The Problem That Hasn't Gone Away

Yale Professor Robert Shiller, author of the called-the-top classic, Irrational Exhuberance, is one of the very small group of economists who "gets it." Although I don't necessarily agree with everything he has to say, he is that rare academic who is guided by facts and an appreciation for how the world really works, unlike the so-called experts who believe in theories that have little or no basis in reality. For that reason alone, I usually pay attention to his insights on the world.

Here's what he had to say about the housing market in a recent interview with Yahoo! Finance Tech Ticker:

I am worried that [the financial crisis] not over...I think there's a definite risk of a turn-down again in home prices, and if home prices decline 10 or 20 percent more, we are in big trouble. It's going to really throw off balance sheets. It's going to bring the economy down.

The obvious question, of course, is how great is the risk that prices are headed lower still? On the basis of the following alone, I reckon the answer is "fairly high":

Looming supply pressures

"Accidental Landlords and the Shadow Inventory" (Calculated Risk)

From Hilary Stout at the NY Times: The Renter Roadblock (ht Brian)

Over the past year or two, many owners who couldn’t sell — or didn’t dare try — made a ... calculation [to rent]. Rather than accept an impossibly low offer (if they even had an offer), they decided to rent out their properties. The idea was to cover expenses while waiting for the market to right itself.

But in recent months, a number of these accidental landlords have been surprised to find renewed buyer interest in their properties. The problem is, the renters are happily in place.

These accidental landlords are part of the "shadow inventory".

My definition of "shadow inventory" are units that aren't currently listed on the market, but will probably be listed soon. This includes REOs (bank Real Estate Owned) that are not currently listed, foreclosures in process and seriously delinquent loans (although some of these may be cured, and some may already be listed as short sales), unlisted new high rise condos (these properties are not included in the new home inventory report) and homeowners waiting for a better market.

That last category includes all the accidental landlords that we've been discussing for years. As the NY Times article suggests, some of these accidental landlords might test the market this year. And there are probably quite a few of them - in a recent interview with Jon Lansner of the O.C. Register, Scott Monroe of South Coast Apartment Association said

"... our members are saying that they are competing quite a bit with what historically has not been a competitor for us - that's the gray market or the shadow market - which are condominium rentals and single family home rentals and things of that nature. There is just a lot of product on the market."

My estimate is about 3.6 million units were converted from owner occupied (or 2nd home) to rental over the last 5 years.

This included investors buying REOs for cash flow, condo "reconversions", builders changing the intent of new construction (started as condos but became rentals), and homeowners renting their previous homes instead of selling. But whatever the reason, many of these properties will probably be offered for sale again - especially the properties owned by the accidental landlords.

A growing regulatory crackdown

"Construction Developer Says Banks Suddenly Playing Hardball, Asks 'Mish, What's Going On?'" (Mish's Global Economic Trend Analysis)

Today I received an email from "Construction Insider" concerned about banks suddenly playing hardball and calling in construction loans.

Construction Insider writes:

Hi Mish

I work in the construction business and something has been creeping to the forefront of my attention for the past few weeks and now it seems to be moving full steam ahead.

Banks are forcing developers/builders (especially smaller ones) to give up their properties (unsold homes and lots).

Banks say the reason is that the properties in question are no longer performing assets. I am sure there are some loans out there that are not performing and the owners are going under. I am equally sure that there are plenty of developers that are still selling homes - just not at the pace originally planned on the pro formas.

Having inside information on one of these scenarios that happened today, I cannot help but wonder what is really going on? The bank told a small developer/builder I work for that they were taking back his ongoing subdivision.

He is selling houses and updated pro formas would indicate that the current sales pace would exhaust all remaining lots within 33 months. Yet the bank stated they would only give him until April 15 to find alternative financing. The bank is also willing to let him buy the subdivision at a 33% discount to what is currently owed.

If he is unable to obtain this backing, the bank will let him walk away without penalty or consequence so they can write it off.

I have been on the phone trying to put some of these pieces together. It seems there are many banks doing the same thing. However, there is apparently no interest [or ability - Mish] from anyone wanting to pick up land/lots at 30% - 50% discounts to today's prices.

Another interesting point is that the banks all state that they must have these situations written off or taken care of by the end of Q2.

These are the immediate questions running through my head:

Why the end of Q2? And why do so many banks seem to be simultaneously doing this?

Is it possible that there is some government incentive to the banks to meet this timeline? And how much will this cost the taxpayers?

There is something extremely concerning about this whole thing, especially from the standpoint that many banks appear to be acting in concert, all with the same specific timeline. Any thoughts you have would be greatly appreciated.

Construction Insider

For questions like these, I turn to my "California Business Banker" to see what he thinks.

"California Business Banker" responds:

Hi Mish

Your construction industry source raises an interesting issue. Since I work for a relative healthy bank, I don't see that in my bank.

However, we have had federal auditors in the bank for the past couple weeks and I've noticed an interesting development. They are getting tougher on banks recognizing loans that they view as a problem and pushing for downgrades.

So, the very problem might be federal auditors are forcing banks to down grade loans to a doubtful status. In such cases as nonperforming real estate assets, this essentially forces the bank to do something more than wait and see if the developer can turn his investment and pay off the bank.

It forces banks to resolve the issue mostly by enforcing their rights on the collateral, which is why they are probably recommending the developer walk away, so they can their hands on the collateral sooner (maybe deeding it over to the bank) versus going through foreclosure and potential bankruptcy on behalf of the client, which can draw out the process for months.

Most banks would like to get in, fire sell it or sell the note, and move on and not expand the loss by waiting over time.

It wouldn't surprise me a bit, if conceptually this or something very close to this is what's going on.

The auditors reviewing one of my loans want to down grade the loan simply because the owners personal credit score has declined. Bear in mind the client is profitable and meets all of their financial covenants.

Personal credit is a red flag but usually not a reason to down grade loans, unless there are other reasons as well. This tells me the federal auditors are getting tougher across the board.

Hope that sheds some light.

California Business Banker.

Signs Say Wave of FDIC Takeovers Coming in 3rd Quarter

Thanks "Construction Insider" and "California Business Banker".

Putting 1 and 1 together, I sense the FDIC has decided to take problem loans by the horns, forcing banks to address those problems. Banks with enough capital to take huge writedowns will survive, those that don't, won't. Many won't.

If the above scenario applies to commercial real estate as well as housing, expect a huge wave of FDIC bank takeovers in the third and fourth quarters, spilling over into next year. In the meantime, expect to see more lending contractions as banks fearful of this regulatory crackdown respond with further cutbacks in business lending, especially small business lending.

Addendum:

"Rebel Farmer" writes:

A friend of mine is a loan officer at a small regional bank here in Oregon. She told me last week that she cannot get any of her mortgage loans clients approved for loans because the bank has raised the qualifications so high that NO ONE is being approved for home loans. These are all borrowers who are more than qualified. If she does not make her quota this month for closed loans, per her boss, she will be getting her pink slip on March 31.

There is definitely something going on at banks for all types of loans. They are hunkering down. My banker friend believes also that there is going to be a massive failure of many banks in the near future.

Diminishing government support

"Window Closing" (Contra Costa Times)

Get ready for the end of two federal incentives meant to entice homebuyers in a down market: a federal income tax credit for first-time and repeat buyers is going away soon.

If that wasn't bad enough, March 31 marks the end to another federal program that has helped keep mortgage interest rates low. And while tax credits are among the factors that buyers consider when buying a home, the interest rate charged on a loan has much bigger impact in the long run, say observers.

To qualify for the home-buying credit, no matter if you are a first-time or repeat buyer, escrow needs to close by April 30. But if you have entered into a binding contract to buy a home by April 30, the deadline for closing escrow is June 30.

Last year, Congress extended the first-time homebuyer credit, which was set to expire Nov. 30, added a credit for repeat buyers and raised the qualifying income limits for homes purchased after Nov. 6, 2009. (California had a $10,000 state tax credit for buyers of new homes in 2009 until funding ran out. In February, legislation was introduced by state Sen. Roy Ashburn, R-Bakersfield, that calls for bringing back the credit for new homes along with extending it to first-time buyers of existing homes.)

Taylor and Mica Heanue rented a one-bedroom apartment in Oakland before they entered into a contract during the last week of February to buy their first home, a three-bedroom place in the Oakland hills.

"It definitely was one of a number of factors," said Taylor Heanue, a 34-year-old mechanical engineer, of the federal income-tax credit. "The interest rates being low played a big part in our decision as well. Another factor is the housing market. It's a good time because of the prices," said Heanue.

The Heanue's offer for the home was above the $499,000 asking price on the property, which was listed as short-sale transaction and had a total of five offers. The couple had obtained pre-approval for a loan amount before they started looking for a place around the beginning of the year. They plan to make a down payment of 20 percent using conventional financing.

"One of the reasons the first-time buyer credit is so appealing is that people are not wiped out of their savings," said David Kerr, a Realtor with Zip Realty who helped the Heanues find their home.

As far as the repeat-buyer credit, Kerr has not seen many people use it. For it to be practical, someone has to either have substantial equity in their existing home or substantial savings on hand to help swing the loan on the replacement home, he said.

Getting pre-approval is a key strategy when buying a home, but even more important when trying to close before the tax-credit deadline arrives.

"What we are seeing is an increased time on loans. We are hearing a lot of loans going from 30 days to 45 days in terms of getting everything done," he said. "(Buyers) should not delay. Right now, we have the perfect storm. Interest rates are still low. Prices are really low for housing, and we've got the tax credit to boot."

The low interest rate component could go away after March 31, say observers. That's the ending date for a Federal Reserve program that has purchased mortgage-backed securities to help stabilize the lending market after investors stopped buying the securities in the fall of 2008.

"The government has been buying mortgage-backed securities. Because of that, rates have been kept low. That program is going to end," said Dianne Crosby, a senior loan consultant at LaSalle Financial Services in Oakland.

Comments

[CrisisMaven]

It would be foolish to think for one moment the crisis was over. Why, contrary to common belief it hasn't even started in earnest! The second wave of mortgage defaults (http://crisismaven.wordpress.com/2010/01/28/bloom-of-doom-ii-of-mortgage-brokers-arms-attrition-and-marathons/) and ensuing foreclosures and house inventory glut and sinking house prices and failing banks ... and ... has not even fully started! In these two years 2010 and 2011 we will probably see a bigger default tsunami than subprime, with the variable rate mortgages resetting. Plus eventually the bond market will start to tank as well due to higher (longer term ) rates and higher default risks. We might even see the first sovereign defaults!

[roger]

It's always amazing to me, the way high caliber intellectuals
focus on the particular,completely ignoring the big picture.
The economy is already "down" and is never coming back "up"
there is a metaphor in process.our way of life will change
in ways not yet perceived ,its a case of force majeur.

[Tyrone]

If you look at California, the big bubble areas MUST fall another 10-20%, minimum. These areas are: San Diego, Los Angeles, San Francisco. 60% of all ARMs loans due to recast over the next few years originated in California. That number is 200,000 loans in CA. The deliquency rate on these is already very high.