March 5, 2007

Real Estate House of Cards Teetering

We all know the stories: Super hot real estate over the last five years has attracted inexperienced investors, some rehabbing and selling, some buying vacation homes, some buying to rent and resell. As the market peaked over the summer 2006, these investors are starting to exit the market; those who bought late are facing losses, particularly for rehabbers.

You don't need to be an analyst to recognize the next story. It goes like this, "I couldn't even afford to buy the house I'm living in." Raise your hand if you've heard that one in recent years. Ah, but the mortgage companies came to the rescue with innovative loan instruments, the most well known being interest-only ARMs. They are only affordable if the value of the home increases to enable a future refinancing. Those who bought recently are just plain out of luck. These are "subprime" mortgages, and in today's world of high finance, in which anything can be bundled and sold as a "bond," we now have mortgage-backed securities.

Add these stories together and you have a lot of people trying to sell real estate at the same time. Enter the principle of "supply and demand," in this case a double-wammie of massive supply of houses for sale combined with little demand to buy those houses. I anticipate housing prices to continue to decline further in 2007.

But guess what? Many large banks, 401k investors, and pension funds have invested in these "mortgage-backed securities," which increasingly are sold with very little documentation of their risk. So, in addition to teetering real estate market, many of our financial institutions are sitting on top of these houses of cards.

While much of today's financial news is focused on stock markets, the jitters are triggered by the stories outlined above. Here's what's being reported by an AP business writer:

HSBC Holdings PLC, Europe's largest bank, said it suffered $10.6 billion in losses in 2006 on bad loans from its U.S. subprime mortgage operations.

Companies involved with subprime mortgages, already dragged down by concerns that too many people are defaulting, were kicked down further when New Century Financial Corp., the second-largest subprime lender, said late Friday that a federal prosecutor and the New York Stock Exchange are conducting investigations into its stock movements. New Century fell $10.09, or 69 percent, to $4.56.

Also spooking investors was Fremont General Corp.'s announcement Monday that it is planning to sell its subprime residential real-estate lending business. Fremont fell $2.82, or 32.4 percent, to $5.89.

The burgeoning subprime worries also hurt banks and homebuilders Monday: National City Corp. and Washington Mutual Inc. fell more than 3 percent, while Toll Brothers Inc., D.R. Horton Inc., and Centex Corp. all lost more than 4 percent.

Ouch! I'm betting there is more bad news to come. My prediction is that there will be a nasty crash and the government will "solve the problem" by bailing out compainies that are too big to let them fail. The bail out will fall on the shoulders of the tax payers, and a small number of the inside crowd will walk off with millions as they have in the past (read "Savings and Loan Scandal." There were two scandals: The common one in which S & L scammers gammed the system, and the one in which Congress hid their complicity and put the burden of the bail out on the tax payer.)

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