Friday, December 17, 2010

The Pit and the Economic Pendulum

The whole world knows, by now, that the United States real estate market is in a pit, and the pendulum of its cyclical market has swung to tight money, with corresponding low asset prices.   Mixed economic signals abound, but the smart money is still placing bets that today’s prices. 

The secondary market for mortgage loans is fully consolidated between three government-owned or sponsored agencies.  New valuation models have emerged in the residential housing markets, based on financing and market to sales times, which are not uniformly factored into bank’s lending calculus before the boom or today.

The twin issues of valuation ambiguity and regulatory mayhem have conspired to cause a sharp consolidation of the national mortgage lending market into the hands of 5 money center banks who control nearly 65% of new originations, and limit competition through their oligarchy.   

  The barely-existent finance market is in the peak of the bust, while residential lending has been regulated to its knees

Investors have scoured the market for rock bottom deals in South Florida real estate during 2009 and 2010 with many pulling the trigger.   This bear market rush virtually exhausted the supply of new construction condominiums in Downtown Miami within a couple of years, rather than the 5-10 year horizon gloomier souls predicted. 

The bear market buying frenzy was helped by a combination of low prices, government assisted lending and many individual cash buyers from foreign lands.   There is a new bifurcation of real estate values caused by the predominance of cash transactions by the great majority of individual buyers. 

Two main investor’s pricing models have emerged for residential housing: Cash Basis and Financing Basis. 

The Cash Basis pricing model from lowest price to highest is the foreclosure auction price, the “short sale” price and the REO or repossessed home price. Cash basis pricing is typically based on the market capitalization rate, or the percentage return an investment yields on a real estate investment proportionate to an interest rate on the equity invested.   These prices assume anywhere from an immediate to 15 day closing, in cash. 

In the middle, real estate pros refer to the “Cash Price” which is the price at which a cash buyer would buy a property without any obvious distress or for a bank owned property in reasonable state of repair.  This is also a price where buyers will invest into a lender blacklisted, fractured or distressed condominium.  In condos, this price is typically 50% of the comparable apartment’s Government Supported Housing price.

The Financing Basis price starts at the price a financed buyer would accept with a 20-25% down payments and bank or GSE agency financing.   The final pricing nuance is: Government Supported Housing.  The highest priced residential real estate, are homes that are eligible for 3.5% to 5% down payments.  These are select condominiums and all single-family homes with sellers accepting financed contracts and up to 60-day closings.    

Banks order real estate appraisals that currently only evaluate “Financing Basis” pricing of home sales.  There’s no model of integrating the Cash Basis sales, unless there are only “Cash Basis” sales inside the sub-market.   The resulting confusion is hurting banks’ ability to lend responsibly and borrower’s ability to leverage real estate.   However, investors are using these pricing variations to buy up bank inventories below end user prices and turn around and flip these properties to end users paying a premium.

Just as national money center banks have become too large to fail, their lending units have taken virtual complete control of the primary mortgage market as supplied through mortgage bankers, brokers and retail originations through their banking franchises.   The Freddy Mac rate survey indicates that even as underlying Treasuries rates have been getting lower, origination fees are rising.  Furthermore, from July 2010 through October 2010 there was a 50 basis point (0.5%) drop in  Treasuries that yielded only a 23 basis point drop in average lending rates.

Bank of America simply painted new colors onto the Countrywide Home Loans lending and servicing operations, and handed them the keys.  Their disastrous robo-signer issues, and newly discovered possible securitization process flaws point to the inherent danger of consolidating too much financial control into a single institution.    However, that didn’t stop the Octopus of Charlotte from dropping their mortgage broker channel in November.   This means the largest lender in the country now has zero transparency regarding yield spread premiums issued to consumers through their entire origination channel.  

The bull of a financed real estate market has been neutered by heavy-handed government regulation.  The mandate that all loans have documented sources of income for repayment is excellent for wage earners, but completely locks self-employed persons out of the home finance markets.  These entrepreneurs are risk takers, who traditionally were able to get a (safe for a generation) loan by simply showing their good credit behavior, cash in the bank and equity in the home.   Traditional standards were 25% down payment for one of these loans. 

Self-Employed people, as well as foreign persons, US Citizens who work abroad and wish to repatriate, permanent residents with legitimate foreign sources of income are forced to seek higher interest rate loans with 50% down payments.  These high rate loans are also the only resource for borrowers whose FICO credit score falls below 640 for any reason.  Non-Traditional and lower income documentation loans are only available for investment properties. 

New regulations require a 3-business day waiting period on ordering appraisals.  Federal disclosures have been transformed from simple, transparent documents that include all pertinent information on a page to a veritable paper mache’.  The new Good Faith Estimate has triple the information, but obscures entirely lender loan profit margins and the total cost of home ownership.  

The bear market cash buying frenzy is showing signs of acceleration even as new lending guidelines further depress available housing demand for end users. 

Certainly, there’s a glut of available properties on the market and in the “shadow market”.  However, these new regulations have created shadow demand as most end users are locked out of the finance market for their own protection.  Ultimately, lenders pricing models need a complete, national overhaul to reflect current realities.     

Until the real estate market shifts from an Investor’s market to an End User Buyer’s market, we won’t see the normal price appreciation that signals a healthy housing market.   It will take years of momentum to chip away the worst of the new regulations, and revive the economically crucial mortgage markets on a national level.  In due time, the pendulum will swing back again. . . 

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