Category Archive 'Banking Rules'

14 Sep 2010

Be Afraid, Be Very Afraid

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Most living Americans, including now approaching geezerhood Baby Boomers, have never seen anything like the current economic hard times. When I go out out of doors, I sometimes feel a bit surprised that the world is actually in color, not in black and white, and no one is dressed in 1930s styles.

But, on the whole, most of us have been facing current adversities with grim good humor. It’s our turn, we tend to reflect. We’ve had it good for so long. Sooner or later, government was bound to screw things up seriously.

But, we shrugged, we can survive. Our parents did. And the world has changed. We have vastly more education, more skepticism and sophistication. The peasant mentality that permitted the Great Depression to drag on for over a decade as the result of one socialist monkey wrench after another thrown into the engine of the economy and the Smoot Hawley Tariff just can’t happen today.

We’ve learned a lot. The policy errors of the New Deal have been exposed and its economics debunked. Today’s American population will not sit passively by and let Washington drive the economy into the ground year after year after year. The democrats will get slaughtered in 2010 and our Kenyan Caliban will be sent packing in 2012. A conservative Republican will take office in 2013 and the land will heal.

But, I have just read two news items in the Wall Street Journal which give me pause.

1) Despite the fact that the newspapers are full of foreclosure auction notices, and we all know people moving and abandoning homes to the banks, we tend inevitably to think that real estate disaster is well along and that we can look forward to the end of all that within an endurable interval.

We may be wrong.

This WSJ article from yesterday ends, I think, with whistling in the dark.

Housing markets began to stabilize early last year as low prices and government interventions broke the downward spiral. Policy makers spurred demand for homes by holding down mortgage rates, offering tax credits for buyers, and extending low-down-payment loans through the Federal Housing Administration.

The government also attacked the supply problem. Regulators relaxed mark-to-market accounting rules, giving banks more flexibility in valuing certain real-estate assets and removing some of the impetus for banks to quickly foreclose. Meanwhile, the Obama administration put in place an ambitious program to modify mortgages.

The Home Affordable Modification Program has fallen short of its goals. So far, fewer than 500,000 loans have been modified, below the target of three million to four million. Yet the program served as a “closet moratorium” on foreclosures that stanched the flow of bank-owned homes to the market, said Ronald Temple, portfolio manager at Lazard Asset Management.

The result: The share of distressed sales fell by November to 25% of home sales, and prices stabilized. After rising in the winter, the distressed share fell to 22% in June, before bouncing to 30% in July.

The problem is that these measures are wearing off. Demand plunged this summer after tax credits expired, and unsold homes are piling up. More foreclosures could move onto the market as borrowers fall out of the loan-modification program.

“We see the perfect storm brewing with rising supply and falling demand,” said Ivy Zelman, chief executive of research firm Zelman & Associates and one of the first to warn of trouble five years ago. She estimated that distressed sales could account for half of the market by year-end if traditional sales didn’t rebound.

The market does have some tailwinds: Housing starts are at all-time lows. Banks have hired more staff to manage problem loans and government entities such as Fannie Mae and Freddie Mac that own a growing share of foreclosures are less likely to deluge the market.

The next leg down in prices “isn’t going to be the foreclosure-induced freefall where you just had inventory coming out the wazoo, and it was going to be sold one way or the other,” said Glenn Kelman, chief executive of Redfin Corp., a real-estate brokerage.

Prices also have come down so much already they have less distance to fall. During the housing boom, prices inflated much faster than incomes rose, thanks to speculation and lax lending. The ratio of home prices to annual incomes reached 1.6 at the end of June, which is below the ratio of 1.88 from 1989 to 2003, according to Moody’s Analytics.

By those metrics, prices are actually undervalued in markets that have already seen huge declines, such as Las Vegas, Phoenix and Los Angeles. But Moody’s data show that prices remain “significantly overvalued” elsewhere, including Boston; New York; Seattle; Orange County, Calif., and Charlotte, N.C. Markets in both camps face supply imbalances that will pressure prices for years.

What I see is houses being offered for sale at significantly lower prices which are not selling, and a huge, absolutely enormous backlog of not-yet-foreclosed, not yet fallen out of the Home Affordable Mortgage Program houses yet to hit the market.

Who would be crazy enough to buy at any price in the current, totally unpredictable circumstances?

It is easy to find experts venturing predictions that home prices may fall another 10%. Why not another 30%, another 50%, or even 90%?

The market is flooded with homes. An enormous number more are somewhere in the pipeline headed for distress sale. Money is tight. People are still out of work, still losing jobs. Mortgage rates are low, but it is very difficult to get a mortgage. And, in the final analysis, who is going to buy now? Who will not believe that the market is still going down?

How low can we go? No one knows. People my age have lived through a period in which government policies lifted home prices into the stratosphere by arranging for 30 year financing for everyone. When I was a boy, working class families bought $5000-$12,000 houses, paying cash or arranging for two or three years of seller financing. The same kind of homes were selling for as much as $500,000 near Eastern cities a few years ago, and for $1,000,000 or $1,200,000 near San Francisco.

There is a very long way down between the prices of homes decades ago and recent prices. And deleveraging is just not happening. That backlog of unliquidated defaulted properties is sitting there, still unprocessed, like a ticking bomb.

2) Then, I read in the same WSJ of internationally-designed new banking rules intended to reduce risk by reducing liquidity and dramatically raising banks’ capitalization requirements.

The focus of the agreement is on the amount of “capital” banks are forced to hold. Capital is what banks use to absorb losses. Regulators and analysts typically believe that banks with more capital have a lower risk of failure or insolvency.

Regulators agreed to require banks to hold a specific level of a basic type of capital known as “common equity.” Common equity is considered the most effective type of capital because it is used to directly absorb losses. Officials agreed large, internationally active banks will have to hold levels of common equity equal to at least 7% of their assets, much higher than the roughly 2% international standard or 4% standard for large U.S. banks.

Who said governments in our time would not undertake “reforms” that reduce credit, constrict economic growth, and preclude recovery?

Remember Japan? Back in the late 1980s, everyone was afraid that Japan was going to replace the United States as the world’s leading economic power. Then along came recession, and Japan responded with the same kind of policies we see being applied right here today. Japan is still in recession, and nobody has been afraid of Japanese economic performance in years and years.

We have been saying to ourselves that housing prices may drop another 10% and that the real beginnings of the recovery may take another year, or maybe two, to arrive. We could be wrong.

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