Rising Markets Create Lender Losses

People anticipate the future will be like the past. From a DNA article, “Why Economists Can’t See a Recession Coming”:

Robert J Barbera, chief economist, Investment Technology Group, in his book The Cost of Capitalism -- Understanding Market Mayhem and Stabilizing our Economic Future, writes: "Since the economy is not in a recession 80% of the time, the safe strategy is to predict recessions only when they have already arrived! That means you're right 80% of the time. Simply put, forecasting the recent past is the way to go and it is the dominant strategy employed by professional forecasters…Most of the time, tomorrow bears a close resemblance to yesterday. After all, both industry and economic trends tend to last for years, not for days. Once we acknowledge that we confront a world of pervasive uncertainty, it is quite reasonable to decide until circumstances change, we will plan as if present circumstances are likely to persist."

This approach to forecasting guarantees lenders will take losses. If you don’t say no when markets are rising, you are certain to have significant exposure at the top of the market which will create losses when the market softens. This time around, although everyone knew at an intellectual level that home prices could go down, the long term trend of rising house prices made it easy to justify rating models and lending decisions which didn’t adequately weight this possibility.

The Commercial Real Estate Landslide

Disasters are interesting, as evidenced by the success of shows like Destroyed in Seconds (30 minutes of one disaster after another, courtesy of the Discovery channel). A while ago the show aired this video of a landslide in Japan:

The images have stuck with me, and I think there are some strong parallels to what is going on in commercial real estate:

• First and most obviously, a disaster is going on, and if you’re in its path it’s a very bad thing.
• As bad as it is for those to be caught in the path, it’s important to realize the whole mountain is not involved. The landslide affects only a portion of the exposed area of the mountain – most of the mountain remains unchanged.
• The earth in the landslide moves from an unstable position to a stable position.

I was reminded of these facts while visiting with a very experienced real estate investor last weekend. I’m guessing he was in his 70’s, and had some money in a development deal that has a poor prognosis. In this CRE landslide he is going to lose a small portion of his net worth in an unstable deal which was exposed. But, he is confident he will buy other people’s exposed deals at stabilized, lower prices which will recover his losses and more over time.

It’s easy to forget that most CRE is not actively traded, is not fully leveraged, and is owned by people with substantial resources who are looking forward to buying busted deals.

Housing Was Not Massively Overbuilt

It’s widely taken as a given that because we have too many empty housing units now and because prices have collapsed, that housing was overbuilt. For example, from Unnatural Rent:

In addition, the recession and rising unemployment have slowed down new household formation, encouraging people to live with roommates. In many markets, apartment rents are unlikely to post any growth during this year, and some may even see declines.
This drop in demand has been combined with a massive increase in the supply of housing (both single family and multifamily) over the past decade. While office and industrial did not experience a huge wave of overbuilding, that isn't quite the case for retail and multifamily.

This is true in a sense – if we had fewer housing units now the situation would be better.  However, throughout the bubble years supply and demand were balanced. My argument is premised on the idea that additions to housing supply should roughly correspond to additions to employment:

1 new job = 1 additional unit

Obviously, not every person who gets a job creates a new household, but households are also created without jobs, and in my experience nothing too bad happens to housing markets where job growth exceeds new housing additions. The data for job creation and residential permits issued since 2004 is summarized below:

Supply and demand were in synch until 2007. In 2008, demand went off a cliff, which goes to show that jobs can be lost faster than residential development can wind down.

I think this data also supports the notion that the bubble price escalation was driven by easy financing, and not fundamental demand.

Employment data is from this BLS website, permit data at this Census Department website.

Waves of Stupid Money, and One Eye Money

 The Psy-Fi Blog has a post on Edward Miller’s research into irrational gambling, which gives some insight into bubble psychology. An excerpt:

Edward M. Miller in Do The Ignorant Accumulate the Money has done some research around the effect on the stockmarket of slot machine investors and reckons that there are periods where waves of stupid money can genuinely cause the rough efficiency of the market to break down. He also shows that these effects can’t last forever – if the stupid money is going into unproductive assets the lower return on these will eventually affect prices, especially as sensible money will be going into cheaper, productive ones.
In fact this isn’t too surprising to anyone with a background in social psychology – you don’t need to really understand economics to recognise that waves of irrational behaviour can sweep through groups linked by social ties. One of the oddest forms of behaviour is that a group’s overall opinion on some subject will tend to be more extreme than the average opinion of the group members. This polarisation effect is to do with the instinct towards group conformity and in the markets can lead people into taking more extreme and committed positions on individual stocks and markets than they would have taken on their own.

“Waves of stupid money” is an apt description of commercial real estate investors and lenders at the peak. Similarly, a general partner I know characterized the money he received from some investors as “one eye money”; cash someone whose primary business was not real estate would give him to invest, and which they would keep only one eye on.

Don’t be part of the wave, and keep both eyes on your money.

Does Tim Geitner Read My Blog? Are Regulators to Blame for the Housing Crisis?

From a Washington Post interview over the weekend, via Calculated Risk:

Geithner: "For something this big and damaging to happen it takes a lot of mistakes over time. And it is that combination of things. Interest rate here and around the world were kept too low for too long. Investors made - took a bunch of risks without understanding the risks. They were betting on the expectation that house prices would continue to go up - to go up forever. Rating agencies failed to rate these products adequately. Supervisors failed to underwrite loans with sufficiently conservative standards. So those basic checks and balances failed. And people borrowed too much. It took all those things for it to happen."

From my March 21, 2009 post, “Whose Error Was the Housing Crisis?”:

Here are some errors which had to align to get to where we are today:

1) Borrowers took out loans they couldn’t afford

2) Lenders made loans to borrowers which the borrowers couldn’t afford

3) Ratings agencies rated securities comprised of these loans as safe

4) Security purchasers relied on the erroneous ratings and bought the securities

Any of these parties could have averted the crisis had they avoided their respective error.

Calculated Risk takes Geitner to task for not mentioning two other factors:

Although there were many factors in the housing and credit bubble, the two keys were: 1) rapid innovation in the mortgage industry (securitization, automated underwriting, rapidly expanded wholesale lending, etc), and 2) a complete lack of oversight by regulators. As the late William Seidman wrote in his memoir (published in 1993): "Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid."
Geithner failed to mention the rapid changes in lending and the failure of government oversight as the two critical causes of the bubble. Either Geithner misspoke or he still doesn't understand what happened - and that is deeply troubling.

Although “innovation” and the regulators were factors, they were by no means the key factors. I think the innovations CR refers to should be viewed more as tools than culprits (an NRA bumper sticker for bankers - “Automated Underwriting doesn’t Kill Lenders, Lenders Kill Lenders”). More on this topic at “Why Did WAMU Abandon Underwriting Standards?”

The role of regulators is more complex. Certainly if disclosures were improved or some practices were prohibited, some bad loans might not have been made or bought. However, the errors listed above are so basic and so self-destructive I question the ability of outside intervention to control the behavior.

Lender Conspiracy to Destroy Competition?

The developers of the Fontainebleau casino and hotel development in Las Vegas believe Deutsche Bank is out to get them. From Zero Hedge:

In a stunner of a development, Las Vegas casino operator Fontainebleau has amended its ongoing lawsuit against a set of banks, and has alleged that Deutsche Bank is now "seeking to destroy the Fontainebleau in order to minimize competition" with the Cosmopolitan Resort and Casino, which was acquired by Deutsche Bank in a foreclosure auction in September 2008 for $1 billion, after the casino had defaulted on a $760 million loan. Allegedly, DB is doing this by pulling Fontainebleau's revolver, making it impossible for the development-stage casino to survive…

As both the Fontainebleau and DB's Cosmopolitan developments are in their final stages of development, their "successful" opening would result in yet another flood of hotel rooms in the already oversupplied Las Vegas market. The Fontainebleau casino would provide 3,800 brand new rooms and condo units, while the Cosmopolitan would supply yet another 3,000 rooms and condos.

How plausible is this argument? This plan would require monumental stupidity at Deutsche Bank. Shutting down the Fontainebleau development would ultimately lead to a new owner who would acquire the development at a much lower basis than the current owner. This would allow the new owner to substantially undercut the Cosmopolitan, pulling that project down too. I’ve discussed this downward spiral effect in more detail in my post CRE Loans and the Death Spiral of Doom.

If you view an income property submarket as an ecosystem, the whole system does best when all the competing properties have similar cost structures. When a predator property with a much lower cost basis enters the system (as a result of a greatly discounted purchase out of a foreclosure or note purchase, for example) it can offer much lower rents, which in turn can destabilize other properties. Eventually a new equilibrium is established, but at a much lower level than before the system was destabilized.

If Deutsche Bank is really trying to shut down Fontainebleau to benefit Cosmopolitan, it’s shooting itself in the foot.

Indications of a Credit Bubble

From Socializing Finance’s post Flashback: The Quality of Credit in Booms and Depressions, some commentary from 53 years ago:

In the past few years important new historical evidence has been developed on the cumulating deterioration in the quality of credit during the period of prosperity that precedes severe depression. […] With respect to the current situation we must concern ourselves with the fact that some, at least, of the economic conditions are in evidence today. What are these conditions? First and foremost is a rapid increase in the volume of credit or debt. Second, a rapid, speculative increase in the prices of the assets that are brought with the rapidly increasing credit, such as real estate, common stocks, or commodity inventories. Third, vigorous competition among leaders for new business. Fourth, relaxation of credit terms and lending standards. Fifth, a reduction in the risk premiums sought or obtained by lenders.” – Moore, G.H. (1956). The Quality of Credit in Booms and Depressions. Journal of Finance 11, 288-300.

How accurately did these conditions predict the current CRE bubble, and where are we today?

1. Rapid Increase in the Volume of Credit or Debt. This clearly occurred during the bubble. As of today, the amount of debt outstanding hasn’t really declined, because few assets have retraded at reduced value levels.

2. Rapid, Speculative Increase in the Price of Assets. Again, this obviously happened. Some distressed sales are starting to occur, but for the most part values have not been marked to market yet.

3. Vigorous Competition for New Business Among Lenders. That clearly went on. Today, there is very little competition occurring; the few lenders that are making loans can pick and choose.

4. Relaxation of Credit Terms and Lending Standards. Terms and lending standards were clearly relaxed during the bubble (Loan to Value, Debt Service Coverage, Interest Only payment structures, etc.). For the most part these standards have tightened, although arguably LTVs are still based on cap rates which are too low, and DSCs calculated on historically low interest rates may not be high enough to ensure an exit if rates return to historical averages.

5. Reduction in Risk Premiums. Again, this obviously occurred during the bubble, with spreads over Treasuries in the 100bp to 200bp range. Today, spreads are much wider, but again maybe not enough in light of the historically low Treasury rates.

So, it appears lenders in 2006 were not attuned to the risks publicized by this article 50 years earlier. And, it appears we are only part way to establishing a normal lending environment.

Your First Loss Is Your Best Loss

Jim Cramer’s reputation as a source of investment wisdom is not at its peak right now, but in the environment today his second commandment of trading is good advice. From a 2005 article on TheStreet.com:

Good trading, no matter what it's based on, technicals, fundamentals, the stars, the news, requires a level of discipline that goes against human nature. We are taught in life to be patient, to let things work out, not to be hasty, yet none of that works when it comes to trading. You have to be willing to cut and run, to use that "flight," not fight, instinct that we supposedly are born with but suppress wholeheartedly when we are grown up.

That's what the second commandment of trading is about, and that's why it is the second commandment of trading:

“Your first loss is your best loss.”

I genuinely believe that most trades need to work almost immediately for them to be right.

John Reeder over at Real Property Alpha has an excellent post making the case that this is true for CRE today, complete with a great example (Lennar’s role in the Newhall ranch development). As John notes, I’ve made the opposite argument –selling in this environment reinforces a downward spiral in values which is hard to stop, with unfortunate consequences for all. It is a classic Prisoner’s Dilemma / Tragedy of the Commons problem, and unfortunately the best individual bank strategy makes the problem worse in the long run. We have met the enemy…and he is us.

Loan Underwriting, Financial Cycles, and Ponzi Financing

Loan underwriting of all types (consumer, residential mortgage, CRE) follows cycles. From Edward Leamer’s “Housing and the Business Cycle” paper:

Why do lenders “forget all about risk”? I’ve previously argued it has to do with certainty of outcomes and slow feedback loops (see here).

The CRE Downward Spiral: Fire!

Real Property Alpha has a good post on deteriorating CRE fundamentals, but the conclusion points in a dangerous direction. Two excerpts:

This analysis, however, is not focused on providing a historical explanation for the office market weakness. Rather, I note the weakness of the fundamentals in order to provide counsel to lender clients with commercial properties on their books. Unfortunately, the downward trajectory of the graph on page 1 shows a market with a steep downward trend. Bank sellers failing to timely dispose of non-performing assets in this environment risk further deterioration in fundamentals and the resulting price decline. Simply based on fundamentals, office pro forma values are off 38% since Q108. The 38% decline is significant as it likely destroys any equity to debt coverage which was assumed during the initial underwriting, assuming that the deal was financed in the last few years…

Despite the tremendous liquidity problem in the financial industry today, I believe that making proactive moves to dispose of non-performing assets will provide reward for banks with the will to do so. Banks that can expedite the process of disposing of non-performing assets will be the first to clean up their balance sheet and begin lending again. The reward for these banks will be a risk environment in the new lending which will be significantly improved from the landscape we see today.

I agree, and disagree. When the banks dispose of their nonperforming assets, those assets become the comparables for and the new basis the remaining portfolio competes against, so those assets are now overleveraged and are disposed, and so it goes. An aggressive disposition strategy reinforces the downward spiral, so unless you get out of the asset class completely, you continue to suffer losses. A disposition strategy that looks smart for an individual asset can magnify your losses in the remaining portfolio. And remember, it’s not just you – the market won’t stabilize as long as other banks are making significant dispositions.

Also, an aggressive disposition strategy is smart, until it isn’t. If you sell an asset and the market continues to fall, you were smart, but if this downturn is like all the rest at some point the market will stabilize and values will start to rise. There is always someone selling at the bottom.

In a perfect world the most highly leveraged assets and the assets controlled by weak operators would be liquidated, and lenders would restructure the debt on marginally overleveraged deals with good operators to allow them a reasonable return and some upside in exchange for maximizing the asset value during the downturn. It’s like a fire in a theater; more people will get out in an orderly exit than if everyone tries to get through the door at once. Of course, we live in a far from perfect world, and at this time it’s hard to argue with Real Property Alpha’s conclusion that lenders should be running for the door.

Does the Relationship Between Median Income and Home Values Explain the Housing Bubble?

It’s taken as a given that one of the reasons housing is in crisis is that home value increases have significantly outstripped income growth (see, for example, these posts at The Big Picture, Option Armageddon, and Calculated Risk). Here’s a chart from Calculated Risk showing the relationship over time:

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

An excerpt from Option Armageddon explains:

Ask yourself, what is a housing “bubble” and how is one created?  The term “bubble” suggests that prices were, objectively speaking, “too high.”  Clearly this was the case.  A chart of house prices relative to median income makes it abundantly clear.  House prices can’t continue to expand forever, not unless incomes expand at the same time.  If prices are expanding faster than income, then prices are “too high” relative to what people can actually afford to pay for shelter.  In other words, we have a bubble.

This is common sense. But is it true? If it is, you would expect that there would be more foreclosures in markets where the ratio was higher. But that’s not necessarily the case.

Via Creative Class, a study from University of Virginia researchers found:

In San Francisco, for example, median value of owner-occupied housing in 2007 was 9.7 times median family income, yet the foreclosure rate was a mere 0.24 percent. In the District of Columbia, housing values were 6.8 times family income, yet the foreclosure rate was 0.12 percent. And in New York City, housing values were 12.3 times family incomes in Brooklyn (foreclosure rate 0.38), 11.7 times income in Manhattan (foreclosure rate 0.04 percent), and 10.3 times family income in the Bronx (foreclosure rate 0.28 percent). Other central cities lacked such extraordinary house value to income ratios, but in no instance were low foreclosure rates associated with low house value to income ratios (Table 4).

Here’s the table:

If the relationship is true, why does San Francisco, which has a value-to-income ratio triple the national average, have a foreclosure rate that is 1/3 the national average?

There is clearly something going on that can’t be expressed in a simple ratio. My suggestion is that bubble markets tend to have relatively low income levels and relatively high concentrations of single family rentals (see this post for a more detailed explanation).

Best Article Yet on the Residential Housing Collapse

George Packer has written a great article, The Ponzi State, in the February 9 New Yorker (the link is to the abstract but the full article requires a payment if you’re not a New Yorker subscriber). Here is an excerpt:

Driving around Florida’s ghost subdivisions, if feel not just that their influence is waning but that they are physically hollowing out. In a place like Lehigh Acres, near Fort Myers, where half the driveways are sprouting weeds, and where garbage piles up in the bushes along the outer streets, it’s already possible to see the slums of the future. More and more of the residents in Hamilton Park will be renters like Lee Gaither. The vacant houses in Country Walk will be boarded up. The St. Augustine grass in the front yards of Tanglewood Preserve will grow three feet high. The open fields with street lights but no houses will become dumps.

Underwater Homes, Exurbs, and Income

Paul Kedrosky’s Infectious Greed picks up on a story in the San Diego Union Tribune which has an interesting graphic of the percentage of underwater homes in San Diego County by zip code:

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

I agree with Paul that the full map tells the story as an exurb phenomenon (I’ve posted on that in more detail here) and relates to vintage (more on that here).

I also think the inset has something interesting to say about household income and underwater homes. The inset area is not an exurb, but there is big variation in the percentage of underwater homes across a relatively small swath of San Diego. Here’s a blowup of a piece of the inset:

Best to worst performance is light grey, yellow, orange, red, dark grey.

Now, here’s a UUorld map of average household income (2000) for the same swath:

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

Note how the higher income neighborhoods have fared better. I’ve written more about that here.

Will We have a Commercial Real Estate Crisis?

Casey Mulligan thinks probably not. From his New York Times piece:

For months now, experts have been predicting that commercial real estate will be “the other shoe to drop.” But in fact, non-residential building fell far behind housing construction during the housing boom. This shortage of commercial buildings relative to housing suggests that a commercial real estate crisis will not occur, or that at worst it will occur with much less severity than did the housing crash.

Here is the chart purporting to support this argument:

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

The error Dr. Mulligan makes is the belief that the housing bubble and future CRE performance was/is primarily a function of inventory. The chart suggests housing prices have collapsed because too many residential structures were built. That’s like saying Citibank’s stock price has collapsed because too many shares have been issued. Home prices have dropped because the financing that people used to buy homes at an inflated price is no longer available, not because there are more homes than people are willing to occupy. To the extent CRE inventories were tight, values were inflated, which won’t help us now if the deals were leveraged based on the higher values.

For example, look at Miami, a residential bubble market. The graph below shows the number residential permits issued in relation to the number of new jobs created on a rolling 12 month basis. The secondary axis is the OFHEO Housing Price Index year over year change.

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

Home price increases began decelerating in late 2005, but at the time Miami was creating twice as many jobs as new units, so if anything the market was undersupplied. Something else was clearly dragging prices down, and in retrospect we know it was the withdrawal of aggressive lending parameters.

Now, of course, most markets are losing jobs, and most markets are still adding units (and commercial real estate) as projects work there way through the development pipeline. We won’t see a recovery until the employment situation turns around.

What does this mean for CRE? We don’t know for sure how many deals were done with aggressive underwriting during the peak years, but we know there were quite a few and so we can expect some decline in values related to the withdrawal of aggressive leverage similar to what’s happened in the residential market. We also know that CRE is sensitive to employment trends, and those are very negative. The CRE situation may not become as bad as residential, but if it doesn’t it will be because the underwriting was better and employment improves. It won’t be because there was a lack of inventory.

Why CRE Goes So Bad So Fast: Vintage

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 (see a discussion of this and other factors in this post).

Here is an illustration from the New York Times, via Calculated Risk:

[M]any landlords find themselves in a bind because they paid stiff prices for property in recent years and need to cover hefty mortgage payments. On average, Manhattan landlords paid $3,348 per square foot for retail properties in 2008, compared with $538 per square foot in 2004, according to the brokerage Cushman & Wakefield.

Loans underwritten in 2004 based on the lower value will fare much better than loans underwritten in 2008.

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.

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.

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.

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.