Foreclosure Beach

The NY Post reports record foreclosures on high-rollers', high-end Hampton's properties:

Homeowners in the some of the toniest ZIP codes in the Hamptons are facing a frightening reality - they can't afford to foot the bill for their high-priced homes, The Post has learned. In the first three months of this year, banks have launched preliminary foreclosure actions - known as lis pendens proceedings - against a record 120 borrowers in East Hampton and Southampton towns.  Twenty percent of those borrowers live in homes that are worth more than $1 million, according to figures from the Suffolk County clerk.

My first reaction was too bad: We're talking about defaults and foreclosures on multi-million dollar loans.

But then I started thinking, why? It's clear as a bell that the tremendous run-up in housing prices in places like the Hamptons, Miami, Naples, Florida, or other similar high-end vacation spots had little to do with demand. We're talking speculation pure and simple.  My research on real estate prices shows that local wages make up about a fifth of local income in Naples, compared to around 90 percent in Silicon Valley.  What drove prices in these markets was "outsiders," certainly - outsiders trying to make real killings on flips and speculation. With these speculative gains wiped out and virtually no mortgage market for high-end loans to speak of,  real estate values in these places have a long, long way to fall.

But looking at local real estate listings many, indeed  most, of these properties including ones in lis pendens are listed at prices above what's owed on their hefty mortgages - that, is way above their current market value. Huh? The reason is simple, actually.  Facing foreclosure, those holding such huge mortgages have every incentive to hold out for their price rather than  cut it and then have to bring a big check to closing.

Of course markets work, eventually. Prices will start to come into line over the next year or two once large numbers of these speculative homes go back to the banks.  My best guess is that they are not even half-way to the bottom yet in these markets, and may well end up somewhere around 2001 price levels before the dust setlles.

Comments

[Jim Bacon]

I totally agree. Speculation was out of control. Here's another example -- http://tinyurl.com/4tfe73 -- a software programmer in Santa Cruz, Calif., who will sell his Santa Cruz home and declare bankruptcy before banks start foreclosing on his 10 properties. He saw himself as an "investor." But "speculator" would be more accurate.

Quotes Reuters: "Where I went wrong is I invested heavily in an area that wasn't my passion and I had a really demanding full-time job so I couldn't pay attention to nuances, the little indicators telling you the housing market was going soft. I was in over my head."

Multiply Mr. Forgaard by 10,000, or maybe 100,000, and you get an idea of what was happening during the real estate boom. Lots of Americans of modest means leveraging themselves to the hilt in the hope of striking it rich.

In this vein, I've just finished reading "Who's Your City" and was struck by your comments about housing prices in the superstar cities. As you noted, "housing has become disconnected from local wealth-building, local productivity, and local economic development." The opportunity to create wealth in the superstar cities is so great that people are willing to pay unprecedented prices to get a place at the table.

That's an interesting hypothesis, and I suspect there's a lot of truth to it. But there's more to the equation than demand. Super-heated real estate markets also tend to be located in metro regions with restrictive zoning that limits builders' access to farmland or inhibits the recycling of aging subdivisions and shopping centers at higher densities.

Combine a booming, creative-driven economy with restrictive zoning and speculators like Forgaard or the house owners in the Hamptons, and you have the recipe for a real estate bubble.

If you are right (in your post) and prices have a lot farther to fall, how does that affect your appraisal of real estate markets in superstar cities?

[hayden fisher]

... a little too broadly stated and over-generalized, I've always respected your writings most Richard because they're so well-cited but this is pure supposition with limited supporting data (the 2001 comment in particular)

[Whitney Gunderson]

Prices in SuperStar cities will not fall; they will increase at or above a normal rate of return compared to the rest of the market. San Francisco from 1950-2000, the most notorious SuperStar city of all, had housing values that increased 3.5% annually, 2% above the national average.... for 50 years. This was due to a variety of factors; limited land availability, high housing demand that remained consistant, extraordinary wage growth, unprecedented economic development, etc. Housing prices in SuperStar cities were not based on speculation, they were based on the value derived from living in a SuperStar city.

There maybe more houses for sale than usual in SuperStar cities today, but as RF pointed out, asking prices in the SuperStars have not "popped" like the housing bubble - which is two-fold. The first fold, or "pop" of the housing bubble, is the simple fact that it is no longer possible to realize large speculative gains in real estate markets. Pre-"pop," investors figured out a way to leverage the mortgage market based on the intrinsic value of a house. A house will always be worth something, but the actual monetary value a home was worth pre-"pop" was fluid - and unsecured. Mortgages were taken out based on the potential for speculative gain. In many cases, gains were realized. But after a while, prices became so high and speculative that the market had to correct itself. Traditionally, mortgages were tied to the actual value of a house and the community a house was located in. I posted the "roots" of the word "mortgage" on this blog a few weeks ago: The word mortgage comes from the French root "mort," which means "dead" and the Germanic root "gage," which means "pledge." For the housing bubble, mortgages were not personal pledges for people to own houses and become dedicated members of the community they were living in, mortgages became tools for speculative gain.

The second fold, or "pop" of the housing bubble is the fact that new housing starts are the lowest they have been since 1991. The reasons for this are more varied - perhaps based on high fuel prices and low consumer confidence.

I have to disagree with Hayden Fisher on this one - I think RF is right when he says that prices have farther to fall - this is an opinion and is hard to cite. Personally, I hope that this particular market correction is a BIG one, so that bankers, investors, home builders, etc., get the speculative virus out of their system for at least another 30 or 40 or 100 years.

[Michael Wells]

I think Whitney's right. The superstar cities are dealing with long term trends and aren't going to crash. Some houses stay on the market longer, but a neighbor of mine just sold in less than two weeks, I'd guess at close to his asking price.

The misery index map a few posts ago is too small to make it out, but it looks like San Francisco may be a little island of green among California's Orange. Boston may be green too, again too small to be sure. Certainly Seattle and Portland are OK.

Speculation is based on buy low/sell high. The Superstar cities didn't have cheap or undervalued housing, so mostly didn't attract the speculators who went into Vegas and Miami.

But notice Richard's benchmark for the falling markets, 2001 price levels. This is a significant drop, and painful for someone who bought after 2005 with a big mortgage, but not apocalypse. For those who have lived in the same house over 10 years and didn't refinance for cash, a non-event.

[Whitney Gunderson]

Here's an interesting article from Des Moines - far from a SuperStar city - but still a place with a high quality of life that Florida defines as creative.

Quote: "This may be the first sign that Regency's commercial holdings [an Iowa real estate company] are being used to help prop up the residential housing operation, which terminated construction at the end of April as a result of financial problems."

Huh. Even in places like Iowa, the housing bubble and subsequent correction may have a long way to go.

http://www.desmoinesregister.com/apps/pbcs.dll/article?AID=/20080514/BUSINESS/805140372

[Whitney Gunderson]

I read the story “California man losing nine homes in mortgage mess,” posted by Jim Bacon, with interest. I can’t help but think that this will end up being a sweet deal for the bank or banks that end up foreclosing on these homes. Over four years, Shawn Forgaard bought 10 homes in places like Las Vegas, Phoenix and Palm Springs, California with negative amortization loans. Forgaard used one home for a family residence and viewed the other nine homes as investment property. To invest, according to Forgaard, he put 10% to 40% down on “neg-am” loans, in which monthly payments do not cover interest so that the loan balance actually gets bigger over time. Forgaard hoped, or speculated, that the combined value of each house would increase faster than the rate of interest and the total loan balance. Amazingly, neg-am loans include balance set points, which cause required payments to increase if the debt climbs to a certain percentage of the original balance.

Let’s presume that one bank will foreclose on all 10 houses, and that Forgaard bought all 10 houses in January 2004. Let’s presume that each house cost exactly $500,000 and that Forgaard made a 25% down payment of $1,250,000 on the total purchase price of $5,000,000. Let’s presume that the combined rate of interest equaled 5%, that the required annual payment was 2.5% of the interest amount, and that the other 2.5% of the interest amount was added to the loan balance annually.

2004
Loan balance - $3,750,000
Payment - $93,750
Interest added to balance - $93,750

2005
Loan balance - $3,843,750
Payment - $96,093.75
Interest added to balance - $96,093.75

2006
Loan balance - $3,939,843.75
Payment - $98,496.09
Interest added to balance - $98,496.09

2007
Loan balance - $4,038,339.84
Payment - $100,958.50
Interest added to balance - $100,958.50

At the end of 2007, the total loan balance would have ballooned $398,298.34 from $3,750,000 to $4,139,298.34. Forgaard would have made $1,639,298.34 in payments to the bank (annual payments, plus down payment). Let’s presume that the value of the homes Forgaard purchased dropped 25% from $5,000,000 to $3,750,000; generous in this case, Forgaard claims values went down 40%.

2004 home value - $5,000,000
2004 loan balance - $3,750,000
25% equity

2008 home value - $3,750,000
2008 loan balance - $4,139,298.34
11% “up-side-down”

Home value loss – $1,250,000
2008 home value-loan balance difference - $389,298.34
Total bank payments - $1,639,298.34

At this point, Forgaard has made over $1,639,298.34 in payments to the bank, but is up-side-down on his loan by $389,298.34 and has lost $1,250,000 in home value. Let’s assume Forgaard ran out of money, or just hired a good California bankruptcy lawyer, and could not make the required 2008 interest payment of $103,482.46. For simplicity, I am not including the balance set point payment increase that has put neg-am loans on the funny pages.

2008
Loan balance - $4,139,298.34
Missed payment - $103,482.46
Interest added to balance - $103,482.46

In January 2009, the total loan balance will be $4,346,263.26. The bank forces Forgaard into bankruptcy and forecloses on 10 homes. The bank now owns $3,750,000 worth of real estate, and gets to keep the $1,639,298.34 in payments Forgaard has made.

2009
Loan balance - $4,346,263.26
Real estate value - $3,750,000
Loan payments - $1,639,298.34
Real estate value and loan payment total - $5,389,298.34

Now, the bank puts the 10 homes back on the real estate market at $450,000 a piece. They do not sell right away throughout 2009, but end up selling for asking price throughout 2010. The bank took the risk of waiting for a good price and it paid off. Something similar to this is happening today – there are more homes on the market, but individual asking prices remain high.

2010
Real estate sale price - $4,500,000
2009 loan payment total - $1,639,298.34
2010 sale price-loan payment total - $6,139,298.34

In 2004, the bank loaned $3,750,000. In 2010, that loan, or investment, managed to grow to $6,139,298.34, a 10.6% annual return. Plus, the bank gets a tax write-off on the loss they were encumbered with when Forgaard did not make his 2008 interest payment. Forgaard will get some money from the sale of the 10 homes, but how the 2010 sale price is split between the bank and Forgaard is up to the bankruptcy judge. The bank makes out like a bandit, but Forgaard signed himself up for highway robbery.

[hayden fisher]

Good stuff. My specific disagreement with Richard is the contention that we're halfway to the bottom, we could be, but that's a very cynical speculation without support. I'm usually never one to put to much credence in the conjecture of "experts" and pundits, but most of them do seem to think that we've hit the bottom or are close to doing so.

Long-term, no question that the super-star cities will maintain property values because of simple supply and demand: more high-earners want to live in them and supply is relatively static, particularly since new construction is screeching to a halt. But the opposite will occur in places that the creative economy leaves behind.

[Whitney Gunderson]

Well Hayden, how can you say that thinking we're halfway to the bottom is cynical when new construction is screeching to a halt and you think housing values will decrease in the places the creative economy leaves behind?

[Michael Wells]

In Portland anyway, there seems to be lots of construction close in, condos and market rate apartments going up everywhere, at least three new office towers, a couple of hotels. The hardest hit sector is low income or affordable housing. Most of the subsidized projects were financed with tax credits that the banks used to buy, and the banks are losing money so they don't need tax savings, so projects are being canceled right and left. The people who will be hurt the most are, once again, the poor.

[hayden fisher]

Because, Whitney, you've defined it-- we're at the bottom; things will begin to crawl slowly upwards from here (my view).

But let me take the opportunity to take another shot at Suburbia; Sting forecast these days years ago (synchronicity II):

"Another suburban family morning
Grandmother screaming at the wall
We have to shout above the din of our Rice Crispies
We can't hear anything at all
Mother chants her litany of boredom and frustration
But we know all her suicides are fake
Daddy only stares into the distance
There's only so much more that he can take...
...The secretaries pout and preen like
cheap tarts in a red light street
But all he ever thinks to do is watch
And every single meeting with his so-called superior
Is a humiliating kick in the crotch...
...Another working day has ended
Only the rush hour hell to face
!!!!!!Packed like lemmings into shiny metal boxes!!!!!
!!!!!!Contestants in a suicidal race!!!!!
Daddy grips the wheel and stares alone into the distance
He knows that something somewhere has to break
He sees the family home now looming in his headlights
The pain upstairs that makes his eyeballs ache
Many miles away....

[Whitney Gunderson]

Hey Hayden - First of all, I find your suburban hatred hillarious. Really, I laugh everytime I read, or sing along to, your latest jab at suburbia. I am also glad that you are a busy person and do not have the keys to a bull dozer. Second, I don't think that I defined that the housing market has hit rock-bottom with my entries in this blog subject. My first entry argued that prices in SuperStar cities will not fall because of a 50-year record of above average value growth. I do not exaggerate when I say that I am astounded at what housing values in San Francisco have done; increasing 3.5% annually, 2% above the national average for 50 years. Simply amazing.

My second entry supports the notion that the non-SuperStar city national real estate market still has quite a bit of a correction cycle to withstand. While housing prices in SuperStar cities will probably continue to increase, real estate prices in other places, both urban and suburban, have reason to fall or remain flat. Construction companies like Regency, with commerical and residential holdings, could easily find themselves in bankrupcy court.

My third entry supports the idea that the housing market correction cycle is far from over. Hypothetically, a home sold in Phoenix for $500,000 in 2004 could be forclosed on this year at $375,000 and then could be sold in 2010 for $450,000. While the speculator who bought the house in 2004 lost a ton of money, the bank that dutifully carries out foreclosure stands to make a tidy profit from the whole deal. This is something we all need to be more cynical about for the next two years.

I mentioned that I am astounded at the performance of housing values in SuperStar cities. I am equally astounded that speculators actually thought they could take out a loan at 5% to 7% interest to buy homes one year and then sell them the next year to make a huge profit. In some cases, it must have worked as planned. But as housing values traditionally increase at 1.5% annually, how did paying 5% to 7% interest to buy a house as investment property ever look like a solid investment?