Wharton says Market not headed up for a while

Optimism Is Up, but the U.S. Housing Market Faces a Painful Shift

Published: April 25, 2012 in Knowledge@Wharton
It's spring, the time when Americans traditionally think about new homes -- trading up for growing families, downsizing for retirees, picking up a vacation home or buying a starter home to escape renting.

But four years after the start of the financial crisis, and six years after home prices began to collapse, the market is still shaky. Nationally, prices are about 35% below their peaks in 2006, according to the S&P/Case-Shiller Home Price Indices released on April 24, and in some markets homes have lost 60% of their value. About one in four homeowners with mortgages, some 11 million households, are "underwater" -- owing more than their homes are worth. Construction and sales of new homes remain anemic, with housing starts about one-third the historical average.

Still, there have been some hopeful signs. A second home-price dip that began late in 2010 seems to have stopped this year, according to the Case-Shiller survey, and the National Association of Realtors says February's existing-home sales were up nearly 9% from a year earlier.

The key question: Has the housing market hit bottom? If it has, are prices likely to climb, or will they bounce along the bottom for some time -- for many months, perhaps for years?

Answers vary from one part of the country to another, says Wharton real estate professorJoseph Gyourko. "It will depend on the market. I think we are somewhere near a bottom; we are bouncing along. But it certainly would not surprise me if we went down a bit." But for the moment, there is little reason for prices to rise, he adds. Wharton real estate professorFernando Ferreira agrees, noting that "If we're not at the bottom, we're very close to the bottom." He also cautions that it's far from certain prices will rise significantly anytime soon.

Mark Zandi, co-founder of what is now Moody's Economy.com, holds similar views: "There are some signs of life, but nothing to suggest that we are moving north in a definitive way." He says the housing crash is "largely over" and points to some strengthening in sales and new-home construction, but does not believe this is enough to lift home prices. "The key is getting through more of the distressed properties that are in the foreclosure pipeline," he notes, adding that this involves some 3.6 million of the nation's 49.5 million homes. "Until we work through them to a greater degree, that is going to remain a pall over home prices."

The bumping-along-the-bottom view is shared as well by Wharton real estate professor Susan M. Wachter. Despite much negative data, she believes that economic recovery, though sluggish, is helping the housing market to mend. She expects to see more improvement this spring, noting that the recent Case-Shiller figures offered a glimmer of hope: better annual returns in home prices in February compared to January. Nationally, home prices are about where they ought to be, given fundamentals like employment levels and interest rates, Wachter says.

The slow housing market does not just affect people who want to buy or sell homes; it is dampening the whole economy, Gyourko notes. When home building is down, construction workers are idle. With fewer home sales, fewer people are spending money to move and form new households, affecting everything from furniture sales to moving firms. And the low level of sales means real estate agents are not getting much work, and are therefore spending less.

Among the housing market's key problems is an excess supply of homes due to the building binge in the late 1990s and early 2000s, Gyourko says. Because homes last so long, an oversupply does not dwindle as quickly as it does for non-durable goods. "This housing stays for decades. Once you oversupply, there's no real way to get out of it." Job growth helps by enabling more people to buy; however, although unemployment is ebbing, "we're still 5.5 million shy of the pre-crisis employment peak," he adds.

Millions of homeowners bought during the market peak in the middle of the past decade, at inflated prices before the crash. It could be years before those homes are again worth what their owners paid, and homeowners with negative equity -- owing more than their homes are worth -- typically cannot move. To do so, these underwater owners must come up with cash to make up the difference between their debt and proceeds from selling the home, and this often comes to tens of thousands of dollars, sometimes hundreds of thousands.

Gyourko's research shows that a homeowner with negative equity is one-third less likely to move than a homeowner with positive equity. "So that's going to affect the trade-up market.... There are a number of reasons, in a lot of markets, that prices were not rational before [the crash]," he notes. "There's no reason to go back to irrational prices, and in a number of markets the supply is very large."

Mounting Obstacles

On the positive side, today's extremely low mortgage rates -- around 4% for a 30-year, fixed-rate loan -- give buyers a lot of borrowing power. However, although the Federal Reserve has vowed to work to keep interest rates low through 2014, a strengthening economy will eventually lead the Fed to lift rates to stave off inflation. Some experts think this could happen before 2014. When mortgage rates start to go up, some potential buyers may rush into the market to beat higher rates, Gyourko says, and that extra demand could push prices up. But higher rates could also slow the housing recovery by making home ownership more expensive and encouraging homeowners to stay with their current, inexpensive loans rather than move and face higher rates, he adds.

"We all realize that interest rates are unsustainably low," Wachter says. As rates rise, we would expect that will have a fundamental negative impact on housing prices once again." While today's low rates would seem to make homeownership attractive, there are other obstacles in the lending process, she adds. "Despite the fact that housing is extraordinarily affordable, it is difficult to get a mortgage. There has been a ratcheting up of [lending] standards, which is quite significant."

Before the housing bust, it was possible to get a loan for 100% of a home's appraised value, sometimes even more. Today, driven by underwriting policies of Fannie Mae, Freddie Mac and the Federal Housing Administration, plus their own bad experiences, lenders want at least 20% down, a big financial hurdle for buyers. Appraisers are under pressure to be more conservative in valuing homes.

Conditions are even tougher for borrowers seeking jumbo loans -- generally above $417,000, though varying around the country. In addition to the 20% down payment, the borrower is required to have a large cash reserve to cover payments should anything go wrong, Ferreira says. To purchase an $800,000 home, one would need $160,000 down, plus $60,000 to $80,000 in reserves -- "very few people have it," he notes.

In the past, buyers used equity in the current home to trade up, but now many people have little or no equity, or negative equity. "What that is doing is leading to very low mobility," Wachter says. "Mobility is at historic lows, and the trade-up market is impacted." Ferreira adds that it could take five to 10 years for underwater homeowners to build equity again, "or they may never do it again."

In addition, buyers' tastes have changed, apparently reducing demand for some homes that were the rage before the bust. Housing industry observers note that today's buyers are turning away from the "McMansions" of the 1990s and early 2000s in favor of smaller, less-expensive homes -- ones both cheaper to buy and maintain. This can make it harder to sell a big home with all the trimmings. Part of this shift in demand is certainly due to the obstacles to getting big loans. Another factor: The ideal buyer today is a renter who does not have to sell a previous home, and renters tend to be young people buying their first home, which is usually modest. Whether the taste for somewhat smaller, more affordable homes will persist is anyone's guess. Fashions can change quickly, and the urge to live in a spacious, showy home -- to keep up with the Joneses -- could swell again when people feel more prosperous.

In the Shadows

For any housing recovery to gather steam, the backlog of foreclosures, and distressed homeowners who could end up in foreclosure, must be reduced, Wachter says. "The concern is this overhang of shadow supply," she points out. While there is also a shadow demand composed of people who would like to buy, many potential buyers stay away for fear they could buy and then lose money if economic troubles turn the shadow supply into real supply. "The concern is that a fire-sale is coming to a market near you," Wachter explains. "And it's a very valid concern."

Just how many homeowners will end up in foreclosure is impossible to predict. Falling unemployment reduces the problem, but the 25% of mortgage holders who are underwater could produce a new wave of defaults if the economy takes a jolt. "That's the shadow supply of homes that could become available if something happens to the owner -- because of a health shock or an employment shock," Gyourko says. Another spike in foreclosures would depress home prices by increasing supply with homes offered at fire-sale prices, since lenders are better off minimizing losses by getting what they can quickly rather than carrying empty homes while awaiting higher prices.

Wachter notes that about half of the borrowers who took out subprime loans between 2005 and 2008 are in default -- typically 30 to 60 days behind on payments. In many markets, 30% of home sales involve distressed properties, she adds, noting that an economic downturn could push this to 40% or 50%, which would seriously undermine prices.

The Obama Administration's efforts to help people avoid foreclosure have had only limited success. Generally, these have focused on reducing the borrower's payments relative to income, and making it easier to refinance at today's low loan rates, which reduces monthly payments. Unfortunately, about half of borrowers who have gone through some type of loan modification default again afterward, Wachter says. Also, while these efforts have helped several million homeowners, they do not tackle the underwater-home problem that is such a dominant factor in today's market. Studies have shown that homeowners are much more likely to default when they are underwater, even if they can afford the payments, because it seems pointless to make payments on a money-losing investment.

Various proposals have been made to assist underwater owners by reducing the loan balance. But lenders cannot be forced to do this, and they have been reluctant to participate in voluntary programs because they don't want to book the losses or encourage other borrowers to default to get a portion of their loan forgiven. "There are a lot of problems with principal reduction," says Zandi. The first issue is moral hazard -- the risk of encouraging more defaults. "Second is the straight-up fairness issue. Is it fair?" After all, most homeowners continue making payments even if they are underwater or wrestling with other financial troubles. "I don't think there is political will for a program that will do principal reductions right now," Ferreira adds. Zandi suggests that principal forbearance can work just as well as forgiveness. Rather than reducing the outstanding debt, forbearance allows the borrower to temporarily make smaller payments, as if the debt were smaller, while in the long run still owing the full amount.

A better approach, Gyourko says, might be a program that makes it easier for troubled homeowners to become renters, perhaps by helping with security deposits, to ease landlords' concerns about renting to people who have defaulted on their mortgages. "But I'm not holding my breath," he notes. According to Wachter, there's some hope for programs, now in the pilot stage, which would make it easier for investors to buy distressed homes and turn them into rentals. With this approach, lenders would take smaller losses than with foreclosures. Since homes would probably sell for more than they do in foreclosure, this would minimize damage to prices of nearby homes, she says.

Still, millions of homes are likely to go into foreclosure in coming years. A year or two ago, the economy was too fragile to handle a large number of foreclosures, notes Zandi. Now he believes it is strong enough that the best course is to "get these problems behind us."

No Longer an Investment

While most experts believe that will happen eventually, and the housing market will improve, it is far from clear whether the housing market of the future will ever look like that of the bubble years. Americans have long viewed the home as a key step to prosperity, a major "investment." While this never was completely true, as home appreciation barely beats inflation over the long run, the housing bust has demonstrated that homeownership has its downside, too.

"People no longer believe ownership is a way to get rich," Gyourko says, noting that the homeownership rate has fallen and demand for rentals has jumped. According to the census bureau, 66.4% of households owned homes at the end of 2011, down from a peak of 69.1% in 2005.

A New California Short Sale Law?!

The California Association of Realtors (C.A.R.) announced its sponsoring a bill that will prevent California homeowners from going into foreclosure if they have negotiated a short sale with their lender or servicer.

Assembly Bill 1745 (Torres, D-Pomona) prevents lenders or servicers from recording a notice of sale if a short sale has been approved. The bill is scheduled for hearing on April 30 by the Assembly Banking and Finance Committee.

The bill would also allow the mortgagee, trustee, beneficiary, or authorized agent to withdraw a short sale approval if a condition in which approval was granted has changed. The bill would require a written notice to the seller no less than 3 days before withdrawing approval, with an explanation of the decision change.

California Attorney General Kamala D. Harris recently introduced her Homeowner Bill of Rights, one of which had a similar provision that prevents dual tracking, or the practice in which a lender proceeds with a foreclosure on a homeowner who is also trying to pursue a loan modification.

Legislators delayed voting on the bill last week before Harris was scheduled to testify. ABC News 10 reported that the California Bankers Associationopposed the ban on dual tracking stating it only delays the inevitable.

Is it time to buy?

We are hearing this question non stop in today's financial media. Warren Buffet says he'd buy a hundred thousand single family houses. Donald Trump says "don't know what to do? - go buy a house!". Even Robert Shiller of the industry standard Case - Shiller report says it probably would not be a mistake to buy now.

So what does Diana Olick say? For once, Ms. Olick and I are far apart with our opinions. Diana declares (and rightly so) that real estate is a local business. However, she then states that the middle price range ($250,000 to $500,000) may be poised for big action. Citing historic interest rates and the debatable fact that the housing market has bottomed, Ms. Olick seems to have succumbed to the mass hysteria of economic optimism, particularly as regards to housing.

I feel quite the opposite. It is my opinion that the economy, and hence consumers, are still too fragile, and therefore unable to buy for some time to come. Even with the slight relaxation of underwriting standards, the truly "organic" buyer (non investor, non all cash buyer) is not ready to move. Possibly trapped in an upside down property already, or just not able to qualify for a home that would be worth jumping through dozens of flaming hoops, the desire is not there.

Folks have been calling the bottom and rushing back into the market for 3 years, only to see more equity and capital go up in smoke in a continuing decline of values.

Of course, the credibility of these optimistic experts is hard to argue. However, I am reminded of a saying my mother used on me for years when I was a child. "Just because your friend Donnie jumped off the bridge, should you?" No mom, I guess not...

Privatized Gains, Socialized Losses

Courtesy Barry Ritholtz "The Big Picture"

The esteemed former Fed Chairman, Paul Volcker, introduced a very simple regulatory concept that bears his name: The Volcker Rule. It was part of the Dodd-Frank regulatory reforms passed after the financial crisis of 2008-09.

There has been enormous pushback against what should be a simple piece of prophylactic rules on proprietary trading by depository banks (see this Jamie Dimon commentary as an example). Why? The profits of speculation goes to banks, driving bonuses and compensation; but the ultimate risk of loss lay with the FDIC and taxpayer. If the banks blow up, someone else besides the banker pays.

Privatized gains, socialized losses.

I want to take a few moments to briefly explain why this rule is so important to taxpayers, especially following the collapse of MF Global and the loss of billions of client assets.

Recall the basic facts of MFG: Management engaged in leveraged speculations with monies — whether it was their own or clients became irrelevant as the losses were so great as to wipe out much more capital than the bank actually had. Billions in losses meant MFG was insolvent and was wound down. On the winning sides of those trades were folks like JPM and George Soros. It is neither their duty nor obligation to verify whose money is on the other side of the trade — the clearing firms make sure the trade settles.

Those trade settlements are the only possible outcome. Why? Imagine a burglar robs a house of cash, goes to a casino and loses the money playing Roulette. The Casino settles that bet, it clears — and the burgled homeowner can never recover the money. Exchanges work the same way. They simply cannot validate the capital sources of every transaction. In the case of MFG, he money wasn’t even burgled — it was simply entrusted to an entity that became so insolvent thru excess speculation that even money in “Segregated accounts” was highly compromised.

And therein lay the dirty little secret of modern banking: THERE IS NO SUCH THING AS A SEGREGATED ACCOUNT. It is simply a helpful way to think about money and banking; it does not exist in the real world.

Consider your basic bank account — checking, savings, passbook, etc. We go through massive contortions to create an illusion that your money is yours, that its safe and sound in a bank with your name on it, in your own virtual safe deposit box. But that is simply not the reality of modern banking. What you perceive as “your money” is little more than an electronic journal on the banks accounting ledgers.

Fractional reserve banking means that the $100 you deposit is lent out — only $10 of your $100 is kept in reserve. Under normal circumstances, with thousands of depositors and millions of dollars, the banks have no trouble giving customers who ask for their money back the full amount at anytime. But it is not as if your money is sitting in an account waiting for you — you merely have a claim on those monies, and that claim is insured by the FDIC, and backed by taxpayers (theoretically).

You are, in fact, a counter-party to your bank.

In the old days, banks were boring. 3-6-3 banking meant borrowing at 3%, lending at 6%, be on the links at 3pm. It was simple. Banks were a utility, making reliable steady money, so long as they didn’t do anything too stupid to screw it up. Glass Steagall, the depression era legislation, prevented them from engaging in the sort of risky Wall Street speculation that caused so much trouble over the years. Think MFGlobal to get a better understanding of what is involved.

Thanks to the sheer ideological idiocy of Phil Gramm, enabled by the corruption of former Treasury Secretary Robert Rubin and the hubris of former Treasury Secretary Larry Summers, Glass Steagall was repealed. Thus, banks could be as stupid as they want to be — and you get to foot the bill.

What does all this have to do with the Volcker rule and MF Global? It is quite simple: Today’s post Glass Steagall repeal Bankers engage in leveraged speculation that potentially could blow the bank up. They did it to themselves with sub-prime mortgages; have no doubt that someone is working on the next ‘financial innovation’ whose losses will be even bigger and better than RMBS and CDOs.

When the next bank blows up — note I said when and not if — their depositors will become counter-parties. Those depositors are you, just like MF Global’s. Only, you as counter-part are not first in line with a claim on the monies — the folks on the other side of the trade get first dibs.

So this bank blows up, the trades settle, the counter party banks/brokers get paid, and whatever is left (if anything) goes to depositors. The FDIC will make good up to $250,000. FDIC’s budgets comes from a small fee on banks. If the losses are great enough, it will exceed their budget and so the taxpayer than makes up the difference.

The risks and rewards are, to use a big word, “asymmetric.” Hit a home run as a trader or banker, collect a huge bonus. Lose it all and then some, and the taxpayer is on the hook. Anyone who fails to see the simple math of this either spends their days shilling for banks or are acting as CEO mouthpieces.

Privatized gains, socialized losses.

Case Shiller - "We're Going Down!"

Data released this morning by Standard & Poor’s for its S&P/Case-Shiller home price index showed declines in November of 3.6 percent for the 10-city composite and 3.7 percent for the 20-city composite when compared to price levels from a year earlier.

Analysts were expecting a year-over-year drop in the range of 3.2 to 3.4 percent, holding constant with the annual declines reported for October of -3.2 percent for the 10-city composite and -3.4 percent for the 20-city measurement.
Eighteen cities’ annual returns were in negative territory in November. Detroit and Washington, D.C. were the only exceptions. At -11.8 percent, Atlanta continued to post the lowest annual results.
In addition to both composites, 13 of the 20 metros included in S&P’s study saw their annual returns worsen compared to October’s data. New York and Tampa saw no change in annual returns in November, while Charlotte, Cleveland, Denver, Minneapolis, and Phoenix saw their annual rates improve.
“Despite continued low interest rates and better real GDP growth in the fourth quarter, home prices continue to fall,” said David Blitzer, chairman of the index committee for S&P. “The trend is down and there are few, if any, signs in the numbers that a turning point is close at hand.”
Both the 10- and 20-city composites of the closely watched index posted declines of 1.3 percent between October and November. Among the 20 cities tracked, 19 saw average home prices slip month-over-month. The only positive was Phoenix, where prices rose 0.6 percent from October to November.
Stiff says in the monthly data too, Atlanta stands out in terms of relative weakness. Home prices there were down 2.5 percent over the month of November, after having fallen by 5.0 percent in October.
Atlanta, along with Las Vegas, Seattle, and Tampa all reached new cycle lows in November, according to Stiff.
The 10-city and 20-city composite readings are holding above their cycle lows hit last spring by +1.0 percent and +0.6 percent, respectively.
Measured from their June/July 2006 peaks through November 2011, the decline for both the 10-city composite and 20-city composite is -32.9 percent.
As of November 2011, S&P says, average home prices across the United States are back to the levels they were at in mid-2003.
For the hard-hit metros of Atlanta, Cleveland, Detroit, and Las Vegas, average home prices are below their January 2000 levels.