Here is a well researched article on the current state of the housing market. It was sent by John Mauldin, but the research is from Gary Shilling. I follow Gary’s work religiously as he called the housing bubble well before it imploded. If you are a realtor, you may not want to read this as he not only does not see a turnaround anytime soon but he also points out housing is not the investment people think it is. Good stuff and food for thought…talk amongst yourselves.

Everyone is curious about the state of housing in the US. My friend Gary Shilling recently did a lengthy issue on housing as it is today. I asked him to give us a shorter version for Outside the Box, and he graciously did. And you want to know what Gary thinks, because he is one of the guys who really got it right early, from subprime to the bubble and the price collapse, and has been right all along. No one is better. This very readable edition is full of charts and fast reasoning.

The quid pro quo for getting him to give us something that is normally behind a velvet rope is that I put a link in to let you subscribe to his wonderful monthly letter. He really is one of the better analysts out there. He has spoken at my conference the last two years and is one of our highest-rated speakers.

You can subscribe and mention the OTB and get 13 issues for the price of 12, plus Gary’s January 2011 report laying out his investment strategies for the year. $275 is the price via e-mail. Call them at 1-888-346-7444 or e-mail insight@agaryshilling.com .

And for those in the Dallas area, it is now my intention to meet some friends at the Zaza after the Tuesday night Mavericks-Thunder game, so drop on by.

Your living the internet-driven life analyst,

John Mauldin, Editor
Outside the Box

Still Home Sick

(Excerpted from the May 2011 edition of A. Gary Shilling’s INSIGHT)

All may be well. That’s what many housing optimists proclaimed a year ago when prices appeared to have stabilized, indeed, started to recover from their collapse (Chart 1). As Insight readers are well aware, we emphatically disagreed. We pointed out that the earlier extremes in the housing market made rapid revival—or any revival for that matter—extremely difficult. In the earlier salad days, housing was propelled by low mortgage rates, lax or nonexistent underwriting standards, securitization of mortgages that passed seemingly creditworthy and highly-rated but really toxic assets on the unsuspecting buyers, laissez-faire regulation, and most of all, almost universal conviction that house prices never fall on a nationwide basis—which they hadn’t since the 1930s.

But housing activity remains at post- World War II lows (Chart 2).

The Administration’s Home Affordable Modification Program (HAMP) was a bust. Tightening lending standards, the renewed decline in house prices, fears of job loss as unemployment remains high and the drying up of mortgage securitization have handily offset the positive effects of low mortgage rates and new homeowner tax credits. Indeed, the jumps in home sales in anticipation of the tax credit expiration first in November 2009 and then in April 2010 were promptly retraced and followed by still-weaker sales (Chart 3).

Mortal Enemy

Most of all, in making the case for continuing housing weakness, we’ve continually hammered home the ongoing negative effect of excess inventories on house sales, prices, new construction and just about every other aspect of residential real estate. In housing, as in every goods-producing sector, excess inventories are the mortal enemy of prices. It’s that simple. Lower prices are needed to unload surplus inventory, but in turn lower prices bring forth more inventory from anxious sellers. And the anxiousness of house sellers and reluctance of buyers is enhanced by the realization that house prices can fall, and are falling for the first time in 70 years.

Just how big are excess house inventories and how long will it take to absorb them? As discussed in many past Insights, we measure excess house inventories by the excess over the earlier trendless norm of about 2.5 million (Chart 4). We consider 2.5 million to be the normal working level for total existing units and new single-family houses (new multi-family inventories are not reported). Notice that this flat pattern, except for the recent extreme volatility, matches the equal trendless patterns of housing starts and completions over time. Note also that total inventories jumped to 5 million as housing collapsed, and still equals 4 million, or 1.5 million over and above the norm.

Hidden House Inventory

But wait! There’s more! The Census Bureau, in its estimate of housing inventory, lists a category called “Held off the market for other reasons”— very descriptive! This category leaped by over 1 million between the first quarter of 2006 and the first quarter of this year. It includes unspecified numbers of houses that have been foreclosed but not yet sold and units that people want to sell—first or second homes—but have not listed due to current market conditions. Of course, if those in foreclosed houses and those who want to sell finally do so and move into other abodes, they’re still occupying housing units and total inventories don’t change. But if they’re unloading extra and vacant houses or doubling up with family and friends, additional excess inventories are created. Many are now beginning to give up hope of higher prices as they continue to fall and throwing their houses on the market for whatever they will bring.

How Long?

Our total estimate of 2 million to 2.5 million excess house inventories, then, may well rise with further foreclosures that will be spurred by falling prices. This surplus is already huge since in the long run the U.S. builds about 1.5 million houses per year (Chart 2). To forecast the length of time to work off this excess inventory, we need to project supply and demand for residential units. New conventional construction of single-family house and apartment units plus manufactured home shipments is running about 700 thousand at annual rates. There’s no reason to expect this rate to change in the next few years, given falling prices excess inventories and other constraining factors. About 300,000 of these units are offset each year by dilapidated houses that are torn down, houses converted to nonresidential purposes and other factors that remove them from the housing stock. So the net supply will probably continue to average about 400,000 annually.

On the demand side, house sales data, especially existing house sales reported by the National Association of Realtors, appear to be overstated. Well, what did you expect? Did you ever meet a residential realtor who isn’t wildly optimistic about house sales and prices? The NAR uses models to expand its actual survey to national total sales numbers. With the collapse in housing activity, many of the multi-listing services that trade group samples have consolidation so the sales of those remaining expanded because their area of coverage has grown. Since the NAR doesn’t correct for this, the sales numbers are likely overstated. Also, the NAR doesn’t sample but estimates the share of sales by owners that don’t go through multi-listing services. That segment of the market collapsed with the housing bust but the NAR has not subsequently adjusted its estimates downward.

In contrast, CoreLogic measures sales by checking property transfer records at local court houses and reports that its data covers about 85% of all house sales. Its numbers are consistently lower than the NAR numbers (Chart 5). In 2010, NAR reported 4.9 million in sales, down 5.7% from 5.2 million in 2009. But CoreLogic recorded only 3.3 million in 2010, a drop of 10.8% from 3.7 million in 2009. So the NAR data may overstate home sales by a third.

If so, and if house inventory data reported by the NAR are correct, it will take much longer to unload excess inventories at current sales rates. In March, NAR reported inventories of existing houses would take 8.4 months to sell at the trade group’s reported sales rate. That’s down from 12.5 months in July of last year but still almost about twice the level of healthy markets. And if NAR sales data are overstated by a third, the month’s supply is still back in double digits.

Household Formation

Because of the NAR’s likely overstatement of sales and for other reasons, we prefer to rely on household formation data gathered by the Census Bureau to forecast housing demand. Now, there’s a lot of misunderstanding about household formation numbers. Many assume that there is a one-to-one relationship between the growth in the population and the number of new households formed. With population growing around 1% per year, or by about 3 million, then with an average 2.77 people per household, 1.08 million new households will be formed, the reasoning goes. But the link between demographics and household formation is at best a very tenuous one, especially in a cyclical time frame.

In the 2001-2010 decade, household formation averaged 888.5 thousand per year. Since those years included boom and bust years, this average, about 900 thousand per year, seems like a reasonable, probably optimistic forecast for the years ahead, given the likely further fall in house prices, high unemployment and declining real incomes in the years ahead. So if demand is averaging 900 thousand per year while supply runs 400 thousand, about 500 thousand of the excess housing inventory will be absorbed per annum. Consequently, it will take four or five years to absorb the 2 million to 2.5 million housing units, over and above normal working inventory, that we believe exist at a minimum.

Prices Down Another 20%

Four or five years is plenty of time for the inventory overhang to depress prices another 20% as we’ve been forecasting. Prices, after reviving somewhat with the new homeowner tax credit, are now essentially back to their April 2009 lows (Chart 1). Another 20% drop would bring the total decline from the peak in April 2006 to 45% and take them back to their longrun flat trend (Chart 6). In that graph, median single-family house prices are corrected for two types of inflation. The first is general inflation affecting all goods and services. The second is the tendency over time of houses to get bigger and, therefore, intrinsically more expensive. As living standards rise, people want more bathroom, fancier kitchens, etc. in their homes. A further 20% price drop may be an optimistic forecast since declines tend to overshoot on the downside just as bubbles expand to the stratosphere.

Other forecasters are coming into agreement with our forecast, dire as it is. The Dallas Federal Reserve Bank states that a 23% decline is needed to return house prices to their long-run trend. Prof. Robert Shiller of Yale says there is a “substantial risk” of another 15% or 20% decline in house prices. The NAR’s March survey of members revealed that 42% of everoptimistic realtors expect home prices in their areas to fall in the next 12 months. Starting last year, Shiller’s firm, Macro Markets LLC, asked us and 110 other housing experts to forecast house prices over the next five years. Since that survey commenced, we have consistently forecast a 20% cumulative decline for 2011-2013, with an 11% drop this year. Last June, the average forecast was a 1.3% price rise this year, but the last survey in early March reported a 1.4% drop.

There are other reasons to expect house prices to fall sharply in coming quarters. Now that the moratoria while mortgage modifications were attempted and during the robo-signing flap are over, foreclosures are likely to resume in earnest. And, as noted earlier, lenders and servicers tend to dump foreclosed houses on the market for quick sales, regardless of prices. These fire-sale prices put more homeowners under water and lead to more foreclosures, but they do attract investors looking for cheap houses who often pay all cash.

Cash-Ins

Many underwater homeowners, of course, still are committed to service their financial obligations, or want to stay in their abodes. Some are even doing cash-in refinancing, the reverse of the cash-outs of yesteryear, and contributing money from other sources to reduce their mortgage balances. A total of $1.1 trillion was withdrawn in 2006 and 2007, and at the peak of the housing bubble in 2006, cash-outs ran $80 billion per quarter and accounted for 90% of refinancings. By the fourth quarter of 2010, however, cash-outs dropped to 16% of refinancings and cash-ins jumped to 33%.

Homeowner deleveraging through cash-ins reduces the vulnerability to further house price declines, but they also reduce the funds available for other investments and current spending. So, too, do the higher downpayments lenders are requiring on house purchases, which also freeze out many potential buyers and otherwise discourage home ownership. Regulators are proposing 20% downpayments for high-quality new mortgages underwritten by private lenders, and Wells Fargo, the country’s largest mortgage lender, has suggested 30%.

For these loans, borrowers will also need to maintain 75% loans-to-market value ratios, 75% for refinancings and 70% for cash-out refinancings. Borrowers can’t have missed two consecutive payments on any consumer debt within two years. Mortgage-related debt payments can be no more than 28% of income and total debt service can’t exceed 36% of income. And mortgage loans must be fully amortizing—no interest-only borrowing. According to CoreLogic, 46% of all mortgagors at the end of 2010 had less than 20% equity in their homes.

Mortgages that don’t meet these standards will be subject to 5% retention by the original lender if they are sold to others or securitized. In other words, regulators intend to end the days when subprime mortgages were packaged as securities by the original lender and sold with no further recourse. Buy them, securitize them, sell off the securitized tranches and forget them was the strategy.

In fact, median downpayments on conventional mortgages already were 22% last year in nine major U.S. cities, according to an analysis by Zillow.com, up from 4% in the fourth quarter of 2006. Those cities are Chicago, Stockton, Calif., Las Vegas, Los Angeles, Miami-Fort Lauderdale, Phoenix, San Diego, San Francisco and Tampa. To be sure, private lenders are now making very few mortgages, with most initiated by Government-Sponsored Enterprises (Chart 7). The Federal Housing Administration, which required only 3.5% up front, accounted for 23.4% of residential mortgages last year. In contrast, in 1950, the median downpayment for FHA first mortgages was 35%, for Veterans Administration first mortgages, 8%, and 35% for non-government conventional first mortgages. Underwriting standards have tightened, but are still loose by those earlier standards.

The elimination of home equity for most mortgages will no doubt have severe detrimental effects on consumer sentiment and spending. It also will magnify the mortgage delinquencies and defaults, and severely depress the value of existing mortgages and derivatives backed by them In recent quarters, banks have booked profits as they reduced their reserves against potential loan losses, but that process will be dramatically reversed. And it goes without saying that mortgage lenders and servicers will severely tighten their mortgage underwriting standards with a further 20% drop in house prices. The top 10 mortgage servicers account for the majority of the market and include the nation’s largest banks.

Needless to say, another big decline in house prices almost guarantees another recession because of its financial impact. At the same time, further declines in residential construction won’t matter much to the overall economy. It was 6.3% of GDP at its peak in the fourth quarter of 2005, but plummeted to a mere 2.2% in the first quarter of this year.

No Help to the Economy

Conversely, we don’t look for any revival of homebuilding in the years ahead that will boost the economy. The housing collapse prevented residential construction from serving its usual role in spurring economic recovery from the recession. Rather than contribute meaningfully, residential construction actually declined in the first seven quarters of recovery. The ongoing housing crisis will probably continue to trouble financial markets, depress consumer spending and keep residential construction depressed for years.

Keep ‘Em Out – Or In?

From a regulator standpoint, tighter controls will continue to discourage homeownership. The Dodd-Frank financial overhaul law requires banks to retain 5% of the credit risks on lower-quality residential mortgages that are securitized and sold to others. These new rules will obviously discourage mortgage loans to all but the most creditworthy borrowers. Also, since Fannie Mae and Freddie Mac are backed by the U.S. government, they are exempt from the retention rules, which therefore will drive mortgage loans to these Government-Sponsored Enterprises. Still, their fates are uncertain.

Government attitudes toward homeownership also appear to have shifted with the housing collapse. On Oct. 15, 2002, when the housing boom was inflating, President George W. Bush said at the White House Conference on Increasing Minority Homeownership, “We want everybody in America to own their own home. That’s what we want…An ownership society is a compassionate society.”

In contrast, in February 2011, the white paper released by the Treasury Department and Department of Housing and Urban Development, which addressed the future of Fannie and Freddie, also stated that homeownership isn’t for every American. “The Administration believes that we must continue to take the necessary steps to ensure that Americans have access to an adequate range of affordable housing options. This does not mean, however, that our goal is for all Americans to become homeowners. Instead, we should make sure that all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step. At the same time, we should ensure that there are a range of affordable options for the 100 million Americans who rent, whether they do so by choice or necessity.”

“Become Renters Again”

The statement echoes the muchmaligned comments by then-Treasury Secretary Henry Paulson of the Bush Administration in the midst of the housing collapse. He said in a December 2007 online Q&A session: “And let me be clear—we will not avoid all foreclosures. Borrowers who are struggling even with the lower initial ARM rate are unlikely to be eligible for assistance, and likely will become renters again.”

Furthermore, Congressional Republicans are proposing the end of tax deductibility of mortgage interest, which would further reduce the appeal of owning abodes. This is the largest of the “tax expenditures” and will cost the federal government $600 billion from 2009 to 2013, according to the Congressional Joint Committee on Taxation. Whether this tax break aids homeowners is questionable, however. In the European Union, where mortgage interest is not tax deductible, the homeownership rate is 75% compared with the earlier U.S. peak of 69%. Furthermore, lack of mortgage interest deductibility may encourage homeowners to pay off their loans faster, and avoid that false assumption that owning an abode is cheaper than renting.

At the same time, homeownership continues to be very political powerful, and many recent government actions can certainly be viewed as an unstated attempt to keep people in their homes, even those who clearly can’t afford to own them. The reality that many foreclosures have tossed homeowners out is powerful not only to those affected directly, but also to many others in and out of Washington. Our friend and superb housing analyst Tom Lawler has taken a hard look at the numbers and worked his way through the many assumptions needed to determine the number of homeowners who lost their homes to foreclosure last year. He concludes it was about 1 million. Tom goes on to point out that many others have really lost their homes but not technically since foreclosures are not yet completed. These “owners” may still be living in those houses— rent-free, by the way!

There’s also sympathy for the many who, despite concerted efforts, have been unable to reduce their mortgage and other debts such as auto, student and credit card loans. Their total debt in relation to disposable personal income (after-tax income) peaked in the third quarter of 2007 at 131%. Debt itself peaked three quarters later in the second quarter of 2008. From then through the fourth quarter of 2010, mortgage debt dropped $517.9 billion and consumer (other) debt has fallen $174.6 billion for a total decline of $691.5 billion.

No Debt Repayment

But in those same 10 quarters, $542.2 billion in mortgage debt was charged off and $333.8 billion in consumer debt for an $875.9 billion total. As shown in the last three columns, after accounting for charge-offs, mortgage debt actually rose a bit, $24.2 billion to $10 trillion, consumer debt climbed $159.2 billion to $2.4 trillion and the total rose $183.4 billion to $12.4 trillion. The rise in mortgage debt ex charge-offs is so small that it’s merely a rounding error, but it’s surprising that it didn’t fall significantly. Perhaps financially stressed homeowners who didn’t lose their homes to foreclosure have not been able to reduce their mortgage debt.

To encourage home-buying, Washington enacted tax credits for new homeowners, which initially expired in November 2009 and then was renewed until April 2010. HAMP’s goal is to stave off foreclosures for underwater homeowners by making their mortgage payments more affordable. The government essentially told major mortgage lenders and servicers to forestall foreclosures while HAMP modifications were being attempted. More recently, 14 large financial institutions have been ordered by regulators to revise their mortgage servicing practices to encourage more successful modifications and speed up foreclosures. Those 14 have until mid-June to establish their plans and then 60 days to implement them.

Among other things, the mortgage servicers will be required to have a single point of contact for borrowers to avoid their being bounced from one servicer employee to another and getting lost in the shuffle. They also must set “appropriate deadlines” for deciding whether borrowers can qualify for a loan workout, and have enough staff to deal with the multitude of troubled mortgages. The goal is to get servicers to contact borrowers earlier and more frequently after one missed payment in order to have a better chance of modifying troubled loans.

Fannie and Freddie

The U.S. Treasury-HUD white paper cited earlier indicates that the Administration, like many other Democrats as well as Republicans, wants a significantly smaller role for government in housing finance, including a “winding down” of Fannie and Freddie and a smaller role for the FHA. House Republicans want Fannie and Freddie eliminated and only the FHA left as a source of federal backing. Currently, federal agencies including Fannie and Freddie guarantee 87% of new mortgages.

As discussed in our new book, The Age of Deleveraging, back in mid-2008, many FDIC-insured institutions were heavily leveraged but still had an average capital-to-asset ratio of 7.9%. In contrast, Freddie and Fannie had less than 2%, so for each buck of capital, they owned or guaranteed $50 in mortgages. Lobbyists from the two convinced Congress that they didn’t need more capital since defaults would be tiny as house prices rose forever. But when the housing sector nosedived, Fannie and Freddie’s houses of cards fell apart. So in September 2008, both were seized by the government in a legal structure called conservatorship. They are regulated, indeed controlled, by the Federal Housing Finance Agency. Initially, each had up to $200 billion backing from the Treasury, but it later was made open-ended through 2012.

Washington regarded Freddie and Fannie as part of the government. Assistant Treasury Secretary Michael Barr said that because they are “owned by the taxpayers in the biggest housing crisis in 80 years, it is logical that they be used to stabilize the housing market.” But since the two technically remain private corporations, their finances remain off the federal budget and their huge prospective losses from sour mortgages don’t need to be counted in the federal deficit. It’s ironic that the government is using Fannie and Freddie as the biggest off-balance-sheet financing vehicles in the economy at the same time it blasted banks for using off-balance-sheet entities in earlier years.

Also, by using these GSEs to support housing, with an open credit line to the Treasury, the Administration doesn’t have to approach Congress for funding bit by bit. The Treasury simply injects enough money, quarter by quarter, to cover their losses. As of Feb. 25, 2011, that was $153 billion for the pair, and the Congressional Budget Office estimates the losses through 2020 at almost $400 billion. Treasury Secretary Timothy Geithner in March 2010 said, “There is a quite strong economic case, quite strong public policy case for preserving, designing some form of guarantee by the government to help facilitate a stable housing finance market,” even after Fannie and Freddie are restructured or unwound.

More Private Capital

Nevertheless, the February 2011 white paper advocated a number of short-term measures to attract private capital into the mortgage market—with higher costs for house financing and its detrimental effects on home ownership. These include allowing the maximum loan limits to fall to $625,000 from $729,750 as scheduled on October 1, increasing downpayments on Fannie and Freddie guaranteed loans to 10%, and increasing FHA insurance premiums, which subsequently was announced to rise by 0.25 percentage points on 30- and 15-year loans to 1.15% on low downpayment loans.

The Administration believes that given the fragile state of the housing sector, it will take at least five to seven years to move to a longer term structure of housing finance. It offered in the white paper—but did not discuss in detail—three options, which no doubt will be hotly debated going into the 2012 elections.

The first is a privatized system with Fannie and Freddie eliminated. Their $1.5 trillion combined mortgage portfolio, out of the $10 trillion mortgage market, is already set to fall 10% per year. Government financial support would be confined to FHA and VA loans, which accounted for 23% of mortgages last year, targeted to help narrow borrower groups. Private lenders would originate and securitize mortgages without government guarantees. Interestingly, small banks oppose this option because they believe it would concentrate the business in the hands of large lenders, much to their detriment.

The second option would create a mostly private mortgage market as well as FHA/VA involvement, with a government “backstop mechanism to insure access to credit during a housing crisis.” Option three involves a privatized market as well as FHA-VA participation. New, privately-owned companies would buy mortgages from lenders and securitize them. Those securities would be guaranteed by the government as long as they met standards. These new private entities would essentially replace Fannie and Freddie.

Regardless of how government legislation and regulation unfold, the nation’s zeal for homeownership may be weakening outside as well as inside Washington. Homeowners have learned the hard way that for the first time since 1930s, house prices nationwide can and do fall. Zeal for a sound home financing system involves measures that discourage homeownership. And the likely leap in the percentage of renters and falling portion who own their abodes will reduce the power of homeownership advocates.

More Renters

Homeownership is falling, as the earlier boom and quick route to riches in a loose-lending environment has been replaced with collapsing prices, tight underwriting requirements, more regulation and horror stories of huge homeowner equity losses. As homeownership slides, the flip side, the renter population grows. Of course, many former and current homeowners are really renters with an option on their house’s price appreciation. They put little if anything down and planned to refinance with cash-out before their mortgage rates reset upward or, in some cases, even before they skipped enough monthly payments to be foreclosed.

Homeownership bulls, naturally, argue that owning a house has never been cheaper. In calculating this index, the NAR assumes that a family with median income buys a median-priced single-family house with 20% down and financed at the current 30-year fixed mortgage rate. The collapse in house prices and decline in mortgage rates in recent years have more than offset the weakness in median family income that, according to the NAR, dropped from $63,366 in 2008 to $61,313 in 2010.

Nevertheless, comparisons between the current attractiveness of buying a home and that in the 1990s and early 2000s is like comparing an octopus to an ant. Back then, incomes were growing; now they’re weak. Unemployment rates were lower; now they’re high. House prices were rising as they had been since the 1930s; now they’re falling and even the stabilization last year has given way to renewed declines. Financing a mortgage was easy with little or nothing down and spotty credit; now it takes 20% or more in downpayments and sterling credit scores. Back then, the prospects of huge house price declines and massive foreclosures weren’t even the subject of horror films; now they’re the real, everyday reality.

Rents Still Cheaper

Despite the collapse in house prices, they are still expensive relative to rentals, even as apartment rental rates rise and vacancies decline. Those rent rises are having an interesting effect on the CPI. In the total index, 32% is weighted for shelter including 5.9% for the rental of primary residences. But an additional 24.9% is “owners’ equivalent rent of residences.” The idea is that homeowners rent their abodes from themselves at market rental rates. Of course they don’t, but this creates an odd situation where house prices are falling, but owners’equivalent rent is rising.

This, in effect, overstates the recent rise in the CPI. Chart 8 shows the year-over-year change in the core CPI, which excludes the volatile food and energy components, and the core excluding the shelter component, which is dominated by owners’ equivalent rent. That component is 32.3% of the core index and total shelter is 41.5%.

Notice that without shelter, the year-over-year core index rose 0.8%, or 0.4 percentage points less than the 1.2% rise in the total core. Back in 2007 and early 2008 before housing collapsed, owners’ equivalent rent was rising considerably faster than other prices in the core index, as shown by the gap in Chart 8 and in Chart 9. The fall in rent rates in 2008-2009 pushed the year-over-year change in shelter costs into negative territory.

The price index for personal consumption expenditures, which we and the Fed prefer to the CPI, also uses homeowners’ equivalent rent, but only weights it at 15% of the total index and 17.5% of the core. Partly as a result of this lower weighting, the core index in March rose 0.9% from a year earlier compared to 1.2% for the core CPI.

Homeownership Downtrend

The fall in the homeownership rate has been swift, but probably understated. The overall rate in the first quarter, 66.4%, was down from the 69.2% peak in the fourth quarter of 2009 and was the same as in the fourth quarter of 1998. But Tom Lawler wrote on April 27 that “if the Q1/2011 homeownership rate by age group were‘correct,’ but the age distribution of households had been the same last quarter as it was in 1998, then the homeownership rate last quarter would have been 65.1%, or 1.4 percentage points lower than in 1998!”

In any event, continuing the rate of fall since its peak will bring the total homeownership rate back to its earlier base level of 64% in the fourth quarter of 2016 from 66.4% in the first quarter of this year. That’s a return to trend. And we are strong believers in reversion to trend. Continuing the average annual growth in households over the last decade of 888.5 thousand increases the total number of households by 5.1 million from the first quarter to the fourth quarter of 2016. This is enough to increase the number of new homeowners by 608 thousand even with the drop in the homeownership rate to 64%.

But it also means the addition of 4.5 million new renters, or 782.7 thousand at annual rates. That’s a lot, but we’re not alone in this forecast. Greenstreet Advisors believes that a drop to 65% homeownership in the next five years will produce 4.5 million new rental households. Some of those people will no doubt rent cheap single-family houses, but most will probably be in rental apartments. In the longer run, only about 300 thousand multi-family units have been produced per year, or less than half our projected increase in renters. Apartment construction may again boom after the absorption of current vacancies pushes rental rates up enough to justify new building.

Our Theme

As we hope you’re well aware, we’ve been advocates of rental apartments as an investment theme for some time. It’s one of our long-term “buy” themes in The Age of Deleveraging. We also listed it as an investment strategy for 2011 in our Jan. 2011 Insight. In addition to all the reasons covered in his report, we noted in our January issue that rental apartments will benefit from the separation that Americans are beginning to make between their abodes and their investments. The two used to be combined in owner-occupied houses back when owners believed house prices never fall. So they bought the biggest homes they could finance. The collapse in house prices has shown them otherwise. Further weakness in the prices of singlefamily houses and condos due to the depressing effects of excess inventories (Chart 4) will add fat to the fire.

Contrary to general belief, a single-family house, excluding the effects of increasing size and general inflation, has been a flat investment for over a century (Chart 6). It does provide a place to live, but that value is offset, at least in part, by maintenance, taxes, utilities, real estate commissions and other costs. Furthermore, even with the tax deductibility of mortgage interest, renting a single-family house or apartment is cheaper than home ownership, absent price appreciation. Our repeated analyses over the years have shown this to be true, and even more so in the period of deflation we foresee when nominal house prices will probably fall on average.

Over time, houses have sold for about 15 times rental income. But that’s in the post–World War II years when owners of rental properties expected inflation to enhance their 6.7% return—before the costs of income tax–deductible maintenance and property taxes. When we were young and house price appreciation was not expected in the aftermath of the 1930s, the norm for rentals was 10% of the house’s value. If we’re right about our outlook for slow economic growth and falling house prices, houses and apartments may sell for closer to 10 times rentals than 15 times, much less the 20 times rental income in the housing boom days.

The separation of abodes from investments should work to the advantage of rentals in future years. We’re not suggesting that Americans will give up on single-family owneroccupied housing. The idea of a singlefamily home of your own is just too deeply embedded in the American culture. But many who have no pride of home ownership and who would vastly prefer to yell for the “super” (New York-ese for the building superintendent) than to apply a wrench to a leaky pipe have bought houses and apartments in past decades only to participate in capital appreciation.

The Old And The Young

They’ll be more inclined in future years to occupy rental apartments. This might be especially true of empty-nesters who don’t like to mow their lawns and who decide to unload their suburban money pits—especially because these homes are no longer appreciating rapidly but rather falling in price. At the front end of the life cycle, young couples may decide that because houses are no longer a great investment, there’s no reason to strain their financial, physical, and emotional resources to buy big, expensive houses as soon as possible. So they’ll stay in rental apartments a bit longer and wait until their kids are of the age that a single-family house makes sense.

Reinforcing our earlier analysis of the future demand for rentals is the surprisingly small shift in housing patterns it will take to make a big difference in the demand for and construction of rental apartments. Today, there are 131 million housing units in the U.S., including vacancies, of which 42 million are rentals. If only 1% of the total 112 million households decided to move to rentals, the demand for apartments would increase by over one million, most of which would need to be newly built after current vacancies are absorbed. This is a big number compared to new apartment starts of about 300,000 on average in the past. Rental apartments will also appeal to the growing number of postwar babies as they retire, downsize, and want less responsibility and more leisure time.

Like other REITs, apartment REITs rose rapidly last year (Chart 10) and may have over-anticipated the performance of the underlying investments in coming quarters. Direct ownership and other forms of investment in rental apartments may be more rewarding in the near future.

Rental apartments are not without their problems for investors. Prices haven’t risen dramatically lately compared to office and industrial buildings, but capitalization rates are relatively low, indicating that prices are high. Also, multi-family mortgage delinquencies and foreclosures are a problem, especially for Fannie, which with Freddie bought apartment loans in 2007 and 2008 as private lenders withdrew. Their share of multi-family loan purchases jumped to 85% in 2009 from 29% two years earlier. They own or guarantee 40% of the $325 billion multi-family mortgage market. Nevertheless, rental apartments are likely to be an attractive investment area for years as the joys and profitability of homeownership continue to fade.

John F. Mauldin
johnmauldin@investorsinsight.com

Great four part story on loan modifications from MSNBC (hat tip Barry Ritholz). I could go on about the inept government HAMP program or the greed of bankers, but this story does the job nicely.

Visit msnbc.com for breaking news, world news, and news about the economy

Interesting video clip from Down Under. I think Australia is heading for a housing bust. Maybe it won’t be quite as bad as the US since Australia’s total Debt to GDP ratio is substantially below our; however, their mortgage debt to GDP is higher than ours was when we peaked. It is interesting to see the mortgage brokers and realtors use the same arguments that our real estate professionals did as the wheels came off. One final note, I am a huge fan of Steve Keen, the Aussie economist.

With the Case-Shiller index showing four months of declining home values and 2.2 million homes now 90 days late (or greater), housing is clearly having issues. The problems are only exacerbated with rising mortgage rates even if the rates are still low historically.

Yet, in his annual ritual, economist Mark Zandi is calling for a bottom in housing in 2011. Of course, he has been doing this since 2007 so he is bound to be right one of these times. Barry Ritholtz does a great job of cataloging Zandi’s predictions. (also see here for another take on Zandi).

Here is Zandi’s comments on housing for 2011:

Despite all these problems, Zandi thinks housing is finally approaching a turning point. He expects the market to bottom out in 2011.

“It’s been a five-year road south, and it’s been a complete cratering of the market,” he says. “But I think 2011 marks the end of that crash.”

Zandi says there are some more housing price declines ahead, as all these foreclosures continue to glut the market with millions of homes at fire-sale prices.

But by next summer, he expects prices to start stabilizing, with some price growth in 2012.

He should just copy and paste these for 2012 as well. As I said, he will eventually be right. I just think housing has a ways to go. I have profiled the number of Alt-A and Prime resets which hit heavy in 2011 and 2012.

These resets haven’t been as painful to date due to the extremely low mortgage rates (adjustments haven’t increased payments as much), but if rates remain steady or rise, it will get worse. Rising rates will impact housing beyond resets. For every 1% increase in mortgage rates, affordability drops 10%.

Hopefully, Zandi will be correct this time around, but I wouldn’t count on it.

This past weekend, I did extensive reading on the mortgage situation. Before digging into it, I assumed the situation could be narrowed down to sloppy administrative procedures by the banks. Foreclosure specialists approving 10,000 requests a month led me to believe it was just an overwhelmed system. After this weekend, it could be much worse than just shotty banking. I was actually scared after reading a few articles. This delves into massive fraud and violations of the very contract law that is the foundation of our economic society. I imagine that a legal work (think duct tape) will be crafted, but it will certainly favor the banks, which will only infuriate Americans more. To give you an overview, I have merely linked to a couple items that do a great job of providing an overview. The first is a video of Barry Ritholz. The second is a lengthy article from John Mauldin, whom I have referenced previously and recommend you follow as well.  John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore
Barry Ritholtz Video on Housing

John Mauldin article:

Trouble, oh we got trouble, Right here in River City!
With a capital “T” That rhymes with “P”
And that stands for Pool, That stands for pool.

We’ve surely got trouble!
Right here in River City,
Right here! Gotta figger out a way
To keep the young ones moral after school!
Trouble, trouble, trouble, trouble, trouble…

- From The Music Man

(Quick last-minute note: I think this (and next week’s) is/will be one of the more important letters I have written in the last ten years. Take the time to read, and if you agree send it on to friends and responsible parties. And note to new readers: this letter goes to 1.5 million of my closest friends. It is free. You can go to www.frontlinethoughts.com to subscribe. Now, let’s jump in!)

There’s trouble, my friends, and it is does indeed involve pool(s), but not in the pool hall. The real monster is hidden in those pools of subprime debt that have not gone away. When I first began writing and speaking about the coming subprime disaster, it was in late 2007 and early 2008. The subject was being dismissed in most polite circles. “The subprime problem,” testified Ben Bernanke, “will be contained.”

My early take? It would be a disaster for investors. I admit I did not see in January that it would bring down Lehman and trigger the worst banking crisis in 80 years, less than 18 months later. But it was clear that it would not be “contained.” We had no idea.

I also said that it was going to create a monster legal battle down the road that would take years to develop. Well, in the fullness of time, those years have come nigh upon us. Today we briefly look at the housing market, then the mortgage foreclosure debacle, and then we go into the real problem lurking in the background. It is The Subprime Debacle, Act 2. It is NOT the mortgage foreclosure issue, as serious as that is. I seriously doubt it will be contained, as well. Could the confluence of a bank credit crisis in the US and a sovereign debt banking crisis in Europe lead to another full-blown world banking crisis? The potential is there. This situation wants some serious attention.

This letter is going to print a little longer. But I think it is important that you get a handle on this issue.

Where is the Housing Recovery?

We are going to quickly review a few charts from Gary Shilling’s latest letter, where he review the housing market in depth. Bottom line, the housing market has not yet begun to recover, and it is not only going to take longer but the decline in prices may be greater than many have forecast. I wrote three years ago that it could be well into 2011 before we get to a “bottom.” That may have been optimistic, given what we will cover in this letter.

First, existing and new single-family home sales continue to slide, in the wake of the tax rebate that ended earlier this year. We have declined back to the down-sloping trend line. If you are a seller, this is not a pretty picture.

The homebuilding industry, which was the source of so many jobs last decade (aka the good old days), is on its back. This country needs a healthy housing construction market to get back to lower unemployment, and until the overhang in the foreclosure market is cleared out, that is unlikely to happen.

Lending is tighter, as is reasonable. Banks actually expect you to have the ability to pay back the mortgage you take out (solid FICO scores) and want reasonable down payments. Only 47% of applicants have the FICO score to get the best mortgage rates.

(Sidebar: Gary writes, “Furthermore, false appraisals rose 50% in 2009 from 2008. The tax credit for first-time homebuyers cost taxpayers about $15 billion, twice the official forecast, in part due to fraud. Over 19,000 tax filers claimed the credit but didn’t buy houses, while 74,000 who claimed $500 million in refunds already owned homes.” Where are the regulators?)

Shilling thinks prices are likely to fall another 20%. Given what I am writing about in the next section, that is a possibility. There is certainly no demand pressure to push up housing prices.

Finally, two charts on foreclosures. Residential mortgages in foreclosure are near all-time highs, close to 1 in 21 of all mortgages, up from 1 in 100 just four years ago. That’s got to be bad for your profit models.

Anyone who tells you the housing problem is “bottoming” either has an agenda or simply does not pay attention to the data. I really want to see housing bottom and then turn around and the home builders come back; the nation desperately needs the jobs. But my job is to be realistic. When we see 3-4 months of non-stimulus-induced housing sales growth, then we can start talking about bottoms.

But housing sales are not really the issue. Let’s look at the next leg of the problem.

The Foreclosure Mess

OK, in a serendipitous moment, Maine fishing buddy David Kotok sent me this email on the mortgage foreclosure crisis just as I was getting ready to write much the same thing. It is about the best thing I have read on the topic. Saves me some time and you get a better explanation. From Kotok:

“Dear Readers, this text came to me in an email from sources that are in the financial services business and with whom I have a personal relationship. The original text was laced with expletives and I would not use it in the form I received it. Therefore the text below has had some substantial editing in order to remove that language. The intentions of the writer are undisturbed. The writer shall remain anonymous. This text echoes some of the news items we have seen and heard today; however, it can serve as a plain language description of the present foreclosure-suspension mess. There is a lot here. It takes about ten minutes to read it. – David Kotok (www.cumber.com)

“Homeowners can only be foreclosed and evicted from their homes by the person or institution who actually has the loan paper…only the note-holder has legal standing to ask a court to foreclose and evict. Not the mortgage, the note, which is the actual IOU that people sign, promising to pay back the mortgage loan

“Before mortgage-backed securities, most mortgage loans were issued by the local savings & loan. So the note usually didn’t go anywhere: it stayed in the offices of the S&L down the street.

“But once mortgage loan securitization happened, things got sloppy…they got sloppy by the very nature of mortgage-backed securities.

“The whole purpose of MBSs was for different investors to have their different risk appetites satiated with different bonds. Some bond customers wanted super-safe bonds with low returns, some others wanted riskier bonds with correspondingly higher rates of return.

“Therefore, as everyone knows, the loans were ‘bundled’ into REMICs (Real-Estate Mortgage Investment Conduits, a special vehicle designed to hold the loans for tax purposes), and then “sliced & diced”…split up and put into tranches, according to their likelihood of default, their interest rates, and other characteristics.

“This slicing and dicing created ‘senior tranches,’ where the loans would likely be paid in full, if the past history of mortgage loan statistics was to be believed. And it also created ‘junior tranches,’ where the loans might well default, again according to past history and statistics. (A whole range of tranches was created, of course, but for the purposes of this discussion we can ignore all those countless other variations.)

“These various tranches were sold to different investors, according to their risk appetite. That’s why some of the MBS bonds were rated as safe as Treasury bonds, and others were rated by the ratings agencies as risky as junk bonds.

“But here’s the key issue: When an MBS was first created, all the mortgages were pristine…none had defaulted yet, because they were all brand-new loans. Statistically, some would default and some others would be paid back in full…but which ones specifically would default? No one knew, of course. If I toss a coin 1,000 times, statistically, 500 tosses the coin will land heads…but what will the result be of, say, the 723rd toss? No one knows.

“Same with mortgages.

“So in fact, it wasn’t that the riskier loans were in junior tranches and the safer ones were in senior tranches: rather, all the loans were in the REMIC, and if and when a mortgage in a given bundle of mortgages defaulted, the junior tranche holders would take the losses first, and the senior tranche holder last.

“But who were the owners of the junior-tranche bond and the senior-tranche bonds? Two different people. Therefore, the mortgage note was not actually signed over to the bond holder. In fact, it couldn’t be signed over. Because, again, since no one knew which mortgage would default first, it was impossible to assign a specific mortgage to a specific bond.

“Therefore, how to make sure the safe mortgage loan stayed with the safe MBS tranche, and the risky and/or defaulting mortgage went to the riskier tranche?

“Enter stage right the famed MERS…the Mortgage Electronic Registration System.

“MERS was the repository of these digitized mortgage notes that the banks originated from the actual mortgage loans signed by homebuyers. MERS was jointly owned by Fannie Mae and Freddie Mac (yes, those two again …I know, I know: like the chlamydia and the gonorrhea of the financial world…you cure ‘em, but they just keep coming back).

“The purpose of MERS was to help in the securitization process. Basically, MERS directed defaulting mortgages to the appropriate tranches of mortgage bonds. MERS was essentially where the digitized mortgage notes were sliced and diced and rearranged so as to create the mortgage-backed securities. Think of MERS as Dr. Frankenstein’s operating table, where the beast got put together.

“However, legally…and this is the important part…MERS didn’t hold any mortgage notes: the true owner of the mortgage notes should have been the REMICs.

“But the REMICs didn’t own the notes either, because of a fluke of the ratings agencies: the REMICs had to be “bankruptcy remote,” in order to get the precious ratings needed to peddle mortgage-backed Securities to institutional investors.

“So somewhere between the REMICs and MERS, the chain of title was broken.

“Now, what does ‘broken chain of title’ mean? Simple: when a homebuyer signs a mortgage, the key document is the note. As I said before, it’s the actual IOU. In order for the mortgage note to be sold or transferred to someone else (and therefore turned into a mortgage-backed security), this document has to be physically endorsed to the next person. All of these signatures on the note are called the ‘chain of title.’

“You can endorse the note as many times as you please…but you have to have a clear chain of title right on the actual note: I sold the note to Moe, who sold it to Larry, who sold it to Curly, and all our notarized signatures are actually, physically, on the note, one after the other.

“If for whatever reason any of these signatures is skipped, then the chain of title is said to be broken. Therefore, legally, the mortgage note is no longer valid. That is, the person who took out the mortgage loan to pay for the house no longer owes the loan, because he no longer knows whom to pay.

“To repeat: if the chain of title of the note is broken, then the borrower no longer owes any money on the loan.

“Read that last sentence again, please. Don’t worry, I’ll wait.

“You read it again? Good: Now you see the can of worms that’s opening up.

“The broken chain of title might not have been an issue if there hadn’t been an unusual number of foreclosures. Before the housing bubble collapse, the people who defaulted on their mortgages wouldn’t have bothered to check to see that the paperwork was in order.

“But as everyone knows, following the housing collapse of 2007-’10-and-counting, there has been a boatload of foreclosures…and foreclosures on a lot of people who weren’t sloppy bums who skipped out on their mortgage payments, but smart and cautious people who got squeezed by circumstances.

“These people started contesting their foreclosures and evictions, and so started looking into the chain-of-title issue, and that’s when the paperwork became important. So the chain of title became crucial and the botched paperwork became a nontrivial issue.

“Now, the banks had hired ‘foreclosure mills’…law firms that specialized in foreclosures…in order to handle the massive volume of foreclosures and evictions that occurred because of the housing crisis. The foreclosure mills, as one would expect, were the first to spot the broken chain of titles.

“Well, what do you know, it turns out that these foreclosure mills might have faked and falsified documentation, so as to fraudulently repair the chain-of-title issue, thereby ‘proving’ that the banks had judicial standing to foreclose on delinquent mortgages. These foreclosure mills might have even forged the loan note itself…

“Wait, why am I hedging? The foreclosure mills did actually, deliberately, and categorically fake and falsify documents, in order to expedite these foreclosures and evictions. Yves Smith at Naked Capitalism, who has been all over this story, put up a price list for this ‘service’ from a company called DocX…yes, a price list for forged documents. Talk about your one-stop shopping!

“So in other words, a massive fraud was carried out, with the inevitable innocent bystanders getting caught up in the fraud: the guy who got foreclosed and evicted from his home in Florida, even though he didn’t actually have a mortgage, and in fact owned his house free -and clear. The family that was foreclosed and evicted, even though they had a perfect mortgage payment record. Et cetera, depressing et cetera.

“Now, the reason this all came to light is not because too many people were getting screwed by the banks or the government or someone with some power saw what was going on and decided to put a stop to it…that would have been nice, to see a shining knight in armor, riding on a white horse.

“But that’s not how America works nowadays.

“No, alarm bells started going off when the title insurance companies started to refuse to insure the titles.

“In every sale, a title insurance company insures that the title is free -and clear …that the prospective buyer is in fact buying a properly vetted house, with its title issues all in order. Title insurance companies stopped providing their service because…of course…they didn’t want to expose themselves to the risk that the chain of title had been broken, and that the bank had illegally foreclosed on the previous owner.

“That’s when things started getting interesting: that’s when the attorneys general of various states started snooping around and making noises (elections are coming up, after all).

“The fact that Ally Financial (formerly GMAC), JP Morgan Chase, and now Bank of America have suspended foreclosures signals that this is a serious problem…obviously. Banks that size, with that much exposure to foreclosed properties, don’t suspend foreclosures just because they’re good corporate citizens who want to do the right thing, and who have all their paperwork in strict order…they’re halting their foreclosures for a reason.

“The move by the United States Congress last week, to sneak by the Interstate Recognition of Notarizations Act? That was all the banking lobby. They wanted to shove down that law, so that their foreclosure mills’ forged and fraudulent documents would not be scrutinized by out-of-state judges. (The spineless cowards in the Senate carried out their master’s will by a voice vote…so that there would be no registry of who had voted for it, and therefore no accountability.)

“And President Obama’s pocket veto of the measure? He had to veto it…if he’d signed it, there would have been political hell to pay, plus it would have been challenged almost immediately, and likely overturned as unconstitutional in short order. (But he didn’t have the gumption to come right out and veto it…he pocket vetoed it.)

“As soon as the White House announced the pocket veto…the very next day!…Bank of America halted all foreclosures, nationwide.

“Why do you think that happened? Because the banks are in trouble…again. Over the same thing as last time…the damned mortgage-backed securities!

“The reason the banks are in the tank again is, if they’ve been foreclosing on people they didn’t have the legal right to foreclose on, then those people have the right to get their houses back. And the people who bought those foreclosed houses from the bank might not actually own the houses they paid for.

“And it won’t matter if a particular case…or even most cases…were on the up -and up: It won’t matter if most of the foreclosures and evictions were truly due to the homeowner failing to pay his mortgage. The fraud committed by the foreclosure mills casts enough doubt that, now, all foreclosures come into question. Not only that, all mortgages come into question.

“People still haven’t figured out what all this means. But I’ll tell you: if enough mortgage-paying homeowners realize that they may be able to get out of their mortgage loans and keep their houses, scott-free? That’s basically a license to halt payments right now, thank you. That’s basically a license to tell the banks to take a hike.

“What are the banks going to do…try to foreclose and then evict you? Show me the paper, Mr. Banker, will be all you need to say.

“This is a major, major crisis. The Lehman bankruptcy could be a spring rain compared to this hurricane. And if this isn’t handled right…and handled right quick, in the next couple of weeks at the outside…this crisis could also spell the end of the mortgage business altogether. Of banking altogether. Hell, of civil society. What do you think happens in a country when the citizens realize they don’t need to pay their debts?”

(I am not sure who wrote this, but if you want your 15 minutes of fame, I will be glad to credit you next week. – John)

Some Foreclosure Takeaways

Let me add a few thoughts. First, I agree, this is very serious. It has the possibility of seriously hurting the housing market, which as we saw in the first section is already on the ropes. But at the end of the day, there is a cure.

Someone borrowed money for a mortgage. Some entity is cashing a check if that person is paying. That entity should have the title until it is paid off. If someone is not making their mortgage payments, they should be removed from the house and it should be sold to the benefit of the ultimately correct and what everyone thought was the proper title holder.

If you took out a mortgage and now the title is in some doubt because the investment banks and mortgage banks and all the middle guys screwed up (big-time!) because they wanted to save some bucks and make some commissions, you did not win the lottery. That is not America as I know it. You can’t pay the mortgage, I am sorry. But you do not get to keep the house. The people who (thought) they bought the mortgage in a fair deal need to end up with that mortgage.

If you pay your mortgage, you get to have the American Dream.

We CANNOT allow this debacle to continue. It will bring the system down. Who will want to buy a mortgage that is in a securitized package with no clear title? Who will get title insurance? Some judge somewhere is going to make a ruling that is going to petrify every title company, and the whole thing grinds to a halt.

Let’s be very clear. If we cannot securitize mortgages, there is no mortgage market. We cannot go back to where lenders warehoused the notes. It would take a decade to build that infrastructure. In the meantime, housing prices are devastated. Whatever wealth effect remains from housing gets worse, and the economy rolls over.

This is beyond my pay grade, but there have to be some adults who can make everyone play nice in the sandbox. Ideally, someone in authority at the Treasury, with bipartisan support steps in and says everyone follow these rules, whatever these rules need to be.

I had a very spirited conversation with good friend Barry Ritholtz today (of The Big Picture). Barry runs money but is also a lawyer and has a somewhat different perspective. He thinks we do not need any legislation and there is a legal cure. He says that real trained people (lawyers and paralegals) need to look at each mortgage and figure it out, and that it can get resolved. It is expensive to the banks; but I agree, if it is just dollars I don’t care. Fix it.

But that is a maybe. Other people I talk to disagree. Some think we need some regulatory fixes. Some think we will need a legislative cure. But if we need to, there need be no finger pointing, no partisan BS. This needs to get solved.

Someone took out a mortgage. Some entity thinks they are owed money. Fix the damn paper trail so that happens, whether in a legal if time-consuming manner, in a regulatory fix, or with legislation.

Now, that is not to say the people who did this stuff did not commit felonies and such. We can sort that out over time. The longer we wait the worse it will get. Fix the problem and then go round up the bad guys. There are bigger issues in play here. (I know this will be somewhat controversial. Oh well.)

I get the fraud being done here. I am regulated by FINRA, the NFA, various states, the British FSA, and ultimately the SEC. If I did something in my business like the stuff described above, someone would come in and justifiably shut me down, fine me, and ban me from the securities business. Oh, wait. These guys ARE regulated by the above groups.

Finally on this topic, I shake my head when I think that the FDIC is now running several of the banks (think IndyMac) that are part of this foreclosure crisis. These are the guys who are supposed to be preventing something like this. Again, where are the adults?

The Subprime Debacle: Act 2

OK, this letter is already getting too long. I am going to finish it next week, as the next topic needs a lengthy treatment. But I will not leave you hanging. A quick preview.

All those subprime and Alt-A mortgages written in the middle of the last decade? They were packaged and sold in securities. They have had huge losses. But those securities had representations and warranties about what was in them. And guess what, the investment banks may have stretched credibility about those warranties. There is the real probability that the investment banks that sold them are going to have to buy them back. We are talking the potential for multiple hundreds of billions of dollars in losses that will have to be eaten by the large investment banks. We will get into details, but it could create the potential for some banks to have real problems.

And all this coming as European banks are going to have to sort out their own sovereign debt problems. Shades of 2008. I hope I am wrong, but it’s all connected.

Yankees, Rangers, and The Endgame

I travel on Monday to New York, where good friend Barry Habib is going to take me to the Yankees-Rangers game. I will be the guy on the second row behind home plate, behind the mayor, wearing the Rangers jacket. Barry assures me I will be safe. Cliff Lee pitching. Can the Rangers hold up to the pressure against the best there is? Stay tuned.

My book, The End Game, is coming along. It is out for comments from friends, and then I will sit down with my co-author in London for four days and we will finish this the first week of November, and then Wiley will push as fast as they can to get it out.

This has been a very tumultuous week for a host of reasons. It’s all good, but exhausting. I am more than ready to hit the send button. I just turned on the TV to watch the last few innings. The Rangers have gone from up 5 to zip to losing 6-5. Can we say disheartening?

Your really wanting to see a World Series analyst,

John Mauldin
John@FrontLineThoughts.com

Copyright 2010 John Mauldin. All Rights Reserved

As I am sure you have heard or read, the banks have not been following the proper procedures for the foreclosure process. Some bank employees have been approving over 10,000 foreclosures a month. This means that the employee has merely been signing his name 10,000 times because it is physically impossible to research the title of the property 10,000 in a month. You may have also heard how some homeowners without a mortgage have received a foreclosure notice.

So again, we are finding out how incompetent the banks are, which is another reason we should have opted for failure over bailout. What is bothering me is the press is now acting as if all these foreclosures are bogus. Every homeowner that has been foreclosed is a victim like the man without a mortgage. This simply is not true. The vast majority of the foreclosures took place where the homeowner stopped paying the mortgage.

The press is looking for any bleeding heart case they can find. Yahoo had an article about Nichole Bradbury, a homeowner in Maine. This woman’s life certainly is challenging. So much so, that it would depress a country or blues singer. Not only is she out of work and living off welfare/food stamps, but her pickup won’t work (so she can’t find any new work) and losing the house means her family will be broken up. I was waiting to read that she had to put down her hound dog, but that hasn’t happened…yet.

Nichole bought the home for $75,000 hoping to provide an upgrade in lifestyle for her family from the mobile home park – certainly noble and understandable. However, Nichole is not making her mortgage payment and hasn’t for a long time. The article details how a pro-bono lawyer shed light on the sloppy foreclosure process of GMAC, and it will keep Nichole in her home for a few months longer.

The article certainly presents a sad tale for Ms. Bradbury and attempts to make her look like a victim, but the harsh reality is she probably overstretched when buying the home and is not paying her mortgage. Currently, 5 million homeowners are delinquent on their mortgage (another 700,000 are already in foreclosure). These folks cannot all be victims. Most, including Nichole, are not paying their mortgage. They should not expect to stay in the home even if their life story would top the Country/Western charts…even if the banks are fools. The press is doing a disservice by attempting to make delinquent homeowners seem like victims at the hands of the bank.  The harsh reality is Ms. Bradbury would probably be able to better make ends meet on her $474 monthly welfare check if she lived in the mobile home.

If we are ever to get through this economic mess, we need to rectify ALL the mistakes and inefficiencies from the bubble. This means the banks should take a hit to earnings for stupid lending, and homeowners who overbought need to be placed back into the appropriate residence. The market is a wonderful mechanism that rectifies inefficiencies. However, it does so by rewarding prudent parties and punishing But, those subjected to the market’s punishment usually learn and come out better in the end.

The housing downturn is obviously a new paradigm for this country. We have never seen foreclosures at this level except maybe back in the 1930s. The banks are not equipped to handle the sheer numbers of foreclosures, especially considering most banks have cut staff to improve their earnings. This will probably get worse as 7.2 million homes are anywhere from 30 days in arrears to in the foreclosure process. Examples are popping up how this administrative overload is leading to mistakes. Today, I read about a home that went into foreclosure when the owner paid cash for the home (hat tip Big Picture). Yes, you read that right.

“When Jason Grodensky bought his modest Fort Lauderdale home last December, he paid cash. But seven months later, he was surprised to learn that Bank of America had foreclosed on the house, even though Grodensky did not have a mortgage.

Grodensky knew nothing about the foreclosure until July, when he learned that the title to his home had been transferred to a government-backed lender. “I feel like I’m hanging in the wind and I’m scared to death,” said Grodensky. “How did some attorney put through a foreclosure illegally?”

Bank of America has acknowledged the error and will correct it at its own expense, said spokeswoman Jumana Bauwens.”

Court records show Countrywide Home Loans filed a foreclosure case in Broward County civil court against the former owner of the home on Southwest 14th Street in 2008. Bank of America took over Countrywide at the end of that year.

The following year, Grodensky and his father Steven bought the house for cash as an investment property. Jason Grodensky’s brother Kenny Sloan lives in the house now. They negotiated a short sale, which means the lender agreed to accept less than the mortgage amount. Documents show the sale proceeds were wired to Bank of America. The sale was recorded in December 2009 at the Broward County Property Appraiser’s Office.

But in court, the foreclosure case continued, the records show. There was a motion to dismiss the case in July, followed the next day by a motion to re-open it. A court-ordered foreclosure sale took place July 15. The property appraiser’s office recorded the transfer of the title to the Federal National Mortgage Association (Fannie Mae) the same day.

This isn’t the only WTF screw up from Bank of America. I can’t find the article, but a friend referred an article to me months ago where a couple in Maine or Massachusetts had a winter home in Florida. The mortgage was paid every month, but Bank of America foreclosed. In actuality, BofA was suppose to foreclose on the home next door, but a clerical error was made. The northern couple discovered the foreclosure when they came down for the winter to see the posting on their front door.

As if this isn’t enough, Ally Bank, which use to be GMAC Bank, recently ceased all foreclosures in 23 states. It turns out that the employees in charge of processing the foreclosures weren’t doing the proper due diligence.

Jeffrey Stephan, a team leader in GMAC’s foreclosure department, told Royal Palm Beach attorney Christopher Immel that he did not verify the accuracy of foreclosure documents that he signed, according to court documents. Stephan, in the same deposition, also said his team presented him with 10,000 documents a month to sign.

“With the volume of foreclosures going on in this country, people just aren’t verifying documents correctly,” said Immel, of Ice Legal. He represents homeowner Ann Neu, whose foreclosure case is pending.

Granted, 10,000 documents a month to properly verify is an impossible task, but he should have asked for some help. You are kicking people out of their homes. It also turns out that not only was he just signing the documents without any research, but he did so without having a notary present. I am betting that he had his wife, employees, or buddies signing his name to some of these documents.

We should expect to see more stories like this as the pig makes its way down the pythons throat.

There has been a lot of press dedicated to the Chinese and Australian real estate markets. Are they overvalued or is demand greater than supply.  Here is an article arguing that Australia does not face a housing bubble or crash as demand greatly exceeds supply (h/t The Real Estate Bloggers).

The source of her frustration — a shortage of 200,000 dwellings — is helping fuel Australian home prices, which are 82 percent higher than in the U.S., and disproving investors such as Jeremy Grantham, who says they will fall 42 percent as interest rates rise in one of the world’s priciest home markets.
“It will take years to turn the shortage around,” said Matthew Bell, an economist at Australian Property Monitors, a researcher cited by the central bank. “When it comes down to it, that’s fundamentally what’s going to drive the market.”
Australia’s median home price was 6.8 times gross yearly income last year, compared with 5.1 times in the U.K. and 2.9 times in the U.S., according to the annual Demographia International Housing Affordability Survey. The nation of 22 million people has six of the 10 most unaffordable cities among the U.S., U.K., Canada, Ireland, New Zealand and Australia, the survey showed.
The median home in Australian cities cost A$468,000 ($395,000) in May, figures from real estate monitoring company RP Data show. The median price of a new home sold in the U.S. in 2009 was $216,700, according to government data.

The demand argument was used here in the States in 2005 and 2006 as demand did exceed supply. Eventually, people learn that housing is a manufactured good whose purpose is to provide shelter. As such, this manufactured good is tied to incomes. Everyone needs shelter, but their income limits the type of shelter they can afford. When the cost for the average home ends up exceeding the average income, a correction will take place. Once families start to realize they cannot afford homes and the demand/supply paradigm shifts, the correction begins. With an Australian home costing 6.8 times the average income, this market will correct. Then these people like Mr. Bell who are claiming the demand/supply dynamics justify current home prices will be amazed they didn’t see it coming.

The State of Maryland is offering mortgage incentives for folks whose jobs are relocating to Maryland due to the Base Realignment and Closures (BRAC). The theory is to get people who might rent or commute from Northern Virginia to buy in Maryland. Like most government programs, it sounds good in theory, but it makes no sense in reality.

Just like the $8,000 home tax credit offered by the federal government recently, there is no proof that this program isn’t a handout to folks who were going to buy anyway. The vast majority of the federal programs incentive went to people who were planning to buy anyway. The incentive may have pulled demand forward, but it did not create any demand.

The government has no means to determine if this is just an extra tax break for someone with a job. If they worked like a business, they might do some real data analysis. They could wait until the BRAC employee has either started renting or remained in an outside region to Maryland such as Delaware or Northern Virginia. Then they could target these folks with direct mail to entice a home purchase. This way the credit would be used as it is suppose to be, not as wasted money for someone who was planning to buy anyway.

Second, Maryland has a $10 Billion shortfall. Why would they give money away for a program that has no clear parameters if it is successful? Sure, they want the transfer taxes, which are hefty in the state, but the state needs to be cutting unnecessary expenses.

Third, the program hurts non-BRAC potential buyers. Lower rates may spur some demand, which could increase home prices (in theory). This hurts non-BRAC folks buying at higher mortgage rates, which could prevent them from buying. So for every BRAC purchase, a normal purchase could fall through.

It just amazes me how these idiots with no business experience come up with hairbrain ideas and then pat themselves on the back. In the business world, these jacknuts would get fired for wasting money.

I have stated several times here and elsewhere on the web that a homeowner should have no remorse from defaulting on a mortgage if it makes economic sense. The mortgage is a contract, not an oath or vow. Contracts cover all actions including non-payment. So, if you are way underwater on a house and renting an equivalent home is substantially below your mortgage, you might be wise to throw the keys in the mailbox and move forward.

However, I despise folks who are using default to live the high life. A New York Times article profiles some Florida residents doing exactly this. These people bought too much home and like to blame the bank for that. Now, they have stopped paying their mortgage and are spending freely.

For Alex Pemberton and Susan Reboyras, foreclosure is becoming a way of life — something they did not want but are in no hurry to get out of.Foreclosure has allowed them to stabilize the family business. Go to Outback occasionally for a steak. Take their gas-guzzling airboat out for the weekend. Visit the Hard Rock Casino.

“Instead of the house dragging us down, it’s become a life raft,” said Mr. Pemberton, who stopped paying the mortgage on their house here last summer. “It’s really been a blessing.”

If you can’t afford your mortgage and decide to move on, then move on. Don’t sit and milk the system so you can gamble and stuff your face with fat induced blooming onions after cruising on your boat. If these folks were unable to pay their mortgage, then they shouldn’t own a boat. It should have been sold to raise funds and save on docking fees.  The article goes on:

This type of modification does not beg for a lender’s permission but is delivered as an ultimatum: Force me out if you can. Any moral qualms are overshadowed by a conviction that the banks created the crisis by snookering homeowners with loans that got them in over their heads.

“I tried to explain my situation to the lender, but they wouldn’t help,” said Mr. Pemberton’s mother, Wendy Pemberton, herself in foreclosure on a small house a few blocks away from her son’s. She stopped paying her mortgage two years ago after a bout with lung cancer. “They’re all crooks.”

People like this are using a defense mechanism to justify their own bad behavior of buying too much house, not adjusting their lifestyle (like owning a boat), or refinancing too many times. The article profiles this older woman with lung cancer. Using a sick woman is an attempt to create empathy, but the reality is Wendy refinanced several times and took equity out of her house. She claims the only money she used for herself was for a new roof. Every other refi was strictly a mortgage broker scamming her into higher fees. Yeah, right. The mortgage brokers motivated homeowners to refinance after showing them how much moolah could be pulledl out of their home. I am betting she visited the Hard Rock Casino on a regular basis. But, this is just a cold-hearted statement on my part because she has lung cancer.

The story goes on to show how our defaulters have used the money to revitalize their business:

Mr. Pemberton and Ms. Reboyras decided to stop paying because their business, which restores attics that have been invaded by pests, was on the verge of failing. Scrambling to get by, their credit already shot, they had little to lose.

“We could pay the mortgage company way more than the house is worth and starve to death,” said Mr. Pemberton, 43. “Or we could pay ourselves so our business could sustain us and people who work for us over a long period of time. It may sound very horrible, but it comes down to a self-preservation thing.”

They used the $1,837 a month that they were not paying their lender to publicize A Plus Restorations, first with print ads, then local television. Word apparently got around, because the business is recovering.

My comment: your business should fail. You don’t know what you are doing. If you are starting a business, then you should not have bought so much house that it would affect your business’ cash flow. You should live in a van down by the river if need be until your business is cash flowing consistently. Apparently, Pemberton didn’t take the time before launching a business to buy a $6 calculator, a 30 cent pencil, and two pieces a paper to put a budget together. Business owners who put so little thought into their business should fail. Again, call me cold-hearted, but the world owes you nothing. If you don’t take the steps to achieve, then the achievement won’t come. Basic budgeting might have prevented this situation, but Pemberton would rather vilify the banks than look in the mirror and have a hard conversation with himself.

These people exemplify the “I’m entitled” mentality that has put us in this position as a nation. They believe they deserve a big house and should have a booming business despite any legitimate planning on their part. Eventually, the market gets what it wants. It wants for people to save, invest, and act responsibly with money. It will inflict pain until folks act this way. Cop out maneuvers like the Pembertons are taking work for the short term, but they don’t last too long. At some point, they will be forced from their homes and have to rent. Their access to debt will be diminished with a horrible credit score, which will affect their ability to pay for their boat and get credit for their business. Unless they shape up, they will end up in financial ruin. This just delays the inevitable and inflicts pain on the banks.

My hope is they read my blog post and get really pissed at me. It may just cause them a second to reflect to see if they should reform their financial actions. While they would still curse a cold-hearted SOB like me, they might get a wake up call before the market gives them one. My wake up will be much less painful.