From a small northwestern observatory…

Finance and economics generally focused on real estate

Posts Tagged ‘mortgage market

Musings about the real estate market — part 2

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A few days ago, I kicked off this series with some comments about the asset side of the residential market.  Today, I’ll discuss the finance side of that market.  Later on (parts 3 and 4) I’ll talk about the asset and financial side of the commercial market.  Keep in mind that these markets are all very different, albeit intertwined.

A quick caveat — don’t use ANY of this to answer Econ 101 exam questions.  I’ve over simplified nearly all of this to make it readable.

If you watched the really excellent HBO movie, Too Big to Fail, you saw and heard the actors talk about huge losses in “real estate”.  While many of these players actually owned real estate assets (see my commentary about Archstone), the real thing that brought them down was their ownership of real estate derivatives.  Now, this may sound like I’m side tracking, but it’s very helpful to understand how we got here, if we’re going to understand how to fix it.

Imagine John and Jane America go to Main Street Bank (MSB) and borrow $100,000 to buy a house.  In the course of a year, Main Street Bank may make 100 of such loans, totaling $10,000,000.  In a typical pool of 100 loans, two of them will go bust, resulting in $200,000 in “paper” losses to MSB.  Now, before you start feeling sorry for the depositors and shareholders of MSB, it’s important to note three things:

1.  This was a fairly predictable set of losses.  Hence, every borrower paid a slight premium on their loan to “share the burden” of everyone else.

2.  The bank has the house as collateral.  While foreclosure sales rarely fully compensate the bank for the losses, they really do cut the pain down to a small headache, and then #1 above kicks in.

3.  Many mortgages have private mortgage insurance, etc., to compensate even further.

Hence, in a normal year, a small number of foreclosures is expected and manageable.  However, the period leading into this recession was anything but normal.  House prices peaked, and actually started tumbling downward, meaning that #2 wasn’t working very well.  The losses started bankrupting the PMI companies, thus making #3 ineffective.  Finally, foreclosure rates got up to huge levels. 

Still, you might say, these numbers should have been reasonably manageable, right?  Well, not so quick, partner.  Now we need to introduce two new concepts:  the mortgage backed security (MBS) and the default swap.  An MBS is a really strange, hybrid, derivative instrument.  Fully explaining it here is nearly impossible, but let’s take a stab.  Remember the $10m in mortgages?  (In actuality, we were usually dealing with pots of loans that were ten times that big.)  Let’s say the average yield on that pool was 6%.  Now, I’ll chop and dice that pool three ways.  First, I’ll sell $5 million of it to widows and orphans, and promise them AAA safety by giving them first crack at the principal and interest.  However, their yield will only be, say, 4%.  Next, I’ll sell some speculators the next $2.5 million of AA rated paper, and give them the NEXT crack at the payments but only a 5% return.  The last $2.5 million will get all the residual returns, which should work out to an 11% yield if nothing goes wrong (see numbers 1 – 3 above).  However, everything went wrong, and these last slices of the pie went down the tubes.

Now, if you’re Lehman Brothers, you take that last slice, and sell IT off  in slices to investors.  However, you promise THEM AAA security by entering into a credit default swap.  Essentially, you’re getting Bear Stearns to guarantee YOUR pools, and you guarantee theirs.  To find out how that worked in reality, go see the movie.

Unfortunately, so much of our investment banking establishment was hinged on these derivatives, and the underlying asset values went so far down, that the system totally broke down.  It’s very close to broken today, which is why getting low-down-payment loans is nearly impossible now-a-days (in effect, the default rate on 80% LTV loans is nearly zero, so that’s the only part of the system that’s working fairly well now). 

Fannie-Mae and Freddie Mac had Congressional mandates to buy tons of these mortgages.  While they were not in the MBS and credit default swap business, they were in the business of borrowing money to invest in loans.  A default rate of 6% or more might have been manageable if the values of the underlying assets hadn’t fallen by 20% – 40% in some parts of the country.  Note that 6% of several trillion dollars is a lot of money when the short-sale only recovers 60 to 80 cents on the dollar.  There is also a huge shadow inventory of properties (by some estimates, 5 million homes with a potential loan overhang of a trillion dollars) that haven’t yet even been foreclosed on but the loans are either non-performing or in serious arrears.

How do we fix it?  The system depends on a complex network of institutional trust coupled with complex insurance and hedges (essentially, a credit default swap was an insurance policy).  Most of that system is irreparably broken.  Following the Savings and Loan Crisis of the late 1980’s, the nature of residential mortgage lending was significantly changed in the U.S. and many other countries.  This situation is far, far more complex than that one, and probably calls for the same level of overhaul we saw in the Great Depression, when the very nature of home mortgages was completely stood on its head.  Unfortunately, we’ve wasted several good years with no settlement in sight.  My guess is that the rest of this decade will be wasted, at the pace we’re currently seeing.

Any good news?  I think so.  There are some great private sector minds who are currently realizing that the Federal Government is NOT going to step up to the plate with a solution like it did in the 1930’s.  Hopefully, the pace will pick up as the market starts realizing that it needs to find new financing instruments to satisfy the demand for housing and restore health to this sector of the economy.


Post Thanksgiving, time to go back to work…

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In past years (say, pre-2008), the Thanksgiving thru New Years period at Greenfield was always slow, as clients and projects seemed to hunker down for the holiday season. Naturally, 2008 was an aberration on a number of levels — the real estate let-down was in full force, and while our business flow was down, we were busy “hunkering down” for what we projected would be a long recession trough.

Last year (2009) was unpredictable. The first half of the year was dreary, but the last half was a rebuilding period for us, as has been 2010. We’re not yet where we want to be (that is to say, back on our pre-recession growth curve), but the accumulations of lessons-learned have put us in a great position for the future.

I’m commenting on our specific experience at Greenfield for a reason. I think our own company experiences are emblematic of what is happening at tens of thousands of other businesses across the U.S. and other countries, and has significant implications for the future of real estate, the economy, and finance for the next few years. I’m always reluctant to get into the prediction business (I’ll leave that up to Faith Popcorn and her ilk), but I can make a few generalizations, particularly as the parallel what I saw back in the 1970’s —

1. Business profits (and valuations — as we see from the stock market) are headed upward, not so much from increased sales (flat across the board) but also thru extraordinarily increased efficiency. One might wonder, if firms are so doggone efficient today, why weren’t they acting efficiently a few years ago? Simply put, “efficient” firms don’t grow very well. Growth usually requires a significant degree of wastage. Hewlett Packard was famous for this — they would budget engineers a certain amount of time and support to just tinker with things, knowing that the sort of Edison-esque profitability that came out of such tinkering. At one time, Xerox was so inventive that they thru away lots of great ideas, the Graphical User Interface being the best known example. Additionally, efficient firms cut wa-a-a-a-a-y back on hiring, training, and marketing. We see this now on college campuses, as new graduates (even in the “vocational” schools like business and engineering) are getting no offers or offers far beneath what their big brothers and big sisters got a few years ago.

2. This “hunkering down” not only cuts the demand for commercial real estate, but also means we may have a substantial excess supply of offices, warehouses, and shopping centers for some time to come. Ironically, business travel is coming back (as executives work harder to sell the same amount as before) but everyone is going “down” a notch on the hotel food chain — executives who used to stay at a Ritz Carleton are now at Marriotts, and former Marriott customers are now at Courtyard Marriotts. (Intriguingly, the Marriott organization is highly vertically integrated, and so actually takes great advantage of this phenomenon). The interesting off-shoot is that while aggregate hotel room counts are up, hotel employment lags (as customers move from “full-service” to “limited service” stays). The same is true with hotel restaurants, as dining-out budgets get slashed.

3. The “trainee” employment picture is worsening in some ways, but may actually improve in others. As noted, new graduates are having real problems getting placed, and are having to accept entry-level jobs far below expectations. I spoke with a young woman recently who graduated in 2010 in Finance. She had great grades and a stellar resume, and fully expected to get an entry-level job commensurate with her expectations. Guess what? No one is hiring. After several frustrating months, she accepted a job as a teller at a Credit Union at about half the starting salary she’d previously expected. Is there a silver lining in this? Yes, two. From the business’ perspective, they’re getting entry-level talent at bargain basement prices, and if they’re willing to mentor and foster these kids, they’ve got talent who will have a much greater familiarity with the nuts-and-bolts of the business once expansion does return. From the “hiree’s” perspective, a foot in the door builds experience and puts her at the starting gate ahead of the rest of the pack.

4. The early 1980’s recession was actually the last of a series dating back to the late 1960’s (the period was called “stag-flation”). While the early-80’s recession was the worst of the bunch, it seemed to have wrung the last of the “bad stuff” out of the economy, and set the stage for two decades of nearly continuous growth. Many credit the pro-business agenda of the Reagan Administration, but that ignores the tremendous pent-up inventiveness which had been waiting for an opportunity. Gates, Allen, Jobs, and Wozniak had been tinkering with computers and software for a decade, but needed a business expansion to really get themselves going. Sam Walton had great ideas about merchandising, but the explosive growth of WalMart depended in no small part on the availability of cheap construction and development credit to build mega-stores at seemingly every street corner. We decry the sloppiness of the mortgage market of the past few years, but no one seems to complain about the millions of construction workers and realtors who rode from apprenticeship to retirement on the wave of the housing boom. Recessions do not last forever, although this one does have the symptoms of lasting for a while longer. When 4% GDP growth returns (and remember, folks, that’s really all it takes), we should be poised for a period of expansion not-unlike the one that started in the mid-1980’s.

Well, folks, that’s really it. Like most of you, I have a lot to be thankful for. I live in a fairly free country, with an economy that considers 9% unemployment and 2% GDP growth to be unacceptable. I get the opportunity to interface with students and young folks on a daily basis, and they constantly refresh my positive outlook for the future.

Written by johnkilpatrick

November 27, 2010 at 11:33 am

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