Paper Economy - A US Real Estate Bubble Blog

Friday, June 30, 2006

Boston Housing Strangled!

Once again, Boston area real estate is feeling the heat of a slowing, some say crashing, housing market. With numerous articles being published daily citing the record levels of foreclosures, doubling of inventory and average days on the market, and slumping sales, one can only wonder how long it will take for the bottom to really come off this market.

Worse yet, now that the Spring selling season is officially over, Summer may bring with it an even slower selling market, pushing inventories even higher and possibly accelerating the median price decline as sellers are forced to compete more actively.

Not convinced that Boston area housing market is in significant decline?

The exemplary inflation adjusted charts published by BostonBubble.com couldn’t be more persuasive. The median sale price is down 9.73% since its peak in June 2005, and year over year sales are showing a strong downward trend since it peaked in November of 2004.

Key Statistics for May 2006

  1. Single Family Sales Down 5.1% as compared to May 2005
  2. Single Family Median Price Down 4% as compared to May 2005
  3. Condo Sales Down 7.75% as compared to May 2005
  4. Foreclosures Up 105% as compared to May 2005
  5. Foreclosures Up 165% as compared to May 2004
  6. Single Family average “Days On Market” Up to 121 days
  7. Condo average “Days On Market” Up to 120 days as compared to 89 for May 2005

Additional Facts

  1. Highest level of foreclosures since the 80s housing downturn
  2. MA has had NO growth in population.
  3. Two Thirds of homes in MA are priced above what a person with the median income can afford.
  4. Inventory of housing for sale in MA as doubled since 2005.
  5. Business Costs are 40% higher in MA than the national average

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Monday, June 26, 2006

Death of a Salesman!

As the market continues to cool it will be interesting to witness how the throngs of middlemen, once riding high on the hog, readjust to the more competitive environment.

Mortgage brokers, Real Estate Brokers (Realtors), Home Appraisers, Home Inspectors, you name it are all headed for rough waters and for many it will mean closing up shop.

To that end, witness the plight of 1-800-Housing.Net LLC. For the past month there has been “announcements” (advertisements) on PRNewswire telling of the imminent sale “of its assets, including Web addresses, a phone number, application software and website”.

After a bit of speak about the value and “name recognition” of their assets, the announcement goes on to say “The owner is working with a short time frame and is motivated to close for the right terms, preferring a private transaction to an internet-based auction… As this is a simple transaction, we anticipate closing within 30 days, either way.”

Well, once a salesman, always a salesman I guess. It seems that even walking out the door, a good middleman can’t resist buttering things up.

Certainly, in the coming months, many others will be forced to follow suit… Be sure and let PaperMoney know if you should notice any interesting action in your neck of the woods!

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Sunday, June 25, 2006

Reduction Reduction

Recently, I discovered that Zip Realty.com not only enables you to see the number of “days on the market” for a particular property but also allows you to view the various individual price reductions a house has had over its listing span. Couple that with the ability to return only properties that have had price reductions and to sort by original listing date and you’ve got yourself one “class A” bottom feeding machine!

The following home data from Massachusetts is anonymous as I would hate to make these sellers lives any more difficult than they already are but I thought presenting some basic data would serve to illustrate some of the markets current woes without doing too much harm.

Some Interesting points:

  1. Since early spring 2006, price reductions seem to have really picked up the pace especially for the homes sitting on the market longest. For many homes, the pattern of price reductions went from little or no reductions (sometimes for over a year) to a sudden month by month slash and burn.
  2. For the homes that have the most number of price reductions, many seem “sloppy” or inconsistent indicating that there may be other, external factors prompting the reduction such as direct competition with other properties.
  3. Many builders seem to play games with the price as it is very typical to see new constructions being price increased for a period of weeks and then decreased again back to or below the original asking price.
  4. Although a surprising percentage of homes show price reductions, many have yet to really dig deep and give up significant percentage of their asking price. It’s typical to see 5% to 10% reductions but not enough sellers have really capitulated to the new market climate of few buyers and bloated inventories. Remember, many of these sellers selected their list prices with the “back in the heyday” pricing model so they have lots of room to reduce.

$500,000 (25%) Slashed and counting in Concord MA! [358 days on the market]

This listing was particularly interesting as it showed that the seller seemed to have some measure of stamina going some five months without a price reduction before knocking 12% off the list price. That bought them three months whereby they seemingly became either more aggressive or possibly even panicky, knocking an additional $250,000 off in the span of two months bringing it to a grand total of 25% price reduction from its original list.

25% in Price Reductions:

12/08/05 -- $1,995,000 to $1,750,000 (- $245,000)
03/08/06 -- $1,750,000 to $1,675,000 (- $ 75,000)
04/26/06 -- $1,675,000 to $1,595,000 (- $ 80,000)
05/30/06 -- $1,595,000 to $1,499,000 (- $ 96,000)

$130,000 (14%) Slashed and counting in Concord MA! [261 days on the market]

After having the house on the market for roughly fifty days (the average here in MA is currently more like 100 – 120 days for a sale) the seller knocked 30K off the top. That bought them another two months whereby they commenced reducing another 99K in the next 2 months. Take a look at the reduction on 03/01/06 then 03/09/06. I have been noticing this pattern (abrupt reduction out of step with the overall reduction pattern) and I have concluded that it is most likely a cause of direct competition. So possibly a roughly equivalent home nearby either came on the market or had a price reduction that forced this seller to adjust for competitive purposes.

14% in Price Reductions:

11/21/05 -- $929,900 to $899,000 (- $ 30,900)
02/02/06 -- $899,000 to $869,000 (- $ 30,000)
03/01/06 -- $869,000 to $859,000 (- $ 10,000)
03/09/06 -- $859,000 to $839,000 (- $ 20,000)
04/06/06 -- $839,000 to $799,990 (- $ 39,010)

$500,000 (20%) Slashed and counting in Lexington MA! [470 days on the market]

This listing has panic and fear written all over it. The seller lasted just over a year without a single price reduction then abruptly knocked 20% off the top in a series of sloppy reductions. Again, it appears that the reductions of 05/01/06 and 05/12/06 are the result of direct competition.

20% in Price Reductions:

03/30/06 -- $2,499,000 to $2,390,000 (- $109,000)
05/01/06 -- $2,390,000 to $2,275,000 (- $115,000)
05/12/06 -- $2,275,000 to $2,245,000 (- $ 30,000)
06/23/06 -- $2,245,000 to $1,999,900 (- $245,100)

$4,900 (.006%) Slashed and counting?? In Ipswich MA [614 days on the market!!!!]

This one is in the category of “step up the pace!! What’s wrong with this seller? This house has been on the market for nearly two years and they have reduced it a .006%!! I suppose they just don’t want to give up on that 700K figure. Talk about penny wise pound foolish… this will surely be an interesting one to watch.

.006% in Price Reductions:

06/18/06 -- $749,900 to $745,000 (- $ 4,900)

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Saturday, June 24, 2006

For Sale by Auction!

An article was recently published in a local Massachusetts newspaper outlining a purportedly “new” way for home owners to sell their home. This new method can be loosely summarized by the following; advertise for five days (web, local papers, signs, etc.), two days of open house, and then put it on the Auction Block!!

Apparently sellers using this method, as devised by author and “consultant” George Cappony, are instructed to set a low starting price in order to draw buyers in.

According to Cappony, since the homes have a “low starting price, people [buyers] automatically want them. It’s a beginning bid, just like on Ebay. That’s the attraction. It’s a magnet that brings in people to the sale. There is a sense of urgency."

Sounds simple! Right!.. Maybe too simple… I sure hope they set their “reserve price”.

I wonder if this is possibly just a way for some sellers to feel, psychologically, as though they are back in the driver’s seat. Perhaps resorting to an auction may be a real “sign of the times”… better you do it now rather than HUD do it for you later.

Also, it seems Cappony’s method is not so new as he has been pushing it since the late nineties. He offers his services as a consultant including providing web-based marketing. Apparently, Cappony charges no more than $5250 to work his magic… well at least he’s not a Realtor.

Interestingly, the article never reports the outcome of the home sale it was chronicling. The homes web address http://www.322purchasestreet.com seems to not be accessible either.

I sent the sellers an email to follow up. Check back as Ill post their response should I get one.

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Tuesday, June 20, 2006

Today’s New Construction Numbers

As was the case with April’s new home sales report, today’s New Residential Construction Report published jointly by the U.S. Census Bureau and the Department of Housing and Urban Development, if digested with additional scrutiny may result in a less optimistic outlook than was widely reported.

Key points:

  1. Authorized building permits were down 2.1% from April and 8.5% below the May 2005 figure.
  2. New home starts jumped up 5.0% but is still 3.8% below the May 2005 figure.
  3. By itself, single family home starts were up only 2.1% but are still 7.6% below the May 2005 figure.

Additionally, home builders have reported that they have been experiencing as much as a 20% drop off in new orders as well as a whopping 60% increase in cancellations.

The most important point here is that the Residential Construction report does NOT account for cancellations. Neither the Census Bureau nor HUD collects data on new home cancellations.

So what we may be seeing here is a short term discrepancy between the standard reported numbers and the actual completed new homes. Only time will tell if cancellations as well as mounting inventories will bring the month over month new home numbers back down in line with the obvious trend of a slowing housing market.

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Betting on housing

In the spirit of putting your money where your mouth is, I thought I would share my (limited) experience using the stock market to “bet against” the housing market.

DISCLAIMER: I know almost nothing about trading options. What I’m about to describe is not an attempt to “pump” shorting particular stocks or an outline of some “get rich quick” scheme. I’m merely sharing my experience of buying and selling “put” option contracts in order to make some money off of the housing markets decline.

WARNING: Trading “put” options is very risky business. Although your loss is limited to the total of your investment, (unlike other options scenarios where your risk may be unlimited) if you make a bad “bet” you will generally lose all your money. So proceeded at YOUR OWN RISK!

So, here’s the scoop.

If you think a stock (or a whole sector for that matter) is going to go south, a simple way of making a few bucks off of its demise is to buy a “put” option contract. Don’t ask me all the intricacies of “put” options because I don’t know them but what I do know is the following:

  1. When buying an option, you are actually trading in a contract that enables you to execute some sort of agreement in the future. In the case of a “put” option contract, it’s an agreement allowing the buyer “…the right, but not the obligation, to sell an underlying asset at the strike price until market close on the 3rd Friday of the expiration month.
  2. You generally DON’T need to execute the options contract in order to make money on an options investment. The contract itself trades like any normal asset as there seems to always be someone willing to buy your options contract at any point in its lifecycle. Also note, you don’t need to wait until the expiration date to trade out of the option contract either. You can sell your option contract at any time.
  3. When buying a “put” option, the “strike” price is the price that if the stock should fall below, within its expiration date, you make money. You get compensated for the difference between the current stock price and the strike price. So the key here is that if the stock goes up ABOVE the strike price, and remains there on the day of the option contracts expiration, you lose ALL your money. Conversely, if the stock price falls BELOW the strike price (a state termed in the money) you make the difference between the current price and the strike price for every share you control.
  4. The key here is leverage. A single option contract controls 100 shares of a particular stock and therein lays the real magic of options. For a fraction of the price of actually owning 100 shares of a particular stock, you can temporarily leverage the volatility of 100 shares, and if your predictions are accurate, gain the real monetary benefits of having owned them long or short.
  5. Options are advertise in large ranges, grouped by expiration date and sorted by strike price. So, for example, “Toll Brothers July 30s” stands for an options contract that expires on the third Friday in July (July 21) and has a strike price of $30 per share.

To buy options you need to have a brokerage account that allows “options trading”. If you don’t have options trading enabled on your account, you can generally get the feature added with nothing more than filling out an options trading account application. For my existing brokerage account, I merely filled out and submitted an options trading account form online, and in a couple of days, I was up and running.

Ok, so you’ve got the general idea, now review the following excerpts to see how I made a few bucks shorting homebuilders, etc:

NOTE: Options are VERY volatile and move dramatically day to day. I was extremely lucky to not only buy my contracts in a sector that has been recently taking a major beating but also in an environment in which every major stock index and average has been WAY down. So again, don’t get too excited, and proceed with caution.

  1. Up 526% in just 8 days!!

On 5/10/2006 I bought 1 May 60 “put” option contract (I think… it could have been a MAY55 either way it was either in or very close to in the money the day I bought it) against KB Home (KBH) for $0.95 cents per share or $95 for the entire contract. In a short time, KB, along with all the other home builders took massive beating as it became even more apparent that the sharp falloff in buyers and large scale cancellations was not an anomaly. KB dropped from roughly $60 per share on 5/10 to roughly $54 per share on 5/18.

On the Thursday before the expiration day, I decided not to get too greedy and trade out of the contract with a healthy profit.

Outcome: $95 investment became $393.28 of profit!

  1. Up 342% in just under 30 days!!

On 5/17 I bought 1 June 55 “put” option contract against KB Home (KBH) for $2.80 per share or $280 for the entire contract. Again, KB along with the other home builders (as well as the market as a whole) took more beatings as investors got spooked by all the Bernanke nonsense. KB dropped from roughly $54 per share to roughly $45.50 per share on 6/16.

On the Friday of expiration, I sold the contract for $9.60 per share.

Outcome: $280 investment became $668.27 of profit!

  1. Current Active Positions:

Keep in mind; I could sell these contracts tomorrow for the percentage gains you see listed and turn my PaperMoney into real hard cash!.

Contrywide Financial (CFC) July 40 UP 54.95% + $138.30

KB Homes (KBH) July 55 UP 173.77% + $1307.55

KB Homes (KBH) October 55 UP 108.93% + $568.30

New Century Financial (NEW) Nov 45 DOWN 10.52% - $71.70

Toll Brothers (TOL) Sep 30 UP 50.03% + $140.00

NET GAIN: $2082.45


So as you can see, there may be some real benefit to being bearish on housing! The key here is, of course, is feeling confident about a steady, long term collapse of the residential housing market and finding basic opportunities where that decline might show itself best.

Some thoughts:

  1. Homebuilders are an obvious choice and although they are all roughly 30% down year to date, I think they could even fall further… maybe something commensurate with their meteoric run up from 2000 on.
  2. Mortgage lenders, brokers etc. may be a good choice as many may get hurt by both a dramatic decline in mortgage originations as well as mounting defaults. Long term, home loan banking may be a real ugly sector if a real protracted meltdown of housing actually occurs. The Federal Reserve has already been prodding lenders to tighten up their sloppy lending practices which may be a precursor to a more active role they would surely play if things get really bad. I bought Country Wide Financial (CFC) based on its high percentage of “sub-prime” (risky loans to borrowers with bad credit) loan originations.
  3. REITs that are heavily invested in residential housing may also be a good play. It seems most REITs are well diversified with a percentage holding both commercial real estate and residential housing but I think you can find some (that offer options contracts) that are skewed toward residential.
  4. Possibly companies involved in the supply of building materials since a drop off in new home building may put lots of pressure on them.
  5. Anything having to do with the American consumer as they will be the ones most affected by an extended housing downturn. I believe we may be entering a period of reverse wealth effect whereby the loss of our perceived home values coupled with widespread struggle to maintain lofty mortgages may greatly effect many Americans. I’m no expert, but it seems fairly likely that there’s going to be a bit of “belt tightening” up ahead.

I hope I have encouraged some discussion on the topic of “shorting” housing and I would be really exited to hear from others that are having luck as well, so please, share your thoughts and experiences.

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Friday, June 16, 2006

Tracking the Bubble!!!!

I have added a new feature to Paper Money that allows you to view the current inventory of properties listed for sale in any town in the United States.

You can select from Single Family, Multi Family, Condo, Land and All when performing your query.

The chart breaks down the resultant inventory into thirty six different price ranges and displays the both the average and median range as well historic high and low watermarks for both the property type and the overall market.

Ill add more historical features, such as comparisons and a market index as the system collects more historical data.

If you notice any bugs or have any ideas for improving the functionality please let me know.

Bubble Charting


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Wednesday, June 14, 2006

New Harvard Study supports Soft Landing?

It was widely reported yesterday that Harvard University’s Joint Center for Housing Studies a released their “State of the Nation Housing 2006” (as well as a Fact Sheet) and that it called for general cooling in the nations housing market and not a market crash as purported by many “doom and gloom” theorists.

The purpose of this report, funded in part by the National Association of Realtors, National Home Builders Association, Fannie Mae, and Freddie Mac, was clearly to legitimize both the current market prices as well as suggest that historic future demand (rationalized by projected demographic data of baby boomers, immigration, and rapid new household creation) would be not only sustain current prices but drive them up even further.

Additionally, there is a suggestion of a “soft landing” whereby the current slowdown will only server to cool the housing market long enough to allow incomes to “catch up” to current home prices.

But again, as has occurred on a number of occasions recently, this report highlights at least as much bearish evidence of current housing market instability as it does bullish future projections.

Key facts highlighted in the report:

  1. 20% of dollar value of all loans originated in 2005 were interest only loans.
  2. 37% of all 2005 ARM loans were interest only.
  3. 10% of all loan originations in 2005 were principle “payment option” loans.
  4. Between 2001 to 2004, the number of households paying more than half of their incomes for housing shot up by 1.9 million. This increase brought the total number of low- and middle-income households with severe cost burdens to 15.6 million.
  5. The amount of home equity cashed out in refinances set another record in 2005, up a whopping 66 percent to $243 billion in real terms. In the past three years alone, owners extracted $150 billion more in equity through refinancing than they had in the previous eight years.
  6. The volume of subprime loans has grown dramatically from just $210 billion in 2001 to $625 billion in 2005 in real terms

Interestingly, the report highlights a decade of seemingly stalled income growth as a factor in generating “Strong Demand Fundamentals” by stating “With each generation exceeding the income and wealth of its predecessor, growth in expenditures on home building and remodeling should match if not surpass the current pace. For example, the median inflation-adjusted income of households in their 40s was $1,800 higher in 2005 than in 1995, while that of households in their 50s was $1,900 higher”.

Of course, the report doesn’t forget to include a major loophole to their optimistic forecasts when stating that “if the economy falters, both job growth and housing prices will come under renewed pressure. This would spark higher default rates, especially among subprime borrowers, and turn housing from an engine of economic growth to a drag.”

The report also mentions that “The most immediate risks to the housing market now come from the rise in interest rates, the erosion of affordability after years of strong house price appreciation, and the growing inventory of both new and existing homes for sale.”

The report also adds that “...unless the broader economy stumbles and job losses mount, home sales and construction activity will likely dip only modestly.”

Given the current trend weakening of home sales and the especially striking about face in new construction activity as well as the recent effects of the current inflation worries, looming worldwide credit crunch and probable forthcoming consumer recession, this report seems either overly optimistic, outdated or just simply out of step with reality.

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Tuesday, June 13, 2006

Housing Overvaluation


Global Insight, a leading financial and economic information company, published a study today entitled “House Prices in America: Valuation Update” which provides an interesting analysis of the hyper over inflated housing market.

The approach taken by the researchers was to use a combination of economic factors such as house prices, interest rates, household incomes, population densities, and historical premiums or discounts metropolitan areas have exhibited over time to determine “statistically normal” house values, then to compare actual house values in order to derive the extent of under or over evaluation.

What seems particularly striking is that the report suggests that as recently as the first quarter of 2004, only 3 metro areas, accounting for only 1% of single family homes, would qualify as being overvalued using their method.

Of course, it’s important to keep in mind that there are many different ways to perform normalized home valuations (rental P/E ratios, analysis of historical events contributing to home appreciation, etc.) and that the researchers work has simply demonstrated that using several fundamental factors that traditionally effect home values, recent gross over valuation is very apparent.

Some key points:

  1. 71 metro areas, accounting for 39 percent of all single family housing value, were deemed to be extremely over-valued.
  2. The coastal states of California and Florida continue to show the highest concentration of overvalued markets, accounting for 17 of the top 20.
  3. Quarter-to-Quarter price appreciation is slowing in most metro areas, and is nearly flat in San Diego and Boston.

NOTE: The appendix of the report lists home valuations, using their method, from Q1 20002 to Q1 2006 for many local housing markets across the country. Look to see if you concur with the report for your area, then let me know if you agree with their evaluation.

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Sunday, June 11, 2006

1000 Words on the Boom


If there were ever a case where a picture said a thousand words it’s this chart produced by Yale University economist Robert J. Shiller. Shiller is probably best know for his accurate prediction of the 2000 stock market crash made in his famed book “Irrational Exuberance”. Now he has revised the book and produced a second edition that specifically addresses the current housing bubble.

This chart seems to say it all, real home prices, building costs, and long term interest rates all have remained relatively flat between 1890 and the mid 1990s while population grew at a regular pace. Then, inexplicably, there is a significant run-up in home prices.

What could explain this increase?

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Thursday, June 08, 2006

Sell Now!

A casual glance at the striking cover of “Sell Now!: The End of the Housing Bubble” by John R. Talbott gives the distinct impression that a reader will be treated a popular characterization of modern times with a decidedly “doom and gloom” outlook.

Although it’s true that the book does forecast some pretty gloomy times ahead, it’s hard to dispute the data Talbott presents.

After dispelling some common myths (baby boomer demographics, construction regulations, immigration, etc.) that otherwise might substantiate the hyper inflated run up in home prices virtually every major metro housing market has experienced in the last 10 years, Talbott goes on to present both the reasons for our current national housing bubble as well as predictions for where things may be going.

Particularly interesting was a section that covered the housing bubbles that have been occurring simultaneously all over the world (except Japan and Germany). This provided some compelling evidence that would suggest that any “local” explanation of the US housing bubble, that is, one that relies heavily on statistical evidence found only here in the US, is probably incorrect.

In Talbott’s view, (with some significant substantiation) the housing bubble was caused primarily by a relaxation of lending standards that had the effect of both creating many more home buyers as well as enabling each buyer to borrow significantly more money with significantly less (and even no) initial investment. Couple that with the basic foibles of human nature as it relates to the frenzy of market speculation, as well as the basic desire for many to both seek and flaunt exclusivity, and you’ve got the first class makings of a mass hysterical, hyper-inflated bubble.

The US Census data does seem to support Talbott’s case as the level of home ownership rose only 1.9% from 1960 to 1994 (that’s a 34 year span) but then abruptly jumped an additional 5% from 1994 to 2004. Additionally, total mortgage debt in the US has nearly doubled in just the last five years.

This book is particularly revealing to the reader who has only been a homeowner during the last ten years, as it dismisses some common misconceptions that have simply become all too commonplace in an environment where prices always seem to rise.

Most importantly, inflation adjusted home prices, that is, real home prices, have generally stayed flat from 1890 to the mid 1990s. Sure, there where ups and downs but over the long run, residential real estate is not that great of an investment if viewed only from a price standpoint. Long term, home owners should consider themselves lucky if they merely beat inflation.

So where does Talbott see things going in the next five years? Well, he presents some compelling evidence to suggest that the basic fundamentals that typically drive housing prices such as household income and inflation have remained relatively flat for the last 10 years. Given this, Talbott insists that one end of the market pricing has to be wrong. Either 1997 home prices were grossly undervalued or 2006 home prices are grossly overvalued, you can’t have it both ways, one end is wrong. Obviously, in Talbotts view, 2006 prices are wrong and will soon correct to account for that error.

If you want to know where things may go in your area, Talbott produces a chart that lists many (if not most) major US housing markets with his predictions of how far each market may drop over the next 5 years. Its disturbing to see just how many markets may be as much as 40% to 50% overvalued. Clearly if Talbott’s predictions are correct, we are in for some gloomy times indeed.

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Monday, June 05, 2006

FHA Back in Business?

In a his testimony given on April 5th 2006 before the United States House Committee on Financial Services, HUD’s Assistant Secretary for Housing, Brian D. Montgomery proposed changes to existing rules (as stated in the bill, House 4804 Senate 2123 titled "FHA Modernization Act of 2006") that would allow FHA lending to be more competitive in today’s market.

Montgomery stated that in the last few years, FHA has been falling behind for reasons ranging from “outdated business practices to cumbersome program requirements”.

Montgomery noted that:

  1. In Florida, FHA loan volume has dropped from 2354 in 2000 to 621 in 2005.
  2. In California, FHA loan volume has dropped from 2207 in 2000 to just 34 in 2005.
  3. In California, FHA insured 127,000 loans in 1999 but only 5000 in 2005.
  4. In 2005, 43% of first-time homebuyers purchased their homes with 0% down. Additionally, the majority of first time buyers that did put money down, the majority put 2% or less. Since FHA currently requires at least a 3% down payment, these buyers were not eligible for FHA loans.

The proposed changes to FHA rules would:

  1. Eliminate the 3% down payment minimum.
  2. Increase loan limits to 87 – 100% of GSE (Government Sponsored Enterprise) conforming loan limits in high cost areas, and 48 – 65% of GSE in low cost areas.
  3. Allows FHA to set loan limits based on “median home price” in each area.
  4. Allows FHA to set loan insurance premiums commensurate with the loan risk (down payment size… or lack thereof) and the applicant’s credit history.
  5. Eliminate existing provisions that complicate FHA loans for condominiums. This would allow Condos to be treated like single family homes.
  6. Extend the maximum mortgage term to 40 years.
  7. Eliminate any existing limit on the amount a lender can recoup from a defaulted loan.

Based on Montgomery’s testimony, support for the proposed Bill seems unclear.

On one hand, if the proposed changes were implemented, the number of sub-prime loans should be greatly decreased as applicants with either poor credit histories or low incomes would surely get a better deal through FHA than through one of the various “predatory” lenders. This would certainly provide a measure of stability to lower income areas that typically have high percentage of sub-prime loans and subsequently, higher degree of defaulted loans.

On the other hand, could it be that FHA is trying to become competitive with the current, irrational expectation of lending?

Zero down, interest only and 40 year loan terms are all inventions that are designed to artificially allow borrowers (especially low income borrowers) to afford houses priced at today’s outrageous levels. The proposed changes seem to ignore the possibility that the primary reason FHA has lost ground in the last five years is because housing has become seriously out of whack. Does our government really want to get in the business of underwriting thousands of loans that have zero to negative equity on day one of the loan?

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Friday, June 02, 2006

The Fed, For the Record

The text of two speeches, one given by the current Federal Reserve Chief Ben Bernanke in October 2002, the other given by Federal Reserve Governor Donald L. Kohn in March 2006, may shed some light on the potential actions the Federal Reserve may take with respect to perceived asset bubbles as they expand and collapse.

Interestingly, although these speeches generally refer to the abstract notion of asset bubbles or to a historical record including the most recent hi-tech stock market bubble, the text seems to be weighing (or debating) the options for the Fed to take with respect to a particularly widely felt asset price correction.

Without a doubt, this debate was specifically coordinated around the current housing bubble, shrouded in notion of the Feds role with respect to asset bubbles in general. Certainly these speeches were “generally” on the topic of the Feds potential response to asset bubbles but I can hardly imagine that this debate was prompted by recent run-ups in the prices of copper or gold or as a post mortem on the hi-tech stock market crash.

In his 2002 speech, Bernanke identifies two groups who believe that the Federal Reserve should take a more active role in controlling asset bubbles. These groups only differ in the extent to which they think the Fed should react in the face of a highly probable asset bubble.

The “Lean against the Bubble” group would prefer that the Fed raise rates an additional 50 to 100 basis points above the level that might satisfy the Feds obligations to regulating the growth of the economy. This group perceives this additional rate increase as insurance against the possible greater effects that an even higher asset price collapse would have on the economy. So, in theory, since rate hikes are a blunt tool, the whole economy may be overly slowed with the additional rate increase, but if the hikes were to take the edge off of the particular asset bubble, the cost may be worth it since the severity of the bubble collapse may be mitigated.

The “Prick the Bubble” group would take an even more activist point of view, asserting that the Fed should raise rates even higher in order to force a collapse of the asset bubble. This group seems to see the severity of a widely felt asset bubble and the possibility of severe financial crisis as grounds for commensurate action.

Bernanke seems to take exception with both of these groups thereby seemingly carving out a third group with a “non activist” point of view for which he is a member.

Bernanke says the following of the “lean against the bubble” group:

“My sense is that this more moderate camp comprises the great majority of serious researchers who have advocated a monetary-policy response to bubbles. And, in my opinion, the theoretical arguments that have been made for the lean-against-the-bubble strategy are not entirely without merit.”

Of the “prick the bubble group”, Bernanke states the following:

“To be frank, this recommendation concerns me greatly, and I hope to persuade you that it is antithetical to time-tested principles and sound practices of central banking.”

Additionally, both Bernanke and Kohn question both, the ability for the Federal Reserve accurately perceive asset bubbles or price assets more accurately than the market, and “moral hazard” that may be posed by a Fed that chooses to price assets.

Bernanke says the following:

“First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.”

“Thus, to declare that a bubble exists, the Fed must not only be able to accurately estimate the unobservable fundamentals underlying equity valuations, it must have confidence that it can do so better than the financial professionals whose collective information is reflected in asset-market prices”

Bernanke goes on to suggest that monetary policy is too blunt a tool to effectively target individual assets classes, and would only achieve the desired results after having causing significant damage to the overall economy.

“In short, we cannot practice "safe popping," at least not with the blunt tool of monetary policy. The situation is further complicated if, as is usually the case, the suspected bubble affects only a specific class of assets, such as high-tech stocks. Certainly there is no way to direct the effects of monetary policy at a single class of assets while leaving other financial markets and the broader economy untouched. One might as well try to perform brain surgery with a sledgehammer.”

“Monetary policy is not a useful tool for achieving this objective, however. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.”

Arguably the most important disclosure in this speech is that Bernanke seems to take the position that the appropriate action is to first, use the Feds supervisory powers and public awareness to help prevent the bubble for forming. If an asset bubble does form though, Bernanke does not see the Feds role as either actively causing the asset bubble to collapse or to bail out the its participants but rather to help quickly “mop up” the damage afterwards by using the Feds regulatory and “lender of last resort” powers to ensure the stability of the financial system.

Bernanke states:

“A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed.”

Key to this point is that the individual investor should not expect individual attention or insurance from the Federal Reserve. Bernanke sees the role of the Federal Reserve as being focused on the health of the financial system as a whole and not on its individual participants.

To this effect Burnanke states:

“Because risk-taking is essential for economic dynamism, we do not want an economy in which investors and businesspeople are not free to take bets that might turn out badly.”

More recently, Federal Reserve Federal Reserve Governor Donald L. Kohn gave a speech in which he supported many of the arguments found in Bernankes speech including the Feds inability to accurately price assets and thus perceive asset bubbles, as well as the dangers implicit in the Fed attempting to set asset prices in order to eliminate speculative bubbles and how, ultimately, a timely response to an asset bubble collapse may well be the best way to prevent a Japan-style financial crisis.

The key disclosure in the Kohn speech is that he specifically refers to the current housing market and more importantly, to what the housing markets individual participants may expect from the Fed if a collapse were to occur.

Kohn states:

“Conventional policy as practiced by the Federal Reserve has not insulated investors from downside risk. Whatever might have once been thought about the existence of a "Greenspan put," stock market investors could not have endured the experience of the last five years in the United States and concluded that they were hedged on the downside by asymmetric monetary policy.”

“The same considerations [as was given to dot-com stock holders] apply to homeowners: All else being equal, interest rates are higher now than they would be were real estate valuations less lofty; and if real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions. Our actions will continue to be keyed to macroeconomic stability, not the stability of asset prices themselves.”

Given the text of these speeches, it seems that any expectation or even enthusiasm about a Federal Reserve that is actively guiding the real estate market in for a “soft landing” should be greatly revised. In fact, it may be that a “soft landing” could prove to do worse damage to real estate over time as an “orderly” cool down may lessen the spillover into other areas of the economy, thus preventing the Fed from taking action.

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