Presented By:

Gary Watts

Real Estate Economist

(July 1, 2008)

 

 

I.                   Last Years Forecast . . .

. . . ended my 33 year run at forecasting the direction of real estate. I apologize for not seeing what Wall Street was doing to the financial structure of our economy and its future effect on real estate.

 

A Historical Overview:

 

The '70s:  

The price of oil doubled, mortgage rates rose from 7.5% to 10%, while unemployment rose to 9%. A single-family home in Orange County began the decade at $27,000 and appreciated every year, ending the decade at $93,400 - a yearly appreciation rate of 15.04%!

 

The '80s:

Oil soared to $39 a barrel (equivalent to $99 today), inflation was 11% but rose to a peak of 21%, interest rates rose to 17% and the unemployment rate peaked at 10.8%. The "OC" single-family home rose from $107,100 at the end of 1980 to $248,200 by the end of 1989 - an annual rate of 9.43%!

 

In 1989, I gave my famous speech entitled: "The Party is Over," and forecasted a major decline in real estate prices that would last quite a few years due to oil problems in Texas and aerospace and defense cutbacks in southern California - due to the Berlin Wall being brought down.

 

The '90s:

Congress made major cuts in defense spending, changed the Tax Code which was unfavorable to real estate and placed sever lending requirements on S & L's.

 

From 1990 through 1996, single-family homes declined from $257,300 to $211,100 - a loss of 15.66%!

 

In 1996, I said the worst was over and real estate would once again be moving upward. As the decade came to a close, the median-priced, single-family home rose to $273,500 and the appreciation rate for the entire decade was 0.90% annually. This rate became positive due to the last 3 years having a combined appreciation rate of 28.42%!

 

The New Millennium:

The decade began with single-family homes priced at (end of 2000) at $300,400. Homes doubled in price by the end of 2007 to $600,000 - a yearly gain of 11.80% or 94.4% over the preceding 7 years!

 

For the last 37 years, OC's single family homes have averaged a yearly appreciation rate of 9.39%!

 

 

 

II.    Is it Sub-Prime's Fault?

         The numbers showed that sub-prime loans were not that big of a problem but the media said differently!

 

♦   Sub-Prime Foreclosures Soar!

The truth is that only 18.79%% of all sub-prime loans are delinquent (30 days or more). That means 81% of the borrowers (who could not get a Discover Card) have never missed a payment!

 

♦   Record Foreclosures Hit 5-Year High for Sub-Prime Loans!   

Interesting headline! In 2001, sub-prime loan volume totaled just 7% of loan originations. By 2006, the volume had exceeded 20%! This explosion would naturally cause a new record in the number of sub-prime foreclosures! Presently, only 20% of delinquent loans end up as short-sales, deeds-in-lieu or foreclosures. The remaining 80% of borrowers either work out a repayment plan, a note modification, refinance, sale or reinstatement!

 

♦   Sub-Prime Write-Downs Cause Financial Crisis!

If you combine sub-prime and Alt.A loans (non-prime), they represent only 12% of the entire home loan market. Half of these loans are fixed-rate, thus the 6% of sub-prime loans that are adjustable are responsible for 39% of all foreclosures! Today, only 3.65% of all sub-prime loans go to foreclosure. This may help to explain why David Wyss, chief economist at Standard & Poor's in New York said, on January 4, 2008: "You look at the magnitude of the sub-prime problem, and it's just not that big relative to the size of the economy or the financial market."

 

So What Caused This Financial Crisis?  A Structured Investment Vehicle (SIV)!

 

Wall Street says these multi-layered finance products, created in the early '90s, were developed to meet the needs of a changing investment market and provide a way for risks to be diversified.

 

 

III. The Structured Investment Vehicle (SIV)

 

So when the sub-prime loans began to weaken in large numbers, the banks blamed the sub-prime loans for their massive write-downs. What really happened was the collateralized debt obligations (CDO) were having problems, the collateralized loan obligations (CLO) were not fully performing, and the asset-backed securities (ABS) were having defaults.  The sub-prime loans were only part of the catalyst that got the whole mess rolling!

 

♦   As sub-prime defaults increased (with them being incorporated in these complex and difficult-to-value

     structured finance products), fears from investors rose.

 

♦   Then the 3 main credit rating agencies (Ambac Financial Group, MBIA, Financial Guaranty Insurance)

     were forced to make precipitous downgrades on a large number of these structured finance products - due to

     rising default rates that exceeded earlier assumptions.

 

♦   With these downgrades, added pressure was put on insurance companies that insured various parts of these

     structured investment vehicles, but it quickly became clear that they did not have the reserves to cover all the

     potential losses.  

 

♦   Banks began to lose confidence in the ability of their counterparties to meet their contractual obligations.

 

♦   Investors did not have a clear idea of what portion of the SIV they owned, who they owned it with, what

     portion (if any) was insured, what was their "tranche" position, and were any of the insuring companies

     covering any of the losses. Not knowing, many investors withheld funding from these complex structured

     products, even those with high-quality underlying assets.

 

♦   With no market to sell all or part of these complex products, values quickly plummeted, and thus the

     resulting financial crisis. 

 

Investment Make-Up of Structured Investment Vehicles

 

 

          Participants  (in these SIVs)  and Percentages: (approximate)

 

1.     Banks  (both U.S. and foreign)              59%  

2.     Hedge Funds & Sovereign Trusts           28%     

3. Insurance Companies                              6%     
4. Corporations                                            2%
5. Pension Funds                                          2%
6. Mutual Funds                                           2%
7. Other                                                         1%

 

To make matters worse, SIVs were entities that allowed financial institutions to transfer risk off their balance sheets (OBSEs) and permit exposures to remain mostly undisclosed to regulators and investors. They did this to improve the loan liquidity and generate fee income, while achieving relief from regulatory capital requirements.

 

During the relatively long period of excess liquidity and low interest rates, credit was made available to various types of borrowers (sub-prime, businesses, credit card holders, leasing contracts, commercial loans, manufacturing, auto loans, etc.) who would otherwise have not been able to obtain such credit! To make matters worse, they were using short-term maturities to originate long-term loans.

 

So what effect did this all have on have on housing?

 

IV.  The Current State of OC Housing

 

Current Listing Inventory:  (As of June 13, 2008)

 

♦   14,880  - a current housing supply of 4.86 months

♦    47.9%  - of our entire inventory is priced below $500,000 representing 57.5% of the demand

♦    39.6%  - of our entire inventory (5,898) is distressed properties:

a.       Short-sales make up 79.6% and have a market time of 7.18 months

b.      Bank-owned make up 20.4% and have a market time of 1.43 months

c.       In southern California, 37.4% of all sales (May) were foreclosed properties

♦   77.5%   - of distressed properties are priced below $500,000

♦   93.5%   - of distressed properties are priced below $750,000

♦   33.2%   - of attached homes are vacant

♦   23.9%   - of detached homes are vacant

♦   17.8%   - demand for homes above $750,000

 

a.       Distorts the median sales price - 9 month decline in the jumbo purchases (40% vs.15.8% today)

(1)      Smaller sales reduces the sample size thus reducing the validity of the conclusions

(2)      The dominance of foreclosures and short-sales usually concentrated in a smaller area

(3)      Median sales price is now being dominated by the low-end/smaller property market

(4)      Larger price declines on distressed sales, actually distorts actual metro sales prices.

       

The New "For Sale" Sign!

 

 

V.   The Future of Orange County Housing

 

       Why The End of This Downturn May Be Near:

 

        ♦   Inventory is decreasing while sales are increasing and the April sales finally ended our 7 month

             record of declining sales.  

    

        ♦   The bulk of sub-prime loans were made in 2005/2006, therefore most of these problem loans

             have already entered the marketplace.

                  a.   During those years, OC funded approximately 22,500 sub-prime loans.

                        (California has 489,801 sub-prime loans and 721,741 Alt-A loans) 

                  b.   They were largely concentrated in the areas of Santa Ana, Garden Grove,

                        Anaheim, Tustin, La Habra, Placentia, and Brea.

                  c.   In May, 78.6% of all buyers who closed loans in OC, chose fixed-rate financing.

 

        ♦   We have a rather stable real estate market

                  a.   23% of OC properties have no loan on them

                  b.   60% have long-term fixed-rate financing with plenty of equity

                  c.   10% will be successful in some form of note modification or re-instatement of their loans

                  d.   In Orange County, only 31.5% of properties entering foreclosure actually end in a foreclosure.

                  e.   The current 1^st Qtr. delinquency rate (60 days) on loans in OC, was only 3.14%.

 

        ♦   Foreclosures (unfortunately) should occur for at least another year, so the market will be "soft"

             through 2009 unless . . .  

 

 

 

VI.   The Challenges

 

         The economy is currently facing four distinct headwinds:

 

1.      Wealth Effect - due to declining real estate prices

a.       Federal Reserve reported that real estate "net" equity declined $879.6 billion last year.

b.      Household equity is at 46.2% - a record low, since keeping track after WWII.

c.       Prime ARM's entering foreclosure now exceed the entering sub-prime foreclosures.

2.      Price Effect - due to higher energy and food prices

a.       As inflation begins to rise, consumers and business spending decreases.

3.      Funding Conditions - due to the "credit crunch"

a.       60% of banks have tightened credit standards for residential borrowing.

b.      40% of banks have tightened credit standards for consumer loans.

c.       80% of banks have tightened credit standards for commercial loans.

4.      Income Effect - due to higher unemployment

a.       Current unemployment rate has risen to 5.5%.

b.      Less income, less paid taxes, more pressure on federal, state and personal budgets. 

           Watch out for the "spill-over" effect. If prices were to continue to decline significantly, another tier of

           properties, with exhausted home equity lines or increasing loan balances, could set off another round of

           potential foreclosures. (Note: 75% of option ARM borrowers have been paying the minimum payment)

 

♦   Current delinquency rate (30 days or more) for all U.S. loans is 6.35% - 20 year average is 4.0%.

♦   Nationally, there were 1.5 million properties that entered the foreclosure process last year - in  

     normal markets, the yearly average is 600,000.

♦   Of all 51 million mortgages in the U.S., only 2.47% are in a serious state of foreclosure.

♦   4 States (CA, FL, AZ, NEV) make up 50% of distressed properties

 

VII.  A Final Perspective

 

           The media will still report decreasing sales and more sub-prime mortgage losses, but let's deal with the

            facts:

 

                 ♦   Global income will hit $53 trillion in 2008 and the U.S. share will be $14 trillion!

 

                 ♦   Sub-prime losses will be about $100 billion this year ($300 billion last year) - but the world

                      earns that amount of money every day!

                          

a.       This loss only represents 0.01% of the $100 trillion in combined assets of all U.S.

households, U.S. non-farm, and non-financial corporations.

 

                 ♦   Lenders will recover approximately 70% of their outstanding loan balances through repossessing

                      homes and then reselling them!

 

                 ♦   Investors have "parked" $3.5 trillion dollars in money market funds - it has to eventually

                      move someplace, and hopefully a large chunk goes into real estate lending once again!  

 

                 ♦   Last year, sales of investment property were down only 7% from the peak years (2005/2006),

                      while vacation or 2^nd homes remained the same at 12% of all existing and new-home sales.

 

a.       The weak dollar is making it very attractive for foreigners to acquire U.S. real

estate.

b.      They are betting that our prices are near the bottom and the U.S. dollar will begin

to rise - giving them the "double whammy," when they sell in the future.  

 

                 ♦   Price declines have allowed first-time home buyers back into purchasing real estate!

 

                 ♦   Pent-up demand from buyers who have been "fence-sitting" for the past two years and are

                      now re-entering the housing market should reduce our current housing supply.

 

                 ♦   OC home sales in May were up 8.3% and the U.S. existing home sales (April) were up 6.3%.