The U.S. housing market has been wobbly for several years, but it has shown some signs of perking up in recent months. The latest reports, however, indicate a setback, with median home prices dropping slightly and sales well below the already depressed levels of 2009. Yet a combination of low mortgage rates and apparent home-price bargains should still be drawing some buyers into the market. Knowledge@Wharton spoke with Wharton real estate professor Susan M. Wachter about the housing market's slow recovery, the prospect of another sharp dip in prices, the effect of foreclosures on the economy, and what it will take to get the market back on track.
An edited transcript of the conversation follows.
Knowledge@Wharton: The latest figures are showing a slight dip in home prices, and sales are still well below where they were a year ago, which was below where they had been previously. Is this just a bump in the road or an anomaly in the figures, or is this serious?
Susan Wachter: It's not just a bump in the road, by any means. We had this run-up -- if we could call it that -- it was only a very slight run-up during the period of the [federal] tax credit [created by the stimulus bill]. That was the anomaly. We are in a period of uncertainty and the uncertainty is affecting consumer confidence and it is reflected in housing markets. This was [apparent] before the tax credit and we are back to that again.
Knowledge@Wharton: Do you think there is a prospect for a dramatic drop in prices -- 10% or 20%?
Wachter: Well, of course, there is always a possibility. That would depend on the overall economy. But with the overall economy slowly improving -- and I emphasize the word "slowly" -- then we should see this kind of bouncing along the bottom in the overall housing market.
Knowledge@Wharton: What are the various factors that are affecting the housing market and keeping it from reviving faster?
Wachter: It's mostly unemployment. As long as the job market is recovering at this slow pace, then we will likely continue to see a very slow up pace ... and even a decline in housing markets because on top of the unemployment picture there is also just overall consumer confidence, which is very weak. Putting that in front of this large decision -- a large purchase -- clearly people are hesitant to go over that fence to purchase during a period of such uncertainty. On top of that and the overall economy, prices have been declining. And you can get into an expectation situation where prices are anticipated ... to fall and then clearly the buyer is going to want to hold off.
Knowledge@Wharton: There has been a lot of news about foreclosures and it wasn't long ago that everybody was complaining about the high numbers of foreclosures. Now there seems to be a lot of worry that they are not proceeding fast enough due to this paperwork problem that has been in the news. To what extent is the overhang of foreclosures a factor in the market?
Wachter: It is a big factor -- the overhang in foreclosures, the heightened inventory and the heightened vacancy rate. Even if foreclosures ... are slowing -- and of course there is this potential discussion of a moratorium [or] a slowdown in some of the banks -- in the short run, that could actually lead to a slight spike in housing prices. But the bigger picture is that it contributes to uncertainty and that is the negative at this moment.
Knowledge@Wharton: And then another factor is the high percentage of underwater mortgages -- somewhere around a quarter of the home owners who have mortgages owe more than their homes are worth. Why is that not resolving itself faster?
Wachter: Well, that is of course the shadow potential foreclosure pool right there and people don't want to strategically default on their homes -- some do, but that's a very small percentage ... overall. Borrowers who are currently in default are usually simply unable to make their mortgage payments because of a lack of a job or because their mortgage has re-priced -- reset -- at a point where their current wage income cannot cover it. So really, again, whether this overhang results in increasing defaults and increasing foreclosures going forward depends very much on the overall economy. And, particularly, we should take note of [Federal Reserve] Chairman Ben Bernanke's recent move, which is to absolutely make certain that markets do not anticipate falling prices. The commitment to preventing deflation is absolute. That should help prevent a continuing slow slide in overall prices and in housing prices. But that doesn't really bring the full weight of recovery. Only job growth can do that.
Knowledge@Wharton: And nobody wants to buy a home they think is going to be worth less six months later.
Wachter: Correct.
Knowledge@Wharton: It has been about a year and a half since the Making Home Affordable program, which includes opportunities to modify or refinance mortgages to make monthly payments more affordable, was announced. And the numbers have been very disappointing. This was the plan that was going to allow people to re-cast their mortgages somehow with lower payments.
Wachter: Right.
Knowledge@Wharton: Why have there not been more homeowners able to do that or willing to do that?
Wachter: Well, it's really the bank's modification process. Banks are hesitant to modify. This is a very difficult negotiated proceeding. The investors are [looking] over the shoulders of the banks. There are conflicts. There is no simple answer to this problem of underwater borrowers. If there were, we would have resolved it a long time ago. Again, if people cannot make their payments, at some point along the lines they are likely to be foreclosed and the modification can only help if there is a job in sight.
Knowledge@Wharton: A prominent part of the housing and mortgage market for quite a long time has been the securitization process where mortgages are bundled and turned into securities that investors buy. What is happening in that market? That's been troubled. Is it improving?
Wachter: There is no securitization other than Fannie [Mae] and Freddie [Mac] and FHA through Ginnie Mae, and that [means that] upwards of 90% of all the loans that are being originated today are basically coming with federal support. So in that sense, the securitization market is doing just fine. If you are referring to the private label securitization market -- that's gone.
Knowledge@Wharton: Any chance it will come back?
Wachter: Well, absolutely. There needs to be going forward a private securitization market, but that's going to take reform of Fannie and Freddie.
Knowledge@Wharton: And that's my next question. Is there progress with Fannie and Freddie? Do you see them being more reckless or less reckless than they were in the past? Or should we be confident in the way things are going?
Wachter: Well, confident is exactly what we cannot be. But that's not because of Fannie and Freddie. Fannie and Freddie are very much at this point, if anything, like other lenders. They have raised the standards tremendously. In fact, the book of business that they are ensuring right now is being extremely carefully underwritten. And Fannie and Freddie really were not the most egregious of the lenders by any means. The private label securitization was really the source of these infamous mortgages that were ninja mortgages -- [going to buyers with] no income, no job, no assets.
Knowledge@Wharton: Do you have a projection of the prospects for this market in the medium and the long-term?
Wachter: I think first of all, it does depend on job growth. We could be surprised. We could have job growth. Clearly corporate profits are up. At some point there is going to need to be a move on hiring and that will be the bellwether for the housing market to recover. In the meantime, as long as interest rates remain low, I think we are finished with this plunge -- this downward plummeting of crisis. So we are bouncing along the bottom, and if you are an investor there are very potential profitable opportunities in the multi-family sector out there.
COMMENTARY: I have done extensive research on both residential and commercial real estate and both sectors have experienced a bubble. Both bubbles were the result of an abundance of "cheap money" and very loose lending practices of the financial institutions, namely the major banks and mortgage companies that created a stampede in real estate construction, principal residential purchases, and investments in income-producing property or "flips" for short-term capital gains.
Beginning in 2006, as the real estate market began to show evidence of overheating, prices in some parts of the U.S. began to drop precipitously as the first wave of real estate borrowers experienced rate adjustments on their variable interest loans during the period of cheap money, increasing their monthly payments and making it difficult for many to make their monthly payments.
The bubble popped in 2007 when symptoms of the recession began to be felt, and employers began laying off workers as the economy softened. During 2007, the first wave of foreclosures began. As the economy worsened in 2008, the unemployment rate rose and consumer confidence began to decline, driving housing prices even lower. Many borrowers were stuck with homes worth less than they owned their bank.
In 2008, stocks prices experienced steady price drops, and in September 2008, Wall Street and the entire U.S. banking industry suffered a major meltdown. The drop in stock prices and buildup in foreclosures and delinquent real estate loans between 2006 and 2008, plus major losses incurred from over-the-counter (OTC) derivatives (securities whose value is derived from the value of other assets).
Many Wall Street investment banking firms and major banks had invested in OTC derivative contracts whose value was based on packages of real estate loans secured by deeds of trust on the property. Those properties had lost 30% to 50% or more of their value during the bubble. The banks and Wall Street firms were left holding the bag and had to write-off or devalue those investments. I won't go through the banking and Wall Street firm bailout of September 2008, except to say that it is all connected with the real estate sector. On October 22, 2009, I wrote a blog article titled "The Treasury Department To Regulate The Trillion Dollar Over-The-Counter Derivative Market" and highly recommend that you read it, because it casts a very scary and dark cloud over the entire financial sector.
As the Great Recession took hold in 2009, homeowners could no longer easily sell their homes or borrow against their equity (which had taken a huge hit or entirely disappeared). The resulting housing shadow inventory or overhang, began to increase alarmingly. In 2010, an $8,000 first-time home buyer credit program created by the Obama Administration, temporarily increased sales of housing units, and reducing the shadow inventory. That program expired in June 2010, then extended through September 2010, but banks tightened their credit even more as the economy languished, and the shadow inventory has started to gradually grow again.
Amherst Securities Group LP prepared a very thorough analysis of the U.S. residential real estate sector and carefully calculated the shadow inventory in a report dated September 23, 2009. That report served as a basis for the prediction of a second real estate bubble by Amherst that would occur in mid-2010. However, the $8,000 credit for first-time home buyers, has temporarily delayed that second real bubble.
I analyzed Amherst's shadow inventory calculations, and wrote a blog article about this in October 2009. As a follow-up to my blog post in October 2009, I wrote a second blog article titled "A Second U.S. Real Estate Bubble A Possibility in 2010 Says Amherst Securities Group LP", in which Amherst predicted a second real estate bubble, citing several reason .
According to Amherst, the first wave foreclosures which occurred between 2007 and 2009, were predominantly to sub-prime or higher risk borrowers. Many sub-prime borrowers were able to obtain homes with little or nothing down and with variable rate (VARs) mortgages with rate adjustments that began to kick-in beginning 2007, and increasing the borrower's monthly loan payment by 30% or more. Furthermore, many banks and mortgage companies, failed to conduct sufficient credit checks to qualify many sub-prime borrowers or often overlooked information that would've disqualified the borrower.
Wharton's Susan M. Wachter, findings concerning the failure of loan modifications to reduce foreclosures are fairly consistent with the Amherst, but she did not discuss Amherst's findings concerning other recent trends, which could negatively impact the number of future foreclosures in 2010 and 2011:
- Failure of Loan Modifications - In the majority of cases, banks are unwilling to modify a borrowers loan because they feel it is not in their best interest to do so. If the loan is modified, within a year or less, the borrower is delinquent, and about 90% of those properties ultimately go through foreclosure.
- Strategic Foreclosures - The distressed borrower, facing foreclosure proceedings, simply turns over the keys and walks away from the property. In nearly all cases, the borrower was unable to obtain a loan modification or failed to make their monthly mortgage payments due to prolonged unemployment or medical reasons. In addition, the majority of borrowers who were able to obtain a loan modification, were unable to meet the conditions of the new modified loan, and the property was eventually foreclosed.
- Prime Borrower Foreclosures - The prolonged recession has kept the unemployment rate relatively high (9.7% nationally), and this is beginning to affect prime or lower risk borrowers who have lost their jobs or whose small business failed, and were unable to obtain a loan modification or financing. Although the percentage of prime borrowers facing foreclosure is relatively small (about 3%), prime borrowers represent 90% of all home borrowers, so when this is factored in, is quite significant.
Due to the above trends, Amherst predicted that the shadow inventory would increase, resulting in a second real estate bubble about mid-2010. However, several states have passed legislation extending or delaying the foreclosure process or period, and this kept foreclosures relatively low.
For a short while the Obama Administration's $8,000 credit for first-time home buyers kept real estate prices from declining further, but the recent spike is definitely cause for concern, as we enter the year-end, the slowest period of home sales.
After a stock market rally which began in early July, prices are approaching the peak of April 2010, but signs of volatility are still there, and many stock analysts are predicting a major adjustment. Businesses are still not hiring, banks still are not lending, and the unemployment rate remains high throughout the country. Corporate earnings are showing some improvement, but prices for food and fuel are rapidly rising.
There is a lot of economic and business uncertainty as we approach the mid-term elections, with many Americans concerned with the historic federal deficits of the Bush and Obama administration, many voters want radical want to reel in federal spending.
According to several real estate experts, besides Amherst, a second real estate bubble is almost unavoidable due to the likelihood of a double dip recession due economic uncertainty and a lack of strong job creation and return of inflation.
Courtesy of an article dated October 27, 2010 appearing in Knowledge@Wharton
I never really thought the loan modifications would have any significant impact on foreclosures.
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