Guan Jianzhong, Chairman of Dagong Global Credit Rating Co. Ltd
Bloomberg reports that China’s Dagong Global Credit Rating Co. reduced its credit rating for the U.S. to A+ from AA citing a deteriorating intent and ability to repay debt obligations.
Having worked on both sides of the world, I have come to associate such statements with shortsightedness. My past experience as a senior research analyst for a brokerage firm in Asia-Pacific would suggest that we are going to see problems in China by 2012.
In this blog post we take a look at how consumers could cope with the Mortgage Mess. Yes, we need strong banks otherwise the Dagong rating will be fulfilled, but this economy is 70% consumer driven. We therefore need stronger consumers, as strong consumers underpin the health of the banks, and not the other way around. Using China as an example, as China’s income per capita rises its banks and financial services companies become more confident of themselves, therefore the Dagong ratings comment above.
I want to inform our readers that QuantumRisk’s CMBS Property Risk Analytics promotion ended September 10, 2010 per an earlier newsletter. The new pricing, valid until March 2011, is available here.
Home Prices Sag in August 2010
The State of the Housing Market
In my August 2009 blog post Have we hit the Housing Bottom? I had suggested that the house prices will bottom in 1Q 2010. Given the graph, I must say that this was a pretty good estimate of timing.
The second question I had attempted to answer then, was home price recovery sustainable? My answer at that time was that it was more likely not.
The economic analysis presented by HiddenLevers (see picture) suggests that house prices are struggling to maintain an upward momentum.
Why? There are two reasons. First the glut in foreclosed homes (1 in 4 for sale are foreclosed) will keep supply substantially greater than demand. Second, 1 in 6 homes in foreclosure translates into 1 in 6 homeowners who will not be able to participate in homeownership for at least 7 years or a 15% reduction in demand.
The graph shows that house prices are now hovering in the 68% to 71% range of their 2006 peak values. From an economic cycle perspective, the housing industry collapsed before the commercial property industry. Given a 15% reduction in residential ownership capacity, it is very likely that commercial property sector will recover before the residential sector does. That is, the trough in the residential sector will be longer than that of commercials.
What is not reported in the news is the residential vacancy rates. A friend of mine who works for a utility company told me a few weeks ago, this utility is seeing 1 in 7 homes vacant. This is 50% more than reported by US Census Bureau for 2Q. That means rental incomes will not increase in the medium term. It also means that utility revenues will fall by 14%.
Some other bank just increased the difficulty of Chief Executive Officer Brian T. Moynihan 'hand to hand combat' over mortgage disputes.
The Next Big Wave: Legal Risk
Most of us are focused on market, credit & operational risks, but the next big wave will be legal risk.
I recently found out that banks are selling the second mortgage on foreclosed homes to debt collectors. Sure this maybe legally possible but lets weigh the pros & cons. The pros. Maybe banks think they can get back they principal in the second mortgage by selling the second mortgage to a debt collector. Sounds great, high fives to the managers who thought up this one. And at worst you don’t even have to write it off your balance sheet just yet. Kudos.
But wait. Does anyone really think they can get their money back from homeowners who could not even pay their first mortgage? Especially if they are unemployed? It also raises another question, what was the function and scope of collateralization?
Now the cons. What this action has done is to clarify that in the event of a foreclosure / repossession, the bank recognizes that collateralized debt survives ownership and can be put back to owner / originators. (Check with legal counsel for an informed opinion.) In the United States one cannot have one set of laws for one group of people and another set for another group of people.
Therefore, investors who bought RMBS bonds can now recognize that their securitized bonds survive any asset ownership issues, and banks are now liable for securitized bonds because they survive ownership.
I found out about a bank’s access to your personal funds some years ago. When I contacted the FDIC about it they said they could not do anything about it. Some mortgage contracts include a single sheet document that states that the bank has the right to move your funds around to keep your mortgage current. This I believe is antithetical to the securities law because securities law does not allow financial services companies to move funds around for a client for the benefit of the company.
The problem here is given such a ‘contract’ will or does the bank have the right to reach out to your 401(k) or similar funds?
Prime fixed rate foreclosures jump
How Consumers Can Protect Themselves
There are several ways consumers can protect themselves from future messy mortgage problems:
1. House Pricing: The graph above (picture in State of the Housing Market, above) suggests that with today’s market conditions a home buyer should consider as an upper limit a purchase price of about 70% of the 2006 appraisal. If the housing situation deteriorates, this 70% number will drop. Looking at CMBS for guidance, this number can get to be as low as 54%.
2. Appraiser Selection: Before purchasing, get an appraisal of the property by an appraiser who does not have links to banks as this minimizes banker bias.
3. Mortgage Origination: If you are purchasing a foreclosed property, it is not recommended that you get your mortgage from the same bank that foreclosed the property. Why? At least in theory, in the event that there are ownership issues, you have a different bank behind you.
4. Safeguards: Given the state of the housing market, it would be prudent for the home buyer not rush into a purchase as the housing market is not likely to recover anytime soon. If you do so, you would need to have staying power. Therefore, before making a purchase, here are some points you should consider:
4.1 Title Insurance: Don’t sign an S&P if you cannot get title insurance.
4.2 Deposit: Make your deposit conditional upon getting a clean title.
4.3 Indemnification: Require that the seller and/or the mortgage provider accepts liability for any future ownership claims in the event of the failure of the title insurance company. The lesson of 2008 was that many securitized bond credit enhancements (credit insurance) turned out to be worthless when the economy as a whole turned south.
4.4 Survival: Require that in the event of a foreclosure/repossession that all collateralized claims (1st, 2nd & 3rd liens) cannot survive the ownership.
4.5 Delinquency: Require that the mortgage provider cannot start foreclosure proceedings until the mortgage is at least 90 days past due. In the state of Colorado there are no laws to prevent a lender from foreclosing on day 2. Yes, even I was surprised by this, and know of at least one recent case where the foreclosure proceeding was started on day 50.
4.6 Miscellaneous Contracts: Do not allow the mortgage lender have access to your other funds. Remove all such ‘subcontracts’ from your S&P agreement.
5. Walk Away: If there are any doubts about the price, property or claims on the property, walk away. This market in not going to recover any time soon, and there will be plenty of second chances.
There are many really good managers in banks, but as a general rule banks rotate their managers. So the great manager you see today could be replaced by a rogue manager tomorrow. Therefore do not feel ‘uncomfortable’ including these conditions in your S&P. You may even have to hire your own legal counsel to protect yourself. Remember it is wiser to walk away then to be burdened by a debt for a property you no longer own.
Summary
The real sad story is that we will eventually see 1 in 6 families homeless. To put things into perspective, James Fry, founder of Mean Street Ministry, reports that when he started this ministry about 10 years ago, there were 2 suicides per year, today there are 2 a week. We as a family have known James Fry, his family & his ministry for many years. Let us in Thanksgiving help someone in return.
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Disclosure: I’m a capitalist too, and my musings & opinions on this blog are for informational / educational purposes and part of my efforts to learn from the mistakes of other people. Hope you do, too. These musings are not to be taken as financial advise, and are based on data that is assumed to be correct. Therefore, my opinions are subject to change without notice. This blog is not intended to either negate or advocate any persons, entity, product, services or political position. Nor is this blog post to be construed as investment advice.
Contact: Ben Solomon, Managing Principal, QuantumRisk
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