Irrational Dejection (the Long Fall from Exuberance)
By TOM POWELL

How could tulips once have been traded at a price higher than gold, start up companies without profits be more valuable than solid performers with fixed assets and liquidity, or a production house yet to be built double in value from the time it was reserved until the time it was completed just twelve months later?  The phenomenon was coined “Irrational Exuberance” by the former Federal Reserve Chairman, Alan Greenspan.  Financial markets – as early as the 1600s – characterized this exuberance with an up and down cycle of chasing opportunities, followed by periodic corrections, and then a leveling off until a new bubble was created in another sector of the economy; boom-bust-recovery-normalcy.

More than two years ago mumblings of a potential housing bubble burst began to emerge in conversations.  Many thought we were headed for a typical housing cycle nearing the top and then suddenly correcting, with the last buyers in having to hold their property for a few, or even several, years until prices began the steady upward climb we all expect.  What we have seen recently, at least according to the news reports, blogs, and talk on the street, is the collapse of the housing market; so much so that Jim Cramer, the host of CNBC’s Mad Money, has been recorded saying that most people should hand the keys to their homes back to their lenders and walk away in order to protect their credit cards (Cramer’s passion is often short of insanity and is meant to sell books and bring in viewers).  Unfortunately, many of the people who most need to learn fiscal responsibility for their actions are those apparently listening to Mr. Cramer and are the cause of a distorted view of the defaults that are being reported.

According to the MBA’s (Mortgage Bankers Association) National Delinquency Survey, what continues to drive the national numbers is the foreclosure starts in Nevada, California, Florida, and Arizona.  Were it not for the increases in these four states the U.S. would have seen a nationwide drop in the rate of foreclosure filings.  The seemingly underreported fact is that the chief driver of the filings is a disproportionately high share of investor loans, or loans to buyers who do not plan to live in the house.  As of June 30, 2007, the non-owner occupied share of defaulted loans (90 days or more past due or in foreclosure) was 32 percent in Nevada, 25 percent in Florida, 26 percent in Arizona, and 21 percent in California, compared with 13 percent in the rest of the nation1.  In the simplest terms relative to Nevada, 1 in 3 loans in default today are from speculators who bought a home hoping to flip it before the first payment was due (a correlation to Tulipmania in the 1630s and the stock market crash of 1929).

The institutional residential mortgage market in the United States is approximately 44 million mortgages and is greater than $10.0 trillion with almost $7.0 trillion in loans being originated in the last three years through new purchase loans and refinances of existing loans.  The homeownership rate remains near record levels at 68.9% with 35% of homeowners having no mortgage and 49% of homeowners having a fixed rate loan.  That leaves only 16% of homeowners with adjustable rate products2.  

So why the continued housing slump, and why is Countrywide negotiating a second multibillion-dollar bailout3?  To start with, Countrywide handles one of every five new U.S. home loans and when the capital markets began to contract the company lost its prime source of cash flow.  In the micro picture, Countrywide lends a borrower the money to buy a home by borrowing short term dollars using corporate paper, lines of credit, and cash.  It then replaces the dollars by finding someone (the market through bonds known as Mortgage Backed Securities) to buy the loan so it can lend more.  In today’s sophisticated markets a loan is sold inside of a “pool,” which includes several loans usually of similar quality. The pools have various degrees of risk known as tranches, and are rated, and then insured through the use of hedge funds and other vehicles with the idea of providing high returns while protecting investors from potential losses.  Subprime and Alternative A-Paper (Alt-A) loans grew tremendously from 2004 to 2006 as lenders, Countrywide included, loosened underwriting standards to maintain volumes in a softer housing market.  As kids we learn that some people return what is borrowed, and some do not.  The looser the underwriting became the more Countrywide was lending other people’s money (the market’s) to people who were not likely to return what was borrowed based on historical lending guidelines.  Soon the market became concerned that Countrywide might not be able to return its money so it closed the window causing a panic (similar to a run on a bank).  The Federal Reserve, in response to the threat of a world-wide collapse of the capital markets opened a separate window, called the ‘discount window,’ allowing Countrywide Bank to borrow directly from the Fed. At this point, most everyone is pointing fingers at someone else, thousands of people are losing their jobs, some are losing their homes, and some are losing their life savings.

Where does that leave us relative to a housing slump?  The forecast is for continued slowing through 2008 according to the National Association of Realtors.  The two-year housing decline is worsening amid a surge in credit costs and the collapse of more than 100 mortgage lenders.  The Federal Reserve said at its last session that “tighter” credit is putting the U.S. economy at risk4.  Given the continued barrage of negative reports it seems amazing that anyone is entering into a purchase contract; that is, unless you understand the American dream.  Property ownership is a cornerstone of our sense and expression of freedom.  The real estate market is a near perfect example of supply and demand economics and the reality is that our Country continues to grow in population, which means the demand for housing will continue to grow as well.  How long will it take to fully recover is yet to be seen, but an entire crop of echo boomers is eagerly waiting for their chance at first-time homeownership.  Couple the echo boomers with the millions of immigrants to the U.S. and the retiring boomers that want a second home in their favorite travel location, the market will normalize within the next two years.  Until then we will have buyers; and a house that is priced properly and shows well will sell in a reasonable amount of time to a credit qualified buyer who shows a history of returning what is borrowed.

This leads us back to Tulipmania – Early in the 17th century, the tulip gained popularity amongst the classes and as a trading product in Holland.  Bulbs reportedly sold for prices that exceeded the cost of a house at that time.  Ordinary people became aware of how much money the upper class made in the commodity and saw it as a quick and risk free way to wealth. People sold their businesses, family homes, livestock, furnishings, and even dowries in order to speculate.  Almost suddenly, the tulip did not seem to be so rare and the prices could no longer be justified.  An over-supply of product purchased on speculation led to lower prices and the financial ruin of many speculators. It sounds eerily similar to the real estate speculation of the past few years with several exceptions: we do not have a debtor’s prison, we operate in a world market of capital, and the houses that were speculated on are still of relative value and will eventually become someone’s home.

Tom Powell is the CEO of IntoHomes Mortgage Services, Inc, a mortgage banking company headquartered in Reno, Nevada. IntoHomes provides institutional mortgage products through its retail network, as well as private equity and commercial lending through Equity Lending Partners, a wholly owned subsidiary.

Tom has a degree in Finance and has over 19 years experience in banking and lending. His involvement in the mortgage industry includes serving as the current Chairman of the Nevada Mortgage Advisory Council. In addition, he has served as the state Ethics Chairman for the Nevada Mortgage Bankers Association, an  executive board member for the Nevada Association of Mortgage Professionals, as well as serving several terms on board of the Nevada Mortgage Bankers Association.
References:

• MBA (9/6/2007). Delinquencies Increase in Latest MBA National Delinquency Survey
• MBA (April 2007). The Facts About Mortgage Lending
• Alistair Barr, MarketWatch (9/11/2007). Countrywide Seeks More New Investors
• Kathleen M. Howley, Bloomberg (9/11/07): Realtors Cut Forecast, Say Slump Will Extend to 2008