It might seem like cognitive dissonance to think about inflation in the midst of falling housing prices. The Consumer Price Index (CPI) tracked by the Bureau of Labor and Statistics shows that housing makes up 43 percent of the entire index. Of this, 24 percent is made up of a category called owners’ equivalent rent of primary residences (OER). This rather interesting category looks at the market value rent of your home if it were turned into a rental. This category however under reported housing inflation on the way up in the bubble and now is under reporting the decline in home prices and also rents. The housing market as we all know has taken a major hit in the last few years. Given the large weight in the CPI, is it possible to have inflation with home prices falling?
In economically tough times, people begin to shift their spending habits to items of daily necessity. It is hard to find examples of home prices falling while inflation picks up. One clear example however is the Weimar Republic hyper-inflation period:
The above is a rather fascinating example of how households will shift budgets to daily necessities. If we look at the 1912-13 period in Germany both rent and food took up about 30 percent of household expenses. But that was the last time any balance like this was seen in over a decade. Quickly, food started taking up a much higher percentage of the household balance sheet as people started shifting to more daily necessities. After one decade, 91 percent of household expenses went to food while rent only made up 0.2 percent of expenses. So if we are arguing the theoretical, it is possible to have housing prices collapse while inflation rages on like the hyper-inflation Germany faced.
Let us now shift gears and look at our current situation. The housing market has been steadily falling since it hit its peak in 2005. Even though it may look like prices have stabilized, rents in many parts of the country are still going lower. Let us break out the components of the CPI for a better perspective:
Clearly housing is the biggest line item in the chart above. Households spend 15.75 percent on food and 15.31 percent on transportation costs. With oil falling as it did and the auto industry in turmoil, this component of the CPI has moderated in the last year.
If we look at the components in closer detail, we start seeing where the change is really occurring. Let us look at the OER component:
OER has never gone negative year-over-year in record keeping history. We would need to go back to the Great Depression to find another time that has occurred. But we are a few months away from going negative for the first time as the chart above highlights. The government has subsidized the housing market with low interest rates and tax credits and has shifted demand from the rental markets. Ironically many commercial real estate developments are hurting even more because of this shift. Those who would have rented are now pushed into buying homes. So you can expect the OER to go lower. Take for example high cost of living areas like Orange County and Los Angeles:
“(LA Times) Maguire Properties, then under the direction of founder Robert F. Maguire, acquired the Michelson Drive building in 2007 as part of a $3-billion purchase of 24 office buildings in Orange and Los Angeles counties. Borrowing money for the heavily leveraged purchase was fairly easy at the time with capital markets still flush with cash.
The bold move greatly expanded Maguire Properties’ presence in Orange County, but the obligations turned into a financial millstone. The hot Orange County market cooled dramatically, leaving Maguire and other landlords to struggle with high vacancy rates and falling rents.”
Commercial real estate and rental prices are falling across the country. Let us look at another component of the CPI with food:
Food has actually fallen on a year-over-year basis. But we are starting to see shifts in consumer behaviors as people start focusing on daily necessities. 36 million Americans are on food stamps so a large proportion of the population is allocating much more than 15 percent of their income to food. With commodity prices already spiking, it will be important to keep an eye on this important measure. Even though prices are down year-over-year, prices have been spiking since September of 2008:
So is it possible to have inflation while home prices fall? The way the CPI is currently set up 43 percent of the index is composed of housing so it will be tough. However, like the stock market rally of 60 percent it is not reflecting the 10.2 unemployment and the 27 million Americans who are out of work or underemployed, the CPI doesn’t necessarily reflect the reality of many Americans. With rents falling and food prices likely to go up, many Americans are going to spend a larger percentage of their take home pay on food. If that is the case, the index needs to adjust to reflect this reality.
Take for example someone that used to pay $1,500 on their mortgage and $500 in food a month. Say this family is one of the millions who lost their home and is now renting an apartment for $750. Their housing expense has fallen in half but it is very likely they are still spending close to $500 on food.
As usual, it is important to dissect the data before rushing to judgment. It is possible to have inflation while home prices fall but it is likely to be hidden in the way the CPI is constructed.
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Wells Fargo Solution to Option ARM Problem? Convert all Pick-A-Pay Mortgages to Interest Only Loans.
2010 will be a big year for four states because that is when the option ARMs are suppose to recast in droves. State Attorney General Jerry Brown of California sent a letter to the top 10 option ARM servicers and banks late last week requesting information requiring firms to stipulate how much of these loans they have on their portfolio, recast dates, and what they are doing to remedy the problem. Apparently Wells Fargo got the news and is deciding to convert its Pick-A-Pay option ARMs into interest only loans.
Let us dissect their press release since there is much to be gathered from what they are saying:
“NEW YORK (Dow Jones)–Wells Fargo & Co.’s (WFC) strategy for modifying its billions in troubled Pick-A-Pay mortgages looks a lot like a game of kick-the-can-down-the-road.
Wells Fargo, the fourth-largest U.S. bank by assets, holds more than $107 billion in debt tied to option-adjustable rate mortgages, a quintessential loan product from the housing boom that allowed borrowers to make small monthly payments in return for increasing their mortgage balance. Now, many Pick-A-Pay borrowers own homes worth far less than they owe in mortgage debt, even as many of them can afford a full monthly payment that pays down principal.”
Right off the bat Wells Fargo realizes that many of these borrowers will fall in that strategic defaulter category. That is, many people will effectively walk away from their obligation because their home is so far underwater. The notion that people will stay just because of an interest only loan is suspect at best:
“To solve that conundrum, Wells Fargo is taking a gamble: The bank is issuing thousands of interest-only loans that will defer borrowers’ balances for as long as six to 10 years. Wells Fargo is wagering that an eventual rise in housing prices in the country’s worst-hit regions, along with a rise in consumers’ income, will eventually combine to cover the bank’s billions in underwater Pick-A-Pay debt.
“We’re banking on the fact the economy will improve and recover over time,” Michael Heid, co-president of Wells Fargo Home Mortgage, said in an interview.”
This is an absolutely risky bet and one that isn’t even assured to pay off. Wells Fargo is assuming that most of these people will remain simply because they are paying on an interest only loan. In essence, they are going from being a neg-am home debtor to a home-renter. Why would someone even do this? Say you have a $400,000 mortgage on a home now valued at $200,000. Just because you are paying interest would you stay? Maybe if the interest amount is on par with rent. But what Wells Fargo is forgetting is many of these buyers bought these homes as step up properties. That is, their vision wasn’t to stay in the place for 5, 10, or 15 years. The 5 year mark was essentially their moving on point:
“Wells Fargo’s decision to shoehorn thousands of Pick-A-Pay borrowers into long-term interest-only loans helps the bank avoid taking hefty writedowns on Pick-A-Pays that a wholesale push into foreclosures would likely produce. But the strategy will also leave Wells Fargo holding billions in mortgage debt tied to distressed properties in depressed housing markets, especially California and Florida, where the future for property values is hardly certain. Write-offs from Pick-A-Pays, therefore, could bring the bank years of burdensome costs.”
That is the key to the argument. Their main goal is avoiding reality. They want at any cost to avoid writing down the mortgage to actual market value. Virtually 100 percent of these loans are based on inflated bubble housing values yet Wells Fargo wants to keep that pretense up. Can they? That is yet to be seen given 45 percent of option ARM borrowers are already 30 days late on their mortgages:
“Heid, who runs Wells Fargo’s mortgage-servicing unit, says most borrowers are motivated to pay their mortgages, even if they owe far more in mortgage debt than their houses are actually worth. One motivation driving borrowers is “kids and schools” having “a very strong play in why do people try and stay in their homes when they’re under water,” Heid said.
Teri Schrettenbrunner, a Wells Fargo Home Mortgage spokeswoman, said: “Not all people look at a house as just a house. They look at it as a home.”
Bank of America Corp. (BAC) and JPMorgan Chase & Co. (JPM) also purchased billions in Option-ARMs when they swallowed failing rivals – Countrywide Financial and Washington Mutual, respectively – although those two banks’ option-ARM book represent much smaller portions of their total loans.”
I hate to tell Heid, that may be true in other parts of the U.S., but many of these California option ARM borrowers did not look at the home as a home. It was a speculative bet on housing prices continuing to go up. And given that option ARMs are largely a California problem (58%) then we can’t use nationwide trends for a the most bubbly market in the country. The play to emotions is suspect. Is a 700 square foot shack just a home if it has a $500,000 option ARM mortgage? You tell me.
“Wells Fargo says it has written $2 billion off Pick-A-Pay balances for borrowers, or nearly $46,000 per modified loan. The bank has modified 43,500 Pick-A-Pays so far this year through September, and said the program is highly effective at keeping borrowers in their homes. It said the program eliminates the nearer-term risk for borrowers of sharply ballooning payments.”
$2 billion down, $107 billion to go. We’ll see how this plays out. Going to interest only isn’t a panacea. In fact, interest only mortgages are toxic mortgages as well. Imagine the government color coded warning system and visualize option ARMs as the absolute worst, followed by subprime, then followed by adjustable rate interest only loans. Let us look at one example:
“One borrower, Danny Annan, an Orange County, Calif., engineer, just finished weighing one of Wells Fargo’s loan modifications. The bank offered to reduce his loan balance by $100,000 and transfer the remaining balance to a six-year interest-only loan with an initial interest rate of about 4.9%, Annan said. The offer will still leave Annan more than $100,000 under water on his home.”
“It looks like a Band-aid,” Annan said. “It’s not like we’re not being appreciative,” added Annan, citing he’s left with little alternative but to sign the bank’s offer by the deadline. He said two homes on his block have been empty for more than a year after his neighbors turned in the keys and walked away.”
So the bank is still writing down the mortgage by $100,000 and the borrower is still underwater by $100,000. It is ironic the tone that is being given. This borrower wants the home to be modified to the current level of homes on the market! I doubt Wells Fargo will be doing many mods like this. What will probably occur is interest only mods and hoping that people still pay on the note. That is simply another gamble from the banking industry. But for the past decade, the banking industry has been resembling Las Vegas more than any traditional banking model.
The Negative Equity Conundrum: Why Having Equity in a Home is Important. 1 out of 4 Mortgage Holders in a Negative Equity Position.
The post title should be obvious but something occurred during this decade that gave the impression that somehow, equity in a property was of little importance. The last time in our history that we saw this massive amount of negative equity was during the Great Depression. But even then, it was a poor comparison because mortgages were short-term falling under 10 years in length. Most of those defaults came because of the employment situation and not the mortgage itself. This decade however we entered into a new realm of housing economics. What happens when 1 out of 4 Americans with a mortgage is in a negative equity position?
The first reason people find themselves in a negative equity position is because real estate values have fallen so precipitously over the last few years:
The problem with the above is that you have almost two markets now. You have one market with new buyers that are purchasing at much lower prices while there is still a significant portion of Americans living in homes with negative equity. In other words, they are stuck. They can’t sell because in order to sell, they would actually have to pay to move. This provides less flexibility than say renting. With 25 percent of mortgage holders in negative equity positions, a large portion of our population is now constrained.
The compounding of this problem is brought to light when you look at state data. The top four states have these negative equity stats:
-1. Nevada – 40% of mortgage holders underwater
-2. Arizona – 37%
-3. California – 33%
-4. Colorado -31%
You would think that Florida would be up here (27%) but Colorado is an interesting pick. Either way, a state like California with 12.2 percent unemployment has a large percentage of its population constrained to an asset that is worth less than the debt attached to it. Think of someone that bought a $500,000 home that is now worth $300,000. Let us assume this person is able to afford the mortgage payment. What happens if a job promotion requires a move? They can’t sell unless he wants to cover that $200,000 gap. He can rent the place but surely he won’t cover the lost income. In many of these cases, a person is likely to strategically default. That is, stop payment on purpose.
That is why having equity is so important. Even a 10 percent buffer allows someone to sell at any given point and take a little bit of money and move on. When you push the lower bound of no down payment, any slight movements (and we had anything but slight movements) will shock values on the downside thus rendering the mobility of Americans. We are now seeing FHA insured loans with massive problems since they only require a 3.5 percent down payment.
Equity is vital. The government now making up 95 percent of the mortgage market must require 10 percent down. Yet they realize putting this stipulation would stunt the housing market. So they are now filling that role of subprime lender. It is no surprise that recent FHA insured loans are defaulting. Without equity, what can we expect?
Sales are virtually tracking with distress properties:
In other words, housing sales are being quickly replaced with additional distress properties that will hold prices lower. If sales pull back in the fall and winter, you can expect prices to come back down again.