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Saturday, December 6, 2008

The Coming Sustained and Unnatural Real Estate Explosion

Given the direction of real estate over the last year or so, I know that most reading this could never imagine another real estate explosion. Yet, it's coming if the government follows through on some of their plans. The government is potentially sponsoring or subsidizing two separate programs that will at some point cause a serious imbalance between the number of buyers and sellers, and it will be unnatural and long term. The first program is loan modifications. (a topic I have spoken of often here) This is the process by which banks create a new loan for borrowers that are struggling to pay their current loan. Terms and rates are set not by credit worthiness but frankly by credit unworthiness. In such cases, borrowers have loans they can't afford. Banks adjust the loan and make the payment something they can afford.

The one loan modification I saw allowed the borrower a rate of 4% for five years, 6% for another two years, and 6.75% for the remaining 23 years. A colleague had heard of loan modifications that received rates as low as 3% though I have not seen that myself. One proprietor of a loan modification business told me that they average a rate of 5% on any loan modification.

Now, the folks that receive a loan modification are overwhelmingly unqualified to get a new loan. In fact, they get a loan modification because their current loan is NOT affordable. As such, if they were to sell their homes, they would certainly not get the type of rate that their loan modification receives. Most likely, these folks wouldn't even qualify for any new loan. Since foreclosures are at an alarming rate, the federal government has committed to doing everything in its power to stem the tide. Loan modifications are now playing a central role in this. The FDIC has pledged to insure millions of modified loans. In California, a bank cannot foreclose unless a loan has been modified first.

What is the end result of all of this? It means that millions of people will be fitted with loans that they could never get in the open market. Furthermore, once the economy recovers rates will go to a more normal rate of 7% or more, and that's for those with good credit. As such, millions of totally unqualified borrowers will have rates far below what the market will offer. Often these borrowers wouldn't qualify for a new loan entirely. Now, imagine you are one of these borrowers. You have a rate below five percent. The market would dictate a rate of 8-9- or even 10% if you were to get a new loan with a new purchase. Now, on a $200,000 loan amount, each eighth of percent increase in rate is about $20 monthly. As such, the typical borrower would be looking at an increase in payment of $500-$1000 monthly if they kept their loan amount the same. You are now EXPONENTIALLY more likely to stay in your property much longer than you ever would have on your own. In other words, millions of potential sellers will be removed from the market in the next 3-5-7- and even 10 years. This will create a major unnatural imbalance between sellers, of which there will be less, and buyers, of which there will be a normal amount.

The second potential event is equally dangerous. The Treasury is planning to manipulate rates to as low as 4.5%.

The head of the government's financial system rescue effort said Thursday the Treasury Department is considering a program to encourage banks to make mortgage loans at low rates to help revive the battered housing market.
Under the proposal being pushed by the financial industry, Treasury would seek to lower the rate on a 30-year mortgage to 4.5 percent by purchasing mortgage-backed securities from Fannie Mae and Freddie Mac. It's unclear exactly how much the plan would cost.

If this were to happen, then in the first few months of 2009, millions of very qualified borrowers will take advantage of a once in a lifetime opportunity to reduce their rate to a level they will never see again. Millions more perfectly qualified borrowers will now have mortgage rates, fixed rates at that, below 5%. Now, when the market stabilizes and goes to 7%, what will be the reaction of these borrowers? It will be much the same as those that are to receive a loan modification. If you are in a fixed mortgage at below 5% and a purchase means you will go into a rate of 7% or more, that means you are far more likely to stay much longer than you otherwise would have intended. The end result is millions more people staying in their homes much longer than they would have without this extra stimulant.

The end result could be devastating in terms of future inflation in real estate. We are now looking at nearly every borrower profile receiving long term fixed rates of below 5%. As soon as the market for new mortgage rates steadies out over 7%, most of these folks will see fit to stay in their properties a very long time. This means there will be far fewer sellers for all of the new buyers that will enter the market. Not only will this cause an explosion in real estate but it will be sustained and frankly irreversible. The government is not going to be able to undo what it is about to do. The government will never be able to renegotiate these rates later on. Even if they tried, the pressure from all the beneficiaries would throw anyone out of office that tried.

It's unclear how long this sustained real estate explosion would last but it could go as long as the next thirty years, the duration of all these loans. Unless the Federal government recognizes the disaster they are creating, we are headed straight for real estate economic disaster.


Anonymous said...

Not sure I would personally stay in a house just because I have a low interest rate. If I get a better job and need to relocate, if I get a divorce, hate my neighbor or whatever, I would sell and move. Your logic that the low cost mortgage will keep homeowners to stay and not sell... then with that same logic, millions of people will be buying today as rates fall. What about those home owners without mortgages? Do they hang on to their home because their mortgage rate is "0" percent? Maybe.

I think those "unqualified sellers" with the low interest rate will jump in to sell when they see their home prices go up.

mike volpe said...

With all due respect, what you would do is frankly irrelevant. You are talking about micro issues. I never said that everyone would stay in their home just for the low rate. I said the low rates would keep millions in their home so that there was an imbalance.

There likely will be an explosion of buying to take advantage of these rates, and that means the real estate explosion might then start early. I don't know who an "unqualified seller" is so I can't comment.

Anonymous said...

Interesting analysis, more unintended consequences from the brilliant minds who go us into this mess in the first place.

Anonymous said...

This guy doesn't know basic mathematics. Those who won't leave their house will not sell their houses. Fine. But they won't buy a bigger house either.

Pure stupidity!

mike volpe said...

I don't know who you mean by "that guy" but your own knowledge of real estate Mr. Ms. Anonymous isn't quite as strong as you think it is. First, those with excellent credit could and often would hold onto one house and buy up. Lot's of well off people own more than one home. By making their rate as low as it is, this gives them more and unnatural incentive to do just that.

Second, those that aren't qualified wouldn't but they shouldn't own the home they are in. They will be kept in properties at low rates artificially when most should be renting. That also creates an unnatural disequilibrium.

Anonymous said...

Administratively set interest rate is the most stupid government tool. We all hear about the free market and free pricing and no capital/product barriers and so, but the most important price in economy, interest rate, is simply set by some people in FED/Bank of Canada/ECB/...
They try to "control" the economy, but all they do is to create bubbles.