Housing

It’s not really an industry

Ireland

Ireland is apparently the first European country to officially fall into a recession. Part of the blame for their economic troubles has been laid to not diversifying the economy and relying on builders. They are not the only country to have mistakenly seen homebuilding as a major part of their economy. Britain and the US have made the same mistake.

Homebuilding is an adjunct to economic upturns, it isn’t the basis for them.

For some time now, many economies, both local and national, have come to rely on the homebuilding business as an integral part of their base. A couple of years ago in California's central valley, the joke among some in the business was that “we are eating our young.” They had a vicious circle going. The pace of homebuilding was such that there weren’t enough personnel available. Thus, workers were recruited from other areas. Of course, these new hires needed somewhere to live, so production increased in order to provide homes for them to buy. Homebuilding was the new industry of the area. While there was some growth from other industries, there was not enough to sustain the real growth that the homebuilders needed. Local people “traded up,” assisted by easy credit, and prices accelerated. Note that I didn’t say values. As has been seen since then, the true value of homes in that market largely remained the same.

Homes aren’t speculative investments- they're where you live.

Unfortunately, in an attempt to make homebuilding an “industry,” many homebuilders moved away from the concept of providing shelter and embraced the idea that people should “move up” periodically. The concept that families only moved when they outgrew their homes, or the breadwinner took a new job elsewhere, became passé. Appreciation was to be counted on and the resulting increase in equity was to be exploited. Why let that asset lie unused, when one could get a newer, fancier house? Lenders and mortgage brokers have contributed to this bad idea by allowing people to “overbuy” with the theory being that appreciation would cure all ills. Hopefully with the meltdown, this practice won't be seen again.

Counting on appreciation lead to speculation. While there is speculation in all aspects of real estate, a relatively recent phenomenon is using one’s own home for speculation. This practice has been encouraged by builders, real estate agents, and lenders. It’s the equivalent of a gambler rolling the dice with all of his money, including that for food and rent. A bad idea. The culture that has encouraged this situation must change.

“Mark to market” continues to rule the day

And the world’s financial problems will continue to sour until true value is found

Greenspan says that there was a flaw in his economic theory.

Alan Greenspan says that he had “shocked disbelief” that financial companies failed to execute sufficient “surveillance” on their trading counterparties to prevent surging losses. Actually, I don’t think that he can be faulted too much for that assumption. The expectation would be that financial companies would do their own underwriting and not rely on others’ statements. As I have said before, greed entered the picture in relation to home mortgages packaged into debt sold on to other investors. The originators took the position that they wouldn’t have to worry about potential defaults and investors thought that the securities had been vetted by the offerors. An irresponsible position for both that was the root of the current worldwide situation.

So, what now?

Again, it’s been pointed out that investors have lost faith and trust. And for good reason. Mortgages need to be repriced to reflect the reality of the the underlying real estate’s value and the ability to the borrower to repay. No, I’m not suggesting “rewards” for people who took on more than they could afford. Of course, some people who gamed the system will come out better than they deserve, but overall, the market will become healthy again. That’s something that we need desperately in order to restore confidence.

We’re not in a recession…

It just feels that way.

Bernanke’s idea

US Federal Reserve chairman Ben Bernanke told Congress today that more government spending may be needed to tackle economic weakness. Statistically speaking, apparently the overall economy isn't all that bad, apparently. At least he thinks that we can spend our way out of it.

Congress’ duty.

An economic stimulus may be a good idea, but if it’s going to do any good, it needs to be better thought out than the last one. Most of the general public who received stimulus checks earlier this year used the money for necessities or to make debt payments. While there was a minor surge in spending, it didn't help the economy.

If Congress moves forward with a new stimulus package, it needs to do so promptly. The last go-around was too little, too late.

Positive signs…

and opportunities.

Warren Buffett

If Warren Buffett is buying stocks, does that mean that we should, too? He’s a smart investor, and obviously sees an opportunity. That people like him are coming back into the market to gather bargain priced stocks is a good sign. There needs to be market stability, of course, but hopefully investors will be prudent. As has been seen in this past week’s market gyrations, there’s a lot of uncertainty, which has caused major, heart-wrenching volatility. P/E ratios are now lower than they should be, a far cry from the bull market where ridiculous premiums were being paid.

Global market reforms

The leaders of most industrialized countries have finally come to grips with the need for a coordinated regulation of financial markets. Although this should have been done a long time ago, a positive outcome of the meltdown has been a realization by major (and minor) governments that proper regulation is required. Hopefully it will be done correctly.

Which leads me to the World Bank and the International Monetary Fund

It’s been suggested that one or both of these institutions should be the global regulator of markets. An interesting concept, but history has shown that both of these agencies, like many UN-affiliated programs, are rife with politics. They have been easily manipulated in the past, though they have good track records overall. If there is going to be an international regulator, perhaps a new agency, specifically chartered for the task, would be a better choice.

errata…

When I started this blog, I entitled it Reality and the real estate market, as it was my intention to write about what was happening to the US real estate market. However, as readers have noticed, my focus has moved to the larger arena, the meltdown of national and world economies. The evolution was a natural one, as what originally was in one market (real estate and mortgages), moved on to effect the world economy.

Thus, as of today, I am re-titling this blog Reality and the economic markets to more fully describe what I write about.

Gordon Brown

A new plan…

Regulation

Yesterday, Gordon Brown, the British Prime Minister and former Chancellor of the Exchequer (equivalent to the US Secretary of the Treasury) said. "You can't deal with the problems of global financial markets within national systems of regulation."

He’s right. As I’ve said previously, the world’s finances are too interwoven for institutions to be regulated purely on a national basis. We need better oversight, and it needs to be coordinated internationally. While the concept will likely raise the hackles of nationalists, it’s past time to such a plan.

Inadequacies

Part of what lead up to the current economic situation is that oversight of financial institutions has been reduced over time. This is particularly true in the US, but has also occurred elsewhere. It’s new painfully obvious that a pure market-driven system doesn't work.

Let me clarify that. As has been seen, the “invisible hand” does work. However, the major market corrections that have recently taken place in many sectors aren’t palatable to most. Thus, we need a beefing up of regulation, and a workable system of international coordination.

It's about time…

Unfortunately, it will take more.

The markets seem to be responding positively to the enormous new commitments by the United States and Europe to shore up banks.

However, it will take a lot of time for them to recover. The record-setting run-up on Monday could just as easily be reversed tomorrow.

Remember, the recovery from Black Tuesday took a quarter century. Hopefully it won't take that long. It took fifteen months for the markets to recover from the 1987 crash. That reflects the changes to the financial markets over sixty years and we can hope that the continuing evolution will help.

In the interim…

The interventions by the governments have to be monitored and if necessary, tweaked, to keep things moving forward. Otherwise, it could be one step forward, two steps back.

A better idea.

The administration is rethinking the bailout that it crammed down Congress’ throat just a few days ago.

Now, they are considering emulating the British solution by partially nationalizing banks that are in trouble. This looks like a much better plan. One, it reduces taxpayers’ risk, and two, it provides a better return on investment for the Treasury.

But it needs to be combined with help for the mortgage liquidity problem.

As I suggested on Thursday, the Bank of America prototype makes sense. Since virtually all of the “toxic” mortgage-backed bonds and their underlying non-performing mortgages have already been “marked to market,” they should be recast to adjust the balances and terms to match home values and borrowers’ incomes. That will make the bonds and mortgages good investments again, which will return liquidity to the market.

A coordinated response.

The Group of Seven finance ministers are discussing responding to the market woes in a coordinated fashion. Hopefully the response will truly be coordinated and won’t be “too little, too late.”

The ongoing financial meltdown has had one positive effect. It has shown that the economists have been right all along. The world’s economies are connected, much more so than many believed or admitted to. We now know for sure that we’re all in this together and it is essential that all countries acknowledge this fact. The denial is one of many aspects that lead up to the current problems. We must not let this happen again.

Politics

A bad idea.

So far in this blog, I’ve left political commentary out, except on its periphery. However, Senator McCain’s proposal is so bad that I’m making an exception.

There’s bailout and then there’s give-away.
What the Treasury proposed that is going through its start-up stage, although not ideal, at least has the concept that gives the taxpayer the potential of the situation being neutral with its worst-case scenario. The McCain proposal doesn’t. As opposed to the Treasury plan, under which the mortgages are purchased as a severe discount, his plan is to buy them at face value. That amounts to putting all of the risk on the taxpayers’ backs and essentially rewarding lenders for bad decisions.

Mortgage write-downs

A potential solution.
Though pushed into it by their settlements with state attorneys general, Bank of America has come up with a solution to the mortgage melt-down that should be emulated. Though this seems on its face to be a radical response, a drill-down analysis shows it to be a shrewd move.

What it really means.
The loans had already gone through a “mark to market” revaluation. By recasting the loan terms, nonperforming mortgages can become performing again, thus increasing their value. If all holders of mortgages did the same, liquidity would return.

According to today’s Wall Street Journal, “The relentless slide in home prices has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults -- the very misfortune that touched off the credit crisis last year.” By acknowledging the true underlying values securing mortgages, lenders could potentially preclude another onslaught of foreclosures. A healthy, realistic market will return value to the mortgages and mortgage-backed bonds, which will reverse the liquidity crisis.

Copyright ©2008 Dow Jones & Company, Inc. 

An alternative to the bailout?
If all mortgage holders followed BofA’s move, the Treasury wouldn't have to buy toxic loans, as they wouldn’t exist. This would be a much better solution than the bailout, as it is more orderly and eliminates taxpayers’ risk.

So much for “Band-Aid” approaches.

Well, surprise, surprise…
The markets didn’t immediately turn around after Congress finally passed the bail-out. They’ve gotten increasingly worse. What the politicians don't realize is that the problems with the economy and the markets are deep-seated. Yes, they originally emanated for the sub-prime debacle, but like viruses, they have mutated. Maybe if the mortgage situation was addressed responsibly a year ago there would have been a positive reaction, but it appears that addressing only one aspect of the problem won't fly.

Band-aids won't solve the problem, and putting duct tape on it won’t, either.
The base problem is that there is uncertainty about the value of investments, not just mortgage-backed bonds. Though many clamored for less regulation in the past, the result was not what they wanted. We need to find an equilibrium that works.

Wachovia
The situation with Wachovia points out truths about the market. The FDIC made a quick deal with Citigroup to rescue Wachovia, arranging a fire-sale price for the banking operations and agreeing to put a cap on potential losses. Then Wells Fargo came in and said that they would pay seven times what Citi would, and didn’t need government help. This shows that the market is able to work, even in this economy. It just needs time. Knee-jerk reactions aren't what’s needed. Time may cure all.

Fear mongers

1929 revisited: déjà vu all over again?

First, President Bush warned that if Congress didn’t pass the bail-out, we would enter a depression equivalent to 1929. Now, Germany's Interior Minister Wolfgang Schaeuble gave a warning that the financial crisis could be as bad as that one that lead to Adolf Hitler rising to power and the subsequent consequences.

Unfortunately the politicians are leading the fear parade. So far, the tactic has worked, but will the bail-out actually help? We needed a market correction, and got one. It will take time to sort things out. However, the real solutions are much harder politically than what the pols have come up with so far. We got here partly as a result of a lack of oversight. For stability to return to the markets, investors and lenders need to feel comfortable about values. Manipulation of them doesn't help. We need to take that factor out.

Now what happens?

Well, Congress approved the “bail-out” and Bush signed, it, but will it really help?

An opportunity.

There’s an opportunity now that the financial markets will stop freaking out, but it’s just an “opportunity.” The larger problem is that we have a partial solution to a world-wide problem. This was just step one. We need better financial oversight. The deregulation of banks and securities companies was a bad move. Their lobbyists will have a hard time convincing legislators that the rules shouldn't be ratcheted up again.

The greater problem is that the run-up has devastated financial markets and economies everywhere. It will take a lot of time to get the markets and lenders to feel better. Unfortunately, we’re in for the long haul.

A solution.

We need revised financial accounting rules. As I’ve said before, “mark to market”, while fundamentally a good concept, requires holders of mortgages and mortgage-backed securities to assume the worst. In come instances, that’s the right stance, but it’s been applied with a broad brush, which isn’t.

The SEC needs to bring back the “uptick rule”. While a good case can be made for short-selling, it needs controls. Short sellers shouldn't be permitted to have uncovered positions. As it is now, the stock market becomes a casino.

Temper the consolidation of the banking industry. Although allowing large “good” (or maybe the correct term is “better-off”) banks to absorb other large banks that are in trouble is a quick solution to some of the recent problems, is it really a long-term solution? Concentrating deposits in a few institutions creates the potential for a repeat of the Japanese banking debacle. We’re at the point in the US that over 30% of deposits will be in just three banks. That leaves the future potential of having many institutions that at “too big to allow to fail”- a bad position to get into.

Restore confidence in the housing market. We had a bubble, now a bust. But was it really? Homes are places for families to live, not investment vehicles. Unfortunately, they became treated as the latter, which lead to unbridled price growth and irresponsible production. Housing prices needed a dose of reality. Their values should reflect realistic affordability in tune with incomes.

The Chickens Have Come Home to Roost

Greed…

The fall of major banks in the US was just a harbinger of what is yet to come. Though there has been some fall-out in the past months from unwise investing in US sub prime loans, many people thought that the major effect would be domestic.

Now it’s Europe's turn. Their institutions saw the same thing that US institutions did- a lot of profit, and they didn’t do their due diligence either. Now they are seeing the same problems. Hopefully their regulators and governments will have better solutions than their counterparts in the US have come up with.