MONDAY, AUGUST 21, 2006
The No-Money-Down Disaster
By LON WITTER
A HOUSING CRISIS APPROACHES: According to the Commerce Department’s estimates, the national median price of new homes has dropped almost 3% since January. New-home inventories hit a record in April and are only slightly off those all-time highs. Existing-home inventories are 39% higher than they were just one year ago. Meanwhile, sales are down more than 10%.
Although the stocks of new-home builders are down substantially, the stock market and many analysts are ignoring other implications of the housing news. In the latest Barron’s Big Money Poll of institutional investors, not a single money manager ranked problems in the housing market among the factors likely to lead to a sharp selloff in stocks in the next 12 months (see “Headed for Dow 12,000,” May 1, 2006). Most experts still predict a 2%-6% rise in housing prices for the year.
These experts and analysts are basing their predictions on a possible increase in wages, inflation and GDP growth. They are overlooking the fact that by any rational valuation there has been no support for the run-up in housing prices since 2001, when the wealth of the middle class was battered by a bear market. Since then, inflation has been low, and wages practically stagnant. Housing prices, on the other hand, are through the roof.
Extrapolating housing prices from their current level based on wages and inflation is like saying a $100 Internet stock with no cash flow and negative earnings will rise as long as it is able to narrow the loss. The analysis ignores the fact that the stock never should have been trading at $100 in the first place.
By any traditional valuation, housing prices at the end of 2005 were 30% to 50% too high. Others have pointed this out, but few have had the nerve to state the obvious: Even if wages and GDP grow, the national median price of housing will probably fall by close to 30% in the next three years. That’s simple reversion to the mean.
A careful look at the reasons for the rise in housing will give a good indication of the impact this drop will have on the stock market. They include, in chronological order: The collapse of the Internet bubble, which chased hot money out of the stock market; rock-bottom interest rates; 50 years of economic history that suggested housing never goes down, and creative financing.
The first three factors might not be enough to cause a crash, except that together they led to the fourth factor. Irresponsible financing causes bubbles. It causes individuals to buy houses they can’t afford. It causes speculation to run wild by lowering the bar to entry. Finally, it leads individuals who bought houses years ago at reasonable prices into the speculative borrowing trap. The home-equity credit line has supported American consumer spending, but at a steep price: Families that tapped into their home equity with creative loans are now in the same trap as those who bought homes they couldn’t afford at the top of the market.
The cost and risk of adjustable-rate financing can be devastating. Consider a typical $250,000 three-year adjustable-rate mortgage with a 2% rate-hike cap. If the monthly payment now is $1,123, after the first adjustment, the monthly payment is $1,419. After the second adjustment, the monthly payment is $1,748, a $625-per-month increase. That’s $7,500 more per year just to maintain the same mortgage. If you think high gas prices are biting the consumer, consider the cost of mortgage adjustments.
Some more numbers:
• 32.6% of new mortgages and home-equity loans in 2005 were interest only, up from 0.6% in 2000
• 43% of first-time home buyers in 2005 put no money down
• 15.2% of 2005 buyers owe at least 10% more than their home is worth
• 10% of all home owners with mortgages have no equity in their homes
• $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.
These numbers sound preposterous, but the reasoning behind them is worse. Lenders have encouraged people to use the appreciation in value of their houses as collateral for an unaffordable loan, an idea similar to the junk bonds being pushed in the late 1980s. The concept was to use the company you were taking over as collateral for the loan you needed to take over the company in the first place. The implosion of that idea caused the 1989 mini-crash.
Now the house is the bank’s collateral for the questionable loan. But what happens if the value of the house starts to drop?
The answer, at least from banks, is already clear: Float the loans. The following figures are from Washington Mutual’s annual report: At the end of 2003, 1% of WaMu’s option ARMS were in negative amortization (payments were not covering interest charges, so the shortfall was added to principal). At the end of 2004, the percentage jumped to 21%. At the end of 2005, the percentage jumped again to 47%. By value of the loans, the percentage was 55%.
Every month, these borrowers’ debt increases; most of them probably don’t know it. There is no strict disclosure requirement for negative amortization.
This financial system cannot work; houses are not credit cards. But WaMu’s situation is the norm, not the exception. The financial rules encourage lenders to play this aggressive game by allowing them to book negative amortization as earnings. In January-March 2005, WaMu booked $25 million of negative amortization as earnings; in the same period for 2006 the number was $203 million.
Negative amortization and other short-term loans on long-term assets don’t work because eventually too many borrowers are unable to pay the loans down — or unwilling to keep paying for an asset that has declined in value relative to their outstanding balance. Even a relatively brief period of rising mortgage payments, rising debt and falling home values will collapse the system. And when the housing-finance system goes, the rest of the economy will go with it.
By the release of the August housing numbers, it should become clear that the housing market is beginning a significant decline. When this realization hits home, investors will finally have to confront the fact that they are gambling on people who took out no-money-down, interest-only, adjustable-rate mortgages at the top of the market and the financial institutions that made those loans. The stock market should then begin a 25%-30% decline. If the market ignores the warning signs until fall, the decline could occur in a single week.
There are other possibilities: The housing market could strengthen; consumers could shrug off higher loan payments and declining housing values; the financial system may have anticipated a collateral disaster (though with banks holding a record 43% of total assets in direct mortgage loans that seems unlikely); the rest of the world could carry the United States for a change. But these are difficult bets to place. Anyone holding stocks, futures or stock-index funds in this environment is taking a tremendous risk.
What happens after the decline depends on our financial policies. When Japan went through a similar situation in the early 1990s, the right advice was clear: Bite the bullet and get the bad loans off the books. Eventually the Japanese acted, but it took them 15 years of trying everything else first.
If we have the courage to take the right medicine right away, the effect of a market collapse could be very sharp and painful, but relatively short-lived. If, like Japan, we fail to act, the coming decade could be very bleak indeed.