Reggie Middleton

Reggie Middleton

Resident Contrarian Badass at BoomBustBlog (you can call me Editor-in-Chief)...

Disruptor-in-Chief at Veritaseum.com, where we're ushering the P2P Economy.

 

Sunday, 02 September 2007 01:00

The Real Trend in US Housing Prices...

Quote from the WSJ: "Underscoring the growing pessimism about housing, economists at Goldman Sachs in New York raised their forecast for the drop in U.S. home prices this year to 7% from a previous 5%. The forecast is based on the S&P/Case-Shiller national home-price index, considered the best such gauge by some housing economists. The Goldman economists expect a further 7% decline in house prices next year. In this year's second quarter, the index was down 3.2% from a year earlier.

Reggie's grassroots analysis:

The S&P index severely understates the glut in housing and the downward pressure on pricing. It uses the repeat sales methodology which only includes houses have that have been sold at least twice, which excludes all new construction. So the homebuilder’s product which is being slashed in price with butcher knives and cleavers don’t even show up in the index, and these homes must be slashed enough to sell in a slow market that no longer has cheap credit, has much competition in excess supply, and no longer has the phantom appraisal pricing which helped sustain the bubble in the first place (more on this later).

Moody's just put Lennar, Pulte and Centex on negative watch for downgrade to junk status. For those who read my earlier posts, non-investment grade entities cannot participate in swap agreements with investment grade entities through the banks to fund the mortgage special purpose companies. In addition, Centex's warehouse credit line expires this month (the credit line that they use to fund mortgages to sell their homes),

and somehow I doubt they will be able to find a replacement. For those who thought the homebuilders will be reaching a bottom soon --- Now, the party begins... They will be saddled with the depreciating assets and increasingly unfunded debt burdens that are throwing the mortgage bankers out of business just when the housing market spiral starts to accelerate downward. Pulte homes relies on their internal financing for almost 100% of their home sales. This is going to get much uglier and I foresee insolvency for more than a few. Despite what I see (and I have been wrong before) the home builders rallied yesterday and are definitely off of their lows.

Macro-economic theory and research as well as the theme in general credited to Dr. Drobny. For the record, the piece this is derived from was written towards the beginning of the year. It may seem to state the obvious now, but it was quite predictive when it was written.

Once upon a time, there was a man at the helm of the Federal Reserve during one of the most explosive equity market bubbles in the history of the US. Technology stocks, and internet stocks in particular, exploded in price by several hundred percent, fledging start-ups with no profit, often no revenue, and speculative business models were being brought public at astronomic multiples, and vast fortunes were being made as mom and pop investors bought IPOs in margin accounts. The Chieftain warned of the “irrational exuberance” in the markets and the dangers that ensued, but oft to no avail, as the market shot up higher and higher. This was an obvious speculative bubble, and during the past extreme bubbles in this country, previous Chieftains pricked them with higher interest rates which invariably led to a recession or worse shortly thereafter.
Now, this chieftain, being the historian that he was, knew the historical effects of the pricking the bubble, so he tried to talk it down through speeches of “irrational exuberance”. Since that did not work, he decided to try something different from all of his predecessors,

and wait for the market to collapse on its own, which, of course, it did. After the market crashed, this chieftain lowered interest rates to near 1% (in terms of real rates) and consequently flooded the US with inexpensive money in the form of easy credit. Since the US is the economic epicenter of the world, the flooding of the US with money is the equivalent of flooding the world with money, and the result was that risky assets US wide and world wide became more liquid, and thus from a liquidity perspective, perceived as less risky. This love fest with risky assets ranged from real estate and mortgages to derivatives, commodities and emerging market debt (and practically everything in between). As a result of this “Great Global Macro Experiment,” real estate (primarily residential) led the US out of the dotcom implosion caused recession and powered the economy for the 6 years.
As a matter of fact, the speculative excesses of the real estate industry, and consequently the mortgage industry that financed it, easily matched if not surpassed that of the dot com era just a few years ago. The Chieftain in seeing this, raised interest rates in an attempt to soak up some of the liquidity that he flooded the world with, but his efforts were to no avail. For the first time in the history of US Fed Reserve Chieftains, the power to directly or even indirectly affect interest rates were out of his reach. He remarked that for some strange reason, that he did not understand, as he would raise rates, the market rates would actually decrease. Thus, one effect of the experiment was that the Chieftain and the fed lost the power to directly manipulate market rates.
As the real estate and mortgage markets crashed (as all speculative bubbles do), this author and investor predicts that real estate will lead us into a recession, the same as it led us out of one several years ago. The difference between now and then is that the entire globe’s risky assets were “mispriced” downward due to excessive and easily available credit and liquidity, thus as the US goes the world will follow. Think about the fact that it took 6 years for the bubble to form, it will not dissipate in 6 months or even 16 months, due to the illiquid nature of the base asset. These are not internet stocks sold in a minute and settled by the end of the day. My experience in selling residential in the NE of the US was a 90 day marketing period to sell a property. These days, many properties have been on the market over 6 months and have not sold (in a fairly wide cross section of locations). Now, if it takes six months or more to move property that is part of a 10 month inventory supply (don’t believe many of the official reports that exclude condos, coops, and multi-family residences that have the inventory stated lower) and that marketing time is getting longer, not shorter, how healthy do you think the environment is??? As the US real estate market (residential, and soon commercial) is tanking, the opaque derivative structures that allowed banks to write loans bigger than their balance sheets follow. This will ripple throughout the world as speculative real estate and exotic financing vehicles follow the same paths in Europe, Africa, Asia, and South America. Spain’s residential real estate market is currently on fire and 92% of the mortgages issued are ARMs, most of which are concentrated to the lower income buyers. Sound familiar? Similar scenes in Brazil. UK residential prices have soared, Australia up nearly 3 times (relative), China homebuilders and contractors or roaring, condos in Dubai everywhere… Add in the US exported structured products… Practically all of the popularized risky assets are destined to follow suit, not just real estate – expect pressure in the emerging market debt markets as a follow-through...

Saturday, 01 September 2007 01:00

How low can prices go, again??

from WSJ.com:

"An auction of about 135 foreclosed homes in San Diego Saturday provided more sobering news for mortgage lenders. Ramsey Su, an investor and former real-estate broker who attended, calculated that the high bids for the homes averaged 67% of the prices they fetched when they were last sold, mostly in 2004 or 2005. At a similar auction in San Diego in May, the average was 73%. The auction was held by Real Estate Disposition Corp., Irvine, Calif., which promotes such sales on the www.usahomeauction.com Web site. REDC officials couldn't be reached to comment."

Will this spread to the greater economy?

"Countrywide Financial Corp., reducing costs as part of its effort to weather a credit crunch, has begun laying off employees involved in originating loans, according to an internal email."

Saturday, 01 September 2007 01:00

Who else is in trouble?

By now, you probably realize that I think the homebuilders are in worse trouble than the mortgage lenders. Their collateral is not as ephemeral, since it is a real asset, but it is also much less liquid. Don't get me wrong, I think the mortgage lenders are in very big trouble as well, but the big lenders cannot be allowed to go out of business due to the damage to the economy. Nobody is going to miss a homebuilder going belly up.

The only way out of the mess is the way we got into it, the hard way.

Saturday, 01 September 2007 01:00

Correction, and further thoughts on the topic

It has been called to my attention that among the many typos in my earlier post, an important one was the reference to the funding costs of DHI. The company in question was actually DHOM - Dominion Homes, not DR Horton - DHI. The general theme still stands, though, these guys as an industry who hold significantly depreciating real assets or options on said assets, financed by debt (all of them) or those who have significant mortgage banking operations without internal financing (ex. deposit accounts, etc.) (the vast majority of them), and who are running consistent operating losses for the last quarter and foreseeable next half (all of them) are in trouble, to say the least.

Saturday, 01 September 2007 01:00

How Far Will US Home Prices Drop?

I do not know, and I doubt anybody else does either. How much they will drop nationwide is a fools question, and to hazard a guess would be an exercise in futility due to the extremely geographic nature of the housing industry. Remember, no one lives in a nationwide home!!! There are some areas where I would bet the farm on a 20-25% drop though from peak to trough, Vegas doesn't look to good and Southern Florida is in for a lot of pain (re: condos). There are southern Florida condo developers who have been foreclosed upon because they could not sell above their cost and the land was too expensive to convert into a rental. That, in itself represents a 25% drop, retail, so it has already started happening in some areas at a rate that is higher than the historical average - and we have just started the real estate bust. Florida is an interesting area due to the inherent demand for clear water, good weather and the pretty women night life effect, not to mention favorable homestead laws. It also has laws that favor condo development for you don't need a red herring in the same fashion as cities such as NYC, hence you can pre-sell condo units with a set of plans and then finance the actual construction with a bank loan and deposits from pre-sales.

Saturday, 01 September 2007 01:00

Thoughts on the US Publicly Traded Homebuilders

I noticed that many pundits are focusing on single family residential market, most likely because it is in the news so often. It is bad, very bad. I am an ex-residential real estate investor who sold off in 2005 due to fundamentals that were totally out of whack. It appears that many do not see how precarious the commercial sector has become, with many deals being done at 2-5% cap rates (net profit yields) in Manhattan and many major metro areas, which is absolutely ridiculous considering the risk and illiquidity of these deals. The compensation for these deals are coming no where near justifying the risk. I am sure the excessive liquidity coupled with significant demand caused the cap rate compression, but the buyers fell for it assuming liquidity and demand would continue for some time. Well, corporate liquidity has just dried up, and

many are stuck holding the bag with buildings that are yielding as low as half that of treasuries, yet easily quadrupling the risk. Some are even selling at lower cap rates in successful flips (reference the Blackstone purchase of Sam Zell's portfolio, which was totally overpriced, yet Blackstone managed to flip much of the portfolio over to speculators, some of which actually flipped it over to someone else at a profit - ALL in a period of a few months). This has now become nigh in impossible, but in an attempt to raise the cap rates, commercial rents have skyrocketed to all time highs in the major metro areas, causing significant pressure on corporate profits (I have inside knowledge of this affecting MAJOR public and private firms who are looking to expand and are getting squeezed).

And now, on to small residential (single family and 1-4 family residential)...


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