Future resale supply depends on when the banks process their foreclosures

Economists and housing market observers pour over sales numbers each month to divine the direction of future house prices. Everyone has their pet theories on whether house prices have bottomed or if there is more pain ahead. Many rely on these numbers as gospel forgetting that these numbers are generated by the actions of people responding to the conditions around them. Change the conditions, and the numbers can change quickly.

For example, in February of 2012, lenders across the Southwest abruptly stopped processing their backlog of foreclosures, not because they exhausted the supply of delinquencies but because of internal policy changes brought about by the foreclosure settlement with state attorneys general around the country. The story of the housing bubble is really the story of unprecedented market manipulation by lenders, legislators, regulators and the federal reserve. Predicting how this all plays out is fraught with difficulty, not because the basic economics are hard to understand, but because there is no way to predict when one of the key players will change a policy, what that change will be, and how that change will effect the market. So far, even when the bulls have been right, they have been right for the wrong reasons. Unpredictable and unprecedented policy responses are what has stopped the deep correction in house prices from becoming a complete catastrophe for loanowners and lenders.

The bears were right

Back in 2005 and 2006, the bears predicted a collapse in housing prices. Toxic mortgage products proliferated driving prices up beyond all reasonable measures of value. Many ordinary citizens became real estate speculators, and housing bears postulated that these people would default resulting in a violent contraction of credit, millions of foreclosures, rising interest rates to compensate lenders for the risk, and a dramatic crash in prices as product was forced into a market with a greatly diminished buyer pool.

The story of the housing market since 2006 has been one of unprecedented manipulations of the market by lenders and regulators. First, in response to the weakening economy, the federal reserve lowered interest rates counter to what the market would have done if left to its own forces. When it became obvious that mortgage lending would soon implode and take the GSEs down, the government reneged on 60 years of promises and took the GSEs into conservatorship. Without the backing of the US taxpayer, mortgage interest rates would have skyrocketed, or mortgage lending would have stopped. Four years later, the government still insures over 95% of the loans in the mortgage market, and there are few signs of private lending returning. The jumbo loan market is still moribund and likely to stay that way.

By late 2008, prices were crashing hard in nearly every market in the country because lenders were doing what the bears said they would do; they foreclosed on those who defaulted and resold the properties. These foreclosures were concentrated in low-end neighborhoods dominated by subprime lending because those loans went bad first. Bears said it was only a matter of time before the alt-a and prime borrowers defaulted and those neighborhoods crashed too. And they would have if banks and bank regulators hadn’t changed the rules.

In response to the crash of prices in subprime neighborhoods, lenders slowed the rate at which they filed foreclosures and finally processed them. Shadow inventory was born. Prior to late 2008, lenders had not done this since the Great Depression. To allow lenders to sustain shadow inventory, government regulators suspended mark-to-market accounting rules which allowed lenders to keep loans on their books at full value rather than reflect what these loans were really worth. Further, regulators allowed lenders to sustain these fantasy values until they foreclosed on the property providing a huge incentive not to foreclose. As a result, when the alt-a and prime borrowers defaulted as the bears predicted, no wave of foreclosures followed. How could bears know that banks and regulators would change the rules? How could bulls know that? Many bulls have smugly said the bears were wrong about the wave of foreclosures. That much is true, but the bears were certainly right about the wave of delinquencies that should have been foreclosures. Only the unprecedented response to these delinquencies was in error.

The completely unpredictable and unprecedented actions taken by banks and regulators did not end with the takeover of the GSEs, the creation of shadow inventory, and suspension of mark-to-market accounting rules. No, the federal reserve took interest rates down to zero, and for the first time in their existence, they bought something other than short-term Treasuries. The federal reserve loaded up on mortgage-backed securities paying prices the private market wouldn’t in order to further drive down interest rates. Who could have reasonably predicted that? The federal reserve had never done anything like that before.

By 2009, some markets began to stabilize while others continued to crash. This mostly sorted out by concentrations of subprime loans. Markets like Las Vegas or Phoenix which were almost entirely subprime crashed very hard. Markets like Orange County which were mostly alt-a and prime were spared thanks to a healthy dose of shadow inventory and high-end squatting.

In response to the continuing deterioration in the subprime markets, government legislators stepped into the fray and passed a series of tax credits designed to stimulate demand. Again, neither the bulls or the bears could have predicted such a response, but both the federal government and the State of California passed tax credits which served to pull demand forward, temporarily raise prices (and hopes), and trap another group of hapless buyers in underwater mortgages.

When the tax credits failed to reignite the housing market — something the bears did predict — prices rolled over and went on an 18 month decline until the spring of 2012. Aided by a 20% to 30% reduction in borrowing costs as interest rates continued to fall per the federal reserve’s plan, the cost of ownership fell below the cost of a rental in most markets.

This prompted many hesitant buyers to act, and it also caused investment hedge funds to enter the market with significant capital to buy up low-end properties. I predicted this back in March of 2007:

Two Levels of Buyer Support

There are two categories of buyers that will enter the market and purchase real estate without regard to appreciation: Rent Savers and Cashflow Investors. These are the buyers that will buy houses even if prices are declining; therefore, they are the ones who call the bottom. Rent Savers are buyers, like me, who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them.

Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and you have an unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.

BTW, if there were any inventory right now, I would be looking to buy a home.

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Proprietary Irvine Housing News home purchase analysis

14 BUTTERNUT Ln Irvine, CA 92612

$930,000 …….. Asking Price
$1,085,000 ………. Purchase Price
4/23/2006 ………. Purchase Date

($155,000) ………. Gross Gain (Loss)
($86,800) ………… Commissions and Costs at 8%
============================================
($241,800) ………. Net Gain (Loss)
============================================
-14.3% ………. Gross Percent Change
-22.3% ………. Net Percent Change
-2.4% ………… Annual Appreciation

Cost of Home Ownership
——————————————————————————
$930,000 …….. Asking Price
$186,000 ………… 20% Down Conventional
3.65% …………. Mortgage Interest Rate
30 ……………… Number of Years
$744,000 …….. Mortgage
$178,452 ………. Income Requirement

$3,403 ………… Monthly Mortgage Payment
$806 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$233 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$168 ………… Homeowners Association Fees
============================================
$4,610 ………. Monthly Cash Outlays

($767) ………. Tax Savings
($1,140) ………. Equity Hidden in Payment
$222 ………….. Lost Income to Down Payment
$136 ………….. Maintenance and Replacement Reserves
============================================
$3,061 ………. Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$10,800 ………… Furnishing and Move In at 1% + $1,500
$10,800 ………… Closing Costs at 1% + $1,500
$7,440 ………… Interest Points
$186,000 ………… Down Payment
============================================
$215,040 ………. Total Cash Costs
$46,900 ………. Emergency Cash Reserves
============================================
$261,940 ………. Total Savings Needed

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Cost of Ownership Analysis

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Nearby Foreclosures

Gain a competitive advantage over other buyers. By locating distressed properties -- before they hit the MLS -- you can discover where tomorrow's REOs and short sales will appear. Most of these properties are not listed on the MLS, but they will be soon. Research properties in advance and get a jump on your competition. Don't miss out on another deal because you couldn't act quickly. Use this tool to your advantage! The red properties are already bank owned. As soon as REO asset managers prepare them for sale, they will be on the MLS. Get ready! The green and blue properties have owners who are not paying their mortgages. They may be offered as short sales, or they may go through foreclosure and become REO. Either way, they will also likely be available on the MLS soon. Find your next home! Be prepared to offer on these properties by researching them in advance or risk losing out to buyers who are have done their homework. Start your research today! To find distressed properties, enter your desired location and press search. Scroll through list by pressing "next."

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Comparative Market Analysis

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	$1,500,000 18651 VIA PALATINO		0.89 miles 4 bd / 3.5 ba 3,895 Sq. Ft.
	$889,000 8 RAINSTAR		0.93 miles 4 bd / 2.5 ba 2,500 Sq. Ft.
	$749,000 18 FOXGLOVE Way		0.96 miles 4 bd / 2.5 ba 2,862 Sq. Ft.
	$1,495,000 2 ANGELL		0.96 miles 5 bd / 4.5 ba 3,850 Sq. Ft.
	$1,325,000 11 BETHANY Dr		1.35 miles 5 bd / 4 ba 3,400 Sq. Ft.
	$860,000 5 PADUA		1.38 miles 4 bd / 3 ba 2,528 Sq. Ft.
	$839,900 5 BIRCHWOOD		1.52 miles 4 bd / 2.5 ba 2,907 Sq. Ft.
	$1,350,000 10 WINDFLOWER		1.53 miles 4 bd / 3.5 ba 2,956 Sq. Ft.
	$1,499,000 4 FLINTRIDGE		1.69 miles 5 bd / 3.75 ba 3,142 Sq. Ft.
	$979,000 19 MEDLAR		1.73 miles 5 bd / 3 ba 3,123 Sq. Ft.