Chapter 13 Updates...

As I am sure you have already recognized, Chapter 13 in our text is out of date. The problem with updating Chapter 13, however, is that we are currently experiencing historic changes (both in magnitude and speed) in our real estate financing system and updating Chapter 13 is very difficult at this point. Basically, we need to update Chapter 13 by watching the news, C-Span, and reading about current events. Also, we should study the 'old' system of real estate finance to understand this systems advantages, but also the moral hazards that it had created.

Last semester, one of our graduate students wrote an interesting blog post on the sub-prime mortgage crises that triggered much of this financial turmoil, domestically and globally. I would like to start our updating of Chapter 13 by asking you to read this post (link below). Thank you!

http://realestateprogram.blogspot.com/2008/11/mortgage-company-executives-in-august.html

Bubble; not a bubble? --> Arlington, Texas

You might be interested in a widely cited report by the Center for Economic Policy and Research. Please visit the following link:

http://www.cepr.net/index.php/publications/reports/the-changing-prospects-for-building-home-equity

An interesting aspect of this report is the Rule of 15. This rule-of-thumb defines a normal (non-bubble) residential housing market as home prices that are approximately equal, or less, than 15 times the annual gross rent. For example, the average rental rate in Arlington is roughly $850 per month or $10,200 per year. $10,200 times 15 would indicate an average residential property value of about $150,000, which corresponds to the actual average residential transaction price in Arlington, Texas --> Not a bubble.

However, in some other areas of the country, we have witnessed a great divergence between the residential rental market and transaction prices (these are the "Bubble" markets). This report defines a bubble as locations where the average transaction price is 18 or more times greater than the average annual gross rent. Most of these bubble markets are located on the West Coast and the Northeast. Check out the report for more details.

Student Question: Mortgage Markets

I have a question for you about this real estate mess that is going on with the market right now. What is going to happen to the people who are signed up for these ARM loans and the rates will be adjusting soon? They're not going to be able to refi because more than likely the value of the house is much lower than the loan they are stuck with. Are they going to be forced into foreclosure? It seems that is the only option for these people in this situation. I know on the Indymac Federal Bank website, they will consider re-writing your existing mortgage if you are in default and going to face foreclosure, but nothing is being done to prevent the problem from reoccurring in a year from now. So, if you have a loan that you know will be a problem in the future, I guess you have to default before you can get help? These loans were still being written two years ago and if you were signed up for a 3 yr ARM, the fun hasn't even started yet. I'm just curious on how you think the future is going to look for these people who are stuck.

REPLY
Yes, what you describe is at the core of this current financial crisis. Way too many people, borrowed way too much money, to buy way too expensive homes. This process was encourage by the Federal government (for several decades, Democrats and Republicans were in a competition to report the highest levels of home ownership during their terms in power) and by government sponsored enterprises, such as Fannie Mae. Federal tax deductible mortgage interest paid on first, and second, mortgages on homes also helps to encourage housing consumption.

The fact that many of these mortgages are adjustable rate is just the icing on the mess. As interest rates increase, you will see a sharp increase in default rates in adjustable rate mortgages. Now the Federal Reserve has to be very concerned about keeping interest rates fairly low which could cause problems with the value of the US dollar and inflation expectations.

These poorly underwritten and often adjustable rate mortgages are clogging-up the financial system because of the expectation that many more will default in the future, making these mortgage bad investments. Financial institutions, and all other owners, holding these mortgages or mortgage-backed securities cannot get them off their books (sell them) because no one wants to buy this junk. One of the few large scale sales of mortgage-backed securities from a while back realized an 80% discount (the purchase paid about 22 cents on the dollar).

My grandfather, who had a lot of old fashioned commonsense and was very conservative with his finances, had an old rule-of-thumb that you should not borrow more than 2 times your gross annual income to buy a house. Although this might be a little too conservative, especially in some of the higher cost of living areas, I would say a maximum of 3 times would be prudent. However, due to the run up in housing prices and lax lending standards, many people have borrowed 4 to 5 times, or more, their annual gross income.

I am afraid that we will continue to see and hear more about foreclosures. However, you don't need to fear that everyone will be out on the streets (this should not be a major concern as long as employment markets holdup). Many of the foreclosures will result in people downsizing to houses and mortgages that are more affordable (from 4 or 5 times gross income to around 2 or 3 times). The average house price in Arlington is around $150,000 so a family earning $50,000 could own a comfortable house under the 3x gross income rule-of-thumb. Finding affordable housing in other areas of the country will be a lot more difficult. If the old school rule-of-thumb of 2 to 3 will in-fact apply, then housing prices in high housing cost markets may have to adjust substantially.

If anyone out there is having difficulty with making mortgage payments, you should contact your mortgage company immediately. Foreclosure is a very expensive process for the mortgagee. It is usually a much better deal for the mortgagee to work something out with the mortgagor (the borrower), if possible. The Indymac website is a good example of a mortgagee willing to work with mortgagors to prevent foreclosures.

Some timely student questions...

A student e-mailed some interesting questions last week. You do not need to agree, but I thought I would share the thoughts on our blog.

1.) How important is finance to the U.S./the world?

Very important. With the decline of defined benefit pension plans and the increase in defined contribution retirement plans, most people are relying on the financial markets for their retirement and general financial security. For most of us, how we manage our retirement investments and the return on these investment will dictate the quality of life we will have during retirement (or even if we can afford to retire).


2.) Has financed changed much over the years? How have events like the Iraq war and Sept. 11 changed finance?

Regarding your question about Sept 11 and the Iraq war, I am amazed at how well the financial markets stood up and bounced back from the September 11, 2001 terrorist attaches, especially considering the physical damage to Wall Street itself. I believe this is a sign of the strength and level of sophistication of the US financial markets. However, there are serious challenges today. Maybe even more challenging than the recovery from 911.

Finance has evolved and change tremendously over the decades. Take for example, residential real estate finance. The old model of residential real estate finance was depicted in the movie, It's a Wonderful Life, the Christmas classic starting James Stewart as George Bailey. George Bailey's job was managing a Savings and Loan (S & L). The original S & L financial institutions simply collected deposits from a local community and made residential mortgage loans to that same community. These old time S & L held the mortgages in-house and therefore needed to make 'good' loans or live with 'bad' loans.

Today we have a sophisticated secondary mortgage market that has its advantages, but also some disadvantages. Very quickly, the new model of real estate finance provides tremendous liquidity to the mortgage markets. Primary lenders, such as the remaining Savings and Loans and many other types now, can sell their mortgages to secondary market, most likely to Fannie Mae (FNMA). FNMA creates large mortgage 'pools' from primary lenders from across the country. FNMA thensecuritizes these mortgages making nice diversified mortgage investments for investors from around the world. Quiet different from the simple Bailey S & L model.

However, we are currently realizing some problems with this modern system. Because primary lenders are most often selling mortgages to the secondary mortgage market, and not holding these mortgage long term, primary lenders now have a big incentive to generate fees from mortgage originations and shift the risk of mortgage default (bad loans) to secondary mortgage market investors. We have originated a lot of bad loan over the last 10 to 20 years and we are paying the price. With changes and innovations comes new challenges.

I am concerned with the financial responsibilities that the US tax payers are taking on by bailing-out some of these companies, such as Bear Sterns, Fannie Mae, and Freddie Mac [nowAIG too]. These bailouts will be a tremendous financial burden, present and future. Also, I am worried about the signals these decisions send. If we keep bailing out people who make bad investments or companies that make bad choices, there is no incentive to stop making bad investments and decisions. Do a deal, makes some money off fees, and if the deal goes well, everyone is happy. If the deal goes bad, not a problem-you get bailed out.

The Iraq War is also a financial strain on our economy but there could be future benefits, including economic, if there are improvements in this region. If chaos breakout in Iraq, we will loose the investment that we have already made and might be forced to reinvest here again in the future. Unfortunately, this issue is such a political hot button it is difficulty for most people to think about this objectively. From a financial perspective, I think we need to do the best that we can here. Especially considering the economic burdens we are taking on at home, I don't think we have a choice.

As opposed to Iraq, there are no foreseeable benefits to these bad loans and mortgage market bailouts, except for some managers, debt holders, and even some stockholders of these bailed-out companies (for example, FNMA preferred stockholders have not been bailed out yet but some are speculating that they will be in the future).

It is a shame. Despite the transparency, sophistication, and strength (especially in times of crisis like 911) of the US financial markets, it seems like we cannot avoid a major self-inflicted financial crisis about every 10-years or so. I attribute this perpetual problem to moral hazards and a little bit of human nature.

Check it out...

As real estate students, you might be interested in a couple posts from the REAE@UTA program blog.

http://realestateprogram.blogspot.com/2008/09/competitive-advantages-of-cities.html

http://realestateprogram.blogspot.com/2008/09/history-of-world-over-last-13000-years.html

Also note that Thomas Friedman will be on-campus this Thursday. Check out the details at:

http://realestateprogram.blogspot.com/2008/08/lexus-and-olive-tree-author-tom.html