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THE BUBBLE FORMS

As we approach the end of 2007, housing prices continue to fall and houses stay on the market longer and longer with no end in site.  Some properties have even been reduced in price well over 25% and still are unable to sell.  Properties that once wouldn’t last a week on the market are staying on the market over 100 days without any offers.  What happened?

The trouble began early in 2005, when the housing boom that was supposed to last forever turned into a housing bust.

Around this time the rate of house price appreciation didn’t just slow, as most economists predicted, nor did prices simply flatten into a plateau accordance with their revised predictions. House prices began to fall sharply.

In fact, these declining prices are even sharper than what is shown in the data, because sellers now are forced to make payments that are not captured in the selling price, such as picking up some of the buyer’s closing costs or making repairs to the house before the sale. These practices were unheard of a few years ago.

THE BUBBLE BURSTS

So what happened?  People acted truly amazed and shocked by the real estate crash, they thought that real estate was an invincible market.  They thought that prices would continue to soar at ridiculous rates and never decline, but they missed one of the prime principals of economics: what goes up, must come down.  If you look at the graph above you will notice that the Home Price Index increased at a ridiculous rate when compared with the Building-Cost Index (cost of materials and labor), the Population (prime drive of demand), and Bond Yield (value of money) which all increased at fairly reasonable rates.  Prices of homes became so disconnected with these fundamentals that they were destined to collapse.

So how could people afford these properties?  Sub-prime loans, Option ARMs, and NegAm Teaser loans.  The lending industry had to allow the average person to more easily borrow more-and-more money to keep up with the rising cost of purchasing the average loan.  Therefore they offered negative amortization teaser loans where for a limited time (usually 2-5 years) a borrower could pay less than interest due for that loan period and tack on the difference onto the end of their pricipal increasing the amount they owed.

Someone buying a home for $500K with a typical principal and interest payment  of $2,500 a month would only need to pay $1,200 during the intro period, however after this 2-5 year teaser period is over their payment would jump to over $3,200.  This works fine when there is a high demand for houses and prices are increasing because people could always either sell their homes or refinance their loans to reduce their payments once their loans adjust beyond their means, however when prices start falling it becomes much harder to sell a home or refinance the loan since the property is now worth less than the amount owed.

How does it effect an individual, lets see:

John makes $3,500 a month with only $1,200 going toward his mortgage payments leaving him $2,300 for other expenses.  He can live well off of $2,300 a month.  After two years his payments jump to $3,200 which leaves him only $300 additional not enough to live on.  He misses one payment of $3,200 and within a month it’s $3,500 with late fees.  His next payment is due with a banance of $6,700.  He can only afford $3,200 and just barely.  He is still $3,500 in the whole, another month slips and it’s up to $7,500 for two months payments with compounding late fees.  He can’t make a third month bringing him up to $10,700 behind on payments. 

He is forced to sell.  His house that he paid $500,000 for is only going for $410,000 and it will sit on the market for a long time at this price.  He could reduce it to $390,000 putting him an additional $110,000 in debt or try to pull off a short-sale which most likely will never happen. 

So he does what’s smart in this market and stops making payments and allows his home to foreclose rather than to go over a hundred thousand in debt. This was actually a smart move on his part.

You know that the system doesn’t work when it’s a more attractive option for people to allow their homes to be foreclosed on than try to do everything possible to make the payments.  This lending system was an iceburg waiting for the titanic.

Front page of the WSJ this morning:

“The subprime mortgage crisis is poised to get much worse.”

“Next year, interest rates are set to rise — or “reset” — on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn’t quite the case.  Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher.   Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Now the real crest of the reset wave is coming, and that promises more
pain for borrowers, lenders and Wall Street. Already, many subprime
lenders, who focused on people with poor credit, have gone bust. Big
banks and investors who made subprime loans or bought securities backed
by them are reporting billions of dollars in losses.”

Subprime mortgages account for more than half of all troubled loans. According to Fannie Mae, 76 percent of the borrowers who had subprime ARM resets in 2006 were unable to pay off their mortgage by selling or refinancing. Half of the borrowers who did not pay off their loan ended up delinquent or in foreclosure. With more resets expected in the coming years and banks reluctant to lend money (and many lenders simply gone), the delinquency ratio is likely to increase.

THE BAD NEWS

The projected supply of foreclosed homes is around 45% of existing home sales which adds four months to the supply of existing homes. According to Dale Westhoff of Bear Stearns, this is a “fundamental shift” in the housing supply and as such, home prices are likely to drop further as lenders dump many repossessed homes.

Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied home, analysts say.  Lenders are eager to unload the properties, and the homes tend to be in poorer condition.

MORE WAVES TO COME

We are only at only seeing the first wave of defaults and foreclosures based on subprime mortgage adjustments.  Over between now and early-2009 the dollar amount of subprime mortgages that adjust will increase from $30B a month to around $38B and the number of option ARMs that adjust will continue to increase into 2011.

“Losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide.” - Michael Bloomburg

“The subprime black hole is appearing deeper, darker and scarier than they thought.” - Hamilton James, Blackstone Group president and chief operating officer.

I predict that when this downturn ends sometime in mid-2011, the sales activity will correct back to 1998 levels.

This chart shows the resets peaking in early 2009. Guess what is going to happen to everyone wishing, hoping and praying for a quick turn around in the Spring?  It won’t happen.

THE LONG SLOW RECOVERY

Reasons why this last longer than expected and will NOT have a quick turnaround:

1) All the people who are being foreclosed on will not be able to re-enter the housing market in the near future because a) their credit will be destroyed and b) all the money they put into the house towards the downpayment, upgrades, or general expenses will be lost.  It will take years for these people to repair their credit and save enough money to re-enter the housing market as buyers.

2) Lenders have lost a record amount of money.  Therefore in the future they will be tighter with lending out money.  Thus people who once qualified for loans that were 7 times their annual income may now only qualify for loans 3 times their annual income.  They will also require that people have higher down payments to get loans and many no longer allow people to do 100% financing.  This will greatly restrict people to buying houses for a lower amount.

3) People will learn from past mistakes and only take out loans within their means.  Instead of buying a house for 7-8 times their annual income they will buy a house for 3-4 times their income.

4) People will no longer be able to falsify their income or cheat the system and lenders that help borrowers do this will now be subject to prosecution.

5) People who own more expensive house, say $700,000 - $800,000 homes will sell their more expensive homes and buy cheaper houses for $400,000 - $500,000 to cover their loses and overbearing debt.  These people may or may not take a heavy loss but will be entering the market with a lower priced home.  They will appear to be buyers which looks good for any market, when in fact they are trading down and further contributing to lower real estate prices and a weakening of the market.

This subprime mess is a national trend affecting some areas more than others.
According to an analysis by Comstock Partners, 70 percent of the borrowers who obtained a pay-option ARM last year owe more on their home now than when they took out a loan. Comstock also estimates that more than 15 percent of 2005 homebuyers (all loans) owe at least 10 percent more than their homes are worth.

The bottom line is that many of ARM holders will not be able to sell, refinance, or keep up with payments, leaving them with only one option: foreclosure (failing some form of mass-amnesty).

We are in for a long haul with currently no end in site.  Prices will continue to fall.  At what rate no one knows.  But they certainly will not increase in the near future. 

How is real estate doing in your area?  What trends have you noticed recently?

The subprime mortgages have plagued Sonoma County especially the Santa Rosa Area.  Santa Rosa is off the charts with the number of subprime loans issued.  Look at the map below:

Sonoma Count Subprime Mortgages

Percent of first liens that are subprime mortgages in each census tract:

RED:  more than 40%
ORANGE: 30-39%
YELLOW: 20-29%
GREEN:  10-19%
BLUE:  Less than 10%

More on Santa Rosa and the Sonoma County markets later…