Wall Street History

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Wall Street History

10/26/2007

A Look Back at Real Estate

This column is about financial market history and on the topic of
real estate and the current debacle in the housing industry, there
is no shortage of material contained within my archives.
Frankly, there is enough material on StocksandNews for a few
books on just this single issue but I thought I would put together
a few items from past commentaries, gleaned from my “Week in
Review” (WIR) columns. Some day I’ll delve more deeply into the
evolution of the crisis.

[Unedited I wanted to make sure there was context for some of
the more trenchant comments.]

WIR 8/27/06

The market meandered downward, pressured by the latest dismal
readings on housing as both sales of new and existing homes fell
yet again in July while inventories soared. By one measurement
the median home price is now up only 1% over the previous year
as the comparisons continue to weaken. Merrill Lynch chief
economist David Rosenberg believes the chances of a hard
landing in real estate are now 40-80% and as housing is the
“quintessential indicator,” just as in the bursting of the tech
bubble it spells big-time trouble.

WIR 9/16/06

Back in the U.S., housing analyst Ivy Zelman of Credit Suisse,
who has been bang on in her analysis thus far, said “We believe
that the housing market is still in the early innings of a hard
landing that will likely take several years to develop.”

WIR 10/07/06

However, before you go popping the Korbel (hey, it’s not like
Nasdaq hit a new high, you know), Federal Reserve Chairman
Ben Bernanke told you this week, in his strongest words yet on
the topic, that real estate was undergoing a “substantial
correction” and that it would shave one percent off GDP the
second half of the year and who knows how much in ’07;
admitting it was tough to predict the “dynamics” of housing and
its overall impact.

And then Bernanke’s vice chairman, Donald Kohn, said the
falloff in real estate has “proven to have been more rapid and
deeper than many economists had predicted.”

Well I’m no economist (my sheepskin says poli-sci major and
beer drinker), but anyone with half a brain knew real estate had
long entered the frothy stage by last fall .a full 12 months ago,
Mr. Kohn ergo, when bubbles pop, the fall can be rough. Or
maybe Kohn forgot Nasdaq 5048. Moody’s Economy.com also
weighed in with research that predicts the average home price
will decline about 4 percent in 2007, with far greater losses in the
hotter markets.

But lest I get too smug, which I’m not entitled to be anyway
because I thought the three major equity indexes would decline 3
to 7 percent this year, I do agree with Bernanke that it’s tough to
predict the dynamics of housing and its overall impact; which is
why I muse about the psychological impact between $450 in the
pocket and a $20,000 hit to the net worth [I was referring to
savings at the gas pump vs. a hit in home value] as well as the
fact that Americans, overall, are spending more on housing
(including for real estate taxes, insurance and utilities) than ever
before, according to the latest Census Bureau data.

WIR 10/28/06

I know I’m not telling you anything you don’t already know,
being the eagle-eyed observers that you are of your own local
scene. But I spent a good deal of my time in the Tucson,
Arizona, area driving around and all I saw were the big boys,
building massive developments, with signs offering all kinds of
incentives.

DR Horton, Clayton, Lennar, KB Home, US Home these are
some of the bigger ones I jotted down in my drive-thrus.

What the casual observer doesn’t pick up on, but what you know
all about from reading this column, is that the homebuilders
haven’t just been overdeveloping, they are liable for all that land
that they may now opt not to build on. That’s what keeps their
managements up at night, I can guarantee you. So much of it
was purchased at the very top, of course, with massive leverage.

Back in New Jersey, we’ve had a few instances of fairly sizable
developers going Chapter 11 already, before any of the real bills
come due.

So to those who say housing, and thus the U.S. economy, are
going to fall softly, I say you have a hard time convincing me.

But I do agree that for right now, when it comes to the
consumer and sentiment, as the readings are proving in this
regard, oil continues to trump real estate. In other words that
little hypothetical of mine from weeks ago, hard annual savings
of $450 at the pump versus a paper loss of $25,000 to $50,000
on your home, continues to carry more weight.

That will change too, however. Josh P. in San Diego passed
along an observation concerning an exclusive development he
has watched closely over the past year. A group of doctors
purchased some spec properties, looking to make a killing, but
then the market slammed to a halt. And now, no matter how
much they slash prices, no one is biting.

What has amazed so many of us is how quickly psychology has
changed. But it still has been slow to impact consumer spending
and falling oil has had everything to do with it. One thing is very
clear, however. The days of using one’s home equity as a debit
card or piggy bank are over. The official numbers don’t reflect
that yet, but they will. All together now .wait 24 hours.

WIR 1/6/07

And if you thought I was too bearish last week in my housing
comments for this coming year, I can thank home-builder Lennar
for making me look good for one week at least.

The Miami developer announced it expects to report a fourth-
quarter loss of around $500 million in the face of land-related
write-downs. CEO Stuart Miller said “Market conditions
continued to weaken throughout the fourth quarter, and we have
not yet seen tangible evidence of a market recovery.”

At the same time Lennar said it would sell a 62% stake it had in a
15,000 acre track in California, not exactly a ringing
endorsement of prospects for a rebound anytime soon there. And
Lennar admitted it is doing everything possible on the incentive
side to move existing inventory, something to remember next
time you see relatively sanguine new home sales data.

I was in Miami myself a few days this week for the Orange Bowl
and not having been to the area in years I was floored by some of
the high-rise condo developments. Now, granted, I was there
over the holiday weekend but on Tuesday, when I expected to
see workers back slaving away on the monstrosities lining the
beaches and waterways, I saw virtually zero activity.

Coincidentally, I saw a Reuters piece by Jim Loney noting that
developers are now pulling the plug on some of the biggest
projects (a la Lennar’s warning). In fact, Miami officials talk of
15 condo projects, representing 1,900 units, that have been
officially pulled, but analysts agree the eventual number will be
much higher, taking into consideration the rest of the overbuilt
market over the entire state. In other words, there are going to be
more than a few eyesores to stare at in the coming years,
buildings half complete or giant pits, waiting to swallow up
unsuspecting tourists.

There were also a number of tidbits this week regarding the New
York City real estate market that foreshadow further softening
rather than a bottom having been hit.

For example, construction permits declined for the first time
since 1998, demand for office space appears to be hitting a wall
(ignore some of the positive spin you may have seen), and the
average sales price for a NYC apartment is now off 4% from a
year ago; this last fact obviously doesn’t represent a crash, but a
pigeon in the mine nonetheless. [The Big Apple being an urban
area and not exactly a haven for canaries .then again it’s been
warm enough for the songbirds, but I digress.]

Of course New York’s housing market will also be the recipient
of much of Wall Street’s largesse, so numbers over the coming
months could be a bit out of whack, especially at the very high
end, though the primary trend now appears to be in place.

WIR 2/10/07

Find me an ‘expert’ who says real estate has bottomed and I’ll
show you an idiot. How many times do some of us have to prove
it? This week it was HSBC that admitted its overly aggressive
salesmanship in going after the subprime mortgage market (i.e.,
those who can least afford it) had backfired in a huge way as it is
writing off $10.5 billion in bad debts, or 20% more than the
company itself expected just a short while ago. Delinquencies
are accelerating in this segment and this is occurring in a strong
economy.

How did this happen? One word. Affordability and
homeowners simply not understanding that they can’t stretch
beyond their means. It’s a painful lesson everyone in life has to
learn at some point, too much debt that is, but the problem in
today’s real estate market is that home values are not simply
going to shoot back up and bail out those who are on the verge of
going under today. Too many used their home as an ATM and
the window has closed.

But it’s not just a class of homeowners that are suffering. The
real estate developers, who should know better, have been
writing off land faster than the French did during World War II.
So, no, we haven’t hit bottom yet.

WIR 3/3/07

Countrywide Financial, the largest U.S. home mortgage lender,
said late payments on its loans were rising rapidly, to 2.9% of
prime home-equity loans, up from 1.6% a year earlier; while
19% of its subprime mortgage loans were now late, up from
15.2% at the end of 2005. Not a disaster for Countrywide, yet,
but you can’t ignore trends that are only going to worsen.

And then you throw in the derivatives angle. Years ago, Lewis
Ranieri basically created the mortgage market. [He is best
known to others for his central role in the 1989 book “Liar’s
Poker.”] Ranieri was the man who came up with the idea of
pooling mortgages, then slicing and dicing them to be resold as
bonds to pension funds and institutional investors. It was the
start of the derivatives market, in many respects.

So last weekend Ranieri told the Wall Street Journal’s James
Hagerty that the business has changed so much that if the
housing market goes down much further, no one will know
where all the bodies are buried, which has been my point on
derivatives for years, frankly. Ranieri said “I don’t know how to
understand the ripple effects through the system today.” If Lew
Ranieri doesn’t, do you think some fresh-faced trader does? I
think not; let alone the fact there are two sides to every trade.
Actually, in the derivatives market that’s part of the problem.
Often there isn’t another side; it just floats out there in the Kuiper
belt.

As talk increased this week of problems in housing and
derivatives thereof, I couldn’t help but think of how we are also
seeing a worsening of the haves vs. the have nots. Many of the
have nots are seeing their dreams go up in flames, while the
haves, battered, are nonetheless still in fine mettle, overall. If a
rising tide lifts all boats, some higher than others, a receding one
carries out the dead, while leaving the rich still sipping pina
coladas from their decks on shore.

WIR 3/10/07

So what should you care about these days? Let me put it to you
this way. You know how Lucy Van Pelt told Charlie Brown the
only thing she wanted at Christmas was real estate? She was last
seen huddling with her real estate expert and accountant on how
much further she needed to slash the sales price of the 600
condos she was intending to flip in order to stay solvent. It was a
fun ride for Lucy on the way up .but there is hell to pay on the
way down, and lord knows Lucy isn’t handling it well. [As for
Charlie Brown he’s chuckling over Lucy’s problems, after all she
did to him. The kid who once gave a home to a scrawny little
tree put the standard 20% down on his first and only home years
ago and is sleeping soundly today. Yes, good things do happen
to good people.]

You see, today’s crisis in the subprime market continues. In fact
it’s almost comical how some just a few weeks ago, let alone
months, were trying to convince you the bottom was in. As John
Wayne would say, gaze fixed on an unknowing target, “Well
hold on there, pilgrim. You see a bottom?” “Ah, no, Mr.
Wayne. Sorry I brought it up.”

You know you have problems when the nation’s second-largest
subprime mortgage lender, New Century Financial, may have
filed for bankruptcy by the time you read this. Or when every
developer, like Hovnanian, or a bank such as HSBC, continues to
speak of serious issues in the housing sector, overall, and not just
subprime.

In fact as you’ve undoubtedly heard, but which I would be
remiss in not mentioning at least for the archives, Donald
Tomnitz, CEO of builder D.R. Horton, told investors in New
York that “2007 is going to suck, all 12 months of the calendar
year.” Let me tell you when this comment hit the tape, it did
indeed move the market. Alan Greenspan? Pshaw. Donald
Tomnitz? He rocks.

The more serious issue on an individual basis is of course the
fact there is real pain out there in America and I truly feel for
those who were either given bum advice or didn’t know to ask
the right questions. Mortgage lenders, like credit card
companies, can be masters of deception when it comes to
explaining loan or credit terms.

WIR 3/17/07

Credit Suisse analyst Ivy Zelman, another who has been bang on
in calling the problems in real estate, sees another issue; a 20%
drop in new-home sales. Her argument is if you can’t sell your
entry level home, you can’t move up. Inventory levels will thus
continue to soar.

WIR 3/24/07

The Housing Sector

Two weeks ago, March 10, I wrote that I was incredulous that
some actually thought what former Federal Reserve Chairman
Alan Greenspan had to say at a speaking engagement or two
moved the markets.

“The man is irrelevant and I see zero reason to bring him up in
the future, unless it’s about his earlier forecasts as chairman
which fell woefully short of being accurate.”

Well, Randall Forsyth had a terrific column in the March 19
edition of Barron’s and on the issue of Greenspan, Forsyth
writes:

“In a speech to the Fed’s Community Affairs Research
conference in April 2005, The Maestro sang the praises of
‘technological advances’ that ‘have resulted in increased
efficiency and scale within the financial services industry.
Innovation has brought about a multitude of new products, such
as subprime loans,’ he continued, adding that technology had
allowed lenders to size up the creditworthiness of borrowers
more cheaply.

“ ‘Where once more-marginal applicants would simply have
been denied credit, lenders are now able to quite efficiently judge
the risk posed by individual applicants and to price that risk
appropriately. These improvements have led to rapid growth in
subprime mortgage lending; indeed, today, subprime mortgages
account for roughly 10% of the number of all mortgages
outstanding, up from just 1% or 2% in the early 1990s.’

Forsyth:

“Since then, subprime mortgages have burgeoned to about twice
that level, to around 20% of the total, according to most
estimates. And the results are becoming apparent .

“Yet among the avalanche of coverage of the subprime debacle,
the deterioration of adjustable-rate mortgages – even of prime
quality – is still more dramatic. But three years ago, Greenspan
was touting ARMs for Everyman. ‘American consumers might
benefit if lenders provided greater mortgage product alternatives
to the traditional fixed-rate mortgage,’ he told the Credit Union
National Association in 2004. ‘To the degree that households are
driven by fears of payment shocks, but are willing to manage
their own interest-rate risks, the traditional fixed-rate mortgage
may be an expensive method of financing a home.’

“As Greenspan spoke, the Fed’s key interest-rate target, the
overnight federal-funds rate, stood at a mere 1%. Just over four
months later, however, the Fed began tightening its monetary
policy, eventually raising the funds rate 17 times, to the current
5.25% level.

“The impact on those who took Mr. G’s advice has been
dramatic. The latest data from the Mortgage Bankers Association
show a sharp jump in delinquencies and foreclosures in the
fourth quarter. People with ARMs with low ‘teaser rates’ at the
beginning are getting into trouble once they adjust up to
prevailing market rates .

“But this latest fiasco goes beyond mortgages. ‘Subprime is
today’s dot-com – the pin that pricks a much larger bubble,’
writes Stephen Roach, Morgan Stanley’s chief economist ‘the
actors have changed, but the plot is strikingly similar,’ he
continues. ‘This time, it’s the U.S. housing bubble that has burst,
and the immediate repercussions have been concentrated in a
relatively small segment of the market – subprime mortgage
debt.

“ ‘As was the case seven years ago, I suspect a powerful dynamic
has been set in motion by a small mispriced portion of a major
asset class that will have surprisingly broad macro consequences
for the U.S. economy as a whole,’ Roach concludes.”

James Grant, in an op-ed for the Washington Post:

“The top man at the Treasury Department urged calm last week
in the face of losses on Wall Street brought on by fears of
defaults on the riskier kinds of mortgages. Really, he said, the
damage is easily containable.

“But of all people, Henry M. Paulson Jr., former head of the New
York investment banking house of Goldman Sachs, should know
just how reasonable this near-panic was. Easy credit has long
been the American financial lifeblood. Anything resembling
stringency on the part of our formerly carefree lenders would
tend to set the economy on its ear.

“Easy credit financed the bull market in houses and the flood of
home refinancings. Americans felt richer and spent as though
they were. It stands to reason that the withdrawal of this manna
will lead them to spend less – with substantial collateral damage
to the housing-centered U.S. consumer economy, and, perhaps,
well beyond. Our captains of industry owe as much to their
lenders’ leniency as does any subprime, or high-risk, home
buyer. They, too, have been able to raise money on terms
unimaginable only four years ago.

“All this sounds scary enough, and it is. But financial history
offers some solace. The U.S. economy excels in the art of facing
up to error – of identifying it, reappraising it and then repricing
it. Loans, especially the risky kind, have been mispriced. They
were, and are, too cheap. They will be repriced – as they were,
for example, in the aftermath of the junk-bond and real estate
troubles of the late 1980s and early 1990s. Borrowing costs will
go up, and the value of the things that debt financed will tend to
go down. In an attempt to ease the pain, the Federal Reserve will
print more money .

“But the ripples from this cold bath go even further than the $8
trillion mortgage market. The truth is that the no-down-payment,
no-documentation, interest-only mortgage loan has its
counterparts in most branches of American finance.

“The date of the last ceremonial burning of an American
mortgage is lost in the mists of time. Outright, unencumbered
ownership of a house, a building or a corporation is no longer an
ideal that most Americans embrace. The new goal is to borrow
as much as possible, as soon as possible, against any asset that
could be financed. And these days – thanks to Wall Street’s
ingenuity – all manner of assets pass as good collateral for a
loan .

“Nowadays, loans rarely rest on the balance sheets of the lenders
who make them. Rather, they are scooped up and fashioned into
securities – ‘asset-backed securities.’ And these are gathered up
and refashioned into still other securities – ‘collateralized debt
obligations.’ And the CDOs, many of them dizzyingly complex,
are sold to investors the world over. No bank regulator watches
over these financial sausage-making operations. As the Federal
Reserve has receded in importance in this worldwide financial
system of ours, so has the U.S. banking system. A parallel kind
of banking system has come into existence. Wall Street calls it
the ‘CDO machine.’ .

“In a speech two years ago, Federal Reserve Chairman Ben
Bernanke pointed to a curious coincidence: Growth in U.S.
mortgage debt tracks closely with the growth in the trade deficit
– that is, the difference between what we consume and what we
produce. ‘Over the past two decades,’ he said, ‘major
innovations in the United States have improved the availability
and lowered the costs of home mortgages. These developments
likely spurred homeowners to tap increasing home equity to
finance consumer expenditures beyond home purchase. In
contrast, mortgage debt is not so readily available among our
trading partners as a vehicle to finance consumption
expenditures.’

“If I were the head of state of one of our trading partners, I would
be asking myself if these ‘major innovations’ were as wholesome
as they used to seem. Deciding not, I would command my
minister of investments to unload U.S. mortgage holdings. And I
would imagine that I would not be the only head of state to
whom this thought had occurred.”

You’d be hard-pressed to find someone who has written more
than I have on the real estate bubble, and I’m continually amazed
by those who offer we’ve already hit a bottom. Robert
Froehlich of DWS Scudder went so far as to say the subprime
mortgage crisis “will be the most hyped disaster that never
occurred since Y2K.” Right, Bob, but then you have mutual
funds to hump so I’d expect nothing less. How the heck can you
compare Y2K, which indeed proved to be nothing (though I was
taken in by it myself) to a real estate debacle that has caused real
pain to a broad class of Americans; those who can least afford it?
It’s that kind of irresponsible shillery (my word of the week) that
gives Wall Street a bad name.

Every few weeks I have to repeat myself on a key point. When
we do hit bottom in the real estate market, it is not just going to
bounce right back up. Think of the plight of the Kansas City
Royals baseball team. They last won 90 games in 1989 (92-70).
They then stair-stepped down the next four seasons before flat-
lining, with the worst period being the last five-year stretch,
2002-2006. Or, since Detroit’s housing market is suffering as
bad as any these days, think the Detroit Lions. We will bottom
and stay there.

WIR 3/31/07

Merrill Lynch chief economist David Rosenberg summed up the
current mood perfectly. “You either believe the housing story
has more chapters to be written or you think it’s over and done
with.”

I myself wrote on 12/30/06:

“Those who are trying to convince us housing has bottomed are
nuts. There is absolutely no way housing, at least as expressed
by prices, has a good 2007.”

WIR 5/19/07

Believe it or not, each week I try to avoid bringing up real estate,
but for the archives I do have to note that housing starts for April
were up 2.5%, a mild positive, but building permits (future starts)
were down 9%, the worst such figure in 17 years. The median
price across the country was also down, 1.8%, in the Jan.-Mar.
period, the third such quarterly decline in a row. And an index of
homebuilder confidence hit a new low.

But fear not, for Federal Reserve Chairman Ben Bernanke said
“the financial system will absorb the losses from the subprime
mortgage problems without serious problems.”

Of course just a little while ago he was acting as if subprime
would create zero problems, but who am I to argue with a man
whose intelligence dwarfs all mortals’?

WIR 6/9/07

Stocks fell back to earth, after the Dow Jones and S&P 500
both hit all-time highs last Friday, while bond yields threatened
to shoot into the stratosphere.

It was all about the 10-year Treasury as it rocketed through 5%
and finished the week at 5.11%, the highest level in about a year.
In a speech, Federal Reserve Chairman Ben Bernanke reiterated
comments from the Fed’s minutes of its May 9 meeting,
admitting that housing will be a “drag on economic growth for
somewhat longer than previously expected,” while inflation was
“somewhat elevated.” Overall, though, Bernanke is optimistic
the economy will pick itself up off the floor after a lousy first
quarter and those looking for a rate cut will be deeply
disappointed.

WIR 7/21/07

Wall Street .Housing Debacle, Part XXVI

There are basically two schools of thought out there. The first
says that the problems in the domestic housing sector will be
contained and that the U.S. consumer will keep spending, even as
their number one asset shrivels up, while the second says that
housing and all the pieces of paper attached to it is far from
bottoming and that eventually this will impact the health of the
overall economy.

It’s pretty funny how Federal Reserve Chairman Ben Bernanke,
a bright guy with a lot of brainpower, just a few weeks ago was
saying that the problems in housing would indeed be contained.
But this week in his semi-annual congressional testimony he was
far less sanguine, saying that housing “could get worse before it
gets better,” and that conditions in the subprime mortgage market
“have deteriorated significantly.” As the line from Meatloaf’s
“Paradise By The Dashboard Light” goes, “What’s it gonna be,
boy?”

Well, you certainly know where I’ve stood on this topic,
consistency being one of my virtues, I’d like to think, so I’ll let
others do the talking first today; such as Freddie Mac CEO
Richard Syron, who knows a thing or two about mortgages. In
predicting the subprime crisis would deepen, Syron said in an
interview with Bloomberg that “Unfortunately I don’t think we
have hit bottom. I think things are going to get worse,” though
Syron adds the crisis doesn’t threaten “the stability of our
financial system.”

But noted fixed income manager Robert Rodriguez, who has
been all over the mortgage debacle, told U.S. News & World
Report, “We’re set up for a storm that could be much larger than
Long-Term Capital,” referring to 1998’s meltdown. “The
elements are all there. The tinder is there. The question is: What
will be the match to set it off?”

Of course the answer is contained in the subprime market itself
and the $1.8 trillion in paper that was issued, including
collateralized debt obligations, or CDOs. Fed Chairman
Bernanke, when asked by a senator to quantify the potential
losses, said $50-$100 billion*. But he doesn’t have a clue. In fact
I can guarantee all he was doing was parroting a story he saw in
Bloomberg or the Wall Street Journal. I’ve passed along that
number, too, as well as another one that said the losses would be
up to $200 billion. Of course I don’t have a clue either what the
actual number will be; except for the archives I’ll say it exceeds
$200 billion when all is said and written off.

[*An article in the 10/25 edition of the Wall Street Journal put
the figure at $400 billion and counting.]

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Wall Street History returns next week.

Brian Trumbore

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