How Did the Falling Real Estate Market Lead to a Global Economic Crisis?

October 27 2008   Real estate has always been cyclical and we’ve been in what looked like a routine down cycle since mid-2006. Real estate has also been the engine of the greater economy with new homeowners buying appliances, furniture, building materials and more – boosting production and creating jobs. So it’s never been surprising when a slow real estate market slows everything down. But how in the world did this real estate bust ever bring down the biggest Wall Street firms and lead to the global economic disaster we’re in today? And why hasn’t this ever happened before? And what are all these new terms we’re hearing like “sub-prime mortgages”, “mortgage-backed securities” and “credit default swaps”? It can all seem mind-boggling, but it’s really quite simple.

In the good ol’ days, your local bank gave you a mortgage for your home and you paid that very same bank back over the next 30-odd years. You may have done all your banking with this particular bank and you and your wife may have even played bridge or tennis with your banker and his wife. Beaver and Opie lived down the street, Donna Reed greeted you at the door in a crisp shirtdress and pearls, Hazel cooked and cleaned while doling-out sassy back-talk, and Father always Knew Best.

For better or worse, those days are long gone. The Republican revolution of the 1980s led by Ronald Reagan followed by Newt Gingrich’s “Contract With America” ushered in a new wave of “small government” and pro-business thinking in Washington. Deregulation became the magic elixir and Wall Street embraced the mantra of “greed is good”. One of the things this new deregulation did was allow banks to sell their mortgages to larger banks, who in turn packaged them together and sold portfolios of these mortgages to investors in financial instruments called “mortgage backed securities”. Some of these portfolios were made up of better quality mortgages, and some of lower quality mortgages and they were rated according to risk. This new packaging of bad loans with good loans made it easier for banks to issue riskier loans to less qualified consumers – and with more people flooding into the housing market, house prices shot up like a rocket. Throughout the 1990s, people who had previously been shut out of the American Dream of home ownership were now welcomed with open arms. Those who wondered how they would ever make the payments when their adjustable rate mortgages actually adjusted were reassured that rising home values would enable them to refinance before their payments increased. Why, they could even take money out of a refi and still lower their payments! Houses became giant ATMs – never mind you were simply giving up equity. There were actually financial experts advising people to never pay off a mortgage – that that was “old-fashioned”, “unsophisticated” thinking!

Before I go any further, let’s take a step back further in time – back to the turn of the last century. The “gilded age” of the 1890s was a decade of rising affluence as cities and municipalities grew rapidly to absorb the mushrooming population of immigrants from the previous 20 years, many of whom were now beginning to prosper. As the industrial revolution took hold, a new wave of manufacturing and service industries grew, and so did the stock market. Investing in stocks became available to the working classes for the first time and with the increase in investors, new investment vehicles sprouted like weeds in a garden. One of these popular new investments was side bets made on the performance of a stock. Without actually buying a stock, you could place a bet that that stock would go up or down. These side bets became known as “derivatives” and they were bought, sold and traded in betting parlors all over the city called “bucket shops”. Since these bucket shops fell outside the scope of federal regulators, nobody was checking to see if the so-called “banks” selling these derivatives had the cash reserves needed to pay off these bets. As the stock market reached a fever pitch in 1907, these derivatives added to the hysteria that led to panic resulting in a stock market crash. So in 1908, this kind of gambling on stocks was made illegal and the bucket shops disappeared. During the depression, even tighter regulation was established by the Securities Exchange Act of 1934.

Now fast-forward to the year 2000. Bill Clinton is a lame-duck President with a Republican-dominated congress. Deregulation is still the mantra and Clinton, a centrist Democrat eager to co-opt the Republican agenda whenever he could, along with his Chairman of the Federal Reserve, Alan Greenspan, enthusiastically signed into law the Commodities Futures Modernization Act of 2000. This not only overturned the 1908 law, but most significantly it removed the trading of derivatives around these new mortgage-backed securities from Federal oversight. Savvy investors could bet that some of these mortgage backed securities would fail as homeowners defaulted on their mortgages. These bets, called “credit default swaps”, were invented by JPMorgan in 1994 as a sort of insurance against outstanding corporate loans and to free-up cash to offset the huge cash reserves they were required to keep against those loans. Hedge fund managers trading them had become the new Masters of the Universe. Now credit default swaps could be traded against mortgage backed securities with no federal oversight – meaning no requirement to keep cash reserves to pay them off, unlike credit default swaps against corporate loans and other investments. Real estate was the new lawless wild west town. This further stimulated a market for ever more risky mortgages, throwing more gasoline on the bonfire. By 2006, the housing bubble began to plateau as prices simply became unsustainable. Homeowners who were counting on refinancing before their mortgages became unaffordable suddenly found themselves “upside-down” (owing more on their house than it was worth). Foreclosures started to mount, swelling to a tidal wave that crashed on the beach in September 2008, wiping out everything in its path, including the giant Wall Street firms who had taken to mortgage-backed securities like a junkie on smack. Without the cash reserves they would have been required to hold had they not been deregulated, they were wiped out.

The problem, as Alan Greenspan now points out, is that he and the others in charge had too much faith in the executives running the banking industry. They believed bankers would be responsible to their shareholders and self-regulate. Instead, these executives paid little attention to the details and took delight in paying themselves enormous bonuses – often in excess of $100 million. Now that a conservative Republican, pro-business/small government administration has (ironically) federalized the banking system, we, the taxpayers, will all be paying for that party for decades to come. Will the bailout work? It’s too soon to tell, but the fact that it’s being administered by the very same Wall Street executives who created the mess doesn’t give JetSetRnv8r much faith. 

Update:  Days after writing this post, it was revealed that the first thing the Wall Street firms did with their federal bail-out money was set aside billions of dollars for executive bonuses. Surprised?

Who’s to Blame for the Mortgage Meltdown? You? Me? Or “Them”?

October 15 2008   With the capital markets frozen and the world economy in crisis, everyone is looking for someone to blame.  The airwaves are full of politicians and pundits lashing out at this party or that party.  The Obama-Biden team blames runaway de-regulation dating back to the Reagan administration.  John McCain blames the rampant “greed and corruption on Wall Street” while his running mate likes to wave her school-marm finger at the “predatory lenders”.  Some conservative talk radio hosts blame consumers for not taking “personal responsibility” while more liberal commentators lay the blame squarely at the Bush administration.

 

We’re all swayed by our own reality and frame of reference.  But I can tell you one thing, I’ve worked inside the system and I could see things unraveling years ago.  The system is broken and has been rotting from the inside-out for many years.

 

When I got into real estate investing full time, the first thing I did was get my appraiser’s license as I felt that was the best way to learn the fundamentals of the industry.  I freelanced for two appraisal companies (more on the life of an appraiser in a separate posting) and had a handful of my own clients who were mortgage brokers.  Banks worked only with the most senior, experienced appraisers who might sub-contract the work to less-experienced appraisers such as myself.  But mortgage brokers preyed on new appraisers who they knew were the most desperate for the work and would do whatever it takes to deliver the desired outcome.  Banks paid their appraisers within days – mortgage brokers paid whenever they felt like it, if at all.  And if pressed for payment, they’d drop you for another new appraiser.

 

I can attest first-hand that appraisers have been under tremendous pressure to “hit the number” – that is, bring the appraisal in at the value needed by all parties – sellers, buyers, agents, mortgage brokers and bankers – for the deal to go through. 

 

What does this mean?  OK, think back to the go-go years of 2003, 2004, 2005.  Values are rising up to 20% per year.  An aggressive seller prices his house high.  An eager buyer, convinced by his agent and financial advisors that values are rising fast, agrees to the price – or offers an even higher price to best any competitive bids – and applies for a mortgage.  Both the buyer’s and seller’s real estate agents as well as the mortgage broker and bank all have an incentive for that price to be as high as possible as everyone along the chain is earning a commission on that sale price.  The mortgage broker – or the bank – hires the appraiser and seeks the one who they know will turn the appraisal around the fastest (2-3 days) with the fewest problems. 

 

The appraisal must be based on “comps” – or the actual sales of comparable homes in the neighborhood during the past few months.  Not listings, not pending sales, not sales that fell out of escrow but actual closed sales.  There are tight guidelines for what kinds of sales are appropriate comps – they must be in the immediate neighborhood – across a busy road or higher up a hill should not be used as neighborhoods can change within a block or two.  Houses larger or smaller by a factor of 20% should not be used.  Houses of similar condition are sought – if the “subject property” (the house being appraised) is a fixer or newly renovated, than the comps should also be fixers or recently renovated.  Amenities such as room counts, bathroom counts, fireplaces, pools, views and number of garage spaces are all considered.  The appraiser finds anywhere from eight, nine, ten or more potential comps and narrows the choice down to three to five for the appraisal report.  Adjustments are made to each comp – adding or deducting value to account for differences from the subject property.  It is three parts science and one part art and requires sound judgment, in-depth knowledge of the area and experience.  The appraiser has the most at stake here as any mistakes or the slightest appearance of fraud can lead to loss of work or worse – lawsuits or loss of their license.

 

Aggressive seller’s agents often meet the appraiser with stacks of “comps” they’ve pulled.  They do this under the guise of being helpful but their real motive is to try to ensure that the appraiser uses the best comps – the highest sales – for their reports.  These comps, however, are rarely useful and the appraiser is discouraged from accepting them.  They pull from better neighborhoods or larger homes in better condition.  Since refusing them will raise red-flags with the agent, the savvy appraiser accepts them with a smile then throws them away.

 

During the recent real estate boom, mortgage brokers (like my clients) would call and say “I need this house to come in at $X”.  Right off the bat, this is a violation of the ethics rules as they are not supposed to pressure the appraiser or influence the outcome.  It wasn’t unusual for the mortgage broker to call two or three appraisers and ask each one for a verbal confirmation on that phone call that they could “hit it” before they’d be hired – also a violation.  If the appraiser couldn’t meet that number, this could kill the sale which would incur the wrath of all parties so that appraisal would be thrown away and a new appraiser hired until they got the results they wanted.  When this happened, everyone accused the appraiser of incompetence and that appraiser would not only not get paid for his work (anywhere from $350 to $1,200) but would be black-balled from any future work from all parties involved in that deal.  It only took one or two such instances to kill a career.  Appraisers who cooperated were highly sought-after and got lots of work from strong referrals throughout the industry.

 

Appraisers did not stand idly by.  They were screaming bloody murder at anyone who would listen – banks, industry organizations, even the press.

 

So who’s to blame for the current crisis?  I blame the legislators who created a system that motivated and rewarded inflated values if not outright fraud.  The consumer is the hapless victim and is the last person who should be blamed.  The consumer was just following the advice of experts they relied on and the government who encouraged them through tax incentives and a steady drumbeat of homeownership as “The American Dream”.

 

What Does the Wall Street Bail-out Mean For You*?

* By “you”, of course, I mean “me” – unless you’re also a Beverly Hills real estate investor and flip-artist.

 

October 3 2008   Excuse me for not posting for a couple weeks, but I’ve been glued to every and any news source I can find to follow the meltdown of our financial system – and staving off my own emotional meltdown in the process.  Regardless of your politics, there’s plenty of blame to be shared across both sides of the aisle and this has been a long-time coming.  Like many of us, I’ve been hearing dire warnings from friends on Wall Street for over a year and dismissed them as kill-joy doomsayers like the crazy guy on the street-corner with the “The End Is Nigh” sign.  Let’s just hope he’s not right, too.

 

The silver lining to this gloomy black thunderhead of a cloud is that this could usher in a whole new era of better government, better oversight, stronger regulation and a newer, stronger, more vibrant and sound economy that opens new opportunities for all of us.  Or not.  We’ll start to find out a month from now.

 

Preparation plus opportunity equals success.  It’s an old saying with many taking credit for it but it’s true and timely.  Every change – no matter how painful – brings opportunity for those who are able to identify it and adapt to take advantage of it.  The real estate business will fundamentally change.  “Flipping” houses may or may not be a viable strategy at least for the near future but plenty of opportunities will exist – some we may not even have thought of yet.

 

The bright spot in the otherwise dreary real estate market up to now has been the high-end.  As the American middle-class weakens, the world’s rich have been getting richer as evidenced by the over-the-top demand for ultra-luxury goods including million-dollar cars and diamond-encrusted human skulls.  The very top-end of the real estate market in the select areas of Beverly Hills, Bel Air and Malibu (“Bevairbu”) has remained strong with a few clever realtors having their strongest years ever.  Houses in $10 to $30 million range in Bevairbu have been selling briskly to all-cash buyers.  When you’re not applying for a loan, you don’t care about mortgage rates.  And you can rationalize paying prices above appraisal values.  This explains the McCourt’s $19 million purchase of a crumbling beach shack on Malibu’s Carbon Beach next door to the Lautner-designed house they bought for over $33 million.  The number of sales of homes over $15 million in Beverly Hills and Bel Air increased over the last 12 months (ending October 1 2008) to a five-year high with more sales than ever getting near or above asking price in fewer than 70 days on market.  Remarkable, given what’s been going on everywhere else.  And positive sales trends in Beverly Hills is reported in a separate posting here.

 

Is that party over?  Too soon to tell for sure.  The world’s super-rich may be too insulated to be affected.  Most of these buyers are foreigners – Russian oligarchs, Middle Eastern oil barons or members of exiled political regimes.  They may be drawn more than ever to the relatively stable market of Los Angeles’ Westside in an increasingly unstable world.

 

My advice for the near term is to move into rental properties, building a portfolio of small homes in solid middle-class neighborhoods with a minimum of a five-year time horizon while keeping an eye on the sales activity in the usually recession-proof Bevairbu. 

 

For more about investing in this tumultuous market, read “Amid the Chaos, Is This Any Time to Invest in Real Estate?

Check back in a few months to see how my advice holds.

Amid the Chaos, Is This Any Time to Invest in Real Estate?

September 21 2008   Bear Stearns!  Goldman Sachs!  Lehman Brothers!  AIG!  Fannie Mae!  Freddie Mac!  Wall Street bail-outs!  Every day a new sensational headline about the meltdown on Wall Street.  Just when we think it can’t get any worse, it does.  So what, exactly, does this mean for real estate investors and is this any time to get into – or out of – the market?

 

Before I answer that, let me share a secret.  It’s the secret to success in business and investing.  And I’m going to share it with you, just you, dear reader.  Ready?  Come close.  Lean into the computer.  Here it is… 

 

“Buy low and sell high.” 

 

That’s right.  Repeat it a few times.  Write it down, if necessary, so you don’t forget it.  All you have to do is invest when prices are low and sell when they’re high!  That’s all there is to it!  It’s that simple.  The only thing you have to figure out is when the prices are low and when they are high.  When you figure that out, let me know. 

 

I can’t tell you when prices are going to be high but I can tell you one thing, they’re low right now.  They might even get a little lower – but the fact of the matter is, they’re pretty darn low today.  And I can tell you one other thing – they will rise.  I can’t tell you exactly when, but I’m pretty sure that within five years they will have at least recovered to their pre-crash levels if not more. 

 

Without getting into the detail of it, real estate has, historically, consistently delivered some of the highest returns on investment over time.  Sure, there are ups and downs along the way and speculators have been known to get reckless and homeowners have suffered.  But those losses almost always occur when there’s a short-term time horizon and homeowners or speculators are banking on short-term gains.  Investors who endure and succeed are the ones who are in it for the long term. 

 

I learned that lesson the hard way with my first real estate investment.  I was looking for a quick buck from flipping a co-op in New York City in the mid 1980s and I lost when conditions in the neighborhood suddenly made it un-sellable.  (The city opened three welfare hotels immediately adjacent to the building.)  At the time, I felt like the first person ever to lose money in the go-go Manhattan real estate market – but I wasn’t the first, nor the last.  Those welfare hotels were gone two years later and the neighborhood quickly gentrified.  In fact, one of those “welfare hotels” became one of the first of the new wave of “hip” high-end hotels.  If I’d had the wisdom, wherewithal and resources to hold on, my $75,000 investment would have been worth at least $1.5 million today.  On top of that, I would have taken in nearly another million dollars in rental income by now.  The property would have been fully capitalized (paid for itself) after only seven years with the remaining fifteen years providing pure profit.  Even after expenses and taxes, that’s not so bad.  My partner in that deal did hold on and that co-op is one of the best performing assets in his investment portfolio today – and he’s a successful hedge fund manager.

 

I predict that five-to-ten years from now, many of the people we read about in the Wall Street Journal and on the Forbes 400 list will have made their fortunes building their real estate portfolios today. 

 

So back to today.  Prices are at historic lows.  Foreclosures are at an all-time high.  The rental market is red-hot with rents rising.  Inventories are at an all-time high making it as much a buyer’s market as it ever gets.  Here’s where two-plus-two equals five.  This is an unprecedented buying opportunity for investors.  A recent article in the New York Times (“Finding Profits in a Distressed Market” 9/14/08) quotes Gene Hacker of Century 21; “You’ll probably never see anything like this in your lifetime again.  With the rental market as strong as it is, and prices as low as they’ve been, this is as good as it gets.”

Here’s my advice.  Buying foreclosures and other well-priced distressed properties and running them as rental properties with a long-term time horizon of five years or more could be a very smart move right now.  That’s why I’m talking to my partners about investing our money in residential income properties – maybe even some commercial properties like small retail centers and coin laundries. 

But pick your markets carefully and, like anything, invest only in what you know and do your research.  For example, I only invest in Los Angeles where the booming entertainment industry sustains an economy insulated from the rest of the country and international jet-setters will always flock to the enduring cachet of Beverly Hills and Malibu.  (Read about sales trends in Beverly Hills here.)  Having worked in the entertainment industry, I understand these buyers.  I would not invest in markets that are shrinking or over-saturated – Phoenix, Las Vegas and Miami come to mind (although I have a friend doing okay with vacation rentals in Tucson – the poor-man’s Santa Fe.)   

 

Stay tuned and I’ll let you know how it goes.  And let me know what you’re doing out there.

 

For more information about investing in this tumultuous market, read “What Does the Wall Street Bail-Out Mean For You?”  And look for future postings here about how to find and buy foreclosed properties, evaluate a real estate investment including calculating the capitalization rate and rate of return.

Fannie and Freddie Fallout

From my mortgage broker on September 8 2008:

“Mortgage rates are dropping significantly due to yesterday’s announcement that Fannie Mae and Freddie Mac will come under control of the government. This announcement came as the government felt both these institutions will no longer be able to meet their mission statement, which is to provide liquidity, stability and affordability in the housing markets.

In summary, the problems in the mortgage industry of late have made it difficult for Fannie and Freddie to issue new Bonds, and thus meet the capital requirements to pay off maturing Bonds. The Treasury stepped in to guarantee the payments on these new Bonds, which will make Mortgage Backed Securities more attractive to investors; these Bonds will have higher yields than Treasuries, with the same government-backed guarantee.

This action by the government will have two major effects. First, rates will drop significantly, possibly around 100 bps (from 6.250% to 5.250%), which will make mortgages more affordable for more borrowers. Secondly, this action will make credit easier to obtain, allowing for more borrowers to obtain home loans. Both effects will help slow, and possibly stop, the housing value downturn the country has experienced these last 18 months.”