Real Estate for the Strong Minded

Dear Fellow Investor:

I still wear the harbinger of doom mantle here…the only "green shoots" I see out there are wads of Wall Street's hundred dollar bills being stuffed into our Congress persons' pockets…

And now Congress is going off on vacation to spend some of it…

Anyway, for those of you who have some vague dream of picking up a couple of houses, and having them appreciate in value, I offer up this comment from www.lemetropolecafe.com, by a guy named Mark Lundeen.  I was thinking of crashing into the RE world myself…but I'm going to sit in apartmentland a while longer.  (If you own a home, and it's paid off, just hang in there.)

(And I'm going to change that little Wall Street ditty, "When rates are low, stocks will grow.  When rates are high, stocks will die."

It can also read:  "When mortgage rates are low, property will grow.  When mortgage rates go high, house prices will die.")  And higher rates is a comin'.

Article posted July 31, 2009.

"Has Real Estate Bottomed?  Not Yet!
People think in herds.  Once an idea becomes accepted dogma of the masses, one loses friends if he argues against it.  One dogmatic perception that really bothers me is, when someone signs on the dotted line at a home closing they become a “homeowner.”  Unless the new house was purchased with cash, this is not true.

What actually occurs at a home closing, is someone takes on a mortgage that allows them to occupy the collateral, as long as they make the payments to the bank.   People usually don’t know what they are actually purchasing when they sign on the bottom line: money, at a certain rate, for so many years, with the house as collateral.

In my mind, there is a big difference between a homeowner and someone who has the right of occupation by servicing a mortgage.  This distinction is becoming widely recognized by many former “homeowners” who “purchased” their houses from 2000-07.

The unspoken truth of the real estate market is it’s actually a market of mortgages.  The practical differences are huge.  In any market, other than the real estate market, the market functions as a price discovery mechanism for that market’s producers and consumers.  However, in the real estate market, the actual price of a house is only a secondary consideration.  The prime consideration in the mortgage market is the ability of the “homeowner” to make monthly payments for 30 years.

The chart below shows the history of US mortgage rates from 1964 to 2009.  Interest rates have a huge effect upon the valuation of real estate.

To see interest rates’ impact upon housing valuations, I’ve created a “what if” table below, using a constant monthly payment, at the peak and bottom mortgage rates in the chart above.  It’s very informative to see the effects of interest rates on the size of the mortgage.

House Valuation with a Constant Monthly Payment

At 18.63% & 4.00% Interest Rates

* House Valuation Assumes no Money Down Mortgage.  Such Mortgages were rare in 1981, and too Frequent from 2000 to 2007.

Two facts should be noted in this table:

1. Financing by debt, has “Homebuyers” pay as much or more in Interest to the Bank than for Labor and Materials for the Actual Home Construction.

2.  Actual Home Values, are tied to the Bond Market.  When US Treasury Bond Yields rise, Home Values will decline.

Graphic by Mark J Lundeen

It’s a point of interest that both the purchaser of the $92.5K & the purchaser of the $300K home (possibly the same house, 28 years later) paid about the same for their mortgage when interest payments are taken into consideration.  But then both mortgages have their “homeowners” pay $1400 a month for 30 years, so this is not surprising.  But people don’t think of details like this, even if bankers do.  This does not make bankers evil, but illustrates the poor quality of practical economic education Americans receive from their high schools and colleges.

We all understand there are many variables bankers and their clients have to deal with that my little “what if” table completely ignores.  Still, the table reveals truths about the real estate market.

One truth concerning the real estate market is the past bull market was primarily a function of the decline in interest rates from 1981 to 2009.  But exactly what kind of bull market was it?  In the table above, did the house’s valuation rise from $92.5K to $300K?  Or did interest rates falling from 18% down to 4% that qualify a client, with the ability to make a $1,400 a monthly payment, for a larger mortgage?  I think the answer to that question is very obvious; the real estate market’s rise in valuation was the result of a bull market in debt from 1980 to 2009.  And what the debt market gave “home owners”, the debt market will take away when interest rates once again rise.  Yes, I’m talking about home valuations.

Can we use my “what if” table to predict future home valuations in an increasing interest rate environment?  Due to the formerly mentioned “many variables bankers and their clients have to deal with, I think not.

An unfortunate fact the real estate market’s participants must deal with in the future is that Congress expanded the Federal Government’s involvement in the real estate market in 1999.   That is never a good thing.  The Federal Government’s mandate of lowering of credit standards not only resulted in the financial ruin of many of the intended beneficiaries of “affordable housing”, but created a financial False Vacuum in the mortgage market that broke in 2007.

For your information, False Vacuums are a Quantum Mechanics' concept of a universal-apocalyptic readjustment where all the laws of physics change. In other words; after the False Vacuum breaks, what was once before can no longer be.
The False Vacuum (an impossible-to-sustain situation) was created by legislation forcing the banking system to loan billions of dollars, at government subsidized rates, in 30 year mortgages, to America’s habitual credit deadbeats.  Congress then had Fanny Mae, Freddy Mac, as well as Wall Street, bundle these mortgages for sale to fiduciaries of other people’s money worldwide.  From 1999 to 2006, the False Vacuum held, as the world of high finance fell in love with “AAA-Rated, US Agency Debt.”  But the False Vacuum broke in 2007, when “AAA-rated Agency Paper” became synonymous with loosing all of your money.  The world has lost its faith in the American Debt markets.  So for the US mortgage market, what was once before in 2007, can no longer be.

The consequences of Congress’s breaking its False Vacuum in the mortgage market will have profound future implications in America’s real estate market.  One of the results of the fallout from the credit crisis is the shrinking pool of qualified buyers.  With an expanding volume of homes being placed in the market due to mortgage defaults, great downward pressure on home valuation is applied to the housing market.  A growing number of mortgage defaulters are former good credits whose only fault is becoming unemployed in a bad economy.  But, as the current credit standards have it, these unfortunate bankrupts are now disqualified for mortgage financing for many years to come.

Another consequence of the False Vacuum’s breaking is, the international market in US Agency Debt has lost much of its liquidity.   This will greatly reduce the ability of Fannie and Freddie to purchase mortgages from mortgage originators, as their ability to sell them is now greatly limited.  Recent experiences with American mortgagers have traumatized fiduciaries worldwide.  This creates a situation where banks in the future will have to use the mortgages they write for their own reserves, as they will not be able to sell them as in the past.

But banks have never liked holding long term mortgage paper, which is why FDR created Fannie Mae and the Savings and Loan industry in the 1930s.  Congress can force banks to do ill-conceived things in the credit markets.  But Congressman Frank writing another chapter in the tale of woe, he and other American politicians inflicted upon the free markets in past decades, will not rekindle the bubble psychology in the housing market.

The future of the government-subsidized 30-year mortgage is grim when one considers:
1.     the inevitability of rising interest rates
2.     the damage done to individual credit standings of a broad segment of society by the recent housing bubble
3.     today’s huge inventory of unsold homes, as well as homes held by banks in foreclosure proceedings, or homes not yet released into foreclosure proceedings.
4.     the impairment of the private mortgage company financing network

I expect housing valuation to deflate to levels not believable today.  It’s a case of rising interest rates, a shrinking pool of qualified purchasers, too many houses for sale, and a greatly impaired financing system.  It will be this way for many years to come.

Mark J Lundeen
31 July 2009
mlundeen2@Comcast.net