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   ARTICLE   |   From Scotsman Guide Residential Edition   |   December 2012

Where Are We Going, Where Have We Been?

With the worst of the bust likely over, many in the industry are feeling optimistic

In the physical sciences, progress is cumulative. In the financial markets, it’s cyclical. Even when real estate prices steadily appreciate for decades in a row, such a trend can’t last forever. The baby boomers learned the same hard lesson that their grandparents did: Real estate is not a surefire bet where the chart goes straight from the bottom left to the top right.

Even so, it seems that the industry is through the worst of the real estate crisis, at least in terms of the nationwide whole. Certain real estate pricing indices — such as those from Radar Logic Inc. and Standard & Poor’s Case-Shiller — finally are showing year-over-year price appreciation. Looking ahead, there will remain pockets of continued weakness, although some of the areas hit the hardest, like Phoenix, are beginning to show signs of a rebound as well, albeit from highly depressed levels.

Before taking a more complete look at what the future may hold for the housing and mortgage industries, let’s take a look back at the past few years and take stock of where we are today.

The past

The bursting of the real estate bubble will go down as a landmark event in our nation’s economic history. As a result of the bust, the U.S. experienced a meltdown of the financial sector, widespread unemployment and a collapse in consumer spending. To put the bubble in perspective, the pre-bust appreciation rate was double the rate experienced in the 1920s real estate boom.

It’s important to keep in mind, however, that the structure of the mortgage market is different today than it was in the ’20s and ’30s. Back then, 30-year fixed-rate mortgages were virtually unheard of; mortgages were generally five-year interest-only loans for which the borrower owed the entire balance as a balloon payment at maturity. This meant that the entire mortgage market had to be rolled over within the first five years of the bust, and unsurprisingly, prices collapsed as homeowners dumped properties that they couldn’t refinance. Luckily, that’s not the case today, and that’s one reason why many mortgage industry professionals don’t foresee another downturn in the market similar to what was experienced in the early ’30s.

The reason why the bubble happened in the first place is subject to debate, with some blaming deregulation and a lack of ethics on Wall Street, while others point to government affordable housing initiatives and the actions of the government-sponsored enterprises (GSEs). In some ways, every viewpoint is correct, but the Federal Reserve also should shoulder some of the blame for trying to use monetary policy to inflate asset prices, which in essence created a real estate bubble to replace the wealth that was lost when the stock market bubble burst.

"From 1998 to 2007, household formation was roughly 1.5 million per year. In 2010, that number dropped to 357,000."

Arguably, the Fed has not learned its lesson in this regard; Federal Reserve chairman Ben Bernanke seems to be attempting to put the wealth-effect genie back in the bottle with the latest round of quantitative easing (QE3). Looking ahead, bond investors may want to take note of this — and beware.

The present

An increasing number of mortgage industry insiders believe that the worst is over for real estate price declines. That said, the judicial states in the Northeast — New Jersey, New York and Connecticut, among others — remain vulnerable as the foreclosure pipeline remains at elevated levels. On a national basis, real estate is as inexpensive as we’ve seen in generations. Median mortgage payments are less than median rent payments in many areas of the country, and the ratio of median home price to median income has dropped beneath its historical range in certain metropolitan areas. Combined with the lowest mortgage rates in several decades, homeownership arguably has never been more affordable.

A recent economic forecast from the Fed predicts that unemployment will remain higher than 7 percent through 2014. In response, the reserve instituted QE3, committing to buy about $40 billion worth of mortgage-backed securities (MBS) per month. This move by the Fed is driving up MBS prices and helping to move rates even lower. Recent changes in the guaranteed fees for conforming mortgages, however, already may be offsetting the intended effect on borrowing rates.

Will the Fed’s actions spur more buying? Perhaps, but to a large extent, the problem with the real estate market is not that rates are too high. Rather, the problem is that many first-time homebuyers remain in a position where they’re unable to purchase homes. This is attributable to several factors — from high unemployment among recent college graduates to the difficulty of saving for downpayments — although the segment of the market that focuses on Federal Housing Administration (FHA) loans is experiencing something of a resurgence.

Because of first-time homebuyers’ continued struggles, the move-up buyer also is stuck, with household- formation numbers bearing this out. From 1998 to 2007, household formation was roughly 1.5 million per year. In 2010, that number dropped to 357,000. Although a drop in immigration may account for some of that decline, the main driver has been boomerang college graduates and young adults rooming together.

Tight credit continues to be one of the most significant problems in the mortgage market today. With the private label securitization market more or less closed to all but the highest-quality jumbo loans, conforming loans comprise a majority of originations. Stated-income loans for the self- employed remain difficult to get, at least for consumers who can’t provide downpayments of 40 percent or more.

In addition, regulation continues to be a problem, as the government still has yet to provide a definition of a qualified mortgage. Without guidance, issuers will assume the worst and build in overlays on the already tight requirements that the GSEs require. Regulatory fear also has forced appraisers to become overly conservative, which is inhibiting some deals. Finally, the Securities and Exchange Commission has been reviewing the tax treatment of mortgage real estate investment trusts, which may mean that another source of capital for the mortgage market is at risk.

Meanwhile, a bright spot in all of this has been the rental boom, as professional investors snap up foreclosed properties and become landlords. Private equity has raised billions of dollars in capital for this activity. The government continues to see demand for its real estate owned property (REO) to rental program, which sells foreclosed properties to large private-equity companies that agree not to sell the properties for a given period of time. Some transactions have occurred at 95 percent of the broker’s price opinion, a price that was unheard of just a few years ago.

The future

There are numerous reasons why mortgage professionals should feel optimistic about the future of the housing market and mortgage industry. For one, affordability perhaps is the best that it’s been in generations, and in addition, there seems to be a tremendous amount of pent-up demand. Although many industry professionals have focused on the shadow inventory and the foreclosure pipeline, these factors may be offset by the decline in homebuilding, as housing starts have remained between 600,000 units per year and 750,000 units per year in 2011 and 2012.

That said, household formations are artificially depressed because of the economy, not permanently lower because of demographics. Household formation is being deferred until the future, and when it eventually corrects, housing starts may spike above the rate of 1.2 million units per year that many economists prefer. This will be a huge boost for the economy, which will create demand for housing as the cycle moves from vicious to virtuous. The stock market has picked up on this already; some homebuilder exchange-traded funds are up as much as 83 percent over 2011.

Although there’s still a backlog of existing homes for sale, the number of underwater homeowners has dropped recently. For instance, in the first half of 2012, the number of underwater homeowners declined from 11.4 million in first-quarter ’12 to 10.8 million in second-quarter ’12, according to CoreLogic. Of the remaining underwater homeowners, the psychological desire to avoid losses will keep some supply off the market. CoreLogic estimates, for instance, that the country’s shadow inventory has dropped about 10 percent from where it was in 2011.

For the past few years, the origination market has been dominated by refinances, although this trend is on borrowed time. Interest rates are being held down not only by the Fed, but also by the flight to quality trade coming from Europe. Although rates likely will remain stable for the next couple of years, they’ll probably begin to creep higher soon after.

For the near future, expect the origination market to continue focusing on conforming paper and high-quality jumbos. Mortgage bankers are beginning to offer products that are farther up the risk curve, beginning with stated-income loans for self-employed borrowers. Loan- to-value ratios are still strict, with maximums around 65 percent. Basel III requirements for mortgage-servicing rights may mean opportunities for smaller players to take market share from the big banks. Because so much capacity has been taken out of the origination business over the past six years, there are large swaths of mortgage demand that remain unmet.

Finally, mortgage professionals should note that the recent bounce in prices may be more than just the usual seasonal uptick; prices likely will remain stable or even slowly grow in the near-to-medium term. Regarding weaknesses, the biggest flaws in the housing market will continue to be at the very high end, particularly in parts of the country that are largely dependent on the financial industry, such as Westchester County, N.Y., and Fairfield County, Conn. Areas such as these will need to see Wall Street compensation back at pre-bust levels, which isn’t happening as big banks continue to reduce staffing and compensation packages.

Overall, however, the future seems brighter for the housing market in general and the mortgage industry in particular. Mortgage brokers and originators certainly should celebrate this news, as weathering the recent economic storm has been no easy feat.


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