CPI and Housing II

I previously posted on the fact that the housing component of the CPI is based on a rent calculation, and not home values.

I just came across an interesting graphic which demonstrates housing is by far the largest component of the CPI. Unfortunately, the description in the graphic of how the housing component  is calculated is vague. Here is the official BLS explanation.

This approach has come in for a lot of criticism. Here is a sample:

Financial Sense University: "The Complete and Utter Failure of Owners' Equivalent Rent"

The Mess That Greenspan Made: "How Owners' Equivalent Rent Duped the Fed"

My Budget 360: "Owners’ Equivalent of Rent: The Fed and BLS Gaming the System"

Retail Outlet Saturation: Target and Walmart

Very cool visualizations of the growth in Target and Walmart locations since the inception of the retailers:

Target

Walmart

The Landes Apartments Project has the Best Multifamily Location in the Whole World

OK, I don’t know this for sure, because I haven’t visited every multifamily site in the whole world. But, I think this location (901 8th Avenue, Seattle, WA) is a contender. Here is my logic:

1. The best apartment location should perform well in difficult market conditions.
2. In difficult market conditions, the sectors which perform best are government, health, and education.
3. The Landes location is ideally suited to appeal to government, health, and education workers.

With regard to the second premise, there is a helpful post at Macro and Other Musings titled "Where are the Safe Jobs?". Here is a chart from that post:

By far the most jobs have been created in the government and education/health services sectors. This is not a fluke of this recession – Eric Janszen put together charts of every sector showing data back to 1940 (posted here) and reaches the same conclusion.

So here is the location of the Landes Apartments (“A” on the Google Map below):

Easy walking distance to Seattle University, three major medical centers, and the Seattle/King County government buildings (shaded in red at the lower left).

There might be better locations, but I don’t know of any.

Why Does CRE Go So Bad So Fast?

CRE problems are escalating rapidly. There is a good CoStar article here discussing the trend. A chart from that story speaks volumes:

(Click on image for a larger version in a new window).

Why do problems escalate so quickly? I don’t have definitive answers, but I can offer three analogies which based on my experience have some validity.

The Blighted Crop Analogy. I grew up in farm country (eastern South Dakota). Crop farmers have really good years, ok years, and really bad years depending on what they planted and weather conditions. Here is a picture of what things look like in a really bad year:

Note this is not a mixture of corn plants doing well and doing poorly; every plant is suffering is a result of environmental conditions. So, under this analogy CRE deteriorates rapidly because the conditions which stress CRE stress all CRE projects. Severe employment loss, high interest rates, liquidity crunch limiting refinance options, etc. are all stressors which have played a part now and in the past. One of the profoundly stupid things you hear some people say is “XYZ lender is not taking enough risk, their loan delinquency rate was only X% last year.” That’s now how it works – you have no delinquencies for many years, and then conditions occur which cause your delinquency rate to skyrocket.

The Vintage Analogy. The is a strong correlation between CRE performance and Loire whites; 1991, 1992, and 2001 were bad years for both. A vintage table courtesy of Robert Parker:

Seriously, like wine, loans are made under conditions which vary over time. There are always a substantial contingent of borrowers who want the absolute maximum leverage a lender will give them, and the willingness of lenders to satisfy that demand goes up during good times. So, during times of peak rents and occupancy levels there are a lot of loans done using aggressive underwriting parameters, and when market conditions soften those loans all go upside down at once. I don’t know how good 2006 and 2007 Loire whites will be, but I am confident those will be bad origination years for CRE loans.

The Blood from a Turnip Analogy. There is a perception that CRE borrowers readily walk when their deals go upside down, because they are coldhearted businessmen constantly evaluating the economics of their deals (as opposed to warmhearted homeowners irrationally committed to their residences), and because their loans tend to be non-recourse. Here, for example, is a Calculated Risk post which takes this position.

In my experience, that isn’t how it goes. Undoubtedly some owners walk early, but in my experience most CRE borrowers feed their deals until they’re tapped out. I’ve written why I think that happens here. CRE owners tend to own multiple properties. As problems develop, they bleed the properties performing well to support the underperformers. This works for a while, but if difficult conditions persist the lack of reinvestment in the good properties drags them down too. None of the properties default, until they all do.

Individually, none of these analogies explains the entire phenomenon, but taken together I think they account for why CRE problems escalate so rapidly.

Workouts 101: Loan Modifications and Interest Accrual

In a previous post, I discussed when a loss has to be recognized on a modified loan. A related question which recently came up on Bronte Capital is, when can interest on a modified loan be recognized, and when is the loan no longer considered a non-performing asset?

The answer, as you would expect, is a fairly involved accounting issue, but the short answer is there needs to be a credible evaluation the payments can be made, and a sustained period (minimum of six months) where the payments were made.  The source is the FFIEC: Reports of Condition and Income Instructions Glossary Pages A-59 to A62. In part:

A loan or other debt instrument that has been formally restructured so as to be reasonably assured of repayment and of performance according to its modified terms need not be maintained in nonaccrual status, provided the restructuring and any charge-off taken on the asset are supported by a current, well documented credit evaluation of the borrower's financial condition and prospects for repayment under the revised terms. Otherwise, the restructured asset must remain in nonaccrual status. The evaluation must include consideration of the borrower's sustained historical repayment performance for a reasonable period prior to the date on which the loan or other debt instrument is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. (In returning the asset to accrual status, sustained historical repayment performance for a reasonable time prior to the restructuring may be taken into account.) Such a restructuring must improve the collectability of the loan or other debt instrument in accordance with a reasonable repayment schedule and does not relieve the bank from the responsibility to promptly charge off all identified losses.

Workouts 101: Loan Modifications and Loss Recognition

Comments on some recent posts dealing with loan modifications suggest some people believe lenders can avoid recognizing losses by modifying loans (see Naked Capitalism "Cramdown and Future Mortgage Credit Costs", Mr. Mortgage "WAMU's New $1 Million 5-Year 1% Balloon Loan Mod", Credit Slips "Cramdown and Future Mortgage Credit Costs: Evidence and Theory") .

This is not the case.

The operative question is whether or not the modification constitutes a Troubled Debt Restructure (“TDR”). From a Center for Audit Quality guidance on the Application of FASB Statement 114:

3) How should an entity determine if a modification of the terms of a residential mortgage loan would be considered a troubled debt restructuring under Statement 15?
In accordance with paragraph 2 of Statement 15, “a restructuring of a debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.”

This covers virtually all material modifications (certainly substantial interest rate reductions or bankruptcy cramdown modifications).

If a loan is a TDR:

Statement 114 provides guidance on how an entity should measure impairment. Specifically, paragraph 13 of Statement 114 states: “…a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical
expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. … The creditor may choose a measurement method on a loan-by-loan basis. A creditor shall consider estimated costs to sell, on a discounted basis, in the measure of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan.”

All of which is to say the loan needs to be marked to market. So, while a modification may postpone the actual cash loss on a deal, on the financial statements the loss needs to be recognized at the time of the modification.

Is it possible a lender could use overly optimistic cash flow assumptions to defer and/or minimize losses? Absolutely, but examiners are sensitive to this possibility, and TDRs get a lot of scrutiny during exams.

Crowe Horwath provides a good general overview of TDRs here.

Bankruptcy Ripple Effects: Lehman and Goats R Us

Every real estate bankruptcy has a ripple effect on vendors who don’t get paid because the property owner withheld payments prior to the filing and/or the bill wasn’t paid as a consequence of the normal billing/payment cycle. From the Wall Street Journal:

A Lehman-financed venture owes a company called Goats R Us about $53,000. The goats performed fire-prevention by munching shrubs and grass on a property the venture owns in Oakland, California…

About $43 billion of Lehman's $639 billion in assets was from the firm's far-flung real-estate operations, which included housing projects, resorts, office buildings and other properties all over the world. Those hurt include hydrologists near San Francisco and chambermaids in Palm Springs. Also left in the lurch were Chinese laborers who were flown into the Turks and Caicos Islands in the West Indies to help build a Ritz-Carlton resort.

Not Everybody’s Recession is the Same

Mark Perry in Carpe Diem says the 1990-1991 recession was relatively short and mild, but that media reporting on severity was hysterically overblown. For example:

"There is no question but this is the worst economic time since the Great Depression.”

 

“.....the worst plunge since the Great Depression.”

 

"This is the most severe economic dislocation we've had since the 1930s. Few are immune."

There are eleven such quotes in the post. When you go back to the original sources, here is how they break out:

• Four refer to specific indicators (e.g., sales, pessimism, job loss)
• Three (in fact, the three cited above) refer to geographic areas (e.g., California, Great Britain)
• One refers to a specific demographic group (white collar employees)
• One refers to a forecast of the severity
• One refers to a specific time period (worst three year period)

This is a good reminder that, which the aggregate data for a recession gives one picture, there is a lot of variation in the geographic distribution and dimensions of each recession. James Hamilton at Econbrowser has some great posts on recession variations between states here, here and here.

Foreclosures in the Exurbs

Foreclosures are concentrated in the exurbs. I’ve previously posted here about how this is primarily a vintage problem; in these new developments the houses were sold and financed in a relatively short time frame at the peak of the market using aggressive financing, and hence when the downturn occurred these neighborhoods have been hit in a very concentrated way.

Green Valley Ranch, a development on the outskirts of Denver, is a poster child for this problem. From an April, 2008 USA Today story:

This small corner of the Mile High City represents an extreme example of how foreclosures are transforming lives and neighborhoods. On some blocks, as many as one-third of the residents have lost their homes, making this one of the worst hotspots in a city that was among the first to feel the pinch of the foreclosure crisis. Many houses here remain empty, bank lockboxes on the front doors…

     Many neighborhoods in Denver and across the nation have largely been spared from that tide, but others have been hammered.

     That's especially true here, along the broad avenues of Green Valley Ranch, a remote subdivision of soft-colored houses with red-tile roofs sewn into the vast carpet of flat, open land on the city's eastern edge. As Denver's housing market boomed at the beginning of this decade, the area became a magnet for low- and middle-income families buying their first homes in the kind of brand-new neighborhood they once thought would always be beyond their reach. Some turned to more-expensive subprime loans, which charged higher interest rates to borrowers with bad credit. Others got adjustable-rate mortgages and saw their payments increase sharply after two years.

This is Green Valley Ranch’s location:

Here is a map from the USA Today article showing foreclosure activity in the neighborhood between 2006 and 2008:

(Click on image for a larger version in a new window)

Note that this is happening in Denver, where home prices have  remained relatively stable (see this post for information on Denver’s performance relative to other markets).

Why Are the Nation’s Worst Housing Markets in the Exurbs?

Housing Wire has a list of the 20 worst housing markets in the United States, as measured by the percentage of homes which are worth less than their mortgages. Here are Google satellite photos of the worst 4:

#1 Zip 95391, Mountain House, CA. You can read more about this unfortunate place in this New York Times article.

#2 Zip 89166 (Clark County, NV):

#3 Zip 89178 (Clark County, NV):

#4 Zip 95742 (Sacramento County, CA):

See a pattern? All of these are new developments at the outskirts of suburban areas.

There is a theory that the collapse of these nascent communities is attributable to high gas prices (see this post in Econbrowser and this article in Muninet Guide, for example). That might have been a contributing factor, but it’s not the primary problem.

The primary problem is one of vintage. In a developed neighborhood, only a small percentage of homes sell and are refinanced in any given time period. In a new development, everyone buys and finances in a relatively compressed time frame. These communities all hit the market during the peak of the underwriting craziness, so a much higher percentage of homes in these areas ended up overleveraged.

Banks, Builders, The Prisoner’s Dilemma, and the Tragedy of the Commons

Why are bank foreclosures of loans to builders now escalating? Why are banks foreclosing on builders with perfect records?

These are the questions raised in a Naked Capitalism post in  response to a New York Times article, Banks Foreclose on Builders With Perfect Records. Here is what I think is going on:

Why Now? You can’t foreclose on a loan that’s not in default. Virtually all land, development, and construction loans are structured so that the borrower’s cash goes in first, and enough loan funds are set aside for interest reserves so that no additional cash from the borrower is required during the term of the loan. So, there were many deals which were clearly going to have problems which weren’t actually in default until the reserves ran out. Also, many of the deals which matured early in the collapse appeared to have equity a year ago (based on appraisals using pre-collapse comparables) and were restructured to provide additional interest reserves in the hope the market would recover. The result is there are now a lot of deals which are clearly upside down and which need to be marked to market. If a bank needs to mark to market there is not much reason to forbear from foreclosure.

Why Foreclose on Builders Who Have Perfect Records? Most builders of any size have relationships with more than one bank (the case cited in the NYT story involved GMAC and JP Morgan Chase pursuing a builder).  And almost all of these types of loans have guarantees. If a builder has some viable assets, it’s very tempting for the first lender who has a maturing loan which is upside down to foreclose and go after the guarantor for the shortfall. It’s a classic Prisoner’s Dilemma problem. If GMAC and JP Morgan Chase cooperated, the overall recovery would probably be higher, but there is an incentive to be the first defector. Often, Prisoner Dilemma situations are iterative and reach a cooperative equilibrium because the parties know they will play the game more than once (for example, a vendor won’t cheat a buyer who is likely to be a repeat customer). In this case, banks are fighting for survival and it’s not clear they will be around to play the game again.

The difficulty of achieving cooperation compounds when the number of creditors increases. This is a Tragedy of the Commons problem, where the builder’s resources are the common resource. Again, cooperation is difficult to achieve.

Which Markets Have Lost the Most Jobs?

Employment has suffered the most in Detroit (no big surprise there). However, there are some surprises in the other rankings, including which markets have held up the best.

A word on methodology. I looked at the highest employment level in each market since January, 2000, and compared it to the latest level. All data is from BLS Local Area Unemployment Statistics.

Here are the results:

Employment as of November, 2008	Peak Since 1/2000	Current	Change from Peak	% Change from Peak
Detroit	2,217,186	1,899,782	(317,404)	-14.32%
San Jose	962,408	845,417	(116,991)	-12.16%
San Francisco-Oakland	2,250,832	2,138,050	(112,782)	-5.01%
Chicago	4,721,131	4,542,407	(178,724)	-3.79%
Los Angeles	6,307,149	6,098,378	(208,771)	-3.31%
Riverside-San Bernadino	1,711,443	1,658,533	(52,910)	-3.09%
Atlanta	2,650,838	2,569,010	(81,828)	-3.09%
Washington DC	2,967,601	2,882,203	(85,398)	-2.88%
Miami	2,739,126	2,668,358	(70,768)	-2.58%
Orlando	1,070,271	1,048,644	(21,627)	-2.02%
Denver	1,346,897	1,323,378	(23,519)	-1.75%
San Diego	1,485,911	1,468,666	(17,245)	-1.16%
Sacramento	1,003,441	994,697	(8,744)	-0.87%
Dallas	3,023,034	3,005,173	(17,861)	-0.59%
San Antonio	906,335	902,089	(4,246)	-0.47%
Austin	831,555	829,083	(2,472)	-0.30%
Houston	2,680,121	2,675,806	(4,315)	-0.16%
Las Vegas	936,369	934,956	(1,413)	-0.15%
Phoenix	2,022,781	2,022,725	(56)	0.00%

Detroit employment peaked in June, 2000, and has lost jobs ever since. Here is a chart showing year over year job loss for this market:

(Click on charts to open larger versions in new windows)

The market with the second worse performance is San Jose. It, along with San Francisco (to a much lesser extent), has never fully recovered job losses sustained in the dotcom bust. Here is the year over year chart for San Jose:

The best performing markets are also something of a surprise: Las Vegas and Phoenix. Both of these markets have severely distressed housing markets, and the conventional wisdom is housing difficulties drag down employment. Here are the charts for these two markets:

Finally, let’s discuss Riverside-San Bernardino for a minute. There is no question this market is hurting – I’ve discussed it previously here and here. But, a Bloomberg story with Calculated Risk commentary suggests a parallel between Detroit and this market because both have the same high (9.5%) unemployment rate. I think it’s wrong to suggest Detroit’s situation, which has had sustained job losses for eight years totaling 14.3% of it’s peak employment base, is similar to Riverside-San Bernardino, which has only lost jobs for a little more than a year and is down a little more than 3% from it’s peak. I’ve previously argued unemployment is not a good measure of market distress, because it’s possible to have very high unemployment rates and still have positive employment growth.

You can download a free report which provides similar employment charts on many other markets here.

Who Cares About Unemployment?

Obviously, a lot of people, and not just those that are unemployed. But is the unemployment rate a good measure of how a local economy is doing?

Here is a chart of year over year employment change and the unemployment rate for McAllen, Texas:

(Click on chart for a larger version in a new window)

In January, 1999 the unemployment rate was pushing 20%, but between January, 1998 and January, 1999 the local economy added nearly 5,000 jobs. In fact, McAllen has added jobs in every year over year period for more than 10 years, during which time the unemployment rate never dipped below 5%. It seems pretty clear employment can be increasing despite a relatively high employment rate. And, I would argue the change in employment is a better indicator of an area’s financial health than it’s unemployment rate.

Data from BLS Local Area Unemployment Statistics

Why Did WAMU Abandon Underwriting Standards?

It was just disheartening,” said Sherri Zaback, a mortgage screener for Washington Mutual. “Just spit it out and get it done. That’s they wanted us to do. Garbage in, garbage out.

This quote, from an excellent piece in the New York Times, epitomized the loan underwriting process which prevailed not just at WAMU, but at all the major players (Countrywide, Indymac, etc.) which have crashed and burned.

Why did this happen?

To differentiate itself and capture market share, a lender needs to be more attractive than its competitors in one or more of these dimensions:

• Price Factors - Interest Rate/Loan Fee, Processing Costs
• Leverage - Loan-to-Value, Income Ratios
• Credit Standards – FICO Scores, Prior bankruptcy and foreclosure history
• Terms - Loan term, Amortization, Payment adjustments (for variable rates), Recourse, Escrow requirements
• Ease of Execution - Documentation to be completed, Accessibility to lender personnel
• Speed of Execution - Application, Rate Lock, Closing
• Certainty of Execution

By the early 2000s it had become more and more difficult to differentiate performance. With the advent of securitization, all lenders had access to the same pool of investor money and interest rates were very uniform. Leverage, credit standards, and terms were all a function of the rating agencies’ default models, and the lenders competing for market share all adopted the most aggressive levels permitted by these models. So, competition among the most aggressive lenders devolved to execution – how fast, easy, and certain they could deliver the loan.

The genius of WAMU and their ilk is just this – if you don’t ask any questions, your lending process becomes very fast, easy, and certain.

If you don’t ask for documentation, it’s easier for the borrower, you don’t have to spend time reviewing it, and there’s no chance it will disclose something that will prevent the loan from being funded (as Calculated Risk calls out, "A Thin File is a Good File)." Even better, you don’t have to spend money on staff to review documentation and ask questions about it, so your processing cost goes down.

If the documentation you do get (for example, a credit report) turns up a problem (for example, a fraud alert), look at the consequences. An underwriter has to look at the file (which costs time and money). They probably have to ask questions of the borrower (more time and money, the ease of execution goes down, the uncertainty of execution goes up). You might even end up turning down the loan, so all that time and money is wasted, the borrower and loan broker are upset, and your failure to execute may lead the broker to direct business elsewhere. Much better to just ignore that fraud flag (read more in this great post from Tanta).

So, these institutions saved a lot of time and money and built good reputations with their fast, easy, and certain executions. The irony is their reputations are destroyed and their successors are spending vastly more time and money cleaning up the mess.

More highlights and good commentary on the Times article at Option Armageddon, The Big Picture, and Naked Capitalism.

CPI and Housing

Econompic has some interesting charts on the latest CPI release. Here is a breakdown by major component:

How is it possible, you may wonder, that housing is up around 3% in the last year, during a period when home prices have experienced historic declines? The answer is the housing component of the CPI looks at rent value rather than ownership (there’s an excellent explanation on this Big Picture post).

Housing is the largest component of the CPI. Now that effective rents are falling, it’s very likely the CPI will continue to decline.

Single versus Multi-Asset Borrowers

One of the most irritating workouts I’ve participated in happened in Los Angeles in 1992 while I was Assistant Director of Special Assets at Home Savings (then the country’s largest S&L). Irritating, because the problem was largely self-inflicted.

We had made 17 loans secured by apartment buildings to Shashikant Jogani. At the time, Shashi was one of the largest apartment owners in Southern California. From a later court filing:

In 1979, plaintiff Shashikant Jogani (who prefers to be called Shashi on appeal) began investing in residential apartment properties in and around Los Angeles County. By 1989, he owned properties having a fair market value of $375 million and a net equity of $100 million. Because of an economic recession that started in the late 1980’s and continued into the mid-1990’s, Shashi faced defaults and foreclosures on valuable properties.

We knew some of our deals with Shashi were struggling, but we thought most of the loans would weather the storm. However, Shashi and his advisors asked for a meeting and presented an ultimatum – modifications to all his deals, or he would file bankruptcy.

At that point in the recession we were well acquainted with bankruptcy proceedings; in fact, sometimes we required borrowers to file bankruptcy to confirm our workout plan so if there was a subsequent default we wouldn’t have to go through an adversarial bankruptcy filing then. So, the threat of a bankruptcy filing ordinarily was not something that concerned us. Shashi’s case was a different, because he held almost all of his properties as an individual. A bankruptcy filing would not just involve our 17 properties, it would involve more than 50 properties and more than a dozen lenders. It would be a procedural nightmare, and there was a good chance our properties which had equity would end up supporting other lenders’ problem properties. Shashi of course knew this, and used it as leverage to negotiate with all his lenders.

We ended up agreeing to split the properties into three groups. For the most severely troubled properties Shashi stipulated to the appointment of a receiver and did not oppose our foreclosures. The marginal properties got substantial modifications (a significant reduction in interest rate for an extended period). For the properties which were performing adequately we agreed to an interest only period and allowed the excess cash flow to support Shashi’s other deals. And, we required Shashi to form separate legal entities for the properties which received modifications and transfer ownership to those entities so if the modifications didn’t work out we would not be facing the same nightmare again. As it turned out that requirement was a good idea, because Shashi subsequently defaulted on the marginal group.

Most lenders require a single asset borrowing entity to avoid these kind of entanglements. However, this ownership structure can protect owners too. The Pierce County Housing Authority recently learned this lesson; lawsuits related to mold at one of its apartment complexes put the entire Authority into bankruptcy a few months ago. From the Tacoma News Tribune:

 

The Pierce County Housing Authority prefers to declare bankruptcy rather than fight multiple lawsuits over a mold-ridden apartment complex in Puyallup.

 

The agency’s six-member board of commissioners voted Monday to take the step. If approved, bankruptcy protection would prevent 81 current and former residents from collecting damages they say they suffered from mold at Eagle’s Watch, a 193-unit complex on South Hill.

 

Charlie Gray, deputy director of the Housing Authority, said Wednesday that bankruptcy is the only way the agency can continue to operate and provide affordable housing for about 8,000 clients throughout the county

 

…[The Housing Authority] owns 1,123 apartment units in 13 complexes throughout the county, along with 134 homes.

Had Eagle’s Watch been owned by a single asset entity, it’s likely damages would have only attached to that single asset.

Isolating ownership of multifamily projects makes sense for both owners and lenders.

The Lumpiness of Housing Inventory

There is an excellent post on TraderFeed describing variations in housing inventory between markets and price ranges:

Someone recently told me that my own local housing market in Naperville, IL is in relatively good shape because there is only about one year of inventory for sale based on 2008 sales figures. If, however, we break down the inventory by price (see chart above), we again see evidence of lumpiness. There is little inventory problem at the lower end of the housing spectrum; speculation in that market had centered on the luxury end, where there is more than 3 years of inventory. At year end 2008, annual sales of homes above $1,200,000 in Naperville were 36, but 114 homes were on the market. Stated otherwise, about 3% of housing sales in that market have been above $1,200,000, but 15% of the inventory is priced at that level.

I touched on this point in my post suggesting we can't just assume excess inventory is a result of overbuilding, but Brett provides much more detail on the variable mismatch between supply and demand between and within markets.

Loan Modification Menu

There are a lot of different ways to modify a mortgage. Here are a few:

Delinquent Payments	Repay over a fixed period (e.g., 6 months, 12 months)
	Accrue to principal, payable at balloon
	Forgive the delinquent payments
Late Charges	Repay over a fixed period (e.g., 6 months, 12 months)
	Accrue to principal, payable at balloon
	Forgive the late charges
Amortization	Waive amortization (i.e., interest only) for a period
	Recast loan over remaining term or amortization period after delinquent payments/and/or late charges are accrued or after an interest only or reduced payment rate period
Interest Rate/Payment Rate	Reduce payment rate for a period, continue to accrue at note interest rate
	Reduce interest rate for a period
	Reduce payment and/or interest rate, capture all or a portion of net cash flow on an income property
Principal	Forgive a portion of the principal balance
	Bifurcate loan – reduce the principal balance on a first lien, the reduction amount becomes a subordinate lien due on sale or default (subordinate piece may or may not accrue interest or require payments)

These options can be used in various combinations, so there are quite a few possibilities.

Cliff Diving: Riverside – San Bernardino

The Wall Street Journal has a piece on the softening commercial real estate market in Riverside-San Bernardino. The money quote: "California's Inland Empire, the two-county region that stretches east of Los Angeles, has gone from a booming development smorgasbord to a basket case in a few short years."

Here is year over year employment change for this metropolitan area:

(Click on image for a larger version in a new window)

Employment growth in this market has been decelerating since 2004, and has been negative for more than a year now. CRE can’t do well in such an environment.

You can download a free report which provides similar information on 18 other markets here.

What Make a Good Neighborhood?

A study published in the Journal of Environmental Psychology on the preferences of active independently living seniors (55 to 80)reports:

Positively related to perceived attractiveness of links were the following street characteristics: slopes and/or stairs, zebra crossings, trees along the route, front gardens, bus and tram stops, shops, business buildings, catering establishments, passing through parks or the city centre, and traffic volume. Litter on the street, high-rise buildings, and neighborhood density of dwellings were negatively related to perceived link attractiveness. Overall, the results suggest that three main aspects affect perceived attractiveness of streets for walking, namely tidiness of the street, its scenic value and the presence of activity or other people along the street.

I think this research complements my previous posts on the negative impact disorder has on neighborhoods.

Low End Housing Gets Hammered in a Recession

Lansner on Real Estate reports the low-end Los Angeles / Orange County home price loss is nearly twice the high end:

I’ve posted before on why low end multifamily underperforms in a recession, and I think the same logic holds for single family values. I think this is also consistent with my argument that part of the reason some markets bubbled more than others is the markets had a high percentage of rental single family housing (discussed here). My conjecture is probably much of the low end houses trading now were probably originally rentals that were sold to owners, were foreclosed on, and are now shifting back to rental stock at prices that can be supported by rents.

Commercial Loan Delinquencies Rise, Jump, Soar, Surge, Double…

We all know we are going to see increased delinquency rates and losses on income property loans. But, it’s not happening yet to any substantial degree. That doesn’t keep some sources from writing headlines like these:

HEADLINE	DATA
Wall Street Journal:  Commercial Property Loses Shelter: As Delinquencies Surge in $3.4 Trillion Market, Investors Brace for a Big Hit	New data from Deutsche Bank show that delinquencies on commercial mortgages packaged and sold as bonds, which represent nearly a third of the commercial real-estate debt market, nearly doubled during the past three months, to about 1.2%…
Calculated Risk: Commercial Delinquencies Double Over Last 90 Days	Same as the WSJ quote above
Smart Money: Commercial Delinquencies Jump in November	Fitch Ratings said delinquencies jumped to 0.64% from 0.51% in October…
Bloomberg: Commercial Delinquencies to Rise, Barclays Says	Payments more than 60 days late on commercial real estate loans that were bundled together and sold as bonds increased to 0.69 percent last month, compared with 0.57 percent in October and 0.51 percent in September, Barclays data show.
Financial Week: Commercial mortgage delinquencies on the rise	Banks with more than $10 billion in assets charged off 0.2% of non-farm, non-residential loans in the first nine months of 2008, according to the Federal Deposit Insurance Corp. The rate remains low, but is more than three times the rate of charge-offs for the same period in 2007.

Please, folks, calm down. Delinquencies and losses have been at historic low levels. Yes, when a rate goes from 0.6% to 1.2% it has doubled, but it’s still a very low rate (for comparison, 1-4 unit delinquencies are 6.99%). I’ve already talked about this in a previous post (Data Trap: Big Percentage Increases in Small Numbers).

Is Overbuilding Responsible for Excess Housing Inventory?

The President of the National Association of Home Builders says “The excess housing inventory in today’s market is the result of unprecedented foreclosures, not overbuilding.” Paul Jackson, Housing Wire, suggests this statement “borders on the certifiably insane ." I may be certifiably insane, but I think the NAHB position is closer to the truth.

Obviously, we have excess inventory. The amount is subject to debate, but arguments can be made for between 1.75 to 4 million excess units (see this Calculated Risk post, for example). Obviously, many of the excess homes are newly completed builder inventory. You can read the story behind the pictured subdivision here.  So, in a sense builders are responsible for at least a portion of the excess inventory. They built it, it’s empty, end of story.

But, of course, it’s not that simple. There are a lot of people who are living in substandard housing, in apartments, with their parents, with roommates, etc. who would be delighted to be living in these “excess” units. The problem is much of the excess is located in places people don’t want to live or can’t find jobs (read, for example, these depressing posts about Detroit in The Big Picture and The Weekly Standard). And, much of the excess is not affordable even at today’s depressed prices to the people who want the units.

I think Miami is a good example of what actually occurred. Here is a chart of residential permits issued in Miami between 1999 and November, 2008:

(click on images to open larger versions in a new window)

On it’s own, this is about as clear a case as you can get of overbuilding – permits obviously spiked between 2004 and 2006, which nicely dovetails with the peak of the subprime craziness. But, consider employment growth in Miami during the same period:

At the same time permits were peaking at around 45K per year, Miami was adding jobs at 100K a year. Can you really say builders were overbuilding when there are twice as many people with new jobs as units being added to supply? If anything, the numbers imply a housing shortage in the peak period. Here is a chart showing the ratio between new jobs and residential permits:

From mid-2002 through 2007 Miami was adding more jobs than housing units, and for most of this period it was adding around two jobs for every new housing unit. This was not an overbuilt market during that period.

In contrast, here is an equivalent chart for Houston:

Housing prices have held up relatively well in Houston, and most people do not consider it to have been one of the bubble markets. But, note Miami had substantially more jobs added per new unit than Houston did during this period. The data suggest Houston was relatively overbuilt compared to Miami.

In fact, the data suggest that maybe part of the problem in the bubble markets was builders didn’t build fast enough to keep pace with the demand created by new jobs (you can see similar charts for Los Angeles, San Diego, Las Vegas, and many more markets here). I’m not ready to go so far as to suggest they should have done so – had lenders stuck to reasonable underwriting standards more of that demand would have shifted to the rental market and we would have seen higher rents and less vacancy in that segment, which I think we all agree in hindsight would have been better than putting people in houses they couldn’t afford.

Data Trap: Limited Series Length

The significance of an event (or nonevent) is easily distorted by limiting the scale and time period of a series. This example is from Odd Numbers:

Looks like an epic increase, doesn’t it? Here’s the same data extended out one more year:

Whenever you look at trends over time, try to get as long a series as possible.

Does the Housing Market Benefit When Investors Buy Foreclosed Homes and Rent Them to Tenants?

Yes, it does. I wouldn’t have thought this question worth posting about since it seems so obviously true, but since Nobel laureate economist Joseph Stiglitz and Yale University Professor Robert Shiller apparently disagree (see this Bloomberg article), maybe I should explain my reasoning. Calculated Risk agrees with me for some good reasons, but I have a couple more.

The Schiller and Stiglitz argument is that the speculators will sell the homes when prices recover, and the reentry of these homes into the for sale market will be a drag on price recovery. There’s no data in the Bloomberg piece, and the anecdotes all involve buyers who are renting out the houses they’ve acquired. Apparently, we would be better off if lenders held the properties vacant until owner occupant buyers can be found rather than sell the properties to landlords.

Everybody including me loves owner occupants, but the day when residential REO can be absorbed by owner occupant purchasers is a long way away. Employment is falling sharply in all the distressed markets: for example, here’s what’s happening in LA:

You are not going to have much residential demand in LA until employment is trending up again no matter what you do to incentivize owner occupant buyers (we could waive down payment and credit requirements, of course, but we know where that got us). It does neighborhoods no good to have lots of boarded up houses for years (just ask someone from Detroit what 60,000 vacant units have done for them).

My second objection is more subtle. I have previously argued that a relatively high percentage of single unit rental housing correlated with the size of the housing bubble in that market. For example, of the markets tracked in the Case Schiller Price Index, Los Angeles, San Francisco, and San Diego had the highest percentage of single unit rentals in 2000.

I believe the investors that owned those units were probably sellers during the bubble days, and that the purchase of REO by investors is a return back to the previous equilibrium rather than a new direction. Unfortunately, we’ll have to wait a while for data and there are a lot of moving parts so we may never know conclusively.

Majority Opposes Using Bailout Funds to Help Defaulting Homeowners

Housing Wire picked up a press release summarizing a survey performed for Reecon Advisors, Inc., which states, “a majority of Americans, 51 percent, opposes using Federal bailout funds to help pay the mortgages of homeowners who are in default. Forty-three percent of those surveyed favor helping homeowners in trouble.”

Although the release has a lot of information about the margin of error, etc., I couldn’t find anywhere what the exact survey questions were. If the release accurately represents the survey responses, I have to think the word “bailout” might has some influence on the results.

The answer to the question will also vary with the kind of borrower the person who answers the question is thinking of at the time. Here is a list of considerations from one of my earlier posts:

Modest housing versus luxury housing. Some believe people who got in trouble buying high end housing should not be helped.
Long term owner versus recent owner. Some argue recent purchasers who bought at the top should take their lumps.
Owner occupied versus investor/speculator. Some argue investors and speculators should not be bailed out.
Limited opportunity for recovery versus good future prospects. Some argue those who are in a position to start over should not be helped.
Loan funds used for necessities/productive purposes versus loan funds used for frivolous purposes. Some argue people who bought big screen TVs and new pickups with their home equity lines do not deserve help.
Limited capacity and/or duped versus knowledgeable and/or complicit. Some argue those who knew or should have known the risks of the loan they were entering into should not be helped.
Unable to make contractual payments versus able to make contractual payments. Some argue those who are able to make their contractual payments should not receive relief.
Able to make modified payments versus unable to make modified payments. Some argue to receive a modification ability to succeed under the modification should be demonstrated.
No housing alternatives versus those with housing alternatives. Some argue those who have housing alternatives after foreclosure (e.g., move back in with Mom and Dad) should not be helped.

I would like to think the majority of Americans are not opposed to federal help for a low income, elderly, long term owner of a modest home who was duped into a subprime loan used to repair the roof and who could afford a loan at a reasonable rates.

The release is correct in stating that public opinion will play an important role in determining what assistance, if any, homeowners will receive. I think the process would be better served if future surveys delved a little deeper into how the public views the issue.

Cliff Diving: Los Angeles Multifamily

For many years I have tracked the relationship between a market’s employment change over the previous 12 months and the number of residential permits issued over the same period. Employment growth soaks up supply additions, so when permits exceed the number of jobs created multifamily markets almost always weaken. Conversely, when more jobs are being created than housing units added, vacancy rates decrease and rents increase.

The November numbers for Los Angeles are very bad:

(Click on charts to open larger versions in a new window)

More than 170,000 jobs have been lost in Los Angeles over the last year, and at the same time more than 15,000 units were added, almost a –11 to 1 ratio. Look for significant softening in the multifamily market.

Workouts 101: Lender Liability

As I discussed in a previous post on discovery and attorney-client privilege, when lenders attempt to collect more than the collateral, income property borrowers almost always raise a wide range of defenses and counterclaims. The list below covers the most common ones.

Few lenders go into litigation knowing they’ve done anything wrong, and borrowers are rarely successful in obtaining substantial damages. However, lenders need to understand that their handling of the loan and borrowing relationship will be examined very thoroughly. The borrower’s counsel is looking for leverage to force a favorable settlement, and there are few loans which are documented and executed flawlessly. I will be discussing some of these claims in more detail in subsequent posts.

• Bad faith
• Breach
• Breach of commitment to fund or extend loans
• Breach of confidentiality
• Breach of contract
• Breach of fiduciary duty
• Breach of good faith and fair dealing
• Breach of interim agreements (final agreement differs)
• Breach of oral commitments
• Defamation
• Detrimental reliance/Fraud in the inducement
• Duress
• Estoppel and waiver
• Failure to comprehend documents signed
• Fraud
• Inconsistencies between written agreement and course of conduct
• Intentional affliction of emotional distress
• Interference
• Interference with contractual affairs
• Interference with corporate governance
• Misrepresentation
• Negligence
• Negligent denial of loan
• Negligent grant of loan
• Negligent Loan processing
• Negligent Misrepresentation
• Negligent Servicing/Administration
• Overreaching and Unconscionability
• RICO Violations
• Fraudulent rate of interest
• Refusal to extend credit
• Third party causes of action
• Control of borrower (third party damaged)
• Fraud
• Good faith and fair dealing - third party creditor subordination
• Tortuously inducing breach of contract

Redefaults on Modifications: History Repeats Itself

The 50%+ redefault rate on loan modifications in this downturn continues to make news (most recently Naked Capitalism and Housing Wire). In Crabgrass Frontier: The Suburbanization of the United States Kenneth Jackson writes about the Home Owners Loan Corporation (HOLC), a loan program signed into law by FDR on June 13, 1933. This program provided a lot of assistance:

Between July 1933 and June 1935 alone, the HOLC supplied more than $3 billion for over one million mortgages, or loans for one-tenth of all owner occupied, non-farm residences in the United States.

$3B was a lot of money back then. To put it in perspective, it represented about 2.5% of the GDP for 1933 and 1934. An equivalent amount would be about $677 billion today. In the 2nd quarter of 2008 there were roughly 75,715,000 owner occupied housing units in the US, so a program similar in scope today would be about 7.5 million mortgages. This is a pretty good sized sample.

How did things go? Again, from Jackson:

…in some states over 40% of all HOLC loans were foreclosed even after refinancing.

I wrote about why this happens here.

Loan Modifications Don’t Get Done: History Repeats Itself

HUD’s Hope for Homeowners modification program has been a dismal failure, with only 312 applications since October (vs. a target of 400,000 over three years, more details at Calculated Risk and Market Movers).

I’ve previously written about how difficult it is to do modifications on a large scale; the logistics are difficult, and borrowers are often not inclined to participate.

Unsuccessful government housing programs during downturns are not new phenomena. From Crabgrass Frontier: The Suburbanization of the United States by Kenneth Jackson:

On July 22, 1932 the President affixed his signature to the Federal Home Loan Bank Act (Public Law 304) to establish a credit reserve for mortgage lenders and thus to increase the supply of capital to the market…within the first two years of the law’s operation, 41,000 applications for direct loans were made to the banks by individual homeowners. Exactly three were approved.

A plug for this book – it is a fascinating account of housing in the United States. The link is to the 1987 edition, but it looks like there is a new edition pending which I am looking forward to.

Low Interest Rates Will Not Spur New Waves of Defaults

Mr. Mortgage’s post Low Interest Rates To Spur New Waves of Defaults is being widely cited (see Infectious Greed, The Big Picture, Option ARMageddon, and Naked Capitalism). Possibly this story is attractive because it’s counterintuitive, and counterintuitive is interesting. In this case, though, I think it’s wrong.

The claim is counterintuitive because lower interest rates lower the risk of default. Lowering the amount of interest a homeowner pays reduces their debt burden, and that lowers the risk of a future default. There’s nothing in the post to indicate there’s any disagreement on that point.

The argument in the post has three steps:

1) The news of lower interest rates is stimulating borrowers to apply for lower rate loans

2) The applicants are being turned down because their homes lack equity and/or the borrowers credit scores have declined, and

3) The realization they lack adequate equity and credit scores will spur the applicants to default on their existing loans.

The basic argument is that borrowers are ignorant of their situation, and once it’s revealed to them a significant number will default. My first objection is admittedly a philosophical one – I am highly suspicious of arguments which depend on people’s ignorance, and especially so when every homeowner I’ve met in the last year is acutely aware of what’s going on. I’m the first to admit there are whole sets of cognitive biases which predispose people to overvalue what they own (endowment effect, post-purchase rationalization), continue to do what they've done in the past (status quo bias, sunk cost effects, loss aversion), and expect a positive outcome to their choices (optimism bias, and valence effects). Given these biases, borrowers may wrongly expect their homes would qualify for refinancing, and getting turned down will be disappointing. But, I don’t think there are very many applicants who would be surprised.

My second objection is there is no evidence to support the claim is occurring – it’s a plausible narrative, but without any support. Here’s the only portion of the post which attempts to quantify the problem:

From early reports since rates fell sharply in early December, 80% of the loan applications are not getting out of the starting gate easily. Loan officers are all saying the same thing — that appraisals are not coming at value due because ‘all of the foreclosures and REO sales have taken the value down’. In the majority of these cases, this kills the loan.

This is obviously anecdotal (I don’t think “out of the starting gate easily” is a metric anybody tracks). We don’t know the normal fallout rate either, but I’m sure these days it’s substantial. I’m sure lower rates prompted some applicants who can’t qualify under today’s underwriting parameters to come out of the woordwork, but I’m equally sure lower rates have resulted in approvals for some applicants who wouldn’t have qualified at higher rates. Without data there is no way to know the net effect, and to forecast "a “wave” of defaults seems a stretch.

My biggest objection to the claim is that it presumes new knowledge they lack equity will cause borrowers to default. Borrowers default because they can’t make their payments (usually as a result of income curtailment). There is no credible evidence lack of equity in and of itself results in defaults.

The argument also ignores the fact that borrowers who lack equity may consider continuing to pay their best option. If they default, they will still need housing, and with no equity from their current home that means the down payment will have to come out of savings. How many homeowners can do that? Alternatively, they could rent, but how many homeowners who can afford their current payments would make that choice?

The only group of borrowers I see who might default as a result of lower rates are those who have substantial liquid assets and can afford a new down payment but hadn’t previously thought about walking away (small group), or who are willing to join the renter class despite the fact they can make their current payments (also a small group).

I don’t see a wave of defaults developing out of lower interest rates.

Data Trap: Don’t Ignore the Increasing Denominator

The current headlines are that initial jobless claims have spiked to 26 year highs (see The Big Picture, Across the Curve, and Angry Bear, to name a few). That sounds really bad, until you pause to reflect, as Mark Perry does in this Carpe Diem post, that jobless claims are reported as the absolute number of claims, and the labor force has grown 41% over the last 26 years. Here’s the right way to look at it in a graph from that post:

When you’re looking at absolute numbers over a long time series, you need to figure out what’s happening with your denominator too.