again

I have been gone for 31 days, and it is good to be back home. And I am home for much of the next three months, at least the way it looks now. I have a speech at the Agora conference in Vancouver late July, and my annual trip to Maine to fish with my son at David Kotok’s event (with so many friends) in early August (which I will likely combine with a few days in New York). And not all that much travel in September, though that could change. That really sounds good right now, as I have almost 100,000 miles on American Airlines alone this year. I hope I can cut that down to about a third for the last half of the year.

Kiev was amazing. I don’t know what I was expecting, but what a vibrant place with lots of things going on and building everywhere. Our host, Andy Bain, came to Kiev in 1992, fresh from Yale with an MBA. He started going east in Europe and kept finding too many MBAs to compete with, until he got to Kiev. He now has some 20 companies and is quite successful.

He invited us to his annual company picnic on Saturday, at a lake park outside the city. There were about 200 people there. The unusual thing was how young the group was. I remarked on that to his CFO, who is only 38 himself. Who are all these young girls and guys?

He pointed them out: “This girl manages that company and that one has this account…” One woman started out as a receptionist two years ago and is now managing three national advertising accounts. I looked around. The only “gray hair” was the ex-patriots. It turns out that when Andy started, he had to hire young people who were trained under Soviet management styles and who would work. They were right out of college, and as the business grew they simply got promoted fast. Andy was essentially training a new generation. This was also an alumni picnic, so many people came who had been trained at his companies but now run other operations. Quite the eye-opener.

My son Trey had a great time, with so many young ladies in bikinis. Kiev may have the most beautiful girls of any city I have ever been to. I think Trey is thinking of learning Russian, which many of them spoke. He is certainly begging to go back. It was fun to have him on this trip. But for Dad, the best moment was when he said, “I have to learn another language. I don’t want to be stuck in the US all the time.” Italian? French? He now gets it. It made the whole trip worth it. I wish I had figured that out at 17. I truly regret not being multilingual. C’est dommage.

It is time to hit the send button. I have to start in tomorrow on the 400 emails that are still in my inbox. I owe a lot of people responses and will work hard to catch up, plus I have some writing to do, etc. While I love the internet and it has been very, very good to me, it has also got me busier than at any time in my life. But who’s complaining? It is a fun life! Have a great week.

Your happy to be home analyst,

John Mauldin
John@FrontlineThoughts.com

1. The History

In 2008, Congress passed the Housing and Economic Recovery Act of 2008, which did two things. First, it re-affirmed the conforming loan limit of $417,000 that had existed since 2006. Then, it established a new higher “jumbo conforming” loan limit in higher priced areas of 115% of the median home price, not to exceed $625,500. I prefer to call them “confumbo loans”.

Subsequent acts in 2008 temporarily raised the $625,500 limit to $729,950, automatically expiring September 30th, 2011.

There were two main reasons that the Government created this new class of conforming loan:

1. To provide liquidity to higher-priced housing markets after the private mortgage market collapsed.
2. To transfer losses from private banks to the GSE’s  (and the taxpayers).

In order to still get a loan of $729,950, you have to have your loan registered with Fannie, Freddie, or the FHA on or before September 30th – meaning you had better be in contract on the home you are buying a week or two before that.

For most of the Country, this is a non-issue. But many local markets in California and parts of the Northeast, are highly-dependent on these loans.

2. The Spin

Predictably, industry groups are throwing a hissy-fit, predicting all kinds of terrible things if the $729,950 limit is not extended further or even made permanent.

The California Association of Realtors complained:

Drop in conforming loan limits would raise cost of housing financing, hamper housing recovery

LOS ANGELES (June 23) – More than 30,000 California families will face higher down payments, higher mortgage rates, and stricter loan qualification requirements if conforming loan limits on mortgages backed by the Federal Housing Administration (FHA), Fannie Mae, and Freddie Mac are reduced beginning October 1, 2011, according to analysis by the CALIFORNIA ASSOCIATION OF REALTORS® (C.A.R.).

“By reducing the conforming loan limit, thousands of California home buyers will be shut out of homeownership,” said C.A.R. President Beth L. Peerce.  “The higher mortgage loan limits are critical to providing liquidity in today’s housing market and are essential to our housing recovery.  We urge Congress to maintain the current limits and make them permanent to provide homeowners and home buyers with affordable financing and help stabilize local housing markets.”

…

Under the new GSE loan limits, Monterey County would see the greatest drop in the loan limit at $246,750, followed by San Diego ($151,250), Sonoma ($141,550), Solano ($140,500), and Napa ($137,500) counties.  Under the new FHA loan limits, Monterey County would see the greatest drop in the loan limit at $246,750, followed by Merced ($201,450), Riverside ($164,650), San Bernardino ($164,650), Solano ($157,300), and San Diego ($151,250) counties.

…

Regionally, Marin County would be impacted the most, with more than 12 percent of home sales rendered ineligible under the lower GSE loan limit, followed by Contra Costa (11.5%), San Mateo (10.7%), San Francisco (9.9%), Monterey (8.8%), San Diego (8.2%), Sonoma (7.9%), and Santa Clara (7.8%) counties.  Under the lower FHA loan limit, San Francisco County would be impacted the most, with more than 14 percent of home sales rendered ineligible, followed by Santa Cruz (13.9%), Orange County (13.3%), Marin (13.2%), San Mateo and Ventura (both at 12.7%), Santa Clara (12.2%), San Diego (11.9%), Alameda (11.8%), Riverside (11.5%), and Contra Costa (11%) counties.

The National Association of Home Builders warned that an alarming 17.2 million homes would be now be ineligible for GSE financing:

Under present law, 3.63 million owner-occupied homes are priced above the conforming loan limits. Under the changes set to take place on Oct. 1, an additional 1.38 million owner-occupied homes will be above the limit, leaving a total of 5 million homes that will not be eligible for GSE funding.

…

Under present law, 8.32 million owner-occupied homes are priced above the existing FHA loan limits. Under the changes set to take place on Oct. 1, an additional 3.87 million owner-occupied homes will surpass the limit, bringing the total number of homes ineligible for FHA-insured mortgages to 12.2 million.

3. The Truth

Despite what CAR and the NAHB say, no buyers will be “shut out of homeownership”. In fact, they will be better off.

It’s basic, common sense supply and demand: all of the homebuyers who could have afforded an $800,000 home will now only be able to afford a $700,000 home. Demand for $800,000 homes will shrink and, after some time, those $800,000 homes will drop to $700,000. The market will reach a new equilibrium.

Homes will be more affordable, not less. Buyers will be better off, not worse.

The “losers” here are the sellers, who are going to watch even more of their equity slip away. But even these sellers aren’t really losers, because most of them will also end up buying again someday at even more affordable prices.

Everyone…all of society…benefits from affordable, lower home prices because that means we have more money to spend elsewhere. Or, heaven forbid, save. Think about it, higher prices simply mean more money paid in interest, more paid in taxes, and more cash tied up in an illiquid asset.

The unique problem we face in this moment in time is that, while low home prices are good, falling home prices are painful. They drain cash, deplete nest-eggs, and lead to defaults, foreclosures, and bankruptcies, which put tremendous strain on our highly-leveraged banking system.

It’s a nasty mess, but we have to go through it to get through it. And we won’t be able to have any real recovery until we do.

The coming drop in the GSE loan limit from $729,950 to $625,500 will result in homes in that price range dropping by that same amount – about $100,000 – pretty quickly. I am guessing within 6 months. Moreover, this price compression will push less expensive homes lower and pull higher-priced ones down as well.

Here’s what you really need to know: if you are a seller from $500,000 to $1,200,000, get sold now, before September 30th. If you are a buyer in this price range, know that you are buying into a rapidly-declining segment and make your decisions accordingly.

Charts and tables are courtesy of “TC”.

Case-Shiller Nominal Price History 10 Least Expensive Metro Areas

click on any chart or table for a sharper image

Case-Shiller Nominal Price History 10 Most Expensive Metro Areas

Case-Shiller Nominal Price Declines Since Peak

Case-Shiller “Real” Price History 10 Least Expensive Metro Areas

Case-Shiller “Real” Price History 10 Most Expensive Metro Areas

Case-Shiller “Real” Price Declines Since Peak

TC writes …

Mish, I’ve attached several Case-Shiller graphs based upon most recent Case-Shiller data.

The charts show that all 20 metros are down from the peak prices between -10.7% (Dallas) and -58.6% (Las Vegas). Note that 13 of 20 cities tracked are presently at the lowest point in the cycle, while 7 cities are presently higher than their early 2009 low.

Of the 7 cities that are higher, San Francisco leads the way at +10.3% (+$43,461). However, San Francisco it still an amazing -40.6% (-$317,790) below peak prices.

Of particular interest is the “Price Level” column which displays how far back prices have reverted. For example, you can see that Atlanta has reverted back to April 1999 prices (and keep in mind this is nominal!). Three-fourths of the US is at the lowest point in the cycle, while 1/4 is up modestly and most likely temporarily.

The fourth chart is of March 2011 real (inflation adjusted) data. It is sorted identically to chart one and again shows that all 20 metros are down from their peak prices with again Dallas in the best shape (-21.6%) and Las Vegas the worst (-63.2%). It also shows that in real terms only 2 of 20 metros are actually higher than their early 2009 low and that both are only up +2.7% (and both still have huge declines of -47.4% and -35.3%).

The remaining 18 metros are all at their lowest point in the cycle. Again, the “Price Level” column is of interest as it shows that 10 of metros are down to levels never seen before in real terms (noted with an asterisk) and have resulted in a “lost” 20+ years of home appreciation. Long story short, housing has collapsed across the country and in real terms national pricing is back to late 1987 pricing – ouch!

I should also mention that this is based upon the latest Case-Shiller data, but many of these homes sold in very early 2011 since it typically takes 45 – 60 days to close and get recorded. So actual current prices (June 2011) are likely even lower and with the lowering of the GSE limits around the corner, we’ll likely see even further declines.

On a positive note, prices today (especially when you account for near historic low interest rates) are the best they’ve been in 25+ years. While prices are still likely to head lower all markets have already experienced the majority of both their real and nominal price declines (i.e. San Francisco is already down in real terms -$420,000 and with median prices at $465,900 another -$420,000 is impossible). That being said, patience will still likely be rewarded with lower prices and maybe even lower interest rates. Time is on the renters side.

Mike “Mish” Shedlock

http://globaleconomicanalysis.blogspot.com