Insight on Housing by a Foreclosure Expert

the subprime “carnage” and “meltdown”

Below is an article by a real estate veteran/foreclosure expert on how he thinks the real estate cycle will play out in 2007. I find it way more real and interesting than big talks by Greenspan or Bernanke.

Foreclosures, Real Estate Financing, and Their Impact to the Real Estate Market

Starting from 2002, every participant in the broad real estate arena has been trained to ignore financing as an integral part of all real estate transactions. It is so easy that it seems anyone who wants a loan can get a loan. No down payment? No credit? No problem.

So where do we go from here? As most of you know, since 1982, my specialty in real estate was foreclosures. I have never seen a cycle like this before so I have no historical comparison to draw from. All I can offer is some thoughts and points to ponder over:

* REOs are “must sell” properties. Once they become prevalent in a market, they will influence market prices.
* Homebuilders’ spec homes are “must sell” properties. They will be competing against other “must sell” sellers for the buyers.
* REOs have no sellers who are intending on trading into another housing unit, be it new or existing.
* Homebuilders’ spec homes have no sellers who are intending on trading into another housing unit, be it new or existing.

* NOD – REO (notice of default to completion of foreclosure) is averaging 150 days in San Diego. It then averages two months or more before the REO is listed for sale. In other words, a default notice posted today is a housing unit for sale six months from now. Defaults started increasing during the second half of 2006 and are showing no signs of slowing. Most of these defaults are inventory that are still months away from hitting the market.
* A homebuilder who begins construction on an unsold spec home will have a completed unit for sale two to six months from now. Homebuilders are sitting on record levels of unsold specs, both finished and under construction. Aside from what has already started, it is unclear whether the builder will keep building regardless of market conditions.
* The percentage of defaults which eventually become REOs changes with market condition. As conditions deteriorate, the percentage becomes higher and higher, as does loss severity.
* The consensus opinion appears to be that defaults are limited to the subprime loans and their impact to the overall market will be limited. Limited to what?
* Homeownership rate reached an all time high of 69% last year, made possible by the credit bubble. If a more sustainable level is in the low to mid 60’s, as it had been prior to the bubble, 10% or more of current homeowners would have to be “demoted” back to renting while removing a huge chunk of the demand in the process.
* 2007 is the peak year for recast. There is no historical comparison for this level of recast, at this low level of equity, with such high debt ratios and such huge potential adjustment in payments. Compounding that with little or no property appreciation, we are venturing into new territories. We will soon find out if the economy is strong enough to absorb this blow. There is, however, no doubt that the recasts would make affordability an issue, even for those who have already purchased a home.
* Financing is not only about interest rates. What has been overlooked are the terms that made home purchasing feasible for many who might not have otherwise qualified. These are called non-traditional mortgages. With the rising default rates, Wall Street is losing its appetite for these toxic products. What percentage of new and existing homes was sold to buyers using non-traditional financing?
* The easy credit was made possible by Wall Street with not only MBS, but all the derivative products. However, no exotic derivative is going to change the basics of a mortgage: the borrower’s ability to repay. Now borrowers are not paying in volume. What will replace the MBS market if the current MBS buyers vanish?
* Where is the demand going to come from? Taking out the demand created by the credit bubble, the core demand never left. They are the ones who are supporting the current 1.04 million new home sales pace, about the same as the 1.09 million sales for 2003, higher than the 976k for 2002. They are the ones who are supporting the current 6.2 million existing home sales, higher than 2003, or as David Lereah of NAR kept repeating, the 3rd highest year in history. As for that artificial demand of the bubble years, I do not think that is going to return without a new bubble.
* The up cycle: lower interest rate creates demand, prices go up, more homes get built, easy financing creates more demand, prices go up more, investors/flippers create more demand, prices go up more, more homes get built, easy financing allows previously unqualified buyers to own homes creating more demand, prices go up more, more homes get built. This cycle ended in 2005, and was confirmed in 2006.
* The down cycle: the “must sell” properties will lower prices to sell their units, lower prices will depress overall prices making it more difficult for those facing recast to refinance or otherwise work out their financial woes, creating more foreclosures, more foreclosures add to the inventory, creating more price competition and further tightening of underwriting standards. How vicious this cycle will be is anyone’s guess now.
* The debate in the real estate cycle appears to be whether the worst is already behind us or is it three to six months away. Is it not possible that this down cycle may be at the beginning?

Conclusion

Time has always been kind to owners of real estate as long as they can hold indefinitely. Homeowners who live in the same house and service the same fixed rate mortgage using income from the same jobs can hold indefinitely. To them, the house is a home, a shelter. The utility of the home does not change with the value. The credit bubble has created circumstances for some homeowners that even if they remain employed and live in the same house, their debt service may rise beyond their ability to pay. Furthermore, the size of this credit bubble could trigger systemic failure, far beyond the S&L fiasco of the late 1980s.

2007 will be the year that we find out how strong the US consumers really are. We know with certainty that the builders have too much inventory in both land and specs. We know defaults are escalating and REOs from foreclosures completed a few months ago are just starting to show up as inventory. Without the fuel from the credit bubble, absorbing the estimated 1 million to 1.5 million units of excess inventory is going to be challenging.

I opine that the biggest danger lies in the complacency exhibited by economists, market participants and regulators. It is not whether they are optimistic or pessimistic; it is quite obvious that many have not given the widely available data much thought before jumping to their respective conclusions.

Does anyone have a plan in the event of a hard landing?

Insight on Housing Market by a Foreclosure Expert