I have often been asked if there is going to be a second real estate bubble, as if I had some profound knowledge and could see into the distant future. Surely, the worst is behind us and nothing could be worst than all those sub-prime loans that ignited the first real estate bubble in 2005. Unfortunately, the real estate bubble started slowly and went relatively unnoticed. By 2007, the real estate bubble had picked up steam, and by the end of the year, the economy also went into recession.
According to some economists, the current recession is officially over and they point to an improvement in housing sales as an indicator. You ask any Wall Street broker or expert on the markets, and I have never seen them more bullish on the U.S. economy, if the rise in the Dow and stocks is proof positive. Banks and real estate brokers hail the drop in real estate loan rates as another indicator. So the recession must be over, right? Ask the 22.5 million Americans that are either unemployed or under-employed and they will tell you that the recession is not over for them.
I look at a different measuring stick. One of these is the huge deficits being sustained by 42 out of 50 states. Many of these states, including my home state of California, are already projecting increasing budget deficits, in spite of the Obama Stimulus Plan. This is happening to both blue and red states. There a few exceptions, but even those states are making plans to layoff government workers. The states see a bleak future, and learned from the Fed that unemployment rates are predicted to remain high (8-10%) for the next two to three years and that property tax collections will continue to decline due to a decline in property values. The states have had no choice, but layoff employees in huge numbers. The actions states have taken signals their lack of confidence in the stabilization and increase in real estate values. To many states, real estate values have not bottomed out yet.
Another indicator that I look at is the banks themselves. These are the ones that caused the financial meltdown in the first place, and got us into the terrible mess we are now in.
The OBama Stimulus Plan was supposed to stimulate the economy. The Feds reasoned that if dollars were poured into the banks, they would be prompted to lend money to small businesses, the biggest job creators, and this would create new jobs or re-hire those that were previously laid-off. As it turns out, the banks have turned risk aversive at a time we need them the most, and are doing very little lending. Many are using the money to buy competitors weakened by the recession and financial meltdown. Examples include acquisitions by Bank of America (acquired Merrill Lynch), Wells Fargo (acquired Wachovia) and Chase Bank (acquired Washington Mutual. Instead of creating jobs, the banks have increased unemployment, by laying off employees from the acquired banks. They call this streamlining or eliminating duplication of effort. The banks reason that these acquisitions will give them a competitive advantage when the economy turns around.
So the questions remains, will there be a second real estate bubble. The quick answer is, It depends.
Being the inquisitive, type A personality, educated and quick learner on my topics, I did some research on this very question and what I discovered sends shivers up my spine. It turns out that there are some alarming trends that are a lot more sinister going on in the real estate mortgatge markets than I ever imagined, and this prompted me to write this article.
One of the key sources that serves as background for this post is from research conducted by Amherst Securities Group LP and compiled into a report dated September 23, 2009 entitled, "Housing Overhang/Shadow Inventory = Enormous Problem". You can download a PDF verision of the report here:
http://www.scribd.com/doc/20351562/Shadow-Inventory-Report-Amherst-9-23-09
What caught my eye is the opening statement in their Executive Summary,
"The single largest impediment to a recovery in the housing market is the large number of loans that are either in delinquent status or in foreclosure that are destined to liquidate. This creates a huge shadow inventory. We estimate this housing overhang at 7 million units, 135% of a full year of existing home sales."
I have learned that every business plan should include an executive summary with a some kind of a bold statement. Well, Amherst Securities Group sure outdid themselves. That's one bold statement. And after reading their report, and researching other data on the housing market, I came to the same conslusion as Amherst. That's the shivering spine that I mentioned earlier.
According to Amherst, the apparent stabilization of home prices and the increase in new and existing home sales, is only temporary, and has led many investors to believe the housing market has bottomed, and is beginning to recover. Amherst believes this optimism is premature, while acknowledging there are a lot of positives in the market--prices have fallen significantly and housing is more affordable that at any point over the past 2 decades, and the national median price increased a couple of grand. The Obama administration's $8,000 tax credit for new home buyers pumped up sales (increased sales to first-time buyers by 10.1%) in the fourth quarter, and expired at the end of November. The U.S. Senate recently voted to renew the credit for the first six months of next year.
The Federal "Cash For Clunker's" program, that allowed U.S. automobile dealer's to offer auto buyers between $2,000 and $4,000 for a trade-in regardless of condition, caused a temporary increase in U.S. auto sales, but the program ran out of money in November, and has not been renewed. I fear that the the renewal of the $8,000 tax credit will temporarily boost sales of homes to first time buyers, but the tight credit standards of banks and potential for an increase in home prices resulting from the program, may only be temporary. What happens when the $8,000 tax credit expires at the end of June 2010, at the height of the home buying season?
What intrigued me about the Amherst report was their use of the "housing overhang" and "shadow inventory" of 7 million units. As you read their report, you realize that what they are talking about is the problem that "hangs" over the U.S. real estate market and hidden inventory of real estate inventory, the "shadow ", that the mortgage and banking markets have overlooked.
Amherst states, "BOTTOM LINE--Loans continue to transition into the delinquincy/foreclosure pipeleine at a rapid pace, but are moving out at a very slow pace. That housing overhang is the single largest impediment to a recovery in the housing market."
What I found interesting, and makes sense to me, after reading the Amherst report several times, is how the shadow inventory was calculated. Amherst uses historical delinquincy and liquidation probability rates in their calculation. By multiplying the historical delinquency by the probability of liquidation for homes 30, 60, 90+ and in foreclusure, this yields a probability weighted liquidation rate. The weighted probability of liquidation for a a home that is 30 days past due is the lowest with a 1.61% chance of liquidation. The probability of liquidation increases to 2.66% (60 days past due), 3.85% (90+ days past due) and 4.30% for homes in foreclosure. These four delinquency classes combine to total 12.42%
Amherst used The Mortgage Bankers Association"s (MBA) Quarterly Delinquency Survey which represents 44.7 million housing units, or approximately 80% of the 55.9 million homes in the U.S. The shadow inventory is calculated by multiplying the 55.9 million homes by 12.42% (see above). This results in a U.S. shadow inventory of 6,942,780 or nearly 7 million homes, which is equivalent to 1.35x the existing home sales of 5.2 million units. You will find the calculations on page 2 of the Amherst report.
Not all regions of the U.S. have been affected in the same way by the real estate bubble, so Amherst calculated the shadow inventory for Riverside, California to make a dramatic point. Amherst determined that the shadow inventory for Riverside was 7,010 or 20% of all properties (34,800 units) in that city and was equivalent to 5 times the number of units listed "for sale" or 1,372 units.
The Amherst report includes a table listing data for the top 20 largest real estate markets that calculates the shadow inventory for each market. The highest shadow inventory was Las Vegas with a shadow inventory 4.15 times the "for sale" listings. The lowest of the top 20 was New York with a shadow inventory of 1.04 times the "for sale" listings. Las Vegas, San Diego, Los Angeles, San Francisco and Phoenix were the top 5 with shadow inventories of 4.15X, 3.39X, 2.89X, 2.79X and 2.77X respectively. This gave me another shiver.
Amherst gives three key reasons for the huge shadow inventory or overhang:
- Increasing default or transition rates - Amherst considers a loan in default when it becomes >=60 days delinquent as the loan has only a small chance of recoveirng. According to Amherst, loans are moving from current to default at a much faster rate, the transition rate. Amherst also states that many investors rely on delinquency/foreclosure data from 18-24 months ago, and are making a mistake by ignoring more current information, and this overstates their yields or return on investment. Amherst supplies several graphs to visually measure the transition rates for prime, Alt-A, subprime and Option ARM mortgates. Very interesting stuff.
- Cure rates are increasingly getting lower - The cure rate, or percentage of loans in default that are brought current, has decreased from 66% in 2005 to only 5% in Q2 2009. That's scary. According to Amherst, cure rates are low because homeowners are stretched financially, one out of every five families has an unemployed bread earner, and there is no economic incentive or ability to cure their mortgages, as they have negative equity or "under water". Many borrowers simply walk away from their mortgage obligations and let the bank foreclose and take over the property.
- Liquidation timelines are becoming lengthier - The lengtening of time between the last payment and liquidation include foreclosure moratoriums (federal and statewide), longer waiting periods prior to Notice of Default and between the Notice of Default and the Trustee Sale, and a slowing of the judicial process in judicial states (where court approval is required to foreclose). In addition, new rules requiring that each loan be tested to see if the borrower can qualify for a modification can tack on additional time. According to Amherst, loan modifications are temporary fixes, because approximately 70% of loan modifications fail, and the property eventually goes into foreclosure.
Amherst explains why housing prices appear to have stabilized for the following reasons:
- Housing prices are themselves seasonal - Spring and early summer are generally stronger than late summer, fall and water. We are now entering the "slow" period so home prices will begin to decline.
- Home sales are highly seasonal yet liquidation volumes are not - The liquidation sales constitute a far higher percentage of winter home sales than of summer home sales.
Amherst provides numerous formulas, tables and graphs to explain and amplify the housing overhang and shadow inventory, and you may have to read the 17-page report several times, like I did, in order to understand their analysis. I summarized their findings in order to keep things concise and simple to understand.
Here are some more scary facts that lend some credence to the Amherst findings:
- 3rd Quarter 2009 foreclosures there were 937,840. This is an increase of 5.40% from the 2nd quarter 2009 and an increase of 22.5% from the same quarter 2008. The seasonality factor is really starting to kick in. Refer to: http://www.realtytrac.com/foreclosure/foreclosure-rates.html.
- Foreclosures are not just sub-primes mortages, but prime and fixed rate prime loans. MBA forecasts foreclosures to peak at the end of 2010, and Chief Economist Jay Brinkmann stated in their "Q2 2009 National Delinquency Survey", "The problem is moving to prime loans, and fixed rate prime loans. Although the delinquency rate is lower for prime fixed rate than for other loans, these loans make up 65.5% of all loans--so the increase matters." The MBA Q2 2009 data shows about 5.8 million loans delinquent or in the foreclosure process nationwide. MBA provides some very eye-opening graphs that provides backup for their dim forecast. Refer to: http://www.calculatedriskblog.com/2009/08/mba-forecasts-foreclosures-to-peak-at.html.
- Total foreclosure filings between 2005 and 2008 were 1,917,860 (2005), 1,259,097 (2006), 2,203,295 (2007), 3,157,806 (2008), 3.2 to 3.4 million forecast for 2009. I don't know about you, but I definitely see an ominous pattern developing here. For this post I relied on data from RealtyTrac.com, which tracks the foreclosure market very well. Refer to: http://www2.prnewswire.com/cgi-bin/stories.pl?ACCT=104&STORY=/www/story/01-29-2008/0004744598&EDATE= and http://www.ritholtz.com/blog/2009/01/us-foreclosure-market-data-by-state-%e2%80%93-2008/ and http://www.realtytrac.com/ContentManagement/pressrelease.aspx?ChannelID=9&ItemID=3988&accnt=64847
COMMENTARY: In order to gain the full benefit of what I have just written, you will have to read or review a lot of very boring material. There are no shortcuts. It took me a couple of days. If you are an investor, you should definitely read this material.
Some of you will strictly view the potential for a second real estate bubble as a "financial opportunity". I refer to those individuals as "sharpies" because their head comes to a very sharp point, in the shape of a dunce cap, if you will. They are the second wave of real estate speculators, the ones that got over extended due to all that cheap money, drove us into the ground in the first place, and lost everything during the first real estate bubble. I know several of them.
I welcome your feedback. Challenge me if you wish, but read the Amherst report before you do.
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