Lies, Damn Lies, and the National Association of Realtors (R)

The National Association of Realtors (R) wants you to know that home values usually double every 10 years. They also want you to know that Real Estate is a great way to build wealth. They want you to know that the only people who can possibly do a good job of helping you sell or buy a home, are Realtors(R). They have launched an advertising campaign using TV ads, print ads, billboards, radio commercials, bus shelter signs, and posters, all to tell us, the ignorant public, that 1) we really, really need a Realtor(R); 2) Realtors(R) are terrific, honest human beings; and 3) Now is a Great Time to Buy a House! They don't qualify that statement, so don't try to sue them if you buy a house and lose your shirt - now is a great time to buy - a great time for Realtors(R).

One ad says: "You might be wondering if buying a home right now is a smart financial decision. The fact is, homeownership is key to building long-term wealth, no matter when someone buys." They cite a N.A.R. study as evidence of their claims that real estate is a better investment than stocks. "Thanks to the power of leverage, a homeowner’s return on investment is even more impressive over time. For example, over 10 years, a $10,000 investment in the stock market at a normal 10 percent market rate of return would yield $23,600. The same investment as a down payment on a $200,000 home at a normal appreciation rate of 5 percent would return nearly 5 times the stock market return, at $110,300."

Begin rant:

My stockbroker can't tell me that buying stocks on margin is a good idea,
but the N.A.R. somehow gets to tell us that housing is a good investment,
encouraging us to use margin (leverage, mortgage loans, debt) to increase our
payoff, without even a footnote about the risk of leverage. What's up with that? Are they trying to position themselves as investment advisors?

End rant

What's wrong with the N.A.R. logic? Carrying costs, transaction costs, liquidity and leverage.

That theoretical $200k house -let's put it in California to make things simple - has monthly carrying costs. Property tax ($167), insurance ($120), maintenance ($85), and the mortgage payment ($1,022 P&I) add up to a monthly carrying cost of $1,392. Assume a 23% combined federal/state tax rate; the homeowner might save $215 a month in taxes, for a net housing payment of $1,178.

Homes are complex because they combine the saving/equity building function with the gives-us-someplace-to-live function. As an investment, any savings below comparable rent is analogous to cash-flow income from an investment (think dividends or interest payments) and any excess cost over comparable rent is a loss. So we have to look at rents. First, let's notice that the homeowner will pay his/her own water, Mello Roos, trash, etc. A renter usually gets basic services included for free with their rent. Let's put the theoretical buyer into the Sacramento housing market because you can find $200k fixers in bad neighborhoods around Sacramento. (We won't burden the house payment with the Kevlar vest, alarm system, Glock, and carry permit you'd need in the neighborhoods with homes priced under $200k.) Okay, so trash and water service will run about $100 a month. Add that to the $1,178 net housing cost and you get a rent-comparable monthly cost of $1,278. $200k buys a crummy house in a crummy neighborhood; Sacramento area rents start at $650 for a house, $1000 will get a 2-bedroom.

So the carrying cost in excess of rent has to be charged against the "investment" value. $1,278 minus $1,000 equals $278 a month. If you didn't buy a house, we assume you would have left the $10k down payment in the stock market, paid $1,000 a month rent, and invested the $278 extra dollars per month. At 10% compounded annually, your $10k investment plus $278 monthly deposit will grow to $73,410, roughly three times more than the Realtors(R) acknowledge in their comparison, but still less than the $110k the Realtors(R) claim you will make on a house.

Oh, but you don't get to keep all of that $110k appreciation. Transaction costs are relatively low in the stock market and more than a little higher on houses. First, you buy the house, and pay closing costs which vary dramatically from one community to another, but 2% is not unusual. That's $4k rolled into the loan on our theoretical house (remember, you only have $10k to "invest"). Then, when you sell you have transaction costs - typically, about 8% (6% to your Realtors(R) and 2% to all the other miscellaneous parasites). So subtract the $4k closing costs you paid at time of purchase, and the roughly $24,800 closing costs you'll pay to sell, and that $110k appreciation you earned on your "investment" is only $81,178 net. But you've also paid down the loan by a little more than $52k; so you walk away from closing with $133k.

Not bad. Except that the Realtors(R) are assuming 5% annual appreciation on a house, an assumption that is aggressive at best in the current housing market. If the home price depreciates 10% in the next two years and then grows at 5% annually, the $200k house will only be worth $253k 10 years after you buy it, slashing your appreciation in half. You pay the Realtors(R), title company, county recorder, etc. 8% of your selling price - about $20k in closing costs - and the loan is paid down by $52k (you took a fixed-rate mortgage, didn't you?). You walk away from closing with a check for $80 Grand. Oh, wait, did you remodel the kitchen or install landscaping? Subtract those costs from your theoretical gains.

But I thought buying a house was going to make me a LOT more than the stock
market! I saw the other ad about how ethical Realtors(R) are - they
couldn't have lied!

Liquidity refers to how easy it is to get your cash out of an asset. Checking accounts are highly liquid, while rare antique sports cars are relatively illiquid - you have to find someone who wants to buy it and can afford your price. Housing is moderately liquid in a normal market. Realtors(R) might say it's always a good time to buy, but it's definitely not always a good time to sell. We are seeing homes in my area sitting on the market for well over 6 months - I've seen some sit vacant for over a year. If you have to move before the house sells, you'll be stuck with 2 home payments. You'll want to leave the utilities on so your Realtor(R) can show the house, and you'll probably hire a cleaning service and landscaper. Over 6 months, your carrying costs on the vacant home will be well over $7,000. If you need to pull your money out of the stock market, there are always buyers for decent stocks (no webvan.com, thank you very much). If you need your cash from stocks, sell today, pick up your check tomorrow. No muss, no fuss. Suppose you think the market is going to crash. With a liquid investment like stocks, you decide to sell one day, sell that afternoon. With a house, selling (or "liquidating" your equity) requires quite a bit of fuss - moving, cleaning the house up so it shows well, even finding a Realtor(R) and signing a contract.

Now back to that leverage that makes me so cranky. Realtors want you to compare a leveraged house purchase against an unleveraged stock purchase. That's not quite fair. If you don't mind the risk of leverage, borrow some money from your stock broker to "lever" your way to riches. If you leveraged your stock portfolio - using 50% margin - you can invest $20k. That $20k would grow to $47,158, leveraged. Add the $278/monthly premium you pay to be a homeowner instead of a renter, and your stock portfolio will grow to $96,990 in 10 years. On the other hand, when you leverage your way into a house with a low downpayment, it's easy to end up upside down in a market downturn, owing the mortgage company more than what your house is worth (before Realtor(R) fees, no less).

Apples to apples, the National Association of Realtors is misleading the public. Shame, shame. But don't just take my word for it - Forbes says the stock market has returned 4 times the returns that housing has from 1980 to 2004:

Real Estate Vs. Stocks - Forbes.com: "But if you take a longer view--say 25 years--you'll find that the S&P 500 has actually stomped the real estate market, from Boston to Detroit to Dallas. From the start of 1980 to the end of 2004, home sale prices increased 247%. A pretty sweet deal, it would seem. Over the same period, however, the S&P 500 shot up more than 1,000%."

If you're looking for an investment, talk to an investment professional. If you're looking for a house, that's when you talk to a real estate professional. And whichever you do, make sure you do due diligence - never take a salesperson's word at face value.


This article is not intended to be investment advice; it is merely intended to provoke greater transparency and discourse in the housing market. Please seek the advice of appropriate professional advisors to determine your personal investing and/or housing needs. Copyright 2008. All rights reserved.

Bubbles and pops

Quoted:

Comparing the early 2000s housing bubble to the 1990's pop:

"When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash."(then) FRB Gov. Bernanke Speech from 2002 on Deposit Insurance crises in 1990s

http://minneapolisfed.org/community/events/100407/strategies_brewster.pdf Page 11

Investment opportunity?

The Minneapolis Fed has a map of nationwide Subprime mortgage concentration. Now, the obvious culprits are shown - Florida, Bakersfield California, Detroit. But another large area of concentration is Western Pennsylvania/Eastern Ohio - coal country. The coal is pretty much mined out. Well, the coal worth mining has been removed - some coal finds were just too small or too deep or too scattered to be cost-effective to mine. The same thing has happened to oil wells, and some closed oil wells AND coal mines are being reopened as rising prices make them economically feasible, after all. But that's not the investment opportunity.

Coal-bed methane is a naturally-occuring gas that can be liberated from coal seams and used just like natural gas. You can cook with it, heat with it, or even pump it into specially-outfitted natural gas cars (dual-fuel gasoline/natural gas vehicles are especially useful, and can be purchased used from fleets). I have seen properties in the region priced as low as $70k claiming "free gas" (though OGM - oil, gas, mineral rights - are not usually specified in the real estate listings). Parts of West Virginia and Kentucky also have some coal-seam methane wells.

http://minneapolisfed.org/community/events/100407/strategies_brewster.pdf Minneapolis Fed map of nationwide Subprime mortgage concentration, page 6

Pick a problem: Inflation, deflation, or stagflation?

Challenges for Monetary Policy in a Globalized Economy - Richard Fisher Speeches - News & Events - FRB Dallas: "To be sure, movement in the fed funds rate, or even no movement at all, may have an immediate psychological effect and influence expectations for future monetary policy action. But the act of changing or not changing the fed funds target rate, in and of itself, has no immediate effect on the economy. Like a good single malt whiskey, the ameliorating or stimulating influence kicks in only with a lag.

The lag time necessary for inflation to respond to policy is especially long. As a policymaker discharging our dual mandate, I am always mindful that in providing the monetary conditions for employment growth, we must not also sow the seeds of inflation that will eventually choke off the very employment growth we seek to encourage. You do not have to be an inflation 'hawk' to recognize that would be a Faustian bargain."

The stock market isn't all greedy hedge fund managers. It's also municipal pension funds, little old ladies, and 401k/IRA accounts (mine AND yours). So while Fisher says that the Fed's mandate doesn't include making Wall Street happy, we have to recognize what a huge impact the stock market has on individuals, municipalities, and corporations.

At the same time, inflation is an enemy of the poor. The government consistently understates inflation (so-called "core" inflation excludes volatile categories like food and energy), so people relying on government benefits find that their inflation-adjusted benefits don't go as far anymore. Inflation gives rise to stories of pensioners eating cat food because they can't afford people food. Anyone can find their purchasing power eroded by inflation, but the poor are disproportionately harmed. Inflation punishes savers by eroding the value of their savings, and rewards borrowers by eroding the value of the principal they have to repay.

In the 70's, we tried to have it both ways - we wanted to avoid the pain of recession, but then complained about inflation. Ultimately, Volker had to tighten interest rates to bring inflation down from teens-percent; by some counts, the resulting recession cost Carter the election. The moral of that story, it seems, was "pay now, or pay later." I think of economic imbalances as being like an economic bought of influenza; you can suck it up and take bed rest today, or keep working 60-hour weeks and risk dying of walking pneumonia. The Fed seems to think popping rate-cut pills and taking a couple liquidity injections will cure this particular bug.

FBI investigating 14 companies for mortgage fraud - CNN.com

FBI investigating 14 companies for mortgage fraud - CNN.com: "'On insider trading, we're looking in some cases at whether executives were aware that the value of their holdings would be going down and the executives traded on that information,' said Power.

'On accounting fraud, we're looking at housing developers who may have reported cash reserve accounts to reflect falsely inflated values,' he told CNN."

The article says the FBI only investigates cases involving a loss of $500k or more. And, no, the FBI won't say who they're investigating right now.

Universal Healthcare - What does it cost?

California's penalty-for-being-uninsured universal healthcare proposal is dying in committee. Liberals argue that single-payer healthcare (socialized, or government-paid healthcare) is a better choice. Democratic presidential candidates say they want universal healthcare for the entire country. So what does that cost?



I have seen insurance advertised at $300 a month for a couple in their 30's. Since children need shots and get into accidents, and seniors need hip-replacements and heart surgery, $150 a person sounds like a nice, if especially low, average assumption. (Under the proposed healthcare reform bill, the State was estimating costs at $250 per person/month, which was considered an unrealistically low assumption.)



California's population is 36,457,549, according to wikipedia. At $150/person/month, that works out to $5,468,632,350 per month, or a mere $65,623,588,200 per year ($65.6 Billion), or more than half of the State's ~$103 Billion combined annual income/sales/property taxes.



The population of the United States is 301,139,947. At $150/person/month, that works out to $45,170,992,050 (thats Billions) per month, or $542,051,904,600 per year. Thats $542 Billion per year. To put that in perspective, our GDP is $13.86 trillion (CIA World Factbook); universal healthcare would consume 20% of the Federal government's $2.7 Trillion budget.



Physicians for Guaranteed Physician Income - I mean "for a National Health Program" - says we spend $7,129 per capita, and that 31% of that money is spent on "private insurance bureaucracy and paperwork." So, if we are addle-headedly optimistic and assume that there will be NO paperwork or administrative overhead whatsoever, we can assume that the cost of providing healthcare is 69% of $7,129, or $4,919/year ($410/mo.) per capita (and, at this price, we have 47 million uninsured, according to PNHP). My $150/mo. figure is crazily low.



In fact, the Kaiser Family Foundation says that "The nations examined spend a median of $2,193 per capita on health care," or $183/person/month. But this is America, the land of ingenuity, so let's assume that we can get our health costs near the bottom of the world average (not because we can, but because I think it's meaningful to realize how much healthcare would cost in an unrealistically low cost environment, and then to consider that realistic costs would be much, much higher). American physicians earn roughly twice as much as doctors in socialized-medicine nations (even adjusted for relative wealth in nations being compared), and physician's salaries have risen "about twice as fast as the average increase for other full-time workers," due, at least in part, to doctor shortages. So you can realistically double my low-ball estimates of costs, possibly more if we don't ration care.



So let's try a new assumption. Using PNHP's $7,129/person/per year minus the claimed overhead of 31%, we get $410/person/month. Let's assume that we can develop greater efficiencies, and ration care, and basically stretch that $410 per person to cover the 47 million uninsured. How much would that cost?



At $410/person/month, California would spend $14,947,595,090 per month, or a $179,371,141,080 per year ($179.4 Billion), or more than the State's ~$103 Billion combined annual income/sales/property taxes. In fact, "California currently spends $36 billion per year on health care for low income Californians," according to California Senator Dave Cox's January newsletter.

At $410/person/month, the United States cost works out to $123,467,378,270 per month, or $1,481,608,539,240 per year. Thats $1.48 Trillion per year, more than half of the Federal government's $2.7 Trillion budget.



Maybe cost-containment would be a better starting point than providing free care to everyone.

Global downturn won't hit China badly

Global downturn won't hit China badly: "'We expect the Chinese economy to grow by 10 percent this year despite a US-led global economic slowdown,' said Liang Hong, an economist with Goldman Sachs in Hong Kong. 'Strong domestic demand, especially investment growth, is expected to sustain the overall GDP growth, though the export growth is set to slow down.'"

Mei Xinyu, a researcher in China's Ministry of Commerce thinks that the weakening dollar will make American technology cheaper for Chinese companies, while it won't reduce China's exports by much. The thinking seems to be: Americans will continue to shop at Walmart, while Saks 5th Avenue's suppliers may fare worse.

Given China's propensity for selling knock-off merchandise, I worry about increasing technology exports to China. Toxic dog food and lead-painted toys are the big headlines, but the economic damage comes from pricier products. From sneakers to golf clubs to re-branded computer processors and counterfeit cars, the Chinese imitations are the most expensive form of flattery. Billions - with a "B" - of dollars, as much as $50 Billion a year, worldwide. Software piracy is so rampant, Microsoft won't even take a piracy report unless the counterfeit is particularly good, with full edge-to-edge hologram.

It's hard to get a guage on the Chinese economy. "'China's policy in international affairs has been to 'hide its capacities and bide its time’,' Mei says, pointing to China’s growing assertiveness in the World Trade Organization and its push for more voting power in the International Monetary Fund. " Indeed, everything from GDP to per capita income is subject to revision for a host of reasons, from data becoming more refined over time, to changes in purchasing power parity formulas. Full and honest disclosure doesn't seem to be one of the Chinese government's virtues.

George Soros: Shoot the messenger

FT.com / Comment & analysis / Comment - The worst market crisis in 60 years: "Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case. ....

"With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

"Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world. "

Soros is a loose cannon with little (if any) loyalty to America. However, he is also a savvy investor and a pretty clever guy (best known for "breaking the Bank of England" and destroying the Thai baht).

News - Couple faced money strains - sacbee.com

News - Couple faced money strains - sacbee.com: "As the woman suspected of inexplicably drowning her baby this weekend at her Granite Bay home was under close observation at the Placer County jail Monday, records show that she and her husband have been under significant financial strain."

St. Louis Fed: Economic Data - FRED®

St. Louis Fed: Economic Data - FRED®: "FRED® (Federal Reserve Economic Data) , a database of 18,725 U.S. economic time series. With FRED® you can download data in Microsoft Excel and text formats and view charts of data series."

Countrywide says: "Maximize your FDIC coverage!"

Countrywide's web site has a cute little banner ad (image at left) offering to tell you how to get as much as $750,000 of FDIC insurance on accounts held at a single bank (preferably at Countrywide, if you please). Essentially, they say, you just title your accounts differently - a joint account is covered for $100k per person; a single account is covered to $100k; a retirement account is covered to $250k, and a testamentary account is covered to $100k per beneficiary. (Here's the FDIC explanation and you might also be interested in the Electronic Deposit Insurance Estimator (EDIE).)

People across the country, even across the globe, are making little side bets about if - or when - Countrywide is going to go bankrupt (even now, when Bank of America has committed to buy Countrywide). I don't know if their little FDIC coverage tutorial is nervy, clueless, an admission of guilt, or an amazing display of integrity and customer service. Then again, Countrywide (B) is rated higher than Bank of America (B-) on thestreet.com's bank ratings.

Here's the Countrywide.com screen shot from Jan. 20th:

Oh, those poor, poor banks

The Modesto Bee Tips for renters: "Demand in writing that the new property owner (the lender that foreclosed) return the entire security deposit. California Civil Code Section 1950.5, subsections H and J, makes the new property owner 'jointly and severally liable with the landlord for repayment of the security.' The new property owner also can be taken to small claims court."

I know it's unpopular to care about the big, soulless banks, but when a bank loses, their investors lose. Banks are a popular "conservative" investment for little old ladies and other retirees.

I have seen ads on craigslist.org selling everything - right down to the air conditioner compressor and water heater tank - before the bank forecloses. Sleazy flippers rent out the home when they realize it's going to foreclosure - better to get a few months' rent than nothing - and leave the bank on the hook to evict the renter AND return the deposit. And then, while the house sits vacant, theives move in to strip the electrical wiring and plumbing for salvage. The result is a thoroughly trashed house that, by some accounts, is effectively a tear-down.

If you have no sympathy for the banks, consider what this means to future buyers. The old-fashioned idea of a mortgage was that the worst a homeowner would do was default. After banks get burned on stripped houses, rental deposit refunds, et. al., they're going to build that risk into future profit expectations.

Ugh.

P.S. I thought that rental contracts attach to the property under California law. Apparently, that only applies to private-party sales. According to the referenced article, "After foreclosure: Don't pay rent to anyone. The previous landlord doesn't own the home anymore, so the rental contract between the tenant and the landlord is void. Lenders that foreclose on the property become the new owners, so renters must negotiate new rental contracts with them before rent is due."

Copyright 2008 All rights reserved

A little window on the Sac metro housing market

About a year ago, my husband and I found ourselves in Lincoln (Northeast suburb/exurb of Sacramento) with a little time to spare. We wandered into one of the new home communities in Rocklin, one of those sprawling multi-builder, multi-village developments.

Although tract-home living doesn't appeal to us, one floorplan in particular did. Indeed, all four models available in that community had appealing features, though most were simply enormous. What possible justification could we have for a 5,000 square foot home than the overtly selfish, planet-hating "we want it"?

Well, the floorplan we liked was sufficiently appealing that we revisited the development this past weekend (mostly out of curiousity). We picked up a flyer announcing their new low prices, and our desired floorplan was listed at $667k, down from $771k. I seem to recall that prices started in the $800s in that development when we first toured. Today, I checked their website, and that same home has been repriced at $515k.

Even if I am mistaken, and their peak price was in the 700s, that would represent a price drop of 35%. Worse, the earliest residents have been living with construction hassles and an open-gate policy on their gated community (allowing potential buyers in to see the models) for two years. Worse yet, the Mello Roos are supposed to drop in half when the larger community is fully built-out, but current market circumstances suggest that the final build-out will only happen in the next housing boom. Early buyers pay double the Mello Roo payment they expected; while they watch neighboring homes sell for 1/3rd less than their own purchase price. Under Prop 13, property taxes are capped based on a home's purchase price - original buyers may see their taxes adjust down in the short-term, but, long-term, new buyers will save $3,000 a year over early buyers in property taxes alone.

Mama mia.

Interest rates and self-interest incentives

Below is a quote from an earlier post about historical mortgage markets. The quote is from The American Mortgage in Historical and International Context , and I thought this point alone was worth its own post.

"Perhaps most important, an entirely private market could well become one that led to an increased reliance on adjustable-rate mortgages. Work from the IMF (2004)—along with the fact that household balance sheets would be mismatched in an adjustable-rate mortgage heavy world—suggests that such an outcome could lead to macroeconomic instability."

Borrowers have a self-interest in obtaining the lowest interest rate mortgage available. During periods of high interest rates, borrowers can take out a high-rate mortgage, then refinance when rates drop, or simply take an adjustable-rate mortgage. During periods of low rates, borrowers have a strong incentive to take a long-term, fixed rate loan.

Lenders, on the other hand, have the opposite incentive. They know that borrowers will probably refinance high-rate mortgages when rates drop, yet lenders will be held to low-rate loans even after rates rise. (Pre-payment penalties discourage buyers from refinancing into lower-rate loans, or else compensate lenders for the loss of income when a buyer does refinance.) When long-term mortgages are funded from short-term money like checking deposits, lenders have a risk of losing money on loans. That's essentially what happened to the Savings and Loan institutions in the 70s, 80s, and 90s, and it bankrupted a number of S&Ls. Securitization - selling mortgage loans as investment vehicles - helps assuage the risk. But lenders still have a self-interest to maximize the interest rate return on the loans they fund.

During the housing boom, interest rates were at historical lows and the economy was booming. The most reasonable assumption about interest rates was that they would rise. Mortgages were highly profitable - a record number of people were buying houses and refinancing, and the total amount borrowed was reaching record highs. The loan origination fees alone were hugely profitable, but the loans presented a risk - if borrowers took out fixed-rate loans at historically low rates, lenders and investors would be stuck with low-paying loans when rates rose.

As housing prices climbed, more and more home purchases exceeded the price cap for government-guaranteed mortgages, which meant that more buyers than ever were taking loans from private lenders (as opposed to the government backed public lenders, Fannie Mae and Freddie Mac). Fannie Mae and Freddie Mac can afford the risk of making low-rate, long-term loans, but private lenders want to earn at least market rate on their loans - today, and in 10 years.

How do you get a borrower to take an adjustable loan when, due to historically low rates, it is in their own best interests to take a low-rate, fixed loan?

You roll out "creative" loan products. Especially since home prices were becoming ever more difficult to afford, borrowers and lenders could acheive a happy compromise - lenders essentially said "I'll give you a low initial payment if you'll agree to take the risk of rising rates." Homebuyers found that an appealing compromise, and adjustable-rate mortgages climbed to historically high levels of total market share at precisely the moment when they should have been falling.

Historical Perspective on Mortgages

(Today's post is a bit long, but well worth it if you're trying to get a better grasp on the history, risk, and potential repurcussions of the housing/mortgage crisis).

The American Mortgage in Historical and International Context is a great 22-page University of Pennsylvania paper (written in 2005) on the history of mortgages in the 20th century, along with some comparisons between the American mortgage market and mortgage markets in select First-World nations. This is not a housing-bubble paper, it's more a defense of the role of government-backed lending. Still, it's a great read for perspective on the mortgage market, and some of the historical risks and benefits of the structure of the American mortgage market. There is also an explanation (perhaps a bit too technical, but I found it almost comprehensible) of how mortgages are securitized.

Prior to the Great Depression, "Home mortgages typically had very low loan-to-value ratios of 50 percent or less and thus did not, by themselves, place substantial stress on lenders, because when borrowers were short of cash, their property could be sold if necessary to redeem their loan. But during the Great Depression in the early 1930s, property values in the United States declined by 50 percent relative to peak values. Holders of these mortgages, knowing their positions were insecure, refused to refinance loans that came due; as a result, borrowers defaulted, having neither the cash nor the home equity necessary to pay the loans back. A wave of foreclosures resulted—typically 250,000 per year between 1931 and 1935. At the worst of the Depression, nearly 10 percent of homes were in foreclosure. Financial institutions would in turn attempt to resell the properties that they repossessed, which placed even further downward pressure on the housing market.

In response to these calamities, the federal government began intervening in the housing finance market."

Some relevant points in the paper:

Securitization (selling mortgages to investors as securities) allows for long-term, fixed rate loans. Without securitization, mortgages are made by banks, who have short-term, rate-sensitive deposits and are less willing to sell long-term, fixed rate loans because of the rate risk (and the Savings and Loan crisis was partly precipitated by the fact that S&Ls were making long-term, fixed rate loans from short-term deposits at a time when interest rates were rising).

Fixed-rate loans provide macroeconomic stability, because homeowners can plan their budgets long-term. Adjustable-rate loans create instability, particularly in housing, but also in the broader economy because housing is such a large portion of the consumer's budget and the nation's GDP.

Banks and thrifts were the traditional savings vehicle for Americans through much of the 1900's, but that began to change in the late 60's as mutual funds and money market funds became available to the average saver. Since bank deposits were a major source of mortgage funding, this shift in savings vehicles was a problem for mortgage banks - especially since savers were transferring funds from banks that had already made mortgage loans at low rates. Rising interest rates in the 70s became a major factor in the failure of S&Ls that were carrying low-rate, long-term mortgages.

80% Loan-to-Value, 30-year fixed mortgages are almost peculiarly American, owing largely to our system of letting the government guarantee many mortgages. In most countries, loan terms are shorter, rates are variable, and loan-to-value ratios are lower (although some countries have 100% - or more - financing available).

The shape of America's mortgage market is a direct result of the Great Depression. Government lending organizations were created during the Depression to rescue borrowers in foreclosure. Fixed rates and long repayment terms were designed to take the short-term, adjustable rate loans that the borrowers couldn't afford, and make it have a payment they could afford to pay. Extending the payment period from the then-traditional 5-year term to what I imagine was unimaginably long repayment term of 20 years, allowed people to stay in homes they could not afford under their original mortgage contract. (What could the government possibly do today for Option-ARM borrowers, that would lower their payments as much as the Depression-era mortgage bailout of quadrupling mortgage terms?)

Some interesting quotes from the paper (with my comments in italics and some key quotes bolded for emphasis):

"By the end of 2003, Fannie and Freddie either guaranteed or held more than $3.6 trillion of mortgages, or about 60 percent of the market in which they are allowed to participate and 43 percent of the overall market." So, in 2003, the mortgage market was approximately $8.4 Trillion dollars.

"The adjustable-rate mortgage (ARM) share of applications generally fluctuates with the yield curve: as the yield curve steepens, the ARM share increases, as the cost of ARMs drops relative to fixed-rate mortgates. The recent increase in the share of ARMs to a 10-year high of 36 percent, coupled with a flat yield curve, is anomalous, which raises questions as to its origin. Many variants of traditional ARMs have also been recently developed such as hybrid instruments, interest only loans and option ARMs, which allow negative amortization. Affordability pressures in some markets may be at work." Remember, this paper was published in 2005.

"Mortgages with a 110 percent loan-to-value ratio are possible, although risky, if they are underwritten as though they are consumer loans with the home as additional collateral." (If I interpret this correctly, they're saying that high-loan-to-value loans should be underwritten like unsecured consumer loans, with careful scrutiny of the borrower's ability to pay, rather than the home's ability to appreciate into adequate collateral. In other words, >100% LTV loans should only be offered to the most creditworthy borrowers. As I understand it, most recent 100%/125% loan-to-value mortgages were NOT underwritten as consumer loans, but, instead, were often offered to subprime and ALT-A borrowers, even as no-documentation and low-documentation loans. This would be extremely risky.)

"Funneling lower-than-market rate financial capital raises the risk that society will invest an inefficiently high amount in housing, and also that the risks of that investment are being underpriced by the market." (Like 2% "teaser" rates?)

"Indeed, in our view, one key to the array of choices being offered to mortgage borrowers is that, because of the funding advantage of Fannie Mae and Freddie Mac, low-risk borrowers are offered an appealing contract so they will participate in the same mortgage pool as higher-risk borrowers. Otherwise, higher- and medium-risk borrowers might face a very different menu of mortgage options than lower-risk borrowers."

"Finally, during periods of financial duress, the risk-based differentials would increase in the absence of mortgage-backed securities, which provide a safe haven for investors. For example, in the immediate aftermath of the 1997–1998 financial crisis and in the aftermath of 9/11, interest rate spreads related to risk widened for many corporate bonds, but the risk spreads of Fannie and Freddie securities changed very little. Similarly, in the wake of the Long-Term Capital Management financial crisis in of 1998, volumes in many debt markets fell dramatically, while they did not do so in the residential mortgage market." Government-backed mortgage securities have been a safe-haven for investors in financial crises when they don't know where else to park funds while the crisis resolves. Today, mortgages ARE the crisis.

"Perhaps most important, an entirely private market could well become one that led to an increased reliance on adjustable-rate mortgages. Work from the IMF (2004)—along with the fact that household balance sheets would be mismatched in an adjustable-rate mortgage heavy world—suggests that such an outcome could lead to macroeconomic instability." (Does this explain the introduction of "crazy" ARMS during the housing bubble, as home prices in some areas exceeded the caps on government-backed mortgages? Certainly a major driver of buyers taking ARMS and exotic ARMs was low initial payments, but perhaps mortgage companies rolled out exotic ARMs to entice borrowers into loans that didn't put lenders at risk of rising interest rates. Interest rates during the bubble were at historic lows as the economy expanded - it was a virtual certainty that rates would increase thereafter. Borrowers and lenders had opposite self-interests: buyers should have taken out fixed-rate loans while lenders wanted adjustable rates. Teaser rates and low initial payments were a compromise.)

"The implicit government guarantees for Fannie Mae and Freddie Mac create moral hazard problems; that is, risky loans may be made in the assurance that the government will not allow a default to occur."

"The International Monetary Fund (2004) pointed out that as more variable-rate mortgages are used to finance housing, the more volatile is the housing market, which can induce the credit risk that raises the chance of a systemic failure. Similarly, an illiquid housing market could lead to falling housing prices, which can increase credit risk, which could induce systemic failure."

If you are an investor, homeowner, homebuyer, or taxpayer trying to better understand the mortgage market and the economic risks related to today's mortgage crisis, I cannot recommend this paper highly enough. It's only 22 pages, a bit technical in some places, but overall very readable, and the information is extremely valuable for putting today's mortgage situation into context.

Want to Be a Millionaire?

Want to Be a Millionaire? "OK, so most millionaires aren't rock stars or scions of wealthy families, but surely they have high incomes, right? Think again. Their median annual income was a mere $131,000. So how did they become millionaires? The answer is so simple it sounds trite: 'They live well below their means.'"

This article is inspired by the book "The Millionaire Next Door", a summary of years of research with self-made millionaires. It should be required reading for every politician in America (when politicians talk about "taxing the rich", do you think of housewives rinsing out sandwich baggies to reuse them? Cause that's what happens in a lot of millionaire households.). Self-made millionaires are driving modest cars (IF they buy a Mercedes, they drive it for 10 years), living in middle-class homes, wearing inexpensive clothes and taking inexpensive vacations. But they put 20% of income into savings every payday, year after year, even if it means eating beans and reusing sandwhich bags to be able to afford to save.

For housing junkies, read the part about housing - the rich buy moderate homes in good school districts and send their kids to public schools. Who are the suckers paying top dollar for an elementary education they could get free and McMansion tract homes? The ultra-rich (top private schools), the poor, and the folks who can get grandma and grandpa to pay the freight. Unfortunately, grandma and grandpa are putting their grandkids' parents into the poorhouse, because the parents feel like they have to live like the classmates' parents - big gas-guzzling SUVs, McMansions, and all. So the parents whose kids go to private K-12 on grandma's nickel tend to have higher-than-average debt.

On the other hand, the book provides hope for Joe Sixpack. Cut your costs, boost your savings, and you, too, can join the list of Millionaires.

Universal Healthcare - Overpromise, under-deliver, and hike taxes

Consumer Advocates to CA Legislative Analyst: Consider Massachusetts Financial Meltdown in Review of Health Care Legislation

"The only publicly available current analysis of ABX1 1, by Assemblycommittee staff, contains no predictions for either cost increases orexpected revenue increases/decreases. Massachusetts, however, is alreadystruggling to control much higher than expected costs. ... Massachusettsestimates that the cost of subsidized plans by the end of the first year,July 2008, will be $147 million, or 30%, over budget. A similar increase in California (with at least 12 times the number of uninsured), would be $1.75billion."

"FTCR also pointed to much lower than predicted employer contributionsin Massachusetts, as well as higher premium costs and lower benefits thanexpected. FTCR said that at a minimum, the Legislative Analyst's Officeshould recommend that ABX1 1 be amended to include premium regulation rulesthat currently apply to auto and other property/casualty insurancecompanies before forcing Californians to purchase their product."

This analysis is well worth the read.

New cars that are fully loaded — with debt - Los Angeles Times

New cars that are fully loaded — with debt - Los Angeles Times: "When Jennifer and Bobby Post traded in their 2001 Chevy Suburban last year for a shiny new Ford F-350 turbo diesel with an extended cab, it seemed like a great deal. Even though they still owed $9,500 on their SUV after the trade-in value, they didn't have to put a penny down.

The dealership, near the Posts' home in Victorville, made it easy; it just added the old debt to the price of the new truck and gave the couple a seven-year, $44,276 loan.

The Posts were a little worried about taking on such a long obligation, but they couldn't pass up a monthly payment under $700."
...
"The job of a successful dealer is to find a funding package that's acceptable to the customer," said Paul Taylor, chief economist of the National Automobile Dealers Assn. "These loans allow them to get a luxury car rather than a more modestly priced vehicle."

There's a cultural shift in America. It used to be shameful to lose one's house, and families would do everything possible to make their mortgage payment. Now, it is considered impractical to live without a credit card and a car, and families will lose their homes before they put their wheels at risk. But in a time when it is common to be upside-down on car and home, to have no savings but high credit-card balances, there are an awful lot of people teetering on the brink. With negative net worth at $15k on the car, $15k on the plastic, and $100k on the house, what motivation do these families have to hang on? When push comes to shove, are they going to work three jobs to keep up the payments on all these underwater loans, or are they going to throw in the towel and move in with their parents? If people start letting their cars go, buying old clunkers, what will that do to the economics of "keeping up with the Joneses"?

"And even those who keep paying their bills may reach a point, like Gerhardt, where they simply can't afford another car. That could send vehicle sales down the drain, a nightmare scenario for an industry that has already taken a hit this year from slower consumer spending and higher gas prices."

Ten resolutions that will help you survive the coming bear market - MarketWatch

Ten resolutions that will help you survive the coming bear market - MarketWatch: "Now the crisis is metastasizing: Hundred of billions of dollars in write-offs reducing shareholder equity, hundreds of millions of dollars in severance pay to CEO losers. Worse yet, Wall Street's insiders rubbed salt in their shareholders wounds by passing out $38 billion of the shareholders' profits in bonuses, averaging more than $600,000."

The advice in the article is good food for thought, if not entirely tasty. Even if the ideas aren't 100% correct, it's good information to consider and accept OR reject.

Happy New Year, folks. Like the old Chinese curse, it appears we're heading into Interesting times.

Politicians, Discipline, and Restraint and insurance surplus funds

In my household, we don't take on a new recurring expense every time we get a bonus. We might save it, spend it, or pay down debt with it, but we don't take irregular income and turn it into a regular obligation. I bet you don't, either.

Your government does. Give them a surplus in Social Security - a surplus built up because the money will be needed - and they can't keep their greedy little hands off of it. Soon, a massive surplus becomes a massive debt, double what they tell us because they have to pay back the Social Security trust fund.

In California, under the "fiscal restraint" of Governor Schwartzenegger, we took an obviously unsustainable bubble in real-estate related tax receipts and converted it into a fiscal crisis that reportedly will be declared a "state of emergency" this month. Instead of saying "Gosh, how nice to be bringing in extra money, let's put that aside for a rainy day, or return the surplus to the taxpayers," the State of California decided to increase spending. Now they are simultaneously fretting about a budget shortfall AND proposing universal health insurance.

If you're not familiar with it, here's basically how insurance works: I apply for insurance; the insurance company groups me with a bunch of similar policyholders and figures out how likely policyholders-like-me are to make a claim under the policy. The insurance company decides how much I need to pay them to give them money to pay claims and make a profit. (Now, here's the key part) The insurance company takes my money, and all the policyholders' money, pays expenses, and invests the rest. Usually, the insurance company makes their profit off the investments. This is what made Warren Buffet a world famous investor - he got control of an insurance company with all that money to invest, and he invested it well. The profits worked out to roughly $100k per share over the years.

Two things are likely to go wrong in insurance - higher-than-expected claims, and lower-than-expected investment results. Spreading coverage over a lot of areas, a lot of people, smooths the blips. Keeping a surplus fund keeps the insurance company in business even when claims exceed the budget for claims.

My dog is smart and well-behaved. He's not allowed to steal food, and he doesn't. But I'm not about to leave a filet mignon unsupervised within his reach. Governments are the same way - they might try to do what's right, but a pile of cash is just too tempting. They just have to nibble on it, and next thing you know, it's gone. This is one of the reasons I oppose government healthcare.

Health care in Canada 10% of GDP

Health care in Canada - Wikipedia, the free encyclopedia: "Health care spending in Canada is projected to reach $160 billion, or 10.6% of GDP, in 2007. This is slightly above the average for OECD countries. In Canada, the various levels of government pay for about 70% of Canadians' health care costs, which is slightly below the OECD average. Under the terms of the Canada Health Act, the publicly-funded insurance plans are required to pay for medically necessary care, but only if it is delivered in hospitals or by physicians. There is considerable variation across the provinces/territories as to the extent to which such costs as outpatient prescription drugs, physical therapy, long-term care, home care, dental care and even ambulance services are covered."

In the U.S., healthcare consumed 16% of GDP in 2005. Canadians aren't getting any more for their money, but they're spending less on it. Canadian health care is held up as a model of what Americans "could" get for their money under "universal healthcare", but Canadian care isn't actually universal and it doesn't necessarily cover as much care as American health care does.