December 11, 2023

Signs Of A Bottom In Real Estate

The Federal Reserve would like us to believe that lowering rates will reverse the decline in housing values.   They have brought interest rates to virtually zero  providing some payment relief to selected borrowers.  In the long run, however, efforts to prop up the price of housing with rate cuts and loan modifications will merely prolong the slide in values.   If the Fed had the power to prevent a decline in housing prices, they would have done so.  In a free market economy, prices will eventually reflect the reality of matching home ownership with income.   The Fed can lean against the primary trend but it cannot change it.

The lending distortions of the past that created the bubble in housing are now gone.   It is no longer enough to say that you make $150,000 – you need to prove it.   It is no longer possible to get 100% financing with poor credit.  The poor lending decisions of the past are causing pain for both borrowers, banks and the economy at large.  Lower rates alone will not clear the market.

The free market has solutions to over leverage and poor lending decisions.   The solutions are called write offs, bankruptcy and foreclosure.   As painful as these measures are, they are the mechanism for building a financially strong base of homeowners who will be far less likely to default on their mortgages.

During the height of the housing bubble several years back, only 10% of California households qualified for a conventional 30 year fixed rate mortgage.  The bubble prices were nurtured and sustained by exotic lending programs with no income verification.  Fast food workers bought $1,000,000 homes.  Now the bubble has burst.  The positive side is that prices are reverting to levels where real buyers with real income can now buy and have an affordable and sustainable payment.

Evidence of a healthier housing market is also seen in the National Association of Realtors housing affordability index.  This index shows an all time high of housing affordability based on income.  The Case Schiller data on price to income ratios also shows a marked improvement of affordability although it is still 20% over the long term average prior to 2000.  This is all good news which is being masked by the ongoing  housing bust.

Hints that we are finally arriving at fundamental values in housing can already be seen in San Diego.

Forbes reports that intrepid investors are buying houses out of foreclosure and renting them out at a profit – often to neighbors who lost their own homes.

Randy L. Perkins amassed a nice fortune in real estate, life insurance and investment banking in southern California over the past 30 years. Since May he has sunk $5 million of it into the one place most investors least want to be: housing.

Perkins has bought two dozen homes in the San Diego area through his Westview Financial Group. One was a dilapidated three-bedroom stucco in Escondido for which Westview paid $158,000–a 61% discount from the previous selling price of $408,000.

Westview eventually spent $40,000 on acquisition costs and improvements. Then it rented the home for $1,800 a month, netting about $18,000 in annual profit after property taxes, maintenance and insurance. That’s a 9% return on the acquisition cost before income taxes…

Currently one in every 32 San Diego homes, a total of 34,854 units, is in foreclosure. That ranks it as the 21st-most-troubled housing market in the nation.

Now first-time buyers and investors like Westview are offering a glimmer of hope. In September the number of San Diego homes sold rose 56% from a year earlier to 3,366, according to DataQuick. More than half were bought out of foreclosure, indicating that Perkins is far from alone in seeing promise amid the wreckage.

Priced properly anything will sell.  Time and price will accomplish what the Fed cannot.  There are oceans of private money looking for an adequate return on capital.  Let the free markets do their work – and the pain of the housing bust will soon be solved.

Deflation Everywhere As Credit Unwinds

Motorola Tightens Belt Again – Wall Street Journal

Motorola Inc. announced most employees won’t get raises next year and put a freeze on its U.S. pension plan and matching 401(k) contributions as the struggling cellphone maker continues to cut costs.

The moves are on top of $800 million in cuts announced two months ago that include 3,000 job cuts and suspending breakup plans.

The telecom-equipment-maker said it will permanently freeze its U.S. pension plans, preserving vested benefits accrued by employees and retirees but eliminating future benefit accruals, effective March 1. The company said it intends to continue to provide funding to meet its pension obligations to present and future retirees. The 401(k) match suspension begins Jan. 1.

Messrs. Brown and Jha have agreed to have their 2009 base salary cut 25%. Mr. Brown also will forgo a 2008 cash bonus and Mr. Jha’s bonus will be cut by the amount Mr. Brown is forfeiting. The remainder will be taken in the form of restricted stock units.

We will be seeing many more headlines similar to this as the great credit unwind continues.  The panic moves by the Federal Reserve to lower credit costs and increase lending are at the margin as demand and spending continue to spiral lower.  Lower demand, lower incomes and asset destruction due to defaults are all deflationary.

Pay cuts, job losses and salary freezes are spreading throughout the economy with increasing speed and frequency.   As this self perpetuating cycle of lowered demand continues, lower interests rates may have only a marginally beneficial affect.  Employees receiving pink slips, pay cuts and lowered benefits are not likely to be spending more regardless of the level of interest rates.

The Federal Reserve is doing what it is supposed to do by stabilizing the economy, but they will not be able to change the economic fundamentals of a market economy that is attempting to correct past credit excesses.

When A Walmart Clerk Beats A $2 Million Trust Fund

The Federal Reserve fired its last bullet today by formally cutting interest rates to zero percent.  A Fed statement noted that  “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability”.   In addition, the Fed will keep rates at this exceptionally low level for an extended period of time.

To date, the Federal Reserve has spent trillions and driven down rates on short term treasury paper to zero.  None the less, rates on loans for most individuals and corporations are much higher than when the credit crisis began.   One area that that has seen rates decline to all time lows is home mortgages, although it is debatable how many borrowers qualify for the best advertised rates.   Those most in need of funding are most often turned down at any rate due to issues with credit, income or collateral.

I have yet to hear of anyone who feels that the Fed really made a difference and saved them from financial ruin by cutting rates.  Whatever savings might have been accrued by the average consumer have been more than  outweighed by the losses suffered in their retirement portfolios and home equity declines.  The banking system was saved, the average worker was not.

One group that has and will continue to suffer great stress due to diminished income is the never mentioned saver.  The saver group by definition spent less than they made due to thrift and hard work and put their savings in their local bank so that they money could be lent out to borrowers who bought homes and such, frequently at 100% financing.  Now that the borrowers are in trouble, the Fed needs to cut rates to help them.  Helping those in trouble is fine, but the consequences of the Fed’s rate cutting campaign is impoverishing those very same people who provided savings capital to lend in the first place.

Let’s take the case of a Walmart clerk who retires after 30 years of service and is awarded a pension of $25,000 per year.  The Walmart clerk’s retired neighbor lives off a $2,000,000 trust fund established by her father who directed that the monies be conservatively invested only in government debt securities.  The trust fund provides a life interest of income only to the beneficiary.   The original $2,000,000 principal goes to charity after the beneficiary’s death.

This $2,000,000 trust fund, laddered in 6 month and 2, 5 and 10 year government paper yields a total of $22,100 at today’s interest rates.   Should the Fed succeed in driving long term rates to the sub 1% level that we see in Japan today, the trust fund baby would be lucky to receive $10,000 per year.

Result of ultra low interest rates?

Walmart worker stays retired and lives poorly.  Trust fund baby lives poorly and goes back to work at Walmarts.

Long Term Housing Stability Based On Strong Borrowers

When will the housing market improve?  That seems to be the question of the day so I offer some observations.

When you hear that financing is hard to get for a home mortgage, what you are really hearing is that unqualified buyers are not being approved.

If you can verify adequate income, are able to make a down payment of at least 3% and have decent credit (at least a 580 FICO score), getting a mortgage approval at a low rate is not difficult.  You will not be approved for a mortgage if you cannot verify your income, if you have terrible credit or if your income is insufficient to support your mortgage and other debt payments.  This is a healthy change for housing long term since ultimately, weak buyers are not capable of sustained home ownership.

Buyer psychology is an important part of the home buying process.  Just as in the stock market,  where higher price trends will entice more buyers, the same is true of housing.   Everyone talks about the wisdom of buying when prices are down, but the fear of future price depreciation deters present buying; everyone wants to wait until they can see a bottom.

Most responsible borrowers need to feel financially secure before purchasing a home.   With a very weak economy, job losses and lack of confidence in the future, most prudent people will think twice before taking on the large financial commitment of owning a home.  The disappearance of 100% financing also means that a buyer faces the loss of his capital investment if the mortgage payments cannot be maintained.

Is it cheaper to rent equivalent housing?  If it is cheaper to rent, does that imply that housing is overpriced?   Have prices been adequately discounted to adjust for past purchases made with easy financing by speculators and unqualified buyers?

A buyer contemplating a home purchase today must consider whether the various government schemes to keep delinquent homeowners in their homes is artificially propping up the market and extending the decline of housing prices.  If a homeowner is unable to pay his mortgage today and with incomes and jobs disappearing, how likely is it that a delinquent homeowner’s income will increase?  Are the loan modification programs and foreclosure holidays making a home buying decision more difficult?  If these programs fail, will the future flood of foreclosed homes on the market cause further large home price decreases?

Is the average buyer today prepared to pay the large maintenance and repairs associated with home ownership?  If buyers today see little chance of future price appreciation, are they prepared to invest a large part of their free time maintaining a home?

Given the large transaction costs of buying or selling a home is it worth purchasing a home unless you know with certainty that you will remain in the home for an extended period of time?  Transaction costs including sales commissions, financing and moving can easily equal 10% of an average home’s value.

Am I really ready to own a home?  In the past, when people foolishly believed that housing values could only go up, this question was rarely asked.  Before considering the purchase of a home, a buyer should discuss in depth with other homeowners the pros and cons of home ownership.  The question of whether to buy or rent has never been more difficult.  A very uncertain housing future and lack of confidence breeds indecision and purchase deferral.

Many of the current problems in the housing market arose due to the easy credit offered to buyers who should have stayed renters.  Buyers should not consider the purchase of a home unless their total mortgage and other debt payments are easily affordable.  Buyers should not use their last dollar of savings when purchasing a home.  Many unexpected expenses will routinely come up.  If you don’t have at least 6 months of income in savings, after your down payment, consider postponing the purchase until your finances improve.   After years of  house buying mania and then a bust, how many confident and strong buyers are out there?

Most mortgage companies and home builders involved with first time home buyers offer advice on determining the affordability of a buyers mortgage payment but do not address many of the other issues discussed here.  Major companies such as KB Homes, for example, discuss the affordability question, but I think more needs to be done in this area.

In the long run an educated buyer with financial stability will be the bedrock of a stable housing market.   Hopefully, future regulations arising from the current housing crisis will address the issue of educating home buyers and make this a mandatory part of the home purchase process.

A World Of Zero Interest Rates

We have arrived at 0 interest rates and the reasons we are at this point are all negative indicators for where we are and where we are heading.

Theodore Ake, head of U.S. Treasury trading at Mizuho Securities USA Inc. in New York, one of the 17 primary dealers of U.S. government debt, said some investors bought three-month Treasury bills from his firm with negative yields of 0.01% to 0.02% Tuesday. By the end of active trade, the yield had inched back up to positive 0.02%.

In round numbers, the investors were willing to pay $100, knowing they would get $99.99 in return, in the belief that a small but guaranteed loss was preferable to investing in stocks, corporate bonds or other securities. Treasurys have been flirting with 0% yields since the Lehman Brothers bankruptcy nearly three months ago.

“The bond market is doing a much better job than stocks right now of telling you about the risks that are out there,” said Thomas H. Attenberry, a partner at First Pacific Advisors, an investment-management firm in Los Angeles. The high yield investors are demanding on anything other than Treasurys is particularly worrisome because companies need to refinance more than $800 billion worth of debt next year, according to analyst estimates.

The notes the extraordinary amount of risk aversion taking place as investors loss their confidence in the ability of anyone other than a central bank to repay their debts.

The investor search for a safe places to store wealth as the financial crisis shakes faith in the system has caused extraordinary moves in global markets over recent days, driving the yield on 3-month US Treasuries below zero and causing a rush for physical holdings of gold.

“It is sheer unmitigated fear: even institutions are looking for mattresses to put their money until the end of the year,” said Marc Ostwald, a bond expert at Insinger de Beaufort.

The rush for the safety of US Treasury debt is playing havoc with America’s $7 trillion “repo” market used to manage liquidity. Fund managers are hoovering up any safe asset they can find because they do not know what the world will look like in January when normal business picks up again. Three-month bills fell to minus 0.01pc on Tuesday, implying that funds are paying the US government for protection.

“You know the US Treasury will give you your money back, but your bank might not be there,” said Paul Ashworth, US economist for Capital Economics.

The gold markets have also been in turmoil. Traders say it has become extremely hard to buy the physical metal in the form of bars or coins. The market has moved into “backwardation” for the first time, meaning that futures contracts are now priced more cheaply than actual bullion prices.

The latest data from the World Gold Council shows that demand for coins, bars, and exchange traded funds (ETFs) doubled in the third quarter to 382 tonnes compared to a year earlier. This matches the entire set of gold auctions by the Bank of England between 1999 and 2002.

Credit markets may have thawed somewhat but after suffering horrendous losses on virtually every asset class, investors seem determined to put whatever cash they have left in the most risk free category possible – even if that means paying for the privilege via negative interest rates.

A desire for a return of capital rather than a return on capital, as the old saying goes, is what we are looking at here.  Of course, at some point, the disgust of receiving a zero return on your money is bound to drive at least a portion of the capital now in treasuries into another asset class.  Investors will be willing to risk some of their capital in another asset class which might be riskier but which also promises some good chance of obtaining a return on capital.

My guess is that one such asset class will be gold, as I previously discussed in  Gold, Cheap at $5000?
I view gold as the ultimate insurance hedge against a government’s propensity to spend itself into insolvency and, accordingly, I believe that gold should constitute 10 to 20% of one’s core investment assets.   Historically, governments  have regularly and repeatedly defaulted on their sovereign debts.  In every such case of default, the citizens of those nations would have been far better off holding gold rather than government paper.