A "Well-Contained" Meltdown

Its always good to keep things in perspective. If you read my last post, it will help to read the text of a recent speech by San Francisco Federal Reserve, President Janet Yellen that was presented on February 21 to the Silicon Valley Leadership Group. She discusses the US Economy 'glide path', or what the media likes to refer to as the 'soft landing'.

She notes that the concern over default rates in the market for sub-prime mortgage backed securities (MBS) appears to be well-contained. Investors have isolated their souring mood to the sub-prime sector, and value of prime MBS are holding well. She suggests that tighter lending standards across the board might not hit with such an impact if the concern remains isolated to sub-prime.

She also discusses the relationship between this marketplace and the housing market, and potential for collapse, saying that "while not fully allayed have diminished".

It sounds like a very calm response to the news from sub-prime. I hope cool heads prevail while this market shakes itself out.

The Liquidity Crack-Down

Last time we talked about the potential for lender guideline reform to clip off the fringe of the buying pool in real estate, and what the implications for this would be to home values, and the economy in general. In the last few days, I have heard more murmer about lenders trying to tighten up so that they don't cut their own throats in the secondary market with a reputation for selling bad paper. Colleagues of mine are seeing their entire business model taken out of the product pool. It seems that some would-be buyers are going to have to be left behind here in the cycle, and the real mystery to me is, how big of a 'fringe' we are talking about...

Often referred to in the industry as a 'liar's loan', stated income loans are facing serious scrutiny. I won't get into when and why these loans make sense and are fair and smart, but I can tell you when it looks suspicious. If an applicant has a job that typically pays a flat steady salary, but they want to 'state' their income rather than prove it, chances are they don't really have the income they are stating. "Stating" is for convenience or inability to prove income, not for concealing or misleading. Lenders historically charged higher rates to off-set the risk associated with not proving income, but as these guidelines have become more and more liberal, the 'stated income' premium has shrunk. Banks and Wall Street knew that the rising value of real estate served as a safety net against any possible default case, so the risks across the board were smaller. Stated? Who cares, the house is doing 12% a year!

But those times have changed. Underwriters know that some people fudge the numbers, and that some people lie. Wall Street, Congress, and Economists are all growing concerned that too much mortgage debt is floating around qualified on false pretenses. With values flat, or declining, borrowers who have over-stated their reach are feeling the heat. Foreclosure numbers are escalating, investors are getting burned, and congress is calling for tighter standards, more regulation, and less throwing money at people who don't qualify for it.

This trend is going to persist for a while. Lenders need to shake out their bad products, get back to basic risk management standards, and deliver quality paper to Wall Street. Risky loans can be great tools for borrowers with the apetite for risk and ample knowledge of how to manage that risk. Risky borrowers can still be homeowners with stable and conservative loan products. But when you mix risky borrowers with risky products, and put them in a flat or declining housing market, look out.

A lot of economists have seen this coming for some time. The excess global liquidity has created an environment where risk premiums have been condensed so far that nobody can evaluate risk adequately any more. Bill Gross talked about this almost a year ago, noting that junk bonds were getting A Paper prices, and concluding that investors were not being fairly compensated for the risk they were taking. In most cases, it was probably not clear how much risk there was. John Mauldin expects this to turn into a full blown scandal in the mortgage debt marketplace, as those who have been buying the subprime debt are paying A Paper prices for BBB- Paper, and have been possibly mislead by creative derivitave products.

Its complicated stuff. Markets ebb and flow. Sometimes the waves get big, and cause a little damage when they smack up against the shore. The longer it takes to correct these problems, the harder the correction hits, and the more it hurts. Ben Bernanke and the Federal Reserve have been working to clip liquidity to the tune of 17 0.25% rate hikes. The Bank of Japan recently came up to 0.50% from a long-time low of 0.00%. This makes it more expensive for banks to lend money, and for people to borrow.

This has helped cool the housing market, but people who shouldn't be borrowing still are. Risky borrowers can still get risky loans, and they have been injecting instability into the system. Now we are going to see institutions step in and self-regulate. And we are going to see congress step in and regulate with red tape. I expect to see the 100% purchase scenario in housing become very difficult relative to the current ease. Stated Income documentation will become difficult for W-2 employees. Down payment, income and credit standards are going to inch up.

If this hits with too big of a thud, there goes the 'soft landing'. Angelo Mozillo said he has never seen a soft landing, and you have to be careful when anybody tells you "this time it's different". Let's hope this all shakes out without a lot of turbulence.

Anatomy Of A Bubble

I'm not convinced that we have seen the bottom in housing. I'm not convinced that we have seen a successful soft landing either. Things definitely slowed down going into the end of 2006, and they are definitely picking up again in early 2007. But I don't see any reason to believe we will return to the hyperbolic growth we saw in previous years - or anything close to it. In fact, there still is some very real concern that we could see a more significant drop in house values.

The Federal Reserve is expected to keep rates flat all year. Some economists think we will see a rate cut late in the year, and some see a rate hike a possibility still. History tells us that the Fed usually starts cutting rates within 9-18 months of their last rate hike.

I have often said that with so many variables in the economy, and in the housing market specifically, all it can take is one environmental change to trigger a shift in consumer mentality, and thus consumer behavior. One of these variables that has re-entered the fold in the last few weeks is Wall Streets control over mortgage lending practices. With sub-prime lenders going out of business, Wall St. has raised concern with sub-prime mortgage backed securities. The lenders are responding by tightening their lending guidelines to uphold or improve their credit ratings.

A year ago, congress was advising the lending industry to do this, but lenders were actually relaxing guidelines in an effort to grab more of the shrinking volume of business. So with this pendulum swinging back the other way, you can expect the fringe of buyer access to be trimmed away, thereby reducing the pool of potential buyers, demand, housing liquidity, and ultimately prices. If lenders go too far too fast, either by their own proactive measures, or in response to Wall St. demand, we could see a shock to this system. And if the consumer perceives this to be significant, thats when the potential to freeze up and panic sets in.

Weakening prices slow what Paul Kasriel of Northern Trust refers to as 'household deficit spending', as homeowners cannot spend their home equity on other consumer purchases. If you don't think this is a big deal, take note of the fact that the US Savings rate is at its lowest since the GREAT DEPRESSION, at a negative 0.5%. People are using their homes like ATM's on a National level. Cutting off access to this slows spending, and the economy in general. Enough of this and the Fed is back into rate-cutting territory.

So while I hear agents advising their clients that "the bubble has not burst", and that offers without contingency and 10% above the asking price are required "if you really want this home", I don't like anybody being too anxious to lead with logic when transacting in real estate. It is competitive right now, yes. But I'd be concerned that the housing market is making a head-fake here.

Real Estate and Tax - What's Important To Know

With tax season officially open for the 2006 filing year, its time to refresh the memory on some important tax issues related to real estate. I see a great deal of confusion and misinterpretation of tax rules when meeting with people in my mortgage planning practice. Realty Times has a good reminder on the homestead exepmtion that Bill Clinton gave us with the Tax Reform Act of 1997. Make sure you know the rules for this tax treatment on homes in the year they are sold - especially if you are thinking about renting the home out at any point. Its also important to know the difference between mortgage interest expense and investment interest expense when trying to write off those mortgage and HELOC dollars. I see the majority of people surprised when confronted with the rules for deduction of mortgage interest. The IRS is talking about taking a closer look at these deductions to make sure tax-payers are walking on the right side of this fine line...

You can find a lot of tax resourse on the IRS website, but you may want to consider letting a professional CPA handle your taxes for you. The more complicated your return, the more value a tax planner stands to offer. Let me know if you need help locating a good one.