Friday, February 29, 2008

Houses for the banks

What will be the result of this whole housing bubble blow up? I will try to describe the whole thing is very broad terms.

Around 2000, the demand for real estate started to increase rapidly. Demand for real estate comes from three different sources. First of all, a population increase can cause this. There can also be demand from people who want to own more than one house. There can also be a change in preference between renting and buying. The first reason, population increase, has been fairly steady over US history and are not the main driver of the recent housing bubble.

The demand for second homes certainly increased. People, in recent times, think of second homes as an investment. After the stock market crash of 2000, the dot-com blowup, people looked for alternatives to stocks. They noted the wonderful returns that they or their parents may have received by buying during or before the inflationary 1970s. This current demand was aided by the very low interest rates following the stock market crash. The two sources of this were Greenspan's Federal Reserve as well as the "vendor financing" resulting from the rise of the US trade deficit. In short, China sends us products, we send them dollars and they buy US financial assets such as US mortgages and US Treasuries. This helped keep interest rates down leading to a refinancing boom and a boom in first home purchases.

This was the first stage of the housing bubble. The number of homes of course didn't change as rapidly. This change in the supply-demand balance lead to the beginning of the price appreciation bubble. This of course feeds back and enticed more people to think of housing as a good investment which led to more buying.

The next stage of the bubble came from converting more renters into buyers. Traditionally people would rent while they were young and save money for a down payment on a home. This is what I learned when I was young. Typically this would be 20% of a house price. This was demanded from banks to create an equity cushion. Mortgages are non-recourse loans that allow the buyer to simply stop paying the mortgage and giving the bank the right, in turn, to foreclose or take back the collateral. The equity cushion provides the incentive for the buyer to do whatever it takes to avoid default. It also allows the bank to suffer as much as a 20% loss on resale without suffering a net loss.

Due to this dramatic run-up in house prices, the banks relaxed their lending standards to allow for lower down-payments. In addition, since house prices were rising rapidly, they were not too concerned about suffering any loss on the value of the collateral. There was no need for a 20% down payment if the house would be worth 20% more next year. Many of these loans were resold to investors anyway. So it would not be the problem of the originating bank or mortgage originator once it was sold off, if the payments were not made.

The worst of this was the subprime lending industry. Fueled by short-term loans from Wall Street banks, these lenders would give loans to just about anybody capable of fogging a mirror. The lenders were extremely profitable because they could sell off the loans very quickly. A 1% gain on a home loan isn't that great if it takes you a year to do it but if you can turn-over 10 such transactions in a year, that is a 10% annual gain on your capital. Better yet, if you can leverage up your assets to 10 times capital, that is a 100% return on capital. What a business model? So faster turnover from the buying mania and leverage created this wonderful business opportunity. However it depended on insatiable demand for houses as well as a plentiful supply of borrowed money from Wall Street and finally demand for these securitized mortgage products in the secondary market.

All this time, the homebuilders were ramping up their building. There was more demand for homes and so this resulted in higher profit margins. These profits created more capital that could be used to buy more land and build more homes. The end result would of course be a much larger supply of houses.

Home prices rose. Economic activity was vibrant with all this building and buying and selling. There were profits all around. Builders made a killing. Banks made a killing. Even the buyers made a killing if you counted the capital gains on the houses. All of these were extremely leveraged. The buyer bough with little or no money down. Putting down 5% (1/20th of the house) and getting a one-year appreciation of 20% meant a 400% return on invested capital. Who needs to work when you can get returns like that just by signing on the dotted line? Bank loans are always leveraged transactions. They are allowed to leverage their capital by about a factor of 10%. Builders were leveraged as well by borrowing from the banks.

Of course this all had to come to an end. Eventually prices got so high that most people simply could not pay the mortgage payment. They could not even pretend anymore. Monthly payments were as much as twice what it would cost to rent the same house. This was almost 50% of the average persons take home wages. The supply of people that could be converted from renters to buyers or single home owners to second home owners began to dwindle. The excess supply of new homes relieved some of the pressure on home prices.

So eventually home price appreciation stopped. Then the whole process which depended on rising home prices would come apart in dramatic fashion. Now we are in a period of falling prices. Now the total supply of houses is much larger than before. The supply of people willing to speculate on house prices has evaporated. The supply of banks willing to make low down payment loans has contracted. The fact that prices are clearly dropping removes any incentive to buy now. The deflationary mindset sets in. Why buy now when you can buy cheaper next year? The supply of houses for sale is even larger due to a massive wave of foreclosures.

What is the endgame for all of this? House prices will eventually bottom. They will do so when it becomes cheaper to buy then to rent. It will do so when a person can buy a home and rent it out for a profit. The trouble is that this break even point between buying and renting seems quite a ways off.

So who is the winner and loser from all of this? Like all bubbles, this has resulted in a miss-allocation of resources. This results in a inefficiency and so a decrease in GDP. Basically, houses will end up on the balance sheet of banks who will have to auction them off at a loss. So banks will have lost money which will easily erase all of the profits from the proceeding years. People who owned before the bubble will have seen their house value go up and down. Many of these will not be impacted. However, some of these may have borrowed against their home and now find themselves with a much higher debt/equity ratio. They may now have to work longer than they had planned in order to retire and so may spend less in the coming years. Again , this will reduce GDP.

Some people with good credit and secure jobs who bought near the peak will have to pay higher than normal mortgage payments for the rest of the life of the mortgage. Some people may have lost all of their net worth by having bought at the wrong time and now have to sell for whatever reason.

Who are the winners? For every losing speculator there is a winning speculator. Some people who bought and sold at the right time made a small fortune.

Young people and renters are winners. They will in the future be able to buy houses much cheaper. There are a lot more houses now and not that many more people.