Q: Could you begin by framing the current state of the housing market? Do you see a double dip market?
Simon: Unfortunately, we are seeing signs of what we have long suspected: There never was a housing recovery. In fact, I argue the market is in a fragile state that is far easier to break than to fix. If policymakers alter the government’s current approach to housing and unwittingly break the market, they may not be able to repair the damage within the foreseeable future.
The appearance of a recovery, in our view, resulted from foreclosures being stalled amid political and media scrutiny as well as lawsuits. That meant that the composition of sales reflected fewer distressed sales and thus prices seemed to be rising. Basically, it was likely a statistical bounce, not a real bounce, and now the housing bulls are back to being bears.
While this will vary by markets, we anticipate an average decline from here of about 6% to 8% in prices across the country.
Before we dive more deeply into specific housing issues, let me point out that we are seeing and have seen things since the market downturn that can be considered very atypical, at least by historical standards. We saw a national decline in home prices, meaning people are dealing with negative equity on a national level. Some people are also talking about getting the government “back out of housing”, when the reality is government has been subsidizing housing since the Great Depression in the form of guaranteeing mortgages, allowing mortgage interest to be a tax deduction, tax credits, etc. And, of course, we have foreclosures on a scale not seen since that historic period.
Q: Does that mean that the issues with the foreclosure process that made headlines amid the crash have been resolved? Are more foreclosures expected to hit the market?
Simon: Issues with mortgage servicing appear to be at the heart of most cases reported in the media. If the allegations in these lawsuits and reports are correct, then many servicers acted in their own best interest rather than in the best interest of either the lender or homeowner. But, frankly, loans were made against homes, and faulty paperwork is not going to allow anyone to own a home free of the debt. Banks don’t lend a million dollars at a low interest rate on a credit card. They need collateral.
So eventually we expect that someone will correct the paperwork or legitimately create new paperwork, and the foreclosure process will likely resume.
Looking ahead, we see potential for a substantial number of foreclosures over the next three years – as many as 6 million to 7 million additional foreclosures, on top of the roughly 2 million we estimate have already occurred. Foreclosures may peak in about two years, but the numbers could still be high for a few years after that and then likely taper off.
Q: Is the housing market weighing on the economy?
Simon: Initially, as housing sales and then construction declined, housing weighed on the economy, but now it is more or less a neutral influence, in our view. Residential construction cannot really go any lower, and it has not been draining GDP. Of course, if we continue to see disappointing housing numbers, then housing can undermine consumer confidence, and that could be a negative for the economy.
As I see it, there is great polarity in potential long-term market scenarios. One extreme: a housing shortage. This could occur if housing construction remains tepid while vacancies and foreclosures decline and household formation increases. I would put maybe a five-year time line on that scenario, if it were to happen.
The other extreme: a housing collapse. We are not anticipating this, but believe it is at least plausible considering what could happen if home price declines increase – beyond our forecast – to 15% to 20%. From a historical perspective, and based on our analysis, Americans have paid their mortgage regularly even if they are up to 15% percent underwater. But when they get to 15% or 20%, there tends to be a big spike in delinquencies, and if that number hits 25%, it could be very ugly. In some markets we have already seen foreclosures spike amid home price declines, but another 15% or more nationally could be devastating. While we think the market could withstand 6 million to 7 million more foreclosures over three years with a modest slip in prices, we don’t think the market could handle 12 million.
Q: Let’s switch gears to discuss housing finance. Is the home-loan market still reliant on government support?
Simon: Yes, government is essentially considered the mortgage market today, but this needs to be put in context. Government has been involved in housing for some 70 years with pro-housing subsidies of all sorts, from homebuyer tax credits to guaranteeing loans to mortgage interest tax deductions.
For most adults today, the government has been involved either explicitly or implicitly in the backing of home loans for as long as we can remember. In our opinion, the pre-financial crisis selling of nongovernment-guaranteed mortgages was essentially an experiment. It was this private-market experiment that we further believe did not work as intended, and at one point threatened the entire global financial system.
If we ended government support in all forms, mortgage rates could rise significantly, because home loan investors would need to be compensated for greater credit risk, and loan availability could decline. Higher rates and less mortgage availability would put downward pressure on home values, with potentially negative consequences for the market and also for the economy as a result of wealth destruction and consumer confidence declining.
Also, on October 1 of this year, the maximum loan size for Fannie, Freddie and FHA loans will drop from $729,750 to $625,500. I doubt anyone will cry for millionaires but this is very important in a state like California. This potentially further reduces credit availability and applies further downward pressure on prices. We feel the banks are restricting credit enough. In our view, if the government overly restricts credit, it will likely bring about the scenarios we fear.
There have been news stories on jumbo loans (which are greater than the government limit, currently $729,750) that highlight they are trading at their lowest rates relative to agency MBS (mortgage-backed securities) since pre-Lehman. While this may be factually correct, it is only correct if you can actually get the loan. The banks have been incredibly restrictive about what it takes to get these loans, from what we have observed. While the following is only one isolated example, I have a friend that is self-employed that told me she has an 800 FICO score, and was trying to put down 25%. She is still trying to get a loan four months later.
Additionally, appraisals are affecting loan issuance. In 2006, we believe appraisals were mostly too high as appraisers only got paid if the deal closed and they were used. Today, we believe that most appraisers are underappraising properties as the appraisers fear potential lawsuits or legal action. If you put down $20,000 on a $100,000 house and the appraiser says the property is worth only $80,000, the bank won’t give you a loan as they view you put zero down.
Q: What are politicians and policy makers proposing to do about Fannie Mae and Freddie Mac? Are there serious alternatives being discussed to provide liquidity to the market?
Simon: From what I have observed in visits to D.C., when the conversation comes around to Fannie and Freddie it is very easy for people to get irrational. Fannie and Freddie seem to draw negativity like giant lightning rods because they lost so much money. But what is often overlooked is that the majority of losses have not come from their core business: 20% down-payment, prime mortgages. They got in trouble because they expanded beyond their core business to maintain market share. By comparison, one might have expected the Federal Housing Administration’s program to be the one to implode, since it makes loans to people with blemished credit histories and/or small down payments. But during the boom, FHA did not compromise its lending standards, even as its market share plummeted, and as such, it has not suffered as heavy losses as the others.
But politicians from both parties look at the losses of Fannie and Freddie and think, “I'd better say Fannie and Freddie stink and we should shut them down and that they are evil.” But the market still relies heavily on Fannie and Freddie. If policymakers err in tinkering with that support while the market is so fragile, the unintended consequences could be extreme.
So far, as best I can tell, there has not been an alternative to the current system offered that has broad support or momentum, but some folks seem to be gravitating to a plan that would theoretically create companies that would have private equity taking a first-loss position and the government backing mortgage securities issued by these companies. And these new entities would face size restrictions, with the intention of avoiding the too-big-to-fail issue. Aside from the size cap, these would really be companies just like Fannie and Freddie but under new names.
I suggest thinking of Fannie and Freddie as utilities. A utility is an entity that provides a public service that has been determined to be a necessity for the greater public good and because of this has typically had some form of government regulatory involvement. Despite my preference for free markets, I would suggest adding mortgages to that list based on the fundamental importance of homeownership to so many people.
Q: And when do you expect action on this issue? Is it something for after the presidential election?
Simon: Despite the heated rhetoric, there appears to be no rush to kill Fannie and Freddie, from what I have observed. Initially, we heard talk of getting the government out of housing in two years, and lately the talk is five to seven years. I think in Washington-speak five to seven years more likely means 10 to 15 years, which is actually a more realistic timeframe in my opinion – by then the housing market should hopefully be on firmer ground. By the way, in five to seven years everyone in Washington will have rerun for office at least once, so it is long enough to not be a meaningful timeframe.
This timing issue gets at what we consider to be one of the stumbling blocks with Fannie and Freddie – some of the most heated arguments have been between two sides that do not seem to be having the same conversation. One side is arguing about what housing policy should look like 15 years from now, and the other is arguing about what should happen today. And so, as I see it, they are not even talking about the same issue.
We believe Fannie and Freddie have been quite good at prime mortgages; their real problems stemmed from forays into subprime and Alt-A loans. Yes they are big entities, but they also have time-tested systems that can handle tremendous volume. However, it may not be necessary to have two of them because they do not compete per se, and the government essentially owns and runs them both in a similar fashion.
If we do indeed transition away from Fannie and Freddie to a new arrangement, we must be careful not to accidentally hurt the homeowner. I argue this is no trivial undertaking, especially amid an already fragile housing market. If Congress missteps and accidently blows up housing, I doubt many of them would be reelected. Some folks in Washington may think that if they shut down Fannie and Freddie too abruptly it would be like Coke Classic: They could bring them back pretty quickly. But if that happens, the market might break simultaneously, with little hope of bringing it back.
Thank you, Scott.