Mortgage News & Commentary - Other Peoples Money

By
Steven Lord

Other People's Money

November 14, 2006

For my money, when Alan Greenspan comes out and says the lion’s share of the housing correction is behind us, I tend to listen. He had a major role in creating the liquidity surge behind the housing bubble, so I figure he has a good idea of when it might revert to a less-frothy level. But it has been amazing to watch the same commentators who lionized Sir Alan when he was Chairman of the Federal Reserve (and applauded the ultra-low interest rate policies which led directly to the bubble in the first place) dismiss the man’s viewpoint. I guess there is little media value to saying things are going to be fine…although with the exception of the speculation-driven areas mostly on the coasts, I think he is right. For the average Joe living in his house, paying his mortgage and not going anywhere, the “correction” has largely been a non-event.

But there is no doubt the market is correcting. Data coming from both production (housing starts) and consumption (home sales) indicates a dramatic slowing in transaction activity. Mortgages are down, although rates are only 75-100 basis points from their lows and still historically very low, and new construction contracts have plummeted. As one would expect, this is being vividly felt in prices, which fell recently at the fastest pace since 1969. An article in the Wall Street Journal illustrated the situation very well when they wrote a whopping 40% of new-build condo contracts in areas like Miami are being broken.

But while this type of data makes for great headlines on CNBC, I think most of the real carnage is being felt at the margin. In other words, those folks canceling condo contracts are not your normal, two-car-one-dog homebuyers – more often they are flippers used to five years of profitably buying and selling within a few months. Invariably, they are perfect examples of the first rule of finance: Use someone else’s money…

The housing “retrenchment” is normal and necessary. No market goes in a straight line, and excesses are always removed when period adjustments take place. Right now, a soft landing looks not only possible but probable, and interest rates in both the markets and the FOMC should be heading DOWN, not up, over the next six months. While this doesn’t mean the housing market will return to the insane pace of the last few years, it does infer the overall economy may tolerate housing’s rebalancing better than many pundits currently expect. And for people in the market for homes and mortgages, this is good news; when added to the pricing power home buyers are beginning to enjoy in earnest, continued low mortgage rates could create a truly win-win situation.

A PRIMER ON LEVERAGE

Virtually all of us use leverage when we buy a home – the down payment is rarely more than 20% of the price, with the rest being financed. And for speculators, leverage can be a very powerful friend when markets are going up. Using someone else’s money to invest means you’ve “geared” your equity in the underlying vehicle, and now have a tremendous amount of leverage to its movement. Effectively, movements in the underlying investment have an exaggerated effect on your equity.

Think about it. Say you take $50,000 and place it along with $1.5 million of borrowed capital into a mansion in Key Biscane or Menlo Park or Greenwich with the intention of tossing that same property back into the market in a few months. When the market was incessantly going upwards, this worked – you would have sold the property for, say, $1.6 million. You would pay the bank back their $1.5 million, put the $100,000 difference into your pocket, and net of your original $50K, you’ve made $50,000 – double your money in a few months on a mere 6.6% rise in the price of the underlying asset (the house).

But as real estate speculators all over the country are learning the hard way, leverage can work the other way. Using the same numbers, the price of the house need only move a mere 3.3% to completely wipe out your equity in it. And with a $1.5 million house, that’s not much margin - sell it for anything less than $1.45 million, and you are looking at a 100% loss. With median new house prices dropping 9.5% year-over-year in September (the largest annual decline since December 1970), it is easy to see why so many of those folks who have quit their day jobs to speculate in real estate have a somewhat glassy look in their eyes.

I hate to say it, but it is always turns out the same. Every time a major bull market comes around, it convinces people who have no concept of how fast things than go wrong to jump into the fray using borrowed money. In the late 1990s it was tech stocks, and so far this decade it has been real estate. The trouble with housing, though, is that it is not a liquid market – you can’t just go online or call your broker and be rid of a bad “trade” in seconds. Instead, in can take months, which causes more dramatic price drops, which in turns keeps buyers away hoping for a lower price, etc. etc. It is a much more viscous cycle when your asset is illiquid, and when you throw leverage into the mix, it is no wonder that those under the gun are selling at literally any price.

As investors have learned since the first share of stock was traded, borrowed money is a blessing when prices go your way, and a curse when they don’t. This time around, the high levels of leverage used by real estate speculators over the past several years is making the housing correction more violent than would have otherwise been the case. But is also probably shortening its duration as the same, which is what I believe Greenspan meant when he said the “worst was behind us.”

And don’t fret – the housing correction is not going to mean the end of the U.S. economy as we know it. It might not be pretty and we will probably have at least a couple more quarters of dismal data to deal with, but I think it is increasingly unlikely the real estate correction will send consumer spending into a tailspin. This was my primary worry a year ago, since a whopping 6% of total consumer expenditures were sourced from cash-out refinancing. But interest rates remain historically low, overall property equity remains high, and employment remains extremely strong – factors that should, all else being equal, allow the average consumer to weather the real estate downturn fairly well.

Other Articles by Steven Lord:
Call To Arms - 06/15/2006
Refi Boom Over? - 09/14/2006
Watching The Fed - 12/04/2006
Any Port in A Storm -01/18/2007

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