January newsletter

Before we get started, I'd like to have you read this article about how bad our national debt is, and how it has to be a principal issue in our politics.

The big picture -
Or, meltdowns explained

The other day, I was visiting my favorite title ladies, and the question was posed "Is this whole mess really about sub-prime loans?"

The substance of the question was, is it that loans were made to people who aren't creditworthy, and those people are all defaulting?


The answer is yes and no. Yes, the tipping point was the sub-prime loans. No, it's not that the sub-prime borrowers are defaulting, causing everyone headaches. Not that you'd have any other impression if you took your news from CNN or the papers.

I'm going to give you the down and dirty, and link you to all of the resources that give the information in more full detail. These articles I'm linking you out to are very detailed, and provide excellent information, and I really recommend that you read them if you'd like a greater sense of what's going on. My explanation is likely to be slightly off in some detail, how specific instruments work, but this is a big picture explanation. I'm a generalist, so don't expect the precision that people more expert than I would give you. However, this is probably the only place you can get the big picture explained in a way that a non-expert cannot do.

If you want to know who brought about this mess, point your finger of blame at:

* The Federal Reserve Board of Governors
* The Federal Reserve Board of Governors
* Policy makers at big banks
* The Banking Commissioner
* The Banking Commissioner
* People's beliefs that what's going up will continue to go up

Bubble, Bubble, Toil and Trouble -


Bubbles are not new as economic phenomenon. In fact, the components of bubble making are so well known that they could easily be predicted in advance, thus warning off the smart ones (the Warren Buffets, for instance) and allowing one to watch the glazed eyed lemmings march lockstep over the cliff who can't distinguish the clear signs.

The most recent bubble? Tech stocks during the 1990s. The earliest? Tulip bulbs in the 16th century. The next one? Probably "green" energy.

The components are: relaxed or non-existent government regulation, cheap financing, and media noise promoting the subject as "the next thing."

In our housing bubble, we had -

* A reduction of interest rates to incent the economy during the tech stock bubble

* A relaxation of banking regulations that allowed banks to contribute more of their capital to non-bank operations, and to lend in riskier markets

* A further, sharp reduction of interest rates to boost the economy during 2001 and the post 9/11 economy

* Existing housing price pressure in many markets

* The ability of speculators to borrow all or substantially all of the money necessary to participate in a real estate market returning more than 10% per year at interest rates below 6%

* Further relaxation of banking and lending restrictions, and the blocking of state based lending restrictions by the Banking Commissioner

* "pop!"

The money generated to lend was created by new financial instruments, asset backed securities. Some six years ago, I was telling people who'd listen that the big banks would realize that they were leaving money on the table by allowing Fannie Mae to package up residential mortgage loans, and issue the securities backing them up.

And, it seems, they (the big banks) were ahead of me.

These securities didn't have any rating history, and the issuers used "monocline rating agencies" to "borrow" a credit risk grade. Basically, the paid to have a rating agency bless their financial instruments, and then sold them as investment grade instruments.

The ratings agencies, however, oversubscribed themselves. This meant that the ratings agencies committed their credit worthiness to far more debt instruments than their capital would support. When the default rate began to press on the ratings agencies' capital structure, their credit ratings nearly immediately dropped into the basement.

And, what that means is that all of the fund managers who subscribed to these securities have to review their rules for whether and how much junk rated assets they can hold, and dozens if not hundreds of pension funds, are now selling these asset backed securities as quickly as possible - into a market that doesn't want them anymore.

The banks that originated these debt instruments have different contractual agreements with the purchasers than does Fannie Mae on their debt instruments. If Fannie Mae packages up a few hundred million into an asset backed security, they retain ownership of the mortgage notes - the bond holders only have the mortgage pool as SECURITY for repayment. If a loan in the pool goes bad, Fannie Mae is still the owner of that loan, and they can enforce their rights under that contract.

These lenders who sold asset backed securities actually transferred ownership of the notes (as I understand it; I'm willing to be wrong about the form here) to the investors. So you may have $100 Million of mortgage notes purchased by a number of investors. Which investor owns which specific note? No one knows. When a given number of loans in the pool goes bad (more than 90 days delinquent) the ENTIRE PACKAGE can be forced back on the issuer.

This has been happening to a number of the very large lending institutions in these United States - they've had hundreds of millions, if not billions of dollars of loans that they've been required to repurchase.

Between the credit rating on the packages they hold a portion of being written down to junk status, and being forced to buy back packages that are characterized as "non-performing," AND that some of the loans are indeed defaulting (and that number is rising) - the banks are taking huge write downs against profits. Write downs that are, in fact, so large, that they are causing some of the major banks to have negative equity and difficulty lending new money.

The real estate side of things -


Hyperinflation is the result when you have speculators trying to jump in on appreciating values - usually speculators with knowledge gleaned only from the media's hype on the market. Speculators coming in on the front of the value curve are able to quickly flip out of the upward-bound market and their extraordinary profits give others strong incentive to "get in."

For six or more years, we were able to avoid ARM rate re-sets, avoid that the borrowers' debt picture got worse, and avoid that they couldn't pay their taxes by refinancing every two years. In Houston, we have not been able to do that for a number of years, because our property appreciation has only kept pace with inflation - a realistic and sustainable growth. However, in hyper-inflating markets, these transactions kept investors from having to make real payments and credit challenged borrowers from having to face the music of their financial picture by allowing people to LIVE on equity appreciation.

Just yesterday, I was talking with a client about her brother - who bought twenty-two properties in Florida - flipped several making better than $20,000 per unit - and is now stuck with eleven units that he's not done rehabilitating - and now owes/has invested more than the properties are worth.

My client is buying multi-unit properties in Houston, and calculates her price based on future rent value less rehab costs = purchase value. In other words, she's looking for properties to cash flow, not appreciate. Her brother says she's nuts.
What do you think?

Crystallizing the ball -

Here in Houston, there are very few pockets where we've had unreasonable appreciation:

* High rise condos, mostly marketed to out of state investors (running, lemming-like to the sea)

* Newly built neighborhoods that are not substantially complete

* Midtown townhouses

These markets have ALREADY corrected or started to correct. Rents in Houston are pushing up quickly, and that will provide upward pressure on housing prices. The economy in Houston is poised to continue to grow strongly, and adding jobs will add more upward housing pressure.

Right now, we're experiencing a slowdown because people THINK that there is a slowdown and that prices should be falling. They heard it on CNN!

Going forward, there will be TREMENDOUS pick up opportunities in Florida, parts of California, and Michigan - but wait until near the end of the year. Use good math skills to forecast ROI based on local rent values. Don't accept anything you've heard from the corporate media as being true without researching it fully.

In the stock market, all our media focuses on is who's losing money. We also have to remember what my dad always said "Buy low, sell high." These mortgage backed securities are now trading around junk value - that is a TREMENDOUS opportunity for people who have the financial strength and fortitude to buy in when the price is right. There are dozens of blue chip companies that have depressed stock prices right now, but DO YOUR RESEARCH. Don't just take someone's word for it, especially if they're in it for a commission.

The Finale -

Okay, I've loaded you down with a bunch of information, but it's information that people need to be aware of. It's not the mortgage brokers who caused this - it's those with far better information, and far more at stake than the mortgage brokers.

Mortgage brokers only sold what products were offered for them to sell - some of them did engage in fraud, or failed to catch on to what was happening. As with any large, engineered marketplace, the rules were not made by the little guys. They were made by the big guys who profited on these transactions in huge ways, and are now better able to weather the downturn than are the mortgage brokers, most of whom have left the business.

Whenever you're looking to figure out why something's happening, always FIRST look for who benefits. In this instance, the big bankers, their institutional stockholders, the ratings agencies, and the investment banks made hundreds upon hundreds of millions selling these financial products and lending out the money. The mortgage brokers and realtors made, each of them, thousands and thousands. Who was in control here? And who is better positioned to shift the focus of blame to people who are unable to resist accepting the blame?

The blame focused on realtors and mortgage brokers is transactional in nature - individual cases of fraud and mis-dealing. The focus on the bigger fish is systemic - manipulating markets, stock prices, credit ratings, public reports, and program.

Meaning, the big banks and the Fed played the fiddle, we all just got up and danced the tune.