The White Paper - Housing

A few years ago, when I first started writing about housing and the problems that were developing, most people thought the word subprime meant a prehistoric species from some long ago period. But quickly, it was learned that subprime meant a mortgage loan given to someone with questionable credentials, and an even more questionable ability to pay the loan back. We also learned that if you could breath, you qualified, and the bankers, mortgage brokers, and any one else associated with housing, including politicians, were more than happy to help you get into the house of your dreams. Unfortunately, you know how the story played out. The Bible says a house built on a foundation of sand (debt)…well, you get the idea.

Now the pundits tell us we are at the bottom. Housing, both pricing and sales, are smoothing out, and in the not too distant future, the real estate asset class will once again be the catalyst for great wealth. Many of you believe this story. DON’T!

Subprime was just the first shot in the salvo of creative mortgage financing. In fact, the Federal Reserve and the U.S. Treasury may have expended all their tools on the mortgage industry’s opening act. Consider this scenario. Imagine if you sat down to a five course dinner, thinking all that was being served was the first course. You gorged yourself, feeling satisfied, and actually contented. So what happens when course two, three, four, and five, are served? Uh oh! For the mortgage markets, the next course is the option adjustable rate mortgage. (ARM) The problem is not interest rates or “resets.” The problem is “recasts,” which usually happens when you either reach 125% of the original loan balance on a negative amortization basis, or 5 years pass, whichever comes first. These loans were pushed (I mean sold), as “affordability” products to people who could not afford to buy the house they wanted. The lender expected the borrower would either re-finance with a new ARM, or sell the house before the recast. Worst case, the house would appreciate faster than the indebtedness, allowing them to pay it off. It didn’t happen. Appreciation occurred, but the borrower with the encouragement of the lender, refinanced again and again, pulling money out to buy SUVs, kitchen make-overs, or once-in-a-lifetime vacations. All things that gave a false sense of growth to our economy.

The pundits, including our political administration, are saying that if they can just keep interest rates low, all will be well. Au contraire. Here’s an example: For a $750,000 house purchased five years ago, even if you get a 4% interest rate based on current “adjustable rates,” you must amortize the 4% over the remaining 25 years. (average) The house is only worth $400,000 in today’s market, and could go lower. So the possibility to refinance into a conventional loan is zero, unless you have the $350,000 difference just “lying around.” Also, your payment goes from $1,000 per month, to $3,945.62, a near quadrupling overnight. Can you say…walk away.

Here’s more bad news. Most of these billions of dollars of mortgage recasts have not happened yet. They are scheduled for the latter part of 2009, 2010, and 2011. Keep in mind, the financial institutions almost blew up when a small portion came due. What happens when the majority shows up on the doorstep? Couple this with alt-a, prime, and agency paper, and you have the makings of one good brouhaha, making the zombie banks of Japan seem like the life of the party. Factor in the inevitable collapse of highly-leveraged traded real estate investment trusts, and you have a story line that could only be scripted in the mind of Steven King.

The collapse of real estate is not near the end. In fact, in the parlance of musical theater “the overture has just concluded, and the curtain is about to go up.”

Till next time,

Bill

P.S. - Next: Emerging markets and China.


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