This is actually a two part series within a twenty part series from an anonymous guest blogger.  I fully believe we are in a land recession.  In part one I am going to walk you through basic land theory and in part two (10 of 20) I am going to run a financial model and explain to you my reasoning on who is screwed and who will win during this land recession.  My goal is that you will come to the conclusion that for a lot of builders their land is worthless and thus they are worthless.

(1) Land and Debt are four letter words.  One of the golden rules to being a homebuilder is to finance land with equity and use debt for financing your homebuilding operations.  Why?  Because when you are highly levered and the market turns on you, then you will not be able to last during the downturn.  It is a rule that has proved out in every housing recession period.  Why then do builders double up their positions and try to grow faster than the market average?  Greed.  The bigger your company the bigger your compensation package.  If not greed, then stupidity.  This is such a basic concept and it holds true in every downturn.

When the residential real estate market falls hard, it falls. New York (Manhattan, too) is different from many other regions because it is denser, harder to build new supply, and has a generally richer demographic. Alas, buildings are still buildings, people are still people, and money is still money - Yes, even in NYC. Manhattan and Brooklyn have been on a tear during the boom. So much so that many actually began to believe that NY was somehow magically immune to real asset cycles. Developers have found a way around the supply issue as well. Just convert everything that stands into condos (NYC use to be a coop market). Those with short term memory must have forgotten the 90's, the 80's, and the '70s. NY residential real estate cycles reliably every ten years or so, give or take. Guess what. It's about ten years, and we have a free credit, cheap money, gentrification housing boom to make this cycle a doozy, both on the way up and the way down.

More on Short Term Memory

Prudential Douglas Elliman, a prominent NYC luxury real estate broker produces a monthly study as a marketing aid that recaps very recent property transactions. Now, if you follow the National Association of Realtors economists and reports, you should realize that those in the industry tend to run a bit, ahem, optimistic. Keeping that in mind, let me run down a highlight of the report for the month of September. Please keep in mind that the way things work in NY is akin to the following:

  1. marketing time increase to point of sale (product stays on market longer to sell)
  2. volume of sale decreases, as sellers refuse to lower prices to meet buyer demand
  3. concessions are given that usually do not show up in public record (seller's concession, private paper held back, furniture/antiques included in sale, etc.)
  4. publicly recorded prices finally drop.

By the time we get to point 4 above, the market has actually been slowing down and effectively dropping in price from an economic perspective from point 1, usually at least a year before. These facts are not reflected in statistics, and it will be hard to get realtors to admit it.

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...

Tuesday, 18 September 2007 01:00

Whaaat!! How much did you cut?

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For those that have been perusing my blog, you know that I am as bearish now as they come. But the extent of this cut is shocking, and the rationale is even more shocking. The reason we are where we are now was too much cheap money for too long. This caused a big bubble (actually, 2 bubbles) to burst. What's the prescription for this ailment? More cheap money, of course. There is nothing like a little over proof rum to make you forget you have a hangover.

Bernanke says that the real estate bust spreading is risking the health of the broader economy. The bust came from a bubble, which came from dropping interest rates. This most recent drop just may exacerbate it. Residential mortgage rates are tied to the 10 year note and commercial mortgage rates are tied to USD LIBOR. Both have decoupled from the Fed Funds rate, as Greenspan has attested.

So, now that you have dropped rates Mr. Fed, what happens when mortgage rates move up anyway? Much of the tightening is already happening because the liquidity in the market from securitization has dried up. No amount of loosening policy will alter that in the medium term.

Addendum: the 10 year T note yield is up, and as a result, the 5 year ARM has increased from last week. The housing market is a mess, not due to interest rates, but due to the fact that sloppy underwriting reigned supreme. People who got houses they can't afford will have to lose them for this to be over, period. Even the CEO of Hovnanian is guilty of taking advantage of sloppy underwriting to buy into the top of a bubble, then trying to borrow his way out of it - and he runs one of the largest homebuilders in the country!!! Mortgage rates can go down and we will still have a housing problem, for too many people got mortgages they simply cannot afford.

'Nuff said.