Once More, Into the Breach

I'm fixing to give up on the basic educational attempt here - and everywhere else.

But before I do, I want to put one final posting out here - one nice long look at the housing and mortgage lending sector, along with basic economics.

I want to start with some basic pieces of information. Note that none of this is my opinion - it is, in fact, what has been recommended for nearly one hundred years as the basic guidelines for safe, sound, secure mortgage lending.

You can find these very guidelines at places like About.Com, but they didn't invent them either.

Why have these standards been in place for that long? Because people have been buying houses for a very long time. They've bought houses in good economic times and bad times. They've bought in good times and then had bad times. Indeed, on average, we have had a recession of significance about once every seven years, give or take a few (yes, this means we're due for one.)

Anyway, these basic qualification points are:

• A "back end" ratio, or "Debt To Income" (DTI) of no more than 36%. This means that all of your mandatory debt service, including your mortgage, property tax, homeowners insurance, association dues (if any), credit card minimum payments, payments on student loans, auto loans, etc - all must add up to no more than 36% of your gross income. "Debt" does not include utility, food, and other expenses which are not "debts", nor does it include your taxes (it is computed on your gross income.)
• A "front end" ratio of no more than 28 to 30%. This is the total amount of your fully amortized principle and interest payment on the mortgage, including property tax, insurance and homeowner's association dues divided by your gross income. In other words, you must have some "room" for debt other than your housing requirements in your total debt-to-income ratio.
• Your total home purchase price should not exceed three times your gross annual income. In fact, three times your income is quite aggressive - a more appropriate ratio is 2.5 times your (gross) income.
• You should have put down 20% of the purchase price as a down payment. The down payment serves two purposes - it insures you have "skin" in the game, and more importantly, it demonstrates conclusively that you have the discipline to amass a decent chunk of cash and sequester - rather than spend - that money. Historically, this money had to be "seasoned" - that is, it could not have come from some other form of loan (e.g. a personal loan) or gift (e.g. your parents give you $20,000); the source of the down payment has historically had to be disclosed and proven.
• The loan should be for a fixed term and carry a fixed interest rate. Typically mortgages were written for either 15 or 30 years. 30 years is really the longest you should consider taking a mortgage for, although there are now 40 and even 50 year products. Why? Because if you buy a home when you're 30, another 30 years makes you 60. It is unwise to retire with a mortgage payment; if something happens to your retirement income you are likely to find yourself out on the street otherwise!

Mortgages written under all of these rules, where all the claimed facts are verified (e.g. income) are extremely safe. In fact, on average only about 1% of these loans will default over their life. There will be times that more defaults will occur (typically in serious recessions) but most of the time the default rate will be lower than 1%. In short, the average risk of the homeowner losing their house due to foreclosure with a loan under these guidelines is less than 1 in 100.

For each of these guidelines you violate, the risk goes up precipitously, especially in a poor economic environment.

Let's be clear - most mortgages are "safe" in a strong economy and they are even safer in a rapidly expanding home price environment, at least in terms of foreclosure. But in terms of risk to your personal financial future, this is not true.

For instance, let's say you take a 1 year ARM in an attempt to drop the payment a bit, so you can buy a bigger house. You figure that if the interest rate rises you will simply refinance into a conventional mortgage. And, three or four years later, that happens - and you do.

All is ok, right? Wrong. You just added three or four years onto your loan! What was a 30 year mortgage just became a 34 year mortgage. Do it again a couple of times and you have a payment when you retire at 65! This is not a good thing, but our short term thinking has blinded us to this reality.

Now let's look at the last seven years of the housing market.

In early 2000, the Tech Stock bubble imploded. Equities fell precipitously; the Dow and S&P500 each lost 50% of their value, while the Nasdaq fell by more than 75%. If you were invested in the market you took a severe haircut. Many people who were investing on margin were totally wiped out. I personally know several friends who had what they believed were safe retirement portfolios - each with far more than $1m in assets - ground into the dirt, losing more than 90% of their value. None of these individuals have recovered their losses, seven years later!

All that money left the market and went looking for somewhere to earn a return. Enter Alan Greenspan. In an attempt to prevent the ensuing recession from turning into a full-on depression, Greenspan cut interest rates to levels that left you with an effective negative rate. That is, the GDP growth exceeded the interest rate being charged! Effectively, the government didn't just print money, they paid you to borrow it! That little obscenity limited the recession to a historically short (and shallow) decline, but it also led to an immediate explosion of demand in the bond market for some way to earn a real return - see, bonds are linked to interest rates, and suddenly, there was no money to be made in Treasuries.

Responding to this demand and the flow of money at an effective negative interest rate banks and lenders started offering all sorts of creative mortgage products. Housing prices spiked due to demand - simply a matter of lots of buyers chasing too few homes. The next several years - up until about 2005 - saw price appreciation exceeding 20% in many markets on an annual basis, and some areas saw doubles year-over-year.

This made mortgage qualification a "no questions needed" game. If you borrowed money to buy a home and got in trouble, you could simply refinance into a new loan with some sort of "teaser" rate, even if you ended up negatively amortizing (that is, your principle balance was actually going UP!) This worked out because the house's value (according to sales of other homes near you) was going up faster than your debt - so the lender didn't care, as they had no risk. Don't pay, they come and take the house, selling it for more than you owed 'em.

But in early 2005 price appreciation came to a halt. All the people who wanted to buy homes already had them! What had replaced buying to live was buying to speculate - that is, the price appreciation had become so far above reason that now people of even very modest means were buying "pre-construction" condos and then, before the building was even completed, "flipping" them to someone else at a profit. Homes were bought, $10,000 worth of renovations put in, and sold for double what they had been purchased for, often to someone who sat on the property for another six months and then flipped it again! Eventually, as this cycle continued over a couple of years, prices go so high that people started to step back and evaluate exactly what they were in fact buying, and whether it could possibly continue. Increasingly, they came to the conclusion that this cycle had to end somewhere, and that they didn't want to be the "bagholder" when the music stopped! This dry up in the market began in the middle of 2005 - almost two years ago.

As the pool of good credit risks and flippers who were in and out of properties in under a year disappeared, lenders, anxious to keep the deal flow going (they are, after all, paid a percentage of each loan made - make no new loans, make no money!) loosened qualifications even more! Suddenly if you had a pulse you qualified. Lenders began qualifying your "debt to income" on the teaser rate - a rate that was GUARANTEED to go up in a year or less! In the majority of these cases the borrower would not have qualified at the fully indexed rate at all.

But this time around there was no price appreciation. Now, when these loans reset to a higher rate, the borrower is screwed. They cannot refinance out because their home is worth less than the mortgage balance, or at least, it exceeds the 80% limit for safe and responsible lending. Their debt to income ratio exceeds the 36% cap, when you try to qualify them at the fully-indexed rate.

Now not everyone who finds themselves in this position will default and lose their house. Many will, in fact, find a way to make the payments.

But this entire industry, with the exception of the "Subprime" lenders, is predicated on a default rate of 1% or less.

This was only true when economic times were good. Now, they're not so good. The leading economic indicators show a big slowdown in the economy. Inflation is running above target, leaving the Fed unable to cut rates. The exhaustion of buyers due to prices rising above their ability to afford new housing has caused a near stop in residential construction in the United States. THAT has led to layoffs in the homebuilding industry, which, of course, means those who worked in that industry now are out of work (many of them are illegal immigrants, so while they don't show up in the unemployment data, they sure do in the cash register!) This, in turn, is now leading to a slowdown in transportation and building materials (the first reports in both areas are just starting to show up.)

As this snowballs, and it not only will, it must, there will be more people out of work as the effects move up the supply chain. In addition, home prices are now falling in many markets, and there are estimates that on a national basis home prices will decline by as much as 5% this year.

You can no longer refinance out of a bad loan, nor, in many cases, can you sell your house to clear a bad mortgage.

A rapid - and accelerating - rise in defaults have led lenders to react by raising qualification standards - not far enough, but at least the move is in the right direction. Unfortunately that just makes the problem worse for those who are trapped, and for those lenders who have these poorly-made loans on their balance sheets.

Now you will - and have - heard that many of these organizations "have it under control." But do they? Let's take a quick look at some examples:

• One of the lenders who people believe "has it under control" started operating as a public company in 2003. They have never been through an economic slowdown; as a consequence their risk models are completely untested in a difficult economic environment! How can you claim you know you're going to be just fine if you've never actually had your business model under the stress of a slowing economy? That's pure insanity - but yet, its what some analysts are saying about one particular lender!
• Two more have most of their portfolio in ALT-A (that is, products where the only qualification for the loan is a high FICO score) and most of that portfolio is in California! This is a state where the current "median house price to median income" level is in excess of 5:1, or nearly twice the safe level. Oh, and this is also a state that has had more than one housing "bust" in the past from levels far lower than this in terms of income, yet those "busts" lasted for several years each. Safe? I don't think so!
• Another has claimed to have "only 9% of their portfolio exposed to Subprime" yet was named as one of the 10 largest unsecured creditors when New Century (a real honest-to-God subprime lender) went bankrupt just a few days ago! Uh, exactly what are your potential losses on that unsecured debt? You do realize that unsecured creditors typically get absolutely nothing in a bankruptcy, right?
• Yet another has four times the FDIC's value considered "safe" in concentration of construction loans - in Florida - where residential construction has basically ground to a halt. Can you spell "impairment charge"? Builders know what that is. Do lenders?
• Two more have no filed financial statements and their auditors' quit in the last week. Gee, is that a problem? Anyone remember Arthur Anderson and Enron?
• Fannie and Freddie now have their "Conforming" loan limit at $417,000. So now you need federal guarantees on your mortgage if you make $139,000 a year? Are you kidding me? To put this in perspective, as recently as 1996 - when I bought my last residential property with a mortgage - the limit was $207,000. That's a double in 10 years, and again, above historical averages - the previous 10 years, from 1986 to 1996 - the rise was fifty-five percent. Yet inflation was much higher from 1986 to 1996 than from 1996 to 2006! Therefore, Fannie and Freddie's confirming limits, in real dollar terms, have risen about twice as fast as it appears over the last decade. Even worse, the rise from 1996 to 2001 was 32% - from 2002 to 2007 the rise was 51% - a sixty percent rise in the rate of increase during the real estate bubble years, while inflation was at historic lows!

Everyone wants to say "oh, but the economy is roaring ahead and will save us."

Is it?

Anyone remember 2001? We were in the middle of a recessionary environment - the markets were in the tank, and yet unemployment was very low. How's that? Those jobs were "McJobs" - service sector employment which, while it provides you with a wage, doesn't give you much in the way of advancement possibility. Most telling, Business and Professional service employment (that is, GOOD jobs) along with manufacturing fell.

But wait - how can you have a recession with full employment? Well, you can't. But employment lags the economic picture by one to two years. It takes time for businesses to recognize a recession and lay off workers, cutting back their costs - and it also takes time for business to recognize expansion and hire to fill those jobs. As a consequence during the end of an expansion and the beginning of a recession employment data is always strong!

We just got the employment numbers this morning (Friday.) The headline number was 180,000 jobs gained, and while the equities markets are closed for Good Friday, the futures and bond markets are open. The futures immediately moved higher, suggesting that people liked that number in the equities markets.

But, just like all the recent economic data, you have to actually read the report to figure it out and you must understand how employment data is actually correlated with the economy.

Here's a few data points and facts from the actual data:

• Rate cut to bail out lenders and/or borrowers? Off the table. Wage growth was 4% YOY, which leaves inflation risk far too likely for the Fed. So you can expect the Fed Funds rate to remain at least at 5.25%, and perhaps be set higher. If you've got a rate-related mortgage problem, sorry, Mr. Fed isn't going to come help you out.
• "Goods producing" industries added 43,000 jobs. But manufacturing cut 16,000, the ninth straight decline. Where was the gain? Construction - up 56,000 - but analysts attributed all of that to weather - February's report in that subsector was brutal, and that temporarily furlowed a number of people. Note, however, that there is no breakdown between residential and commercial construction (gee, why not?)
• Service-sector employment increased by 137,000 jobs. But in that number we had yet another nugget of important information - business and professional services lost 7,000 jobs - the first decline in that sector since November 2004. Those are some of the best-paying jobs, of course. Health care and education added 54,000 while government added 23,000. Retail added 35,900, which, frankly, was a surprise (to me anyway)

So let's see - we have "retail" jobs (which are low-wage) up, we have health care and education up (no big surprise there; boomers get sick, need care, etc), and we have a weather-smoothed reasonably steady commercial construction sector.

But both manufacturing (good wage) and business and professional services (good wage) jobs are experiencing net losses in employment.

There's no actual good news in here for the housing sector.

Again - employment is a lagging indicator of the economy, not a leading one.

Proof? How about a history lesson? In 2001 - the middle of the Tech Crash, when it was clear that there would be huge job losses (remember everyone screaming about how it was all Bush's fault?) unemployment was 4.1% - essentially above full employment. It was not until later in the year and going forward into mid 2003 - that that unemployment rise was apparent. The last recession began in March 2000, when unemployment was at its lowest level, under 4%, and was essentially over in November of 2001, at which point unemployment stood at 5.75% - and had another half-percent to rise through 2002 and into 2003, peaking in June!

During this entire time Democrats were screaming about a "jobless recovery." That screaming went on for TWO YEARS, from the date George Bush took office until roughly 2003 - when unemployment peaked and started downward.

But the recession was OVER in 2001!

So if you wish to be sanguine about the economy - and the markets - go right ahead.

I see four leading economic indicators pointing to a recession, none pointing to expansion, a jobs market that is behaving exactly as you would expect heading into a recession and a housing market in the tank.

What's not to love? Let's drive the DOW up another 200 points Monday so we can have an even bigger selloff when earnings season begins and the truth about the mortgage lenders and homebuilders becomes apparent!

Six months from now I believe you'll be wishing you were not fully-invested in equities.