Regulator Revenge: There's a New Sheriff in Town
Back in September I did a piece called The Psychology of Asset Cycles where I tried to lay out a roadmap for the unwinding of asset bubbles and the various phenomena that are commonly seen along the way, which might serve as a guide for what was to come. I talked about the outsized leverage employed in a bubble - oftentimes not widely known or understood until after the fact - as well as the high incidence of fraud in bubble assets, etc. We have been seeing all of this play out in the residential real estate market. The deflating of the bubble has been following the script very closely. That's why I want to revisit a concept I call Closing the Barn Door. In my piece I wrote...
The last phase of the saga is the closing of the barn door. This happens of course when the horse is in the next county and wreaking havoc there. The great legislators of our country wake up to the fact that an asset bubble caused misbehavior intentional and unintentional and they create laws to protect the populous from this ever happening again.......... Importantly, these laws make the pain in the asset worse and really put the nail in the coffin. Whereas before you could borrow to your heart's content to leverage an asset, the new rules significantly impede the ability to do this, making the asset less profitable to play in, so more people sell it. The related professions that were supposed to have some watchdog function in the industry that failed, like bond rating agencies and real estate appraisers get, tarred as criminals.
Before we go any further let me state for the record: I don't have anything against bankers, investment bankers, appraisers, mortgage brokers, sub prime borrowers or lenders, regulators, rating agencies, bond insurers, et al. Did some of these guys do nefarious things? Undoubtedly! Are they all evil? No. It's the bubble people. Greed makes people do crazy, illegal, unethical, immoral and flat out stupid things. It's human nature. People who crossed the line into illegal territory will be punished. I view the rest as victims of human nature....same as it ever was.....same as it ever was. The mistakes that will be maid by overzealous lawmakers and regulators are part of the same cycle...so don't hate these guys either.
Let's check out the beginning phases of the Barn Door Closing now underway - and remember the key here is that the closing of the barn door makes the bear market in the asset even worse than it has to be. As you will notice, the allegations, accusations, finger pointing and "regulating" are starting to take place up and down the supply chain of residential housing.
First off, have no worries because the FBI is now on the case. The G-men have reportedly launched a probe of the sub prime crisis with 14 criminal investigations launched. Really makes you want to be in the mortgage business, right? No wonder as Noah noted this morning, mortgage rates are going up while the Fed slashes Fed fund rates.
An appraisal fraud conference was held in St. Petersburg, Florida. Joni Herndon, the incoming Chairwoman of the Florida Real Estate Appraisal board, was interviewed there. She had some harsh things to say about her own peers. "In most cases, you can't have mortgage fraud without an appraiser. A fraudster is not going to pay cash for a home. They have to get a lender, who hires an appraiser to inflate the value. The appraiser is key to mortgage fraud. She also commented about the increased level of complaints by the public about her colleagues. "In 2000, we had 220 complaints. For the 2006-2007 fiscal year, it was up to 681. At our last meeting, we revoked eight licenses. We're also getting five times as many voluntary surrenders of license". Real punishments are being meted out for illegal behavior. One Arlington, Texas appraiser was sentenced to 5 years in prison.
Now some appraisers are striking back at the system that put them under intense pressure to play ball. WaMu is being sued by an appraiser who claims she was blacklisted for giving a housing market forecast that was too downbeat. She has company: a 2006 national survey of appraisers reportedly found 75% said they got stiffed on fees or didn't get future business if they refused to inflate home values.
Further, up the line from the home valuation process there is an arcane business conducted by mortgage loan due diligence firms. These companies will scrutinize a certain percentage of the loans that are being submitted by a Wall Street firm into a pool of mortgage backed bonds set for securitization. Apparently, some of these firms warned their Wall Street clients that a decent percentage of the bonds going into securitization pools did not conform to their clients' own quality standards, but they were overridden and these mortgages were allowed to get to market as part of MBSs. Attorney General Andrew Cuomo has reportedly entered a "cooperation agreement" with at least one firm, Clayton Holdings to help him understand how the whole process worked with their various Wall Street clients.....nice of them, eh? Considering that according to the Wall Street Journal New York State Attorney general Andrew Cuomo is said to be poised to use the Martin Act of 1921, which allows securitites fraud suits to be brought, without the persecutor proving intent to defraud, who wouldn't cooperate?
The credit rating agencies, were one group I foresaw coming under scrutiny back in September. Frankly, I think the U.S. government has been going easy on them so far because they are worried about what will happen to markets if their credibility is totally shredded or if they start to really over-react to the political pressure on them. The EU has been less shy about voicing their dissatisfaction: According to the Financial Times
Credit rating agencies were warned last night by European leaders to address conflicts of interest and provide better information to the markets or face new regulation at a "credit crunch" summit in London.
Note that the rating agencies aren't taking this laying down. They are pointing fingers toward the Wall Street firm's and their outsourced due diligence purveyors. According to Tom Brown's excellent BankStocks.com blog, while relaxing in the luxury of the Davos World Economic Forum and Ski A Go Go, the CEO of Moody's opined that. " The key assumptions failed in part because the information policy, completeness and veracity feeding the work agencies were doing was deteriorating."
While we are on the subject of the veracity of data being impugned, we might as well bring your attention to hedge fund manager Bill Ackman's recent letter to the New York insurance regulators regarding MBIA and Ambac's disclosure of the details of their bond guarantee business. Bottom line is according to his letter Ackman is short these stocks. He has had some very sharp, hard working analysts put together a massive model that says these guys are gonna lose a bunch of money and in my opinion is putting indirect pressure on Moody's, Fitch, et al to downgrade them, which will make their situation worse, while pressuring regulators not to bail them out, by making them look like they don't deserve a bailout or that one will be fruitless. These guys are smart, that's why they get paid the big bucks. Apparently, this ploy is working as a downgrade of a smaller bond insurer has just occurred.
Now these are just the initial signs of fear and loathing descending on this residential real estate mess. Not much in the way of new laws have been passed yet (correct me if I'm wrong as there may have been something pushed through on mortgage brokerage professional standards). But don't doubt it for a minute: new laws are coming and they won't make it easier to buy a home, get a mortgage or trade in securities linked to mortgages. They will raise the cost of home ownership and make it less profitable to be a lender. Already the regulatory climate that will cause this is heating up. Tom Brown has another article on his blog about the new chief national bank examiner just promoted at the Office of the Comptroller of the Currency. Bottom line is according to Tom, the guy has a reputation stretching back to the early 1990s real estate debacle as a very tough cookie with regard to bad loans. Others are already calling for overpaid bankers to "pay the price" for their mismanagement.
If my cycle road map is right. The final phase I call "The Hating" is still coming. It happens around the time the bad guys are getting sentenced, and new laws are passed to make sure a bubble like this can never happen again (or at least for 20 years until people figure out how to get around the new regulations). We will know this phase has arrived when bus loads of "bargain hunters" are no longer seen making the rounds of ghost town condo developments looking to make a killing in residential real estate. In the mean time my prediction is there is more pain to come in this asset class.
Posted by AA
Thu Jan 31st, 2008 02:10 PM
Hey Jeff, enjoyed this piece and the one on The Psychology of Asset Cycles. Wanted to know where on your psychology sin wave you think we are? I assume we're past denial, but not sure where we are after that.
Posted by Jeff
Thu Jan 31st, 2008 02:54 PM
I think we are at the desperation/panic area of the continuum. 125 basis points of rate cutting in a week attests to that. I don't think we are at capitulation....in fact we are still fighting it tooth and nail. When we get to despondency and depression, you will stop hearing people talk about real estate as the main path to long-term wealth ....who made that up anyway.....we all know commodities are the only path to long-term wealth LOL!!!! In my opinion, when this is all done in many markets buying a home will be seen as a dangerous if necessary evil, not a pleasure. In fact check today's Wall Street Journal personal section article on the new trend to "house swapping" between people who need to relocate.
Posted by AA
Thu Jan 31st, 2008 04:57 PM
Jeff
Interesting that you mention commodities. I’ve got a theory that I want to run by you that I haven’t read about elsewhere. The theory is that much of the rise in single family home prices (not condos) is due to the rise in commodity prices. It seems to me that the price of a new house is determined by the following factors – the price of land, the cost of labor, the cost of materials, the builder’s margin. The price of land is determined by supply/demand variables in the area which is based on demand for houses and commercial real estate. Land prices have gone up due to heavy demand for homes/commercial real estate. I imagine the cost of labor has gone up but probably not so substantially that a decline in this causes a major decline in the cost to build.
Now the cost of materials, isn’t that determined by global demand? If global demand for commodities remains high, shouldn’t this over the long term buffet home prices?
The reason I ask is that I am considering making a speculative purchase in a Florida home near the beach. It seems to me that many of the bank owned homes are selling at the cost to build. Let’s say the cost to build, generally, is $150 a sq/ft(includes labor, materials, builders margin but not land) and the asking price of a relatively new existing 2000 sq/ft home is $300k. It seems to me that I’m getting some pretty desirable land for free. Based on those numbers, assuming a long term investment horizon of say 10 yrs, why would I not want to make that purchase?
I’m assuming that FL has decent demographics, where population is increasing, as oppose to a place like Detroit, where people are fleeing. Does all that make sense?
Posted by jeff
Thu Jan 31st, 2008 05:13 PM
You make some great points I will try to respond to. Most importantly, my guess is that buying Florida condos at less than construction cost will be a great fifteen year bet (remember real estate markets often sit for 10 years and do very little adjusted for inflation). I like Myrtle Beach even better than Florida as it has sold at a big discount to Florida, has great demographics and is moving upscale from historically being the "Red Neck Riviera". It also has fewer hurricanes. With regard to the impact to housing prices from commodities, I think this has certainly been a contributing factor to price appreciation, as has lower financing costs and easier lending standards, and higher demand (driven by a feel good attitude towards real estate in addition to the actual positive demographics). I think the higher commodity costs were a factor, but not the overiding one and it won't cushion prices that much as the other factors recede, it will stop builders from building until either land prices adjust drastically or sell out prices rise again to levels where a good profit can be made on the construction cost. But hey the fed/economy will eventually get mortgage rates back down to where its cheap to buy again. I fear that the easy lending standards that came with the consumer romance with real estate is gone for a good long-time.
Posted by AA
Thu Jan 31st, 2008 05:57 PM
That's interesting about Myrtle, but I think I have to be in Boca.
You brought up another interesting word, "inflation". Why, with home purchasing specifically, is inflation an important factor? If I purchase a home at cost, and let's say over 10 years, inflation is 3% per year. Let's also say, that the price of the home appreciates only 1% per year over 10 yrs. That's a horrible under performance vs bonds adjusted for inflation. If you assume 0 carrying costs (say I live in it for the winter/rent it out which covers that), my sales price would be $331 after 10 years. If you assume 0 transaction costs (which I admit is an enormous assumption), I've more than doubled my money but lost 34% due to inflation. If I've done my math correctly, that ends up be a 4.3% rate of return. Now 4.3% sucks, but I think that might be pretty baseline. If you assumed home appreciation of 2%, that gives you a 9% rate of return, but still trails inflation by 100bps.
To me, it seems like housing is one of the few ways you can lever up 9x your initial investment, and lock in a low fixed rate for a very long time horizon and have that interest be deductible.
Now, assuming a high inflationary environment, those numbers look drastically different if you put 20% down vs 10%.
So I guess my question is - is inflation really a big deal? If you expect a high inflation environment going fwd, is a low down payment invesment in a home a good way to go?
Posted by jeff
Thu Jan 31st, 2008 09:22 PM
AA,
The reason I mentioned inflation adjusted returns is just that people somehow have gotten this idea over the last 10 years that real estate is the ultimate wealth building investment blah blah blah. The truth is, that any superior investment will atract enough capital to make it overvalued and thereby make it a crappy investment. It's all about timing anf risk/reward. Bonds have a lower rate of return over time, but less risk (academics usually use volatility as measure but its imperfect). Stocks have a higher rate of return but they are more volatile. Real estate has some great characteristics that work to the value buyer's advantage in a big way. You can employ a good deal of leverage, particularly if you buy at a low cash flow multiple and good time in the cycle. You get tax benefits. Volatility of prices is usually low, but and its a big but, when prices move they move fast...they are discontinuous, when a comp trades a new price point is often established, unlike stocks which generally gap up and down less. But with any of these asset classes including commodities, they have their cycles. The best time to buy them for investors is when everyone else hates them....but stocks, commodities and real estate have all gone through long periods when they were our of favor and did returned very little vs. inflation.
Posted by AA
Fri Feb 1st, 2008 08:33 AM
Sure Jeff, Sharpe ratio, etc. I agree completely about your big gap down theory, which is why I'm wondering why now isnt the right time to buy. Banks in FL are flush with foreclosed real estate holdings. I imagine they are anticipating more coming on the books, with the option arms resetting, etc. Now in any market, you want to buy the rumor, sell the fact. Banks have to scramble to get out of real estate to make room for more. They may sell these holdings at really rock bottom prices, which could be well below cost. So to get out, prices for a time will have to gap down.
Now you can only purchase an asset below cost when there is a major inventory problem. Inventory problems don't last forever, maybe 3 years in FL?
Also, did you see this - "Housing - BusinessWeek cover story - Housing Meltdown - Why home prices could drop 25% more on average before the market finally hits bottom…" How does that fit into your theory of magazine covers?
Posted by Law Guy
Sat Feb 9th, 2008 10:08 PM
Very interesting!Facsinating phenomina!