Tuesday, September 27, 2011

Real Estate Collateral Based Lending Run Amok ... Time for the Truth?

Our residential housing market is in a state of bust. That's for sure. New Home Sales Drop says this about the just released annualized number of new starts at 295,000:

"New-home sales amount to about a quarter of their peak before the bubble began deflating around five years ago. Sales are far below healthy levels, considered to be an annual rate of around 750,000.

Consumers have slowed their spending sharply this year, pulling down economic growth and preventing unemployment from falling. High joblessness and a weakening economy are raising Americans' doubts about their prospects for the future, leading many to save money and pay down debts rather than taking out loans.Some people can't get financing due to tight lending standards enacted after the housing bust."

And regarding homes already owned and occupied, the value of the collateral to the lender often isn't worth as much as the amount owed on the loan. As a result, far too many borrowers are in either actual or practical default status. Whatever the status, they are in a world of hurt.

In addition to the financial damage being done to individuals and their families, the housing bubble bursting has done great harm to banks. But if you are not in a mood to pity the banks, and who is, how about a little pity for the taxpayers?

Most mortgages are held or guaranteed by taxpayer backed government agencies (FHA, Fannie Mae and Freddie Mac). So we the people will get the final bill, as usual.

By now, we know all about the housing bubble and its bursting. But how did it happen, how long will the pain last, and will there be more shoes to drop? We'll try to answer those questions now.

What is referred to as collateral or asset based lending played a big role in getting us into the hole we've dug for ourselves. This type of lending is also going to play a big role in keeping us in that hole for a very long time to come.

In an effort to make an extremely complex story simple, let's face facts. The collateral, or value of the real estate, isn't worth anywhere close to the outstanding loan amount.

And this problem of diminishing collateral value to the amount of the loan outstanding has been exacerbated by many people adding to the initial loan balance. We did this "adding" through an ATM approach to securing home equity loans and refinancings.

All this, when combined with government subsidized cheap and easy credit, as well as extending non-recourse walk-away loans to buyers, resulted in the widespread nationwide housing fiasco of today.

Let's use a simple example. If we purchase a home for $100 and borrow all the the money to do so, we owe $100. We also have an asset worth $100 to offset the loan of $100.

If the nominal price of homes more than doubles within a few years, which indeed happened between 1996 and 2006, we will then have an asset worth $200. But we owe only $100.

Our real estate related net worth or wealth has now grown by something approaching infinity, since we had zero net worth when we bought the house, while now we have $100. That's because the house is now worth $200, but we owe only $100.

Now we make a big mistake.

So we take our valuable appreciating $200 asset as collateral and secure an additional bank loan for another $100. Now we owe a total of $200 for the two loans, and our asset is worth $200.

We're back to square one. We own something valued at $200 and we owe $200.

Now we make a really big mistake.

We buy a boat, take a vacation, buy a car or go to Las Vegas with the $100 acquired by refinancing the original loan.

Now it hits the fan.

The housing price bubble bursts and the home is now "worth" less than $130. We still owe $200 and now sit squarely between a rock and a hard place.

That's debt induced deflation at work.

Sadly, many Americans are now in the situation described above. As a result of their underwater collateralized asset based loans, they are hurting with no easy solution available.

What would have been a bad situation, due to the collapse of home prices, has been compounded by the effects of prior "asset based" borrowing due to the housing price bubble. But now the bubble has burst, of course.

Are there other related shoes to drop and if so, on whom? Yes, there are.

Many local commercial borrowers are in serious jeopardy, and especially heavily leveraged raw land buyers, builders and developers.

The perverse incentives or law of unintended consequences applies in spades to our real estate industry, both residential and commercial.

Let's look to Spain for an interesting contrast to our American situation. Spain is a nation in a world of hurt financially, and in addition to their real estate and banking woes, they have an unemployment rate of in excess of 20%.

Yet less than 2.5% of the Spanish residential mortgages are in trouble compared to several times that percentage in the U.S. How can that be, and what does it mean? In other words, what lessons can we learn from Spain?

Spain's Banking Mess provides an analysis of the Spanish real estate market. It makes for an interesting comparison to the way we do things here. About the U.S. versus Spanish housing market contrast, the article says in part:

"The most important fact may be that refinancing is very unusual in Spain. They are generally unnecessary; since mortgage loans are made at variable rates, there is no need to take out a new loan if rates are declining. The absence of refinancing, along with the absence of home equity lines of credit, meant homeowners could not take out cash to spend on other things.

As a result, if you bought a house in Spain a few years before the peak, you still have equity in the home, even with prices down. If you lose your job and can no longer afford the payments, you can sell the home and emerge with something.

That would also be true in the United States if mortgages were for only house purchases. But in the housing cycle that led to the recent bubble — unlike previous cycles — it was far easier for homeowners to cash in their equity and use the money for whatever they wanted. So some people who have been in the same home for decades are desperately under water.

There were other differences as well. There were no “originate-to-distribute” strategies in the mortgage markets, so the loans were not bundled into securities to be sold to foolish investors.

Banks that made the loans expected to profit if — and only if — they were repaid. There were few loans to investors who planned to rent or flip homes. Moreover, mortgage loans in Spain are recourse. Buyers cannot walk away if they have other assets, as they can in some American states."

In the U.S. there existed a casino or ATM mentality with respect to using homes as collateral for acquiring other loans. Spain had no such approach.

Unlike us, Spain required from home buyers considerable down payments, loan terms with variable interest rates, offered no home equity loans and thus had no reason for home refinancings.

And to top it off, Spain didn't offer non-recourse loans to to home buyers. In order to make money on the transaction, banks needed to be repaid the loan, unlike our government subsidized walk-away practice.

Accordingly, whether taken separately or as a whole, the Spanish housing situation is completely different from our customary American practices.

Essentially, we encourage the assumption of maximum levels of debt and then make it worse by allowing underwater home owners to walk away from their real estate related debts.

And that's the story of why Spanish home loans have a 2.5% delinquency rate, a fraction of ours, despite the fact that home prices in Spain are collapsing and Spanish unemployment rates are in excess of 20% today.

For sure, the Spanish residential housing market is in much better shape than the American market. They do things differently than we do.

But the Spanish banks couldn't leave well enough alone, and that's a revealing story as well. It most likely augurs poorly for us, too.

In fact, my guess is that commercial real estate loans will be the next shoe to drop for many local builders and developers, as well as many community based American banks. Let's look to Spain for guidance here as well.

Spain has suffered falling land prices of 30% and home prices of 22% since the housing 2007 peak (both inflation adjusted), according to surprisingly candid comments by the Bank of Spain's head banker in Spain's Banking Mess. The banking official had this to say about the commercial real estate loan situation in Spain:

"“In both cases, we expect further corrections in the years to come,” he said. For land prices, he said, the bank’s “baseline scenario” was that prices would fall to little more than half of the peak level. The “adverse scenario” indicated that the decline could be significantly worse.......

But if lending to home buyers was conducted in a far more prudent manner than it was in the United States, lending to real estate developers and construction companies was, if anything, more irresponsible. The higher land prices went, the more eager the banks were to push out loans.

The story of how Spain’s banks got into the mess — and the way its mess differs from that of American banks — show that it is impossible for banks to walk away from a collapsing bubble in real estate. It also shows that the structure of mortgage markets can make a major difference in how a collapse plays out.

The figures released by the central bank this week showed that by the middle of this year, 17 percent of Spanish bank loans to construction companies and real estate developers were troubled — or “doubtful,” the term favored by the central bank. That figure has been rising rapidly, reflecting the deterioration in real estate values."

My guesstimate is that we have a similar troubling story developing in the U.S. If so, the end of the home owner mortgage debacle won't represent the end of the American real estate saga. Not even close.

For a clue, I suggest that you look at the situation in your neighborhood. What about the builders and developers that have raw land and incomplete or largely unoccupied finished construction projects? How good is that collateral in relation to probable loans outstanding? Not very, I would guess.

If I'm correct, these local real estate related loans will plague local commercial borrowers and their community based banks for years to come. The insufficient collateral values are now tied to empty or half empty offices, strip centers, retail stores and new neighborhood developments.

As these properties continue to sit half empty and the "asset based loans" don't generate enough cash to service the interest owed, let alone the agreed upon principal payments, what are the lessons to be learned?

There are many, of course, but perhaps the biggest is that housing mania in America was and is a sucker's game. For all of us.

But with the encouragement of almost everybody, including government, builders, developers, real estate brokers, lenders, teachers, families and friends, it was and still is a popular game to play. That will change, because it must.

In comparison, let's look at the "risky" stock market. Who encourages people to borrow money to make a single purchase of an undiversified asset like shares of stock? Nobody does.

In fact, if you want to borrow money to buy shares of stock, you are always at risk of having to repay the loan immediately if the stock's price falls (margin call).

Thus, while most people would correctly think it's crazy to buy stock with borrowed money, why do these same people buy homes with no money down and no money to repay the loan on demand?

It's not because of the difference in the value of the collateral. In one case, the collateral is the price of the stock and in the other it's the land and house.

Besides, we can always sell the stock on a minute's notice. Not so with the house.

So why did we get into this nationwide real estate related insufficient collateral mess?

My own view is that's it's our well developed and totally wrongheaded culture telling us that buying a house as early as possible, and borrowing as much as possible, makes all the sense in the world. The truth is just the opposite of that.

Thanks. Bob.

1 comment:

  1. Hard money lenders are lending money based on only collateral. It does not matter even if the borrower's do not have any credit and income information.