Finding the Bottom in Housing

This post first appeared on Minyanville.

The Holy Grail de jour of financial market prognostication is predicting the bottom in housing. It's a fool's errand, however. Investing based on a perceived end to declining property values has so far been a losing proposition.

Unlike equities and futures, the housing market has no central clearing house: The Plunge Protection Team's reach doesn't extend to real estate. Try as they may, Beltway bureaucrats can't create a false bottom in home values.

Nevertheless, economists at UCLA are out with a report that uses a single data point as evidence that California's housing market may be recovering. They call a recent upswing in sales in Riverside County (east of Los Angeles) a "very dim flicker of the light at the end of the tunnel."

That a few bargain hunters are testing the waters isn't a sign of stabilization. Witness Billionaire investor Joe Lewis' failed attempt to call a bottom in Bear Stearns. Values can't fall forever, but to say the market will recover "eventually" isn't terribly helpful.

To hazard an educated guess about when home prices will stop falling, it's necessary to understand the mechanics of a real estate transaction and what still needs to happen for property values to put in a meaningful bottom.

Homebuilders like KB Home (KBH) and Toll Brothers (TOL) continue to clamor for handouts from Washington to stem the decline. Rational market players, on the other hand, recognize that until prices return to more traditional levels of affordability, said bottom will continue to be elusive.

Contrary to what's reported in the mainstream press, the fundamental factor putting pressure on home prices isn't the rising tide of foreclosures. The National Association of Realtors and politicians who pander would like us to believe that banks, saddled with impaired assets, are unloading properties at below market value and exacerbating the downward spiral.

Bureaucrats aren't necessarily wrong in trying to prevent repossessions (the impact of a family being forcibly removed from its home is on many levels costly), but targeting foreclosures is characteristic of government policies that address the symptom rather than the cause.

Minyanville's Mr. Practical has long argued the most visible manifestation of the current financial malaise -- illiquidity -- is just a symptom of the true problem: bad debt. Likewise, foreclosures are the most visible part of a phenomenon that's preventing meaningful price discovery in the residential real estate market.

Goldman Sachs estimates that 30% of U.S. homeowners will be upside-down on their mortgages by the end of the year. Also known as being "underwater," being upside-down puts a borrower in the unenviable position of owing more on his home than the home is worth.

For the market to find a sustainable bottom, sellers need to reduce their asking prices to levels average homebuyers can afford. For upside-down homeowners, this isn't an option.

To repay the bank in full, an underwater borrower must put up the difference between the sale price and the outstanding balance on his mortgage. Refinancing would require the same out-of-pocket cash - something most troubled homeowners don't have. Many are choosing to simply walk away, a trend Professor Shedlock has covered in detail.

As a result, properties sit on the market for months, the seller unwilling to budge for the simple reason that he can't. This adds to the latent supply on the market and further depresses prices.

The latest in a wave of housing bailouts now making its way through Congress attempts to address this issue. Meanwhile, the free market, as it's apt to do, is solving the problem itself. Market-based solutions will get the job done regardless of the bickering and posturing that goes on in Washington. Those eager to call a bottom and snap up distressed assets would be wise to exercise patience; these workouts take time.

Mortgage market participants are solving the problem of upsided-own borrowers in two primary ways. First, opportunistic investors are buying delinquent mortgages at a discount to par and forgiving part of the borrower's loan balance. They then write a fresh loan for less than the new, lower property value.

If that didn't make any sense, don't worry. If it were easy, everyone would be doing it. Here's an example of how it works.

Let's assume in 2005 Snapper the Turtle bought a brand new McMansion from Cassidy's Craftsman Cottages for $500,000. He made a $50,000 down payment and took out a $450,000 adjustable rate mortgage (ARM) from the Bank of Boo. Unfortunately for Snapper, his lovely 5,000 square foot model home on a 5,500 square foot lot is now worth just $400,000. Snapper's ARM just reset and he's fallen behind on his mortgage payments.

The Bank of Boo's balance sheet is loaded with delinquent mortgages just like Snapper's and management is actively jettisoning non-performing loans. The bank auctions the loan to investors, who bid based on the property's resale value and Snapper's credit profile. Their goal is to buy the mortgage on the cheap and restructure it, turning a profit.

Hoofy's Hedge Fund, a specialist in distressed debt, snaps up the loan for a mere $0.60 on the dollar, or $270,000. Now the owner of Snapper's loan, Hoofy forgives part of Snapper's debt and writes a new mortgage for 80% of the value of the house, or $320,000. Hoofy covers the amount he paid Boo for the mortgage and pockets the difference: $50,000.

So, Hoofy turns a profit, Boo gets a problem loan off its books and Snapper gets a second chance. Since the transaction was completed prior to foreclosure, Snapper's credit is even salvaged.

Hedge funds and other vulture investors have raised vast pools of money to invest in distressed mortgage assets, some trying to execute this strategy with hundreds of millions of dollars. But Ph.D.'s in Greenwich, Connecticut dreaming up complicated structured finance models don't know the first thing about loan workouts. So, hoping they can make up for sloppy implementation with scale, they outsource the logistics, use valuation models to approximate home prices and lower profit expectations. The logic sounds eerily familiar to what got us into this mess in the first place.

As they're extraordinarily labor intensive, loan workouts, like the one described above, work best on a small scale. Successful firms take it one loan and borrower at a time and are conservative in their property valuations. The home's value represents not only the maximum amount for the new loan, but an investor's downside risk should the deal go sideways.

The second method for handling upside down mortgages is old fashioned litigation. Lawyers reach out to troubled borrowers and offer to negotiate with lenders or mortgage servicers on their behalf - for a hefty fee. However, this segment of the market is wrought with fraud, as slick attorneys and shady mortgage brokers can easily prey on desperate homeowners at risk of losing their homes.

Respectable firms, on the other hand, are doing a brisk business. The most successful are targeting lenders who wrote so-called "liar loans," where borrowers weren't required to provide verification of income or assets. The lender (or servicer) then has two choices: Forgive enough principal to bring the loan balance below the new property value, or take a trip to the local courthouse.

The threat of lawsuit hinges on the borrower and attorney proving the bank unfairly coerced the homeowner into taking out a mortgage they could never reasonably afford. The borrower effectively pleads ignorance. With the complexity of exotic loan products cooked up during the boom by the likes of Countrywide (CFC), Bear Stearns and Washington Mutual (WM), it's not a hard case to make. Fearful of the lousy headlines, many banks are more than willing to settle and give the borrower a second chance.

Simple loan modifications like the ones proposed by Hope Now and Project Lifeline don't address the root of the problem. They delay the inevitable, as borrowers are stuck making loan payments despite being upside-down. Houses just sit on the market, which prevents healthy price discovery from clearing out the glut of supply.

Until this inventory is worked through the system, home prices will continue to fall. Rather than watching publicly released housing data for signs of a bottom, watch the spread: When the difference between asking and selling prices returns to rational levels, we've found the bottom.

Until then, let the prognosticators prognosticate, forecasters forecast and economists make educated guesses about bottoms they can't predict. Savvy investors will take advantage of truly undervalued assets. It's just a question of who can be patient enough to wait this out.