“Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19%. Over the same interval, real business investment in structures has increased by 21%. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down — and their slopes would be quite steep. Indeed, their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.”

Poole is quite correct. Outlays for business structures will not continue to increase at double-digit rates. Commercial real estate is extremely overbuilt. Overcapacity is rampant.

“Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices…”

“Some potential homebuyers are no doubt delaying purchase because they expect house prices to fall.”

This is a critical point. Consumer psychology is extremely important. The secular bull market in housing reached a pinnacle in summer of 2005 with people standing in line overnight hoping to be one of the lucky ones to buy a Florida condo. It does not get much more insane that that. A massive overbuilding of commercial real estate has occurred, as well. A consumer-led recession will highlight all the commercial malinvestments sooner or later.

“As seen in Figure 8, prices have decelerated sharply nationwide. According to the price index published by the Office of Federal Housing Enterprise Oversight (OFHEO), through the second quarter of 2007, prices are still a bit above year-earlier levels.

“However, another measure of national house prices — the S&P/Case-Shiller price index (SPCSI ) — actually declined 3% in the second quarter from a year earlier. A subset of this measure, indexes based on house prices in the 10 and 20 largest U.S. markets, suggests that prices have declined even more in the third quarter. In July 2007, the 10-city composite has declined 4.5% from 12 months earlier and the 20-city composite has declined about 4%.”

Any index that suggests home prices are up year over year is fatally flawed. On this point even Shiller is a blazing optimist. By excluding enormous declines in new home prices, builder markdowns, and incentives, Shiller has dramatically understated the nature of the declines. The OFHEO data are from Mars.

“Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

“The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents.”

Poole is correct that the Fed has no power to bail out bad investments (at least not forever). However, it is disingenuous to state it has no desire or willingness to try to do so. Recent Fed actions should be ample proof.

“Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

“Thank you. I’d be delighted to take your questions.”

Who’s Responsible?

The most galling thing about Poole’s speech is his attempt to blame the free market for problems entirely created by:

• The Fed
• The SEC
• Political hacks.

The Fed’s Role in the Housing Bubble

It is widely understood that the Greenspan Fed fueled the blowoff top in housing by slashing interest rates to 1%. In a direct challenge to Poole’s statement that “The Federal Reserve has neither the power nor the desire to bail out bad investments,” the Fed did just that. Instead of letting banks suffer for stupid loans to dot-com companies and foreign countries, it bailed out the banks by blowing an even bigger bubble in housing.

However, the Fed’s role in this mess goes far beyond an ill-fated decision to slash rates to 1%. The Fed has had a decade’s long history of keeping rates too low too long, and throwing liquidity at every problem that arises. By purposely punishing savers for the benefit of risk takers, the Fed creates a moral hazard and an expectation of still more bailouts when something goes wrong.

Minyanville Professor Vitaliy Katsenelson spoke about this on Tuesday in “The Cost of a Government Bailout”:

“The largest cost of a government bailout is one that is not readily apparent — the so-called moral hazard, wherein society shields investors from the fallout from their actions. The unintended consequence of a government bailout is that it sets the stage for an even greater housing crisis next time, since it suggests to purchasers that owning a house is a risk-free endeavor. If your home’s price goes up, great. If it goes down, you claim to be a victim, and society compensates you for the risk you’ve taken. With screwy incentives like that, the cost of the next bailout will make today’s housing crisis look like a cakewalk.”

The SEC’s Role in the Housing Bubble

Poole is claiming, “Weak underwriting practices put far too many borrowers into unsuitable mortgages.” That finger is pointing the wrong direction.

The real problem with underwriting is the conflict of interest at rating agencies in conjunction with interest rates policies that encourage speculation. I spoke about that idea in “Time to Break up the Credit Rating Cartel.”

Government sponsorship of rating agencies created the problem. The free market solution is to let Moody’s, Fitch, and the S&P sink or swim by the accuracy of their ratings. Instead, they operate with impunity, like any government-sponsored monopoly.

The Political Hack’s Role in the Housing Bubble

The ownership society, 300-plus housing bills to make housing affordable, the creation of GSEs, tax incentives, etc., all play a role to make housing unaffordable. Government should not promote one means of living over another. It gives an unfair advantage to a select percentage of the population (single-family homebuilders and homeowners, for example) at the expense of renters. Promotion of housing also leads to rising property taxes that become a burden to those on fixed incomes.

The latest insanity comes from Barney Frank, chairman of the House Financial Services Committee, who sponsored a bill creating an Affordable Housing Trust Fund designed to provide affordable housing for low-income families.

No Housing Lessons Learned

• The Fed has learned nothing
• The SEC has learned nothing
• Political hacks have learned nothing.

Poole was wrong when he said, “There is no new lesson here.” He was wrong because he does not even understand what the problem is.

Instead of attempting to figure it out, we see legislation on top of legislation on top of legislation. The legislation onion grows more layers every year. Each layer of legislation masks (at best) or compounds (at worst) the problems of the previous layer. The only way to fix the problem is to scrap our tax laws in entirety, dissolve the Fed, stop promoting housing (and everything else, too), and get government out of our lives.

Regards,
Mish

October 10, 2007

Poole Party — No Housing Lessons Learned was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

State Tax Revenues Slump

In “Housing Slump Pinches States in Pocketbook,” The New York Times is reporting on tax shortfalls:

“‘It’s the year of the housing hangover,’ said Sean M. Snaith, director of the Institute for Economic Competitiveness at the University of Central Florida.”

Lower Earnings, Less Capital Spending, Less Hiring

MarketWatch is reporting, “Lower earnings could cut into capital spending, hiring”:

“U.S. corporate profits fell in the fourth quarter of 2006, signaling the end of one of the greatest profit cycles in postwar era, economists say.

“Economic growth is slowing, hurting corporations’ top line. Meanwhile, costs are rising, squeezing profit margins.

“‘Profits growth has turned decisively down, and the end is not yet in sight,’ wrote Gabriel Stein, an economist for Lombard Street Research.

“‘As the expansion matures and unit labor costs rise, profit margins will be under pressure,’ said Stephen Stanley, chief economist for RBS Greenwich Capital…

“‘The deceleration of profits may be dramatic,’ wrote Mickey Levy, chief economist for Bank of America, in a research note. ‘If so, weaker profit growth may affect business hiring and capital spending decisions, and will likely influence financial markets.’

“‘Weaker profits may undercut any rebound in capital spending,’ Levy said.”

Pink Slips Litter Loan Industry

The Chicago Tribune is reporting, “Turmoil in the subprime mortgage sector hits some workers as hard as borrowers”:

“The tumult in the subprime mortgage sector has hit some of the industry’s employees as hard as its borrowers.

 ”Nationwide, job losses in the category that includes mortgage lending, real estate, and construction climbed 346% in the first quarter, to 21,245 from 4,764 in the same period last year, according to outplacement firm Challenger, Gray & Christmas Inc.

“‘It’s a whole sector of the economy that’s leaking,’ Chief Executive John A. Challenger said.

“In California, the 3,679 mortgage industry jobs lost in the quarter pales compared with the 70,000 construction jobs that economists figure could disappear over the next two years. When considered individually, though, the loss of a higher-paying white-collar position can be more significant for the economy.

“‘Each one of these finance jobs is worth at least two construction jobs,’ said Ryan Ratcliff, an economist with UCLA’s Anderson School of Business.

“Added Esmael Adibi, director of the Center for Economic Research at Chapman University in Orange: ‘The ripple effect is significant.’

“The layoff wave began about a year ago, when Ameriquest Mortgage Co. fired one-third of its employees. In December, Ownit unloaded 800 workers. Last month, the Orange-based parent of Ameriquest Mortgage and Argent Mortgage Co. announced major layoffs, as did Fremont General Corp. of Santa Monica. General Electric Co.’s WMC mortgage unit, a major player in the subprime business, said it would snip 20% of its payroll.

“‘We went on a big real estate bender,’ Ratcliff said. ‘And this is sort of the beginning of the hangover.’

“Shelly Dusing of Aliso Viejo, who lost her $48,000-a-year job at Ameriquest last month, said she would not return to the industry. In fact, she said she would work ‘anywhere but’ because mortgage lending was too volatile, ‘whether you’re prime or subprime.’

“For Dusing, who’s nearly eight months pregnant, the situation at Ameriquest became so tense that getting fired was a relief.

“‘You go to work every day and you don’t know if you’re going to have a job or not. You don’t know if your badge is going to open the door,’ she said. ‘We knew bad things were coming and it was just a matter of time’”…

“The abrupt end is a bitter memory for Tamika Williams, her family’s primary breadwinner when Ownit collapsed shortly after she bought a home in Phoenix.

“The 29-year-old mother of four lost a job that paid $21 an hour, plus commissions. Williams landed a new job March 2, making $12 an hour handling collections for a bank.

“‘I’m surprised I haven’t called myself yet,’ she said.

“The end came quickly at Ownit, said Lisa Seeley, another former employee.

“‘Now you wake up every morning and wonder, “Who’s wheezed their last today?,”‘ she said. ‘If there’s anybody who isn’t wondering about their job today, they’re not paying attention.’”

Property Tax Soup

The Orange County Register is asking, “Are Property Taxes in Subprime Soup?”:

“If you’ve got a mortgage from a subprime lender in deep financial trouble — and that’s a good-sized bunch — you may want to gulp.

“The county’s tax collector is concerned that some ailing lenders may be unable to get borrowers’ payments to their rightful place, such as prepaid property tax payments.

“‘This is a very serious issue,’ says [tax collector Chris] Street, who adds the unsettling notion that property owners are still liable for a tax bill — even it goes unpaid due to a lender’s failure to forward your cash to the tax collector.

“Street’s not yet seen evidence in his tax collecting efforts of such mistakes or misappropriations. Still, O.C.’s overall late tax payments are already running at an 11-year high. But one company in the subprime game claims they’ve witnessed borrowers’ mortgage payments go awry.

“Wall Street banker UBS sued New Century Financial, the once subprime giant now mired in bankruptcy. The UBS beef? That the Irvine [Calif.] lender failed to forward $3.8 million in borrowers’ payments — plus $1.7 million in escrow payments for house expenses — to UBS-sponsored owners of certain mortgages.

“A New Century spokeswoman would not comment on the UBS allegations. She did say that protections are in place to keep borrower payments separate from New Century’s other financial obligations. Court filings indicate that New Century has the right to continue forwarding prepaid bills to tax officials.

“‘I’m just being prepared that one, two or many of these lenders will have used the money that should have been set aside,’ says Street, who notes that New Century forwarded its borrowers’ tax payments to his office on Friday. The current installment of tax bills is due Tuesday.”

Imagine you are a subprime borrower who paid taxes to New Century Finance or some other now bankrupt subprime lender and you wake up and find that those tax escrows you made were not paid. Subprime being what it is, exactly how are you going to come up with $2,000-4,000 or more to pay tax bills you have already paid?

Some borrowers have avoided escrow payments simply because they could not afford those on top of a mortgage. Where are those borrowers going to come up with the money to pay property taxes?

California Foreclosure Sales Near $2 Billion in March

The Central Valley Business Times is reporting, “Unprecedented’ foreclosure activity”:

“Foreclosure sales are now 15% of all home sales in California.”

“5,316 homes were lost to foreclosure sales in March in California, according to figures compiled by Foreclosure Radar, a Discovery Bay-based foreclosure listings and software company.

“The homes sold at auction last month represented a 27% increase from February and a 264% increase in the last six months, the company says. Of the $2 billion worth of properties sold in March, 4,796 went back to the lender after receiving no bids, representing $1.82 billion, it says.”

4,796 homes out of 5,316 homes at foreclosure sales received no bid. That is a pretty stunning 90% of homes at foreclosures auctions receiving no bid. Obviously, those homes have a bigger mortgage than what they are worth.

Hot Employment Numbers?

In regards to the highly touted 180,000 March payroll numbers, there are some anomalies that need to be addressed. I talked about this in “March Employment Numbers & Leading Indicators,” and Paul Kasriel talked about the job numbers in “An Autopsy on the March 2007 Employment Situation Report.” From the latter:

“With regard to the 35,800 person increase in general merchandising retail, it seems odd that this accounted for all but 100 positions in the net monthly increase in total retail payrolls. Something very volatile appears to be going on in general merchandizing hiring.General merchandise employment in relation to total retail employment has gone from 18.81% in November 2006 to 19.25% in March 2007, a very sharp reversal, as shown in Chart 5 [below]. I wonder if there are not some seasonal adjustment issues in play here. Whatever the case, if a lot of our job growth is occurring in retailing in general, then this is unlikely to result in strong consumer spending from income growth inasmuch as the average hourly wage in this sector is only $12.74, with only leisure and hospitality paying less ($10.19 per hour). If Circuit City’s hourly pay cut plan is successful, other retailers might opt for a variation of it, which will lower the wages in this hotbed of employment growth even more.

“Now, let’s turn to the March 2007 Household Survey, which also provided a surprise in the form of a 0.1 point decline in the unemployment rate, to 4.4% — matching a cycle low. In terms of age groups, the largest decline in the unemployment rate occurred among teenagers, where the rate fell to 14.5% in March, from 14.9% in February. But the ‘adult’ unemployment rate also fell a tick, to 3.9%, matching its cycle low. Did teenage employment increase in March? No, it declined by 59,000. What was driving force behind the sharp decline in the teenage unemployment rate? A 0.6 point decline in the teenage participation rate to a cycle low 41.6%. In fact, as shown in Chart 6, the March 2007 teenage participation rate of 41.6% is a post-WWII low”…

Judging from the enormous drop in the teenage participation rate, the latest drop in the unemployment rate is a complete fabrication of reality. While Kasriel and I focus on different aspects of the payroll numbers, we both reach the same conclusion, expressed by Kasriel: “In sum, an autopsy of the March 2007 Employment Situation report suggests that labor market conditions are not nearly as robust as the headlines that accompanied the report.”

Now factor in the fact that 2.1 million homeowners missed a mortgage payment in 2006, according to USA Today. Does that look like containment? I suggest that the containment is spreading, even as Bernanke and others deny its existence.

Regards,
Mish

April 10, 2007

Containment Is Spreading was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.