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Unintended Socialization of the Housing Market and Its Consequences

by: Trader Mark April 15, 2008 | about stocks: DIA / QQQQ / SPY    
Trader Mark

Trader Mark

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I've argued many times that the best thing, as a nation, despite short term pain - would be for housing prices to fall nationwide to a level that would allow most homeowners to only spend 30-35% or their income on housing costs. [Dec 6: Analysis: What Should Median Housing Prices Be Today?] This would allow people to for example... ro buy food and heat their homes... without stress of wondering how they'll afford to do it. Or do crazy things like... well, to save or invest. By people I mean people not in the upper 10-15%. Heck this would even allow for a huge flow of spending and consumerism which is what our economy is based on.

But it would require a shorter term, painful period of adjustment of home prices from their completely out of line (in major urban areas) levels, where "typical people" with "typical jobs" have to resort to financial engineering just to have a roof over their head. When you have a chart like this below, you see bubble-economics at it's best - the market will eventually overwhelm the interference the government is trying to achieve until a true equilibrium is met... when a police officer can afford to buy a home in the city he patrols would be a good measure - you know - like in the 60s, 70s, or 80s.

Right now we are trying to build a dam in the price erosion to keep prices inflated at say 2004 or 2005 levels. Not going to work - until people can afford normal homes with normal payment terms with 5-10% down with normal median incomes - we are not done with our little correction...

I found a great article on SeekingAlpha.com discussing one major unintended consequence from the coming proposed bailouts - one of many we create by interfering with "free markets" - i.e. ethanol boondoggle, keeping interest rates at 1% for ages, etc. Well we are going to embark on a new era of "solutions" which will create even more problems... again, the best thing would be a quick (albeit painful) readjustment period in housing prices, which would allow people currently renting to afford homes. But the government seems inclined to (attempt to) stem home price deflation by any manner possible... this is socialism at it's best.

  • If I understand its terms right—and I think I do—Barney Frank’s ballyhooed $300 billion plan to stem subprime foreclosures figures to take a bad situation and make it even worse. Reason: the plan would give up-to-date borrowers a powerful incentive go delinquent on their loans, perhaps on a massive scale. This is supposed to help fix the problem?
  • But as it’s written now, here’s how the Frank plan would work. The holder of a delinquent subprime mortgage would take a writedown on the loan, then dispose of its loan in a short sale funded by the issuance of a smaller, government-guaranteed FHA loan. In return, the holder escapes further credit risk. Fine. The specific size of the loan writedown, though, would depend on the size of the new FHA loan, which in turn would be set according to terms “the borrower can reasonably be expected to pay.” In particular, the maximum allowed loan-to-value ratio of the new mortgage would be 90%.
  • As I say, if the government has ever before put in place such a powerful inducement for wholesale borrower delinquency, I can’t recall it. Let’s walk through some numbers and you’ll see what I mean.
  • Take two neighbors, who both took out 0%-down, $300,000 ARMs, each with a 5% introductory rate, in mid-2006. Since then, the houses they bought have fallen by 10% in value, to $270,000. At reset (which will happen any month now, to around 8%) their monthly payment will rise to $2,000 from the current $1,250.
  • OK so far? The only difference between our two borrowers is that Borrower A is current on his loan, while Borrower B is delinquent, and so qualifies for relief under the Frank plan.
  • And, indeed, Mr. B applies for relief. His new, FHA-funded loan comes to just $243,000—90% of his home’s $270,000 appraised value—so his monthly nut (at the same 8% he would’ve been paying under the terms of the old loan) is now just $1,620. Still-current Borrower A, recall, is paying $2,000 per month, after reset, for the identical house. Oh, and Borrower B now has $27,000 of equity in his home, while A is upside down by $30,000.
  • What do you suppose the Borrower As of the country would do at this point? I’ll tell you one thing: a lot of them would go delinquent on their mortgages on purpose, to qualify for the same sweet deal that the Borrower Bs have gotten.
  • You might object at this point, and say that that Congressman Frank has built safeguards into his bill—like, say, insisting on a government claim on any subsequent home-price appreciation--to prevent intentional delinquency from happening. You would be mistaken. Sure, the feds would have a claim on any gains the borrower realizes after a sale. But the size of that claim declines the longer the borrower stays in the house, and falls to zero after year five in any event. In the meantime, the borrower gets an immediate $57,000 boost in his equity, to $27,000 from minus-$30,000.

We are telling every American (currently 1 in 10 homes nationwide, and growing by the day) who is "upside down" on their mortgage (value of home less than they owe) to apply for Mr Frank's program. And then everyone else who plans to stay in their home for at least 5 years and has less than 10% equity? Do the same - you go from sub 10% equity to "10% equity" instantly, and a lower mortgage payment to boot. And the plan still makes sense for those who plan to move in 2,3,4 years - all you need to do is give up some of the "gains" from selling your home to the government (not all of it though!) - which is still more than the "no gain" you would have (since you are underwater!) if you did not go delinquent and get a new government sponsored mortgage. 

So you go from having to bring money to the table at closing to get out of our mortgage, to getting a windfall - even if you only live in the house 1 year... magic! Talk about incentive to go bad on a mortgage! Now that I think about it what is to stop people who have more than 10% equity (say 20-25%) to take a 2nd mortgage or a home equity line of credit, take the cash out of the home ATM, and then you too will be under 10% equity - and then can default!

The government will quickly come in and give you 10% equity - magic! And you get to keep your cash out which you probably bought a nice SUV or did a kitchen remodel with. Fantastic! And so once again, by trying to step in and stop the market from going where it will eventually go - we will create moral hazard and unintended consequences left and right. Just about par for the course from this short sighted Nanny state.

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This article has 13 comments:

  •  
    Apr 15 08:02 AM
    That is one scary chart...
    Reply
  •  
    Apr 15 09:02 AM
    No good deed goes unpunished!
    Reply
  •  
    Apr 15 09:21 AM
    Looks like I'm getting a Heloc and maxing it out. Can't get these kind of guarantees from the stock market.
    Reply
  •  
    Apr 15 12:42 PM
    Mark, current homebuyer psychology could result in Frank's proposal rapidly escalating the downward trend of home prices thanks to the high likelihood of panicked-crowd-behavio... documented ad nausea via public tragedies as well as stock market crashes. Here’s how:
    An unmanageable swelling of mortgage-current homeowners (the big pool of 9 out of 10) will choose delinquency, slowly at first and then escalating in numbers, thus hemorrhaging bank revenues and brutalizing compliance with reserve requirements. This crashes bank stocks as well as investor confidence.
    Simultaneously, the above rapidly accelerates the decline in appraised values of homes, far faster than appraisers can handle and document.
    Simultaneously, there's an unmanageable mad dash by the 1-of-10 delinquent homeowners to Frank’s program, overwhelming the government staff as well as the appraisal industry. Frank's new program seizes up mid-stream like a Bush-era FEMA program <snicker>.
    Any delusions of a feasible and orderly fix of America's housing crisis are vanquished. The stocks of all residential-real estate related industries sink at an accelerated rate in search of a new bottom.
    Voila.....we hit the new equilibrium in home pricing faster than planned….unfortunately with tremendous velocity and inertia..
    Unable to overcome inertia, home prices overshoot the equilibrium point, downward. Meanwhile, banks, Fannie/Freddie/FHA, gov't and the appraisal industry try to untangle the mess after months of finger-pointing (there’s always an election coming up). The public freezes up like deer-caught-in-headlig... refusing to enter into any buy/sell transactions.
    It's so inter-connected that the sequence of the above can unfold numerous ways but ultimately still arriving at the same destination.
    The lubricant for the above is the speed of news information: it allows panic behavior to occur far more easily than before. A nation of 300 million hears the bad news all at the same time, thus allowing mass panic.

    BUT WAIT. There’s more!
    The creator of the 90s TV Show, Babylon 5 wisely noted that it’s not wars that are so interesting, it’s the unfolding aftermath (e.g. compare the 6 years of military and survival tactics of WWII against the 45 years of ensuing Cold War politics, economic and social shifts, military counter-moves and feints, that followed).
    The battle for a new equilibrium in housing prices across different markets and related stocks will see reformists battling socialists battling capitalists in terms of new regulatory and market agencies, intermediaries, and rules.

    So…to prevent all the above, the Frank Proposal will have to include targeted moratoriums on certain transaction, probably by geography, housing market, or by date-of-default….kind of like how the Dow uses circuit breakers. It, in turn, will fuel incredibly resentment across congressional districts as homeowners have to “wait their turn” at the trough.

    Reply
  •  
    Apr 15 12:59 PM
    That said (whew), I agree with you, Mark..we need to get median home prices to get closer to median wages and salaries, by market and by category. The only thing sustainable is different housing markets and prices (for-sale and rental) that are affordable to job-holders at every wage level.
    But there’s too many forces affecting equilibrium and preventing sustainability, so I expect house prices to move like waves in an ocean seeking an elusive equilibrium.
    Reply
  •  
    Apr 15 01:39 PM
    Nanny state? I would call things as they are: Communist state.
    America was built on giving power to individual to make his decisions. There are two kinds of borrower under water:
    1. Those who want to appear rich and eventhough they have jobs, they need new house, best furniture, new cars...live life they cannot sustain.
    I don't want to help these people at all!!!!! They need to learn their lesson
    2. Unfortunate immigrants, who don't know any better or people with lower IQ, uneducated who get easily bamboozled. I am sorry for this group, and I thought maybe there shoudl be some nonprofit entity to protect them.. Free market however cannot take into account this group to operate like it should--freely.

    Both groups would learn something from it. We should rely on ourselves only and blame only ourselves for mistakes. It is us who sign the mortgage.
    Reply
  •  
    Apr 15 03:47 PM
    I don't know if this is addressed in the bill or not, but how many times does a borrower get to do this re-negotiation / re-finance? What if 6 months to 1 year later the value of the home continues to fall and borrowers are upside down again? Can they go through the process again?

    Big assumptions are made about being able to set the right appraised value that will only stay constant or go up, with no risk of going down. Dangerous.
    Reply
  •  
    Apr 15 04:06 PM
    Agreed with all of the above statements. We began creating an entire Socialist government the minute the FED starting bailing out the banks. Of course, the irresponsible builders, speculators and stupid want there bailout and now how can you argue with them? The cycle of this bad behavior of course is government passing 'fairness in lending laws' (Socialism). Then the FED manipulates the free market interest rates (Communism) to recover from 911. Then the greedy and irresponsible drive up price of housing making it affordable ESPECIALLY if your here illegally or of some special interest group or elite crowd with inside info (Socialism/Communism). The irresponsible Socialists are bailed out by taxpayers (Communism) and eventually responsible Main St. is broke, Wall St/banks crash and the resulting government is Fascist. Some events/results that may possible change this:

    - Good government gets elected (probably 2012 after failed Socialism) and creates millions of jobs in Green energy and STOPS Socialism (hard to do when lots of people get on the dole, riots erupt and what not when you cut them off)
    - Open revolt - possible but not probable
    - America attacked by WMD, country stays a Republic and sacrifices as Patriots for one another, like first Great Depression and resulting war(s) creating the next 'Great Generation'.

    Keep in mind the general population and elites alike partied it up prior to the Great Depression. The older generation called the elites 'uppity, ungrateful snobs' and the younger generation 'ballyhood speakeasy folk'. Part of the problem is American's have just started feeling pain from the party and hangover and Washington & NYC (rulers of our country) are encapuslated and foolishly thinking Wall St. and banks don't need the little guy made up of the middle class. Corporate earnings now show otherwise, perhaps leaders will look at charts now in that regard.
    Reply
  •  
    Apr 16 12:24 AM
    The problem with any socialism/communism is it does not work for long.

    Very fast people learn how to avoid working and maximize stealing.

    Then, people start to resent each other.

    Then, hate each other.

    Then, welcome to a "paradise" with no personal freedoms but with concentration camps for "enemies of people"...

    Remember that "any road to hell was paved with good intentions".

    In Russia, people say: "Wanted to do better and ended as always in deep shit".
    Reply
  •  
    Apr 16 01:24 AM
    Great break down of Frank's misguided attempt at socialing the losses of the greatest housing bubble in history.
    Reply
  •  
    Apr 16 02:26 AM
    Ithinkbig and pharma......Bravo Bravo! Well said indeed. If a person combines human nature, with history, the economic laws, etc....the cause and effect of different economic systems is easily understood. One can almost predict the future. Sadly we are trapped in the viscious cycle where as each year goes by the theives and irresponsible are sucking the good people dry. My wife and I are doing well but I've made all the right decisions so far. In America a person could afford to learn from the school of hard knocks, recover, and still succeed. You could do well for yourself without a college education. The margin for error is less and less and I think its because we've allowed the elites to rob the middle class to pay for their own lifestyles, prop up their businesses, while at the same time creating a dependant class that will keep them in power. If I had to predict the future America will continue a slow decline. I fear that big corporate business, the banking system, and the government are forever tied together via fascism and socialism until it all falls apart. History suggest it could be hundreds of years before mankind recovers from the kind of financial chaos it will take to end this fascism and socialism. We might even return to might makes right and power to the strong. Or worse we could go to a one world government controled by the same fascist and socialist that brought about our demise. Then decisions will be made about with local region lives and dies.

    I hope I am wrong and this country can return to a more free market, rugged individualism, libertarian type of democracy before a complete melt down. It will be difficult but I think its achievable. The internet may be our salvation.
    Reply
  •  
    Apr 16 07:23 AM
    Time wounds all heals
    Reply
  •  
    Apr 19 07:37 PM
    Trader Mark, thanks for the effort, but do you really believe the government can or will implement this solution. It aint gonna happen. These politicians are blowing smoke up your ass. Stick to the day trading.
    Reply
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