Fannie Mae has this program since June 15th. It will end at the end of October. It has been extended once already a month ago. I’m guessing it will be extended again.

The 3.5% must be in the form of closing costs, which you can use for any settlement costs, and buy down the (already-low) interest rates. You do have to buy one of the foreclosed property from Fannie Mae, and it’s pretty to search through their properties online.

You can find the details of home path program here.

Freddie Mac also has a “home steps” program for extra home warranty and $1500 condo association credit. But it’s most likely less than 3.5% unless the property is extremely cheap.

I still expect the home prices to drift down further, but if you are ready to buy for non-financial reasons, by all means, you should take advantage of this offer.

This is just my personal opinion which I have been saying since 2007 housing market peak:
I am fairly certain that US housing prices will not recover its inflation-adjusted price until 2027 at the earliest. In terms of nominal prices, I am less certain but I also tend to think that housing prices will not recover its nominal prices until the same time-frame. My reasoning is fairly simply. Every financial bubble in human history will NOT repeat itself for at least 20 years. Usually it’s AFTER 20 years have passed that the same asset class can have a new chance to begin to rise in prices.

The two main negatives that have not been priced in by the current buyers are
1. Bond bubble bursting causing rise in interest/mortgage rates, AND shortening of the duration of the mortgage term. This will cause the domestic US buyers to decrease their offering prices.
2. Increasing deficits will most likely result in increase in property taxes. This will increase the holding cost of houses and therefore decrease the home ownership benefits.

The third negative that has not been priced in by the foreign cash buyers is that the current US housing price can possibly become 50%-off, once US dollar drop another 50% against the stronger Asian(Japan-excluded)/commodity currencies. These buyers will probably not flock into US after 50% off because the relative political/economical stability across regions can change in detriment to US, and that these “savvy” businessman and “corrupted” government officials won’t probably be throwing good money after bad.

Regardless, if the home ownership cost is way below the current rental cost, it obviously makes sense to buy. You could use my Rent vs Buy calculator to see if it would make sense.

There is a serious mortgage paper fraud bubbling to the surface. I was aware of this several years ago, but I was not aware of the magnitude. It is so serious that I think it can easily turn the whole world up side down (for the second time, I guess).

Some background first. The US bankers and Wallstreet or more properly called “fraudsters” first selling all the worthless “mortgage-back” securities back by phantom 100% financing loans from 2005 to 2007, cheating the entire world out of savings. They turned the world up side down with the financial crisis, and then had Paulson from Goldman Sachs being the US treasurer at that time, saving their ass with taxpayers’ money, transforming or rather downloaded all the worthless mortgage paper onto Fannie Mae, Freddie Mac, and AIG. Of course, everyone thought that was a great mission accomplished.

Now, when they try to foreclose homes, but lawyers demand to see the promissory notes, they find out, “Damn, where is that piece of crap?” Imagining all the homes that cannot be foreclosed on, due to missing documentations for the promissory notes? All the mortgage-back securities now will be truly back by NOTHING!

Here is what I will venture to guess the potential outcomes.
1. The only way to foreclose these homes will be through non-judicial foreclosures (including California, the home fraud center). Rather than getting nothing for the mortgage paper, it’s far better than getting something for it. Once the avalanche starts rolling, every bank will start scrambling to sell the homes out of the flood gate. Home prices will fall by another 20% in the coming 2/3 years. Or at the minimum, the shadow inventory of the homes on bank’s balance sheet will dramatically rise.

2. If this is not resolved through Congress passing a new law, back-patching the shoddy works by bankers, and the news start to spread around the whole world, US dollar will drop to a new dramatic low. Imagine another 3 trillions loss (out of 11 trillion) on Fannie Mae/Freddie Mac backed debts, all USA government owned? By the way, if this event unfolds, stock markets will panic first, but later will reverse to break 52 weeks high. Bonds will plummet for sure. Real estate will go into extended nuclear winter.

3. New laws get passed through Congress to save the bankers’ ass. Congress initially side with home squatters in the name of protecting voters, until all the law-abiding citizens take the street, demanding fairness. Then Congress realizes that it’s too late to stop the revolution by the majority of the law-abiding citizens, turning to lawless resolutions everywhere.

Just some crazy ideas. But certainly less insane than what has been going on in US real estate markets. And all of the rotten apples (Wallstreet bankers, home speculators, and all the mortgage “consultants”) are still in there unbelievably.

I thought that what happened in US since 2007 (and in Japan back in 1990) would have taught people some lessons. But human greed knows no bound. Either they don’t read news, or they’re too greedy. There are still booming undying bubbles in China, Taiwan, Canada, Australia.

It is apparent that most participants recognize the value of housing investment in protecting assets against inflation. It has been the preferred financial instrument, especially in Asian culture, to buy real estate because
1. It won’t go to zero, because it’s “real” estate, and you will always have it.
2. It pays out dividends in the form of rent.
3. It always “goes up” in the long term.

My colleague asked me whether I know how much real estate has gone up since 50 to 60 years ago. He told me it’s tens of thousands of percents. Well, but one must recognize the fact that since 1930, $US has depreciated 94% in buying power, according to government official statistics (and probably worse if using unofficial figures). The primary reason that real estate goes up in the long term is because of general inflation. Since a couple of decades ago, another factor that helps real estate price is that the financing costs/interest rates have been going down. However, over the long term, the average real estate prices cannot exceed inflation rate by too much and/or for too long. Why? If real estate simply returns 1% more every year than the general inflation, after 100 years, real estate price will be 270% higher than the general wages. After 200 years, real estate price will be 732% higher than the general wages. Well, the economic law of supply and demand will always balance things out. Eventually, either people cannot afford homes anymore, and younger generation stops forming families, resulting in reduction or stagnation in population, and therefore reducing demands for homes, or the home prices will simply FALL behind the general inflation rate. And I can bet you that it will happen before real estate prices are 732% higher than the general inflation rate. In fact, both Japan and Taiwan are already showing such signs of either declining population or stagnant growth. If you have so much money that you don’t need to worry about future, housing, employment, etc, and you have all the leisure time in the world, won’t you tend to have children? On the other hand, the opposite extreme scenario would probably be true also. So if the population is declining, who is going to fill up the existing housing space, not to mention that builders will always build more. Imagining a hypothetical scenario, where for every grand kid, he or she is inheriting at least 2 homes from both sides of the grandparents, and/or parents, and/or any unmarried relatives who have passed away, now won’t the housing and/or rent price go down because there are extra supplies versus demands? Of course, before long, economic law of supply and demand will kick in, and population would have increased.

What I’m trying to point out is that it is simply IMPOSSIBLE for housing prices to stay higher than inflation rates for too long. Those that bet on housing prices will increase 10% above inflation rate every year are simply delusional.

Very infrequently I come across some articles that are so well written that I feel obliged to recommend them to people. And I found it at Irvine Housing Blog. IrvineRenter, the owner of the blog has written a couple of excellent articles that should be must-read for every home buyer.

On “Valuation of Lots and Raw Land”, IrvineRenter explained in details how the valuation of an investment in raw land would work out. To sum it up, land investment works like a call option on the housing market.

On “Loan Assumption is the Appreciation of the Twenty-Teens“, IrvineRenter gave his best advice (and I concur too) that the best bet in building your home equity is probably by buying with an assumable AND fixed-rate loan. Unfortunately, as far as I know, the only assumable loans these days are FHA loans, which have higher fees in general. Why is that? A good deal to the borrowers is always a bad deal to the lenders. The scarcity of such loans automatically tells you that assumable loans are not good for lenders.

And at last, on “Fundamental Valuation of Houses – Part 1“, IrvineRenter explained in details about the math of home ownership cost. His article almost acts like a companion manual to my online java housing cost calculator. All of the factors that he has mentioned, I have included them in my online housing calculator, plus commute cost difference. But just one caveat, garbage in, garbage out. My calculator is only as good as the validity of your input assumption. If your assumption on the housing parameters such as rent/housing inflation or tax rate, are inaccurate, then the results will be inaccurate as well.

So what’s the buying strategy for the housing market? In case you missed it, it’s using assumable fixed rate loan. On a longer term, I believe that the mortgage rates will be going up. Contrary to all the unscrupulous realtors, the best time to buy real estate is when the mortgage rates are at the highest, not when they’re at the lowest. Lower mortgage rates always cause the housing valuation to expand, while higher mortgage rates will rein in the price. Assuming a forward picture of higher than normal inflation, and mortgage rates trending higher, the inflation force may arrest and balance out the decline caused by higher mortgage rates. Nominal housing prices may stagnate for a decade or even two decades, but inflation-adjusted price will continue to decline. Such picture does not bode well for many participants. The renters will see their rents going up due to general inflation. The new home buyers may still see price declining if the nominal prices have not reached bottom. Worse yet, if the equivalent ownership cost of their home is higher than prevailing rent, then they’re effectively speaking draining any potential savings that they could have built without buying a home. In such picture, the only potential remedy would be to have an assumable fixed-rate loan, so that one could recover the price benefits between future higher mortgage rates and the current lower mortgage rates.

And if you cannot find such loan, make sure you put the least amount of down payment, and borrow as much as you can for 30 years fixed. Forget about adjustable ARM. The only way to short the bond markets and US dollar simultaneously and safely without margin calls is to borrow against your real estate holding.

I have blogged about “different ways for a busted refinancing plan” back in 2006 at the height of housing market. I argued that once the housing markets fall, most of the real estate “investors” will NOT be able to refinance out of their payment troubles. It was very clear to me that a housing Ponzi scheme simply cannot last forever, and was destined to pop. Of course, according to Greenspan, Bernanke, Wallstreet, and traditional news media, nobody could have seen the financial crisis coming.

I definitely thought that things would be worse in the housing markets. Due to various factors that I didn’t forsee, including Obama’s home affordability programs, delays in foreclosure processes by banks, and a dramatic drop in the interest rate curve, things are not terrible as of now. In fact, in 2009, housing markets actually went up (at least in California), sucking in the last bunch of ever-hopeful real estate “investors”. Regardless, numbers won’t lie, and let’s see how the negative amortization or option ARM homebuyers are doing.

Below is a summary from the monthly payment history based on a hypothetical case that I’ve made up for a California home ($500K, 20% down). I think it is pretty representative. You can get the original complete Excel spreadsheet here. All the interest rate data are from X-mortgage. I’m listing both MTA and COFI indexes which are the two most common indexes for option ARM:

Needless to say, an increase of 71% in 5 years will be huge for anyone. Very few family will be able to make it thru a combination of salary increase, second job, and/or having non-working spouse going back to workforce. Unfortunately, refinancing to 30-years loan at today’s 4.75% will not be an option either, since the monthly payment for 30-years is about $2200, the same as the recast option ARM loan, if not more. I originally thought that these people probably would have problems with LTV or loan-to-value ratio. But Obama’s home affordability program has “solved” the LTV problems for these most of these homeowners. The monthly payment issue is still there. One cannot make an unaffordable home in the first place to be affordable.

Looking forward next year, once the home affordability program expires in mid-2010, we will probably get more defaults and walkaways from homes. Due to Bernanke’s cutting of interest rate, and a huge buying program in both treasury and mortgage market, current interest rates are temporarily held down. If the option ARM indexes like MTA and COFI rise up to 3% for example, the monthly adjustable payment will go up by another 25% to 30%. I don’t think the housing markets will recover anytime soon due to this impending supply of homes (from defaults of the option ARM loans).

So what should you do if you are one of the option ARM homeowners? There are many sites & articles that talks about foreclosure options. In my opinion, short sale would be the best choice (if you have this choice), since you won’t be liable for the deficiency judgment, and it will hurt your credit report the least. The second best choice is loan modification, although not many can negotiate a good deal with banks. The rest of the choices such as foreclosures are not ideal, but it’s probably earlier the better under the assumption that it does not affect your job prospects based on a much worse credit report.

Here is some of good sites & articles that I’ve found on foreclosure-related options. Some of the site owners are very helpful, and may be able to provide you with needed advice or services:

• Foreclosure option networtk. Hanna was particularly helpful to me on a couple of nasty legal questions.
• Foreclosure options from MSN
• More info on various foreclosure options from foreclosure university.

From several of my friends, I’ve heard that people are bidding the homes again like crazy for the last four months. Many properties sold at the asking prices or above, receiving multiple bids. Home prices actually have gone up by up to 10% versus prices from last year. People just never learn (especially about history). Human greed and fear is always with us, and therefore there will always be bubbles.

Frankly I am totally disgusted by the “get-rick-quick” crowd and their mentality. Nobody wants to work & save diligently. Instead people are afraid of missing the next stratospheric real estate boom, afraid of missing the bottom in stock markets, and afraid of missing the next generational boom in emerging & BRIC markets. Just sit down and think a little bit. If all of these people will get rich, retiring with more than a million in net worth in inflation-adjusted dollars at the age of 55, who is going to serve the table when you go to restaurant? Who is going to be nurse taking care of elders? Who is going to be the hotel cleaning lady when you go and travel? Robots or imported cheap labor from African countries? I don’t mean to disparage the above jobs at all. For the society to function at all, everyone needs to perform their duty and job function. Everyone is indispensible (at least in a collective sense). And so, it just happens that NOT everyone is going to retire on the beach, enjoying the sunshine. That is just a fact, until robots can replace all human labor.

The recent bubble in (international) real estate has been the biggest ever in size in human history, driven by massive credit liquidity multiplication. There was a paradigm change and the credit liquidity is not going to be the same possibly for decades to come. Just remember that if real estate in Japan of just four main islands can go down in prices for 20+ years, then there are more reasons for real estate to go down in prices in bigger continents.

I’m not saying that home prices cannot go up. There are two main drivers for home prices:
1. Persistent increase in wages: I seriously doubt that it’s going to happen anytime soon. The unemployment rates are going up. There is no pressure to increase wages. Furthermore, in order to reverse outsourcing trends, either US wages go down, or US dollar goes down.
2. Long term interest rate drops more: I have doubts that the condition of low long term interest rate in US dollar can persist. Due to all the Wallstreet bailouts and fiscal deficit at Washington, at some point, the liquidity crisis will hit US bond markets again. Foreign central banks are shunning away from US bonds now. I believe long term interest rates will trend up rather than trend down. That does not bode well for home prices.

Of course, if the above two factors change to favoring home price increase, then my opinion will change. Until then, I wish those home buyers and real estate “investors” good luck. Our generation doesn’t really understand the word investing anymore. Calling speculation as investing does not reduce the risk of speculation by any tiny bit. Rather it just pampers your own greed.

Ten large banks are paying back treasury with 68 billion dollars, so that they can be freed from government meddling in paying their executives. Now that all of their accounting book is blessed with marked-to-fantasy, they don’t need the cash anymore. Can we put in a clause in the payback that “please don’t come back again even if you’re insolvent (after squeezing out more bonus for executives)?”

I’ve said many times, and I will repeat it again. Option ARMs and AltA are resetting starting from about now until the end of 2011. The wave of notice of defaults is already coming (Dr. Housing Bubble has got all the charts here). It’s not a question of if, but when (the next wave of financial crisis will hit). Mark-to-fantasy by thinking that you have not sold your stocks (mortgages on the book of these banks) after 60% losses and that they will come back to full value after 10 years will not help at all. The end game will come, when the homeowners stop paying mortgage and/or walk away from properties. When the properties go into foreclosures and get sold, banks have to mark down the losses without a choice. The fact that banks are not in a hurry to foreclose all the properties tell you that the level of losses in a foreclosure will probably destroy the banks. By choosing not to foreclose (and not mark-to-market), insolvency can persist in fantasy land.

And before they go down, CEOs are going to squeeze out more from shareholders, bondholders, and taxpayers. They’re definitely a smart bunch.

Here is just some decision flowchart on what I think you should do for your home/mortgages in many circumstances. It’s based on my personal opinion, and you should always consult professionals & legals when it applies. There aren’t many solutions for you besides out-right sale, short sale, refinancing, loan modification, foreclosures, and walkaways. But you should choose carefully on each option. Anytime you choose short sale, foreclosure, and walkways, it’s implicit that you will lose all the amount of any down payment that you have put into the home when you first bought it.

1. Case #1: if you are “underwater”, meaning that your loan amount is greater than your home market value, your decisions should be dependent on your loan type.
   1. Case #1A: if your loan was a PURCHASE loan, meaning that you have never refinanced your loan since your home purchase, in many states such as California, where there are laws protecting home buyers from loss of incomes or jobs, you should probably walk away from your home. In such cases, you should be protected by state laws, and you should not be responsible for lenders’ loss. The laws however cannot protect you if you have lied about your income and assets on your loan application. Please make sure that you consult lawyers for specific details, because I cannot be responsible for your legal troubles. Please NOTE that if you have a second loan, but the second loan was a purchase loan which you’ve probably paid PMI insurance on, you should still be okay. However, the same does NOT apply to home equity or piggy-back loan. Home equity loans are recourse loans, and it means that banks can theoretically or legally hunt you down, extract all of your current assets and future salaries, until you file bankruptcy.
   2. Case #1B: if you have more than one loan, and the second loan is home equity loan, you should probably try a short sale first, and then try doing a loan modification. The short sale is better in the sense that your credit is just partially ruined. The banks need to take their deserved losses. If you cannot do a short sale, you should try to modify your loan thru Obama’s home affordability program. With this method, I believe that your credit profile stays the same. However, you’re stuck with your own losses, banks get off the hook, and taxpayers may be stuck with your losses if later down the road, you walk away.

   For both of Case #1A or #1B, you may want to stop or slow down on paying your first loan or the purchase loan, so that you can force bank to come to the negotiation table with you. However, you will be risking a real foreclosure. Also, in case #1B, you should continue paying down your home equity loan regularly because it’s a recourse loan.

   3. Case #1C: if you have refinanced your home loans, then you’re out of luck. Legally, you’re 100% responsible for your loans. Nevertheless, you should try contacting banks for short sales, and doing loan modifications, like in Case #1B. Both will be to your advantages, if they go through.
2. Case #2: if you are at about the same the “water level”, meaning that your loan amount is about the same as your home market value, you should in general try to refinance, and/or short sale if you decide that you don’t want to keep your home.
   1. Case #2A: If the prevailing rent is still higher than your home cost: mortgage payment after tax benefits, plus any property tax, or potential interest credits, then you could try wait out the downturn (although I think the downturn will be much longer than anyone expects). You should at least try refinancing and see if you can lower your monthly cost. The Obama’s home affordability program will allow refinancing of up to 105% of your home value, if your mortgages are owned by Fannie Mae or Freddie Mac. You can check that at the home affordability page.
   2. Case #2B: If the prevailing rent is lower than your home cost, I think you should try to do a short sale, and forget about doing any refinance. Your short sale will be easier to go through bankers. And this way, it will prevent you from suffering further home losses down the road.
3. Case #3: if you still have substantial equities in your home, meaning that your loan amount is smaller than your home value, you are financially sound. I would advise to do refinancing through the normal channels, cash out any equities that you can, and hold on to your cash in 5-year US treasury for another two to three years for better opportunities. The best refinancing time is either now or possibly in Oct/Nov if stock markets take a dive at that time.

Here is the Obama’s home affordability page, in case you don’t know about it. If you follow thru the links, you can find out how to verify that your loans are owned by Fannie Mae or Freddie Mac.

And for potential new home buyers, my advice stay the same: just stay put and wait for year 2012. Your patience should be rewarded (in my opinion). That $10,000 home buying tax credit cannot come close to the amount that you may gain through further home value erosion.

Ed Ross who just had a book “Forecasting for Real estate Wealth: Strategies for Outperforming Any Housing Market”, is saying that NOW is the time to buy and jump back into the housing market. It is my personal opinion that anyone claims such given the preponderance of evidence against him or her is just irresponsible. Yeah, housing prices always go up if your investment horizon is to hold it for more than 20 years. Oh no, 20 years was not a typo.

Home as an investment vehicle is no different than any other kinds of investment, subjected to considerations of risk versus return. The best advantage is obviously that it affords you the leverage power of 5X to infinite X (if you put zero down, or even doing 125% financing) without the danger of getting a “margin call” (until you cannot make the mortgage payment). As I have explained in “Leverage: the secret of making big money”, those are the major reasons of why your home could be your best investment. But the days for 100% or >100% financing are over. And you only get to do such deals until you get busted and fail.

But the leverage power that you get from investing/buying a home works both way, magnifying your percentage of potential return or loss. To make a statement of “home prices always go up in the long term” is just totally irresponsible. The only reason that it is true is because the inflation rate is always more than zero percentage in the long term. Obviously, inflation rate is positive because societies have gone away from gold standard to a fiat money system.

Now if we look at the most recent housing bubble occurred in Japan as an example, we will find that the prices have NOT recovered to the peak of 1991. In fact, prices in 6 largest cities have dropped 64% from 1991 to 2004. And interest rates have been cut to almost 0% and loan terms extended to 90 or 100 years without being able to stimulate the housing economy. If such declines in home prices can happen in a country where the lands on islands are the most precious commodity and population density is relatively high, then there is no reason that it cannot occur here in the United States.

While I don’t think US will follow the deflationary model of Japan, but rather Argentina’s inflationary track, housing market in nominal prices before adjusting for inflation is most likely to continue to fall towards 4th quarter of 2012. Certainly, my call on the bottom can be wrong, but at least I was intelligent enough to know that we are in the post-peak of housing environment back on August 4th 2006 (in the last paragraph of “Why Stock Markets Crash”).

My date of 4th quarter of 2012 is based on the following observations. First and foremost, the second major wave of mortgage payment reset is not over until the first quarter of 2012.

While the peak of the option ARM resets is at about mid-2011. Since option ARM holders can continue to choose to pay the minimum payment on their mortgage until right before their reset, I assume that the flood of REOs (real estate owned by lenders) won’t be in the market until 6 to 9 months after the first missed payment. With the number of the homes potentially going thru foreclosures and downsizing of the banks, I won’t be surprised that the foreclosure process will take a whole year. Therefore, the housing supply situation will probably be very bad in mid-2012 (1 year from the peak resets in mid-2011) until first quarter of 2013. If you add 6 to 9 months on top to the mid-2012 for the time to sell a REO, there will NOT be any real recovery until 1st or 2nd quarter of 2013.

For the people who are looking to buy, the major bulk of the price declines should have happened by 3rd/4th quarter of 2012 or earlier. I believe that there is still a potential 15% to 20% downside from the current prices. If you’re looking forward to invest, there is just no reasons that you should put your money in a potentially sinking boat.

Interestingly, from Martin Armstrong’s economic confidence model, the credit cycle probably will bottom near July of 2011, which is consistent with the above timeframe. The above date probably will coincide with a bottom in the financial stocks (or the stock market for that matter) will certainly occur first probably with a minimum lead time of 9 to 12 months ahead of the actual housing bottom.

With an inflation rate that is probably going to be higher than normal going forward, a low Fed rate will not be helping much on the mortgage rate either. For those housing bulls who think that a low Fed rate will come to rescue, they don’t understand that an initial teaser rate at 1% (while the long term rate was still at 4.5% or above) will most likely NEVER come again. Since long term rates will most likely go higher due to heightened inflaiton, mortgage rates will be higher too. That certainly won’t help the housing prices.

Mortgage rates have gone up quite a lot along with the fall in bonds. The rates have been rising across the board (by almost 0.75% now).

I cannot understand who is selling the bonds, along with $US rising (just a little bit). This is truly a weird combination. Where is the money going?

The only sensible scenario that I can come up with is that Fed is lending all the financial institutions treasury bonds on its book in exchange of toxic mortgage bonds. The financial institutions are selling the treasury bonds in exchange for cash right away to resolve their credit crunch to satisfy cash demands from customers or depositors. Since all the transactions are domestic, $US exchange rate is not affected much. In effect, Fed is indirectly creating these new cash through these financial institutions, and supporting the solvency and liquidity of the financial institutions.

Still, eventually (or immediately) these new cash will find a new home. Apparently, they have blown up the commodity prices.

Fed is obviously trying to prevent housing deflation. Apparently, they have opted to save the greedy bankers and brokerage houses, and dumped the homeowners. To bring down the mortgage rates, Fed should actually buy up treasury bonds and/or mortgage bonds. Reducing the supply of bonds will increase its price, and therefore reduce the yields. Of course, such monetization effort will result in the immediate increase of cash circulation.

I guess Mish’s deflationary thesis has been right on. Cash is in demand. Not bonds, not stocks, not gold (yet) either. Before cash becomes trash, cash is still king. But I don’t think Fed has any ways out of this mess, besides trashing US dollar (or cash).

You will be amazed on how fast these homes get sold. In a single day, some 500+ homes get sold. And you will be amazed too by the number of people in the crowd. Definitely, there are still way too many would-be speculators who want to pick up investing properties on the “cheap”.

Most homes that are very far from metropolitan area are selling 50% off or more. The homes that are near to where the jobs are, they are at best 10% lower than the listing prices. And the most amazing thing is that there is a huge crowd, probably more than 1000 people. Certainly, very few of them realize that the housing markets just won’t be the next best investing vehicle, possibly for the next decade. From the number of people going to auction, I’m fairly certain that this housing bear market has definitely not hit the bottom.

Again, I have been projecting a potential intermediate bottom for housing market at about 2011, which is still 3 years from now. Depending on how the inflation unfolds, that bottom may or may not be the lowest bottom. If $US tanks and US interest rates soar, I believe that US housing markets will tank beyond the level of 2011. How high the interest rates may go under a hyper-inflationary scenario? No one knows, but I think it could be more than 10%. At an interest rate of 10%, compared to a 6% rate on 30-year mortgage, the monthly payment will go up by 46%. Alternatively speaking, for the same fixed “affordable” payment, the loan amount will go down by 32%. In that scenario, I believe housing prices will fall, despite the supposed belief that houses are a good inflation hedge (only if it’s not hyper-inflation).

Some of my colleagues at work have been buying several investment properties, and I’m talking about 3 to 6 properties. I am fearful of their bets turning bad, but since I’m no oracle, I won’t comment on their purchases. My position has been bearish, and my projection is also bearish. The nasdaq is still not even 50% of its height back in 2000. That’s how a bubble can wreck your finances for a couple of decades.

Don’t be too greedy. The only result coming out of tremendous financial leverage is either a great success or a great failure. And you know for a fact that a great success is simply a much rarer event probabilistically speaking.

I think few people realize that America/the world is facing the biggest financial storm ever, and how dangerous it is for investing in stocks before a full implosion. The housing-induced credit crisis has gone far beyond anyone can potentially control, probably not even the Fed.

Reading over so many current/future proposals from politicians and bloggers, I have my own thoughts in this. For sure, there simply isn’t a solution without pain. But there can certainly be solutions that are more fair and less pain.

One of the most fair and easiest way to help propping up the housing market is to subsidize all the buying or holding cost for primary residences. Instead of helping on the sell-side directly, the government can help the buy-side. Of course, the subsidy will indirectly go into sellers. But the solution is market-based.

Why is this a fair solution? For sellers, there is simply no direct bailout. For anyone who chooses to buy, the buying decision is done on the open market where everyone else is competing on the same ground with subsidy, and existing real estate investors will also be helped with a more stable housing price. For any renters who choose not to buy and take up the subsidy, their decision is solely of their own based upon their evaluation of the current housing market and personal circumstances.

What kind of subsidy will make sense? The easiest way is certainly done through mortgage interest reduction or tax deduction. The tax deduction cannot be limited by the amount of adjusted gross income, and has to be actually beneficial on top of the existing standard deductions. By reducing the overall housing cost, government will encourage more of it, and prop up the housing market.

Since 65% to 70% of the Americans are home owners, most of this housing aid will effectively become a tax cut for middle class. I suggest that 50% of the total amount of both property tax and mortgage interest from primary residence can be used as a tax credit (rather than tax deduction in the itemized section). Here are some examples of the housing aid scenarios, with loan interest at 6%:

1. $700K home in California with 20% down for someone with tax bracket at 28%:
Because loan amount is $560K, the interest is $42K a year, and the additional tax subsidy amount will be roughly (50% – 28%) * $42K / 12 months = $616 a month. This monthly subsidy will effectively lower the interest rate from 6% ($3357) to 4.25% ($2755). That will be a tremendous stimulus.

2. $500K home with 20% down for someone with tax bracket at 15%:
The additional tax subsidy amount will be roughly (50% – 15%) * $500K * (1-20%) * 6.00% / 12 months = $700 a month. This monthly subsidy will effectively lower the interest rate from 6% ($1852 payment) to 3% ($1686 payment). This is an even better deal for lower income people.

Effectively speaking, this tax cut will target middle-class home owners specifically. Using the assumption of a median home value of $240K, and an average tax bracket of 15%, this tax aid comes to be about $4032 dollar per family household, 110 million US households, with 70% home owners, it will be about $300 billion annually. I’m not going to re-do my numbers here, but probably instead of 50%, one could go for 40% of the interests as tax credit. This will adjust this bill from $300 billion to about $214 billion. I hesitate to go to much lower, simply because in California, where most of the housing problems are, you have to be at 25% to 28% tax bracket to afford the homes. Since one is already getting existing tax benefits at 25% to 28% through itemized deduction, the 40% as tax credit will only give 15% to 12% additional benefit.

Bottomline, this printing of tax money will be truly the best way of distributing the helicopter money, since it goes to the homeowners directly without discrimination, AND it is also tax-progressive. The rich who has a bigger loan do get a lot more, but only because they are paying a lot more for their home. But the middle class will not be left out at all, and will enjoy the biggest piece of the tax reduction. This will effectively encourage home purchase/consumption, and props up housing market. The solution is also market-based without ANY bailouts to those people who abuse the mortgage markets.

In respect to Republican tax position, this is a market-based solution. In respect to Democrat tax position, this is a tax aid for most of their incumbents. In respect to stock markets and US economy from Keynesian economics, this is a huge positive. Tax cuts stimulate economy. On the other hand, money from direct taxpayer bailouts go into the pockets of these fraudulent bankers and homeowners, and continue to encourage moral hazards and speculation.

Frugal at 1stMillionAt33.com

The Hope Now Alliance is going to freeze the rates on ARM loans instead of letting them reset. That is absolutely unfair to anyone who doesn’t benefit from such deals. Why don’t I get some free points to buy down the interest rate, paid by the alliance too? Of course, if they can get all the investors in different trenches to agree, then I have nothing to say.

In any case, the banks are desperately trying to keep the mortgage losses under cover by whatever means. This freeze of ARM rates will definitely postpone the reckoning day. I originally expect a heavy down year in 2008/2009 for real estate prices. Now I am less sure of such. However, home prices definitely won’t be going up in 2008/2009. Lending standards for new loans are still tight.

One thing that I’m most curious of on the details of the freezing plan is that on all these ARMs, there are both payment and interest rates. When the payment rate is less than the interest rate, the loan is negatively amortized. I really wonder whether they plan to freeze both payment and interest rates, or just the payment rate. My initial guess would be that it would simply the payment rate that will be frozen. In that case, no one involved will take an actual accounting loss. The interest money will continue to pile up, despite the fact that those interest money may never get paid by the subprime homeowners. Obviously, if given long enough time (and a good amount of inflation), eventually home value will exceed and allow the paid off of these interest money. However, for these mortgage investors, they are still at the losing end of the stick. The inflation will eat away any of their recovery of the interest money.

If anyone knows somebody who get into such plan, please ask him and let me know that whether both interest and payment rates are frozen. Thanks in advance.

I assume that such modified loans will still be un-transactionable, or illiquid. No one in their right mind will buy such products. But keeping these loans away from foreclosure will prevent the banks to liquidate the homes and assigned the final value to the loan at loss. And so the fairy tales will go on, and the losses can be slowly written off. Banks can then “properly” meet the capital requirement ratio from FDIC.

Did anybody who read my blog got into this world-record breaking hedge fund which returned 10X in 1 year? I got the performance number from Minyanville’s article on 1000% Subprime contained. Boy, I only wish I had more cash/money to be brave enough to take a piece of that action. If I did, I would have almost doubled my net worth (since minimum investment was $100K). Unfortunately, I didn’t. But did you?

Certainly, somebody inquired him from reading my blog. Because I was asked by the fund manager Andrew Lahde to removed the proprietary PDF file, even though I had every good intention of promoting his business.

Well, I’m sure he and his clients made out like a bandit. 10X return in one year. That’s probably good enough for the next 10 year.

Were you that lucky? I guess rich does get richer, and I just needed to be a little richer to be in the league to participate and play.

I’m very surprised that bond market has actually gone up (bond yield coming down) along with the stock market. The ^TNX (10 year treasury) has come down to 4.383%, and ^TYX (30 year treasury) has come down to 4.663%. Regardless of how the bond yields are coming down, whether via direct monetization through Fed’s printing, or bond market forecasting economic slowdown, the lower yields will definitely bring some stablizing effect to the housing market fallout.

Although I would like to say that it makes more sense to me that the bond market actions are due to Fed monetization, I cannot find any evidence in their Fed operations of permanent repo. In any case, assuming that Fed can fake everything else, the only thing that it cannot fake is the $US exchange rate with other foreign currency. Furthermore, under normal circumstances, bond yields should have risen when the stock markets go up. Although such weird episodes have happened before, the recent occurrence of synchronous rising is the first one since many months.

If the 30 years treasury yield fall further, it will be on track to match its all-time low at about 4.25% in June of 2003, and June of 2005. That’s just roughly 12% =(4.66%-4.25%) * 30 yr away from the current level. I don’t know how it could possibly make sense to any of the bond buyers, but a 30 year bonds yielding at 4.66% is simply too low. Investing money in a farm will probably bring a much better yield.

This week Fed is supposed to cut interest rate by another 0.25%. I think Bernanke going forward is more likely to surprise the market on the upside (meaning cutting more than less). His philosophy has always been that aggressive cutting can stave off crisis. The only thing that I see however is that there will soon be another bubble in either foreign markets or commodity markets or both, due to these aggressive rate cutting. It’s very important for investors not to sell out completely in the energy/precious metal sectors.

If Fed can successfully bring long term interest rates down to a very low level, then it may actually make sense to start buying real estate at the lower priced area. Although initially I was estimating that the bear market in housing will last all the way to 2012, if bond markets behave irrationally than my original thinking, then the buying time of real estate could be sooner at least for the lower priced area.

Incidentally Mark Hulbert is posting another bullish post “Ahead of the (yield) curve – Commentary: Post-Fed curve much steeper, a good sign for the economy”. I must say that everything of what he said about a smaller chance of recession based on the steepening of yield curve is correct on paper. However, I cannot agree that one can simply use only the yield curve to determine the odds of recession.

For one thing, because the long term bond markets are not collapsing or dropping dramatically after Fed raising interest rate, while the short term interest rates are falling, it appears to be a good sign that Fed still having everything under control for now, except on US dollar index cutting through multi-years support at 80. But based on Bob Hoye’s historical analysis (pg.2 at this link), such post-bubble yield curve steepening is more ominous rather than a bullish sign. Bob’s recent forecast has been quite accurate, and I would trust his words as a market historian rather than Mark Hulbert’s who has been putting out 8 to 9 bullish articles out of 10 this year. Such yield curve steepning according to Bob Hoye is simply part of the post-bubble credit contraction process. Certainly, if long term bond yields start to go up much more, they will simply deepen the housing recession. Now, I don’t care about how accurate the predicative power of yield curve. It is simply a black-and-white matter that housing markets will get worse if the bond yields go up. With the housing bubble unfolding, my only attention would be the absolute level of the long term bond yields, rather than whether the curve is inverted or not.

By the way, if I didn’t make it clear in my yesterday’s post on “is it 1998 or 1970?”, I will now. I believe that more of the emerging markets will be in the 1998-style progression, while more of the senior markets will be in the 1970-style. I think US stock market will be going thru an extended period of sideway with possibly a bullish slant, with $US falling gradually. The best thing for US dollar holders should be trading in this sideway market to make up the $US fall in purchasing power. But you do need to wait for a round of cleansing before jumping into it.

Best luck, and have patience.

At this time of home prices falling, and possibly not being able to roll over/refinance the home loan, it is important to revisit this older post of mine: Deficiency Judgment: Think Again Before You Walk Away from last year

To the current homeowners: think again before you send the keys to the bank and walk away from the house. Do you think that when the housing prices fall, you can simply walk away from all the loans? Well, if you didn’t know, I am going to explain it to you. There are loans that you can walk away, and there are loans that you cannot. It’s called a recourse or a non-recourse loan.

A non-recourse loan means that there is no other recourse available to the lenders besides taking back the home. A typical non-recourse loan is a home loan for purchase. If the house falls below the balance of the purchase loan, the buyer can walk away from the house without any serious consequences (maybe except a big blemish on the credit report). On the other hand, a recourse loan means that the homeowner is personally liable for any “deficiency” when the lenders cannot recover the loan amount by selling off the house. A typical recourse loan is a home equity loan or a line of credit from home equity. As far as I could research, I don’t think a refinanced home loan is definitely a recourse loan. But I’m almost certain that a cash-out refinanced loan is recourse loan. As far as the legal language is concerned, a refinanced loan obviously is not a loan made for purchase.

…Click to read more….

Again chances of judicial foreclosures are “usually” small. But you just don’t know what a badly hurt banker will do with a mounting losses on his back, especially with more and more home loan defaults. If it means that it will reduce his losses, he might as well create an off-the-book company to specially deal with lengthy foreclosure process with more money recovered.

Casey Serin at I am Facing Foreclosure.com is shutting down his website in about 18 days. I received an email notification from him about the news:

I’m shutting the blog down on August 3rd. That’s about 23 days from now.
….
Any publicity is good publicity. Right?

Wrong.

My marriage and my family has been affected in a big way by my actions and this toxic exposure. The internet could be a cruel place and I am the one who put myself and my family out there. If I knew things were going to get this bad I would have done investing and blogging in a much different way.

Now I may lose my wife over this.
….

I think he made a tough but wise decision. Family should be always first, money or fame second. You just cannot buy a happy family, no matter how much money you want to spend, but little time for them.

When I first heard about Casey’s blog, I wonder it was for real. At least personally I will never document my own crime if I commit such white-color crime. I assume that getting more publicity will only bring investigation (in his case, FBI) sooner, since one of the million readers must either be a policeman himself or know a policeman well enough.

In any case, he was able to sell his blog for some $20K to $30K, and also had a book publisher interested in his story. Frankly, he has a good chance of making himself a multi-millionaire if he simply play his cards right.

His blog and real estate experience is simply one of the housing bubble phenomena. Unfortunately, all the debts left behind by these liar’s loans (some 2 million in Casey’s case) will not be paid back, but rather get discounted after foreclosures. Well, as you are fully aware, the stratospheric housing price was simply too good to be true. The housing price is only as good as the loans and the money availability behind them.

Who is going to take the loss? Mainly the loan investors, but eventually the whole society takes up the cost one way or the other. We will be paying for the cost of housing bubble through the coming higher inflation and higher interest rates (if not already).

For anyone who will face a mortgage ARM reset going forward, but doesn’t have the income to pay for the monthly payment, the Ponzi game is over.

From the latest New York Times news:

The banks obviously don’t like this, because they understand that they have simply played with fire. Now they are getting caught, but still would like to continue to pass these hot potatoes (risks) to unsuspecting income investors. Without being able to extend the loans to these falling subprime borrowers, the current investors and banks will be stuck with the hot potatoes.

But don’t you wonder why banking regulators still want to increase the regulation, possibly knowing what may happen? Well, for the people in politics, they only care that when all the foreclosures are under the sun, they can at least claim that “oh yes, I did do something for this problem (by making it worse?).”

In any case, we will see more of ball kicking between government officials/politicians such as between Greenspan and Ed Gramlich.

But now Edward Gramlich, a former colleague of Greenspan, has reportedly gone on record to say the former Fed chairman blocked a proposal to increase scrutiny of subprime lenders under the Fed’s broad authority. What’s more, he asserted, that additional scrutiny might have helped curtail questionable lending practices that are now blamed for soaring defaults by mostly low-income borrowers many of whom fell prey to predatory lenders’ unscrupulous lending practices and high interest rates.

I am not sure Greenspan’s denial is in any way effective. He has got his fingerprints all over the housing bubble. How can you even deny it?

I just checked my local housing market this past weekend. It appears that prices are down at least by 5% from just a couple of months ago. This is true for both new homes and resales. End game is slowly coming. The 2008/2009 negative ARM reset is not even here with us yet. It could be ugly.

Finally, I can walk into a sale office for new homes, with the ability to purchase the home outright without putting my name down on a long waiting list. And the price got cheaper even compared to a few months ago.

Just a note to all the home buyers out there, the housing market will play through series of tango in the upcoming decline. First new home prices will undercut resale prices. This is happening now. Then resale prices need to come down to match or be lower. Then the drama replays again and again until it reaches bottom. Two months ago, some of the resale home prices are simply outrageously stupid. Why would I buy a 20 year old home which is more expensive than a new home? Be warned. Don’t be those stupid buyers. Real estate agents will be working overtime and cheat you into buying one of those resales. You think they would have told you that the new homes just around the corner are cheaper, but since they don’t get any commission from those sale, these “buyer”‘s agents will rather let you lose out tens of thousands of dollars on a stupid deal, and tell you straight in the face that “home prices always go up in the long term” or “all the people who got rich made their money in real estate”. Don’t listen to their lies. Sometimes, I can’t believe how these agents can face their conscience day-in and day-out. That even includes my Christian friend (as my buyer’s agent) who hasn’t told me a thing about any new homes. I guess lack of disclosure does not officially make him guilty.

With the mortgage rates jumped up by some 0.5% in the last week, that will spell disaster for the home inventory. There seems to be a rush too for all these home builders to rush out and build up their lands. I haven’t seen so many new communities opening up for such a long while. The bad news for the builders is that each new phase gets postponed further out due to lack of demand.

Still I can’t figure out how these people around me can afford such expensive homes. If I include the opportunity cost of down payment by treating it as an interest-bearing at the same mortgage rate of 6%, a home that I just looked at for the price of $710K has a total annual cost of $60K, roughly 5,000 dollars per month. My own home has an opportunity cost of about $22K a year, or about 1,800 dollars per month. I really don’t understand how people can afford a $5,000 dollars per month, without putting up several hundreds of thousands of dollars for down payment.

Well, of course, the real estate agents still keep repeating the same words. “There is never a better time to buy a home.” “Markets have stabilized.” “Prices will not come down too much.”

I’m not really sure about that. I do hope that all of my blog readers won’t lose out when they buy their next home. It could very well determine whether you can be richer 5 to 10 years later by $100K to $200K depending on your personal situation. That gain is obviously not coming from buying a home, but rather coming from not losing that much of money in buying a home I believe. The only financial discipline that you would need to stick to is to save up your money if you’re a renter. If you tend to squander through your disposable income, you might as well buy a small home.

I cannot believe how dare these government officials to use the taxpayers’ money (my annual $20000 to $50000 tax contribution included) to “save” these subprime homeowners from foreclosure. Why don’t they give me a free two loan points on the loan or the cash back to me for buying a home? America is about fairness, but it has all but disappeared in these callings for help.

If you cannot afford to buy a home, then you should not buy to drive up the prices further. Such bailouts are unethical and unfair. It creates moral hazards where speculation is encouraged and prudence is thrown out of window (well, actually this is probably not the first time nor will be the last time). American society has been getting more speculative and materialistic as a result. Being a diligent saver or conservative often gets you nowhere. These subprime borrowers and lenders who have taken excessive risks are not punished but rather rewarded by big gains before blow-up, and then (plan/hope to be) compensated by taxpayers’ money later. In the name of “saving home”, government officials are trying to please these constituents and sounding politically correct.

In all these blowups, government officials even dare to make the investors legally responsible for the entire mess. These investors who provided all the money to make everything possible, will be the biggest losers among all. Once the homes go into default and foreclosure with negative equity, the bond investors will not only lose interest but also principal. And now Chairman (of House Financial Services Committee) Barney Frank, D-Mass., and Spencer Bachus, R-Ala., want to hold bond investors legally responsible. If such legislation passes, it will dramatically make the mortgage-back bonds to be a lot more expensive, making the homes be even less affordable.

Out of all politician in the USA I like Ron Paul the best. He is the only one who sticks to the original spirit of US constitution and can stop the government getting bigger and bigger in increasing the burden on everyone else in the private sector. I will definitely vote for him when/if he runs for president in 2008.

Here is some of the latest real estate headline news:

1. Home builders’ confidence falls to 16 years low.

2. Notice of defaults in California up by 23% from last quarter, and up by 148% from last year.

3. New Century goes bankrupt, slimming down from 6000+ employees down to 100+ people, right at Irvine, Orange county, the center of the mortgage fraud so to speak (Impac, Ameriquest, Resmae, Option One are all here).

4. California new home sales down 37% on an annual basis. Slowest total March sale since 1997. You got to remember one thing that if the absolute number of sale is worst than 1997, it is actually much worse than 1997. In these 10 years, California has been growing population at about 1.5% annually. Normalizing the real estate sale by population, the sale would actually be 14% worse.

I have been saying that the bottom of the bubble zone of real estate won’t come until after 2009/2010, which I have arrived by adding 5 years (before negative ARM gets fully amortized) to 2004/2005, plus 1 extra year of time delay for a home to go through the entire foreclosure process. Jim Puplava said in his online radio that he expects the bottom to come at about mid-2008. I personally think that real estate market is still in the denial stage, where sellers are not willing to drop price. That attitude will really take time to change, until the home owner/mortgage holders get burned through monthly negative cashflow for an extended period like 1 to 2 years. If the amount of price drop is more than 2 years worth of the negative cashflow, sellers are more likely to hold out than cutting price.

I didn’t need a chart to convince myself, but above (click to enlarge) is the mortgage resetting “map” going forward. As you can see, the subprime mortgages are not flushed out yet and coming to reset in volume later this year. The next bigger wave is the 5-year period from the loan origination, which will come in 2010 through 2012 for the option ARM. If you use 9 to 12 months for the foreclosure process, the real estate market is likely to have a small break in 2010 before getting hit by mortgage reset again.

I think that the only way to stop the housing deflation is through inflation of everything else. I expect the real inflation (not the one published by government) to stay above normal for an extended period.

For me to come out and recommend a real estate fund, you know this mutual fund needs to be more than truly outstanding. I’m very bearish on real estate as the regular readers know very well. But this real estate fund, plus its other fund offerings in other categories are simply outstanding. In fact, I should say that it is one of its kind, so outrageously probabilistically impossible.

I first noticed this mutual fund back in year 2002/2003, when I was studying various funds for asset allocation. Certainly, real estate must be an essential element to anyone’s portfolio, especially if you don’t own your home. At that time, I noticed that this fund had a very good performance record. Not only that, when I compared its major holdings with other real estate funds, its holdings are wildly different. Most real estate funds hold companies that hold residential or commercial rental properties, collecting rents to produce their yields. This fund however held mostly home builders. Well, from year 2003 to 2005, home builders had great returns, probably out-beating 80% of the stock selections that you can ever pick yourself. But today’s CGMRX holding has not even a home builder stock in its top ten holding, keeping its 20% annual return for the past ten years completely intact.

The fund manager Heebner of this fund company Capital Growth Management is no doubt a VERY smart investor. Here are some highlights of his recent words:

[On housing markets] It will be the biggest housing-price decline since the Great Depression,” Heebner, 66, said today in an interview in Boston. Prices may fall by a fifth in some markets….That would leave home prices at levels last seen in 2003 and 2004, the middle of boom that lifted prices to a record in 2005. The damage from high-risk mortgages will slow the U.S. economy, though not enough to send it into a recession….
[On financial brokerage stocks] The investment banks and brokerage firms that package and sell these products won’t get hurt because they have passed on the biggest risks to the investors, “They know the product is toxic; they’re not going to get caught,”
[On mining, China, infrastructure plays] He is buying shares of mining companies that benefit from growing infrastructure needs in India, China and Russia. CGM Realty Funds also holds shares of Las Vegas Sands Corp., the casino operator that is developing real estate in Macau, China, and Mexican homebuilder Desarrolladora Homex SAB.

On very few occasions, you can witness such a smart investor. Keep him on your list to watch. Take his words and regurgitate during your contemplation. And if you really have to buy a real estate fund, CGMRX is probably one of the better choice. In this particular case, I would really say “FORGET about the low fee Vanguard”. Here is the comparison chart between VGSIX and CGMRX. Don’t use Yahoo to plot because Yahoo plotting doesn’t take into account the almost 20% capital distribution/dividends in the last couple of years by CGMRX. The following plot uses the price on 12/31/1996 as 1. CGMRX returned almost 7 times or 700% in the last 10 years. (I mispelled CGMRX as CMGRX in the chart.)

On the last note, CGMRX and its other offering are mostly concentrated bets and non-diversified. You will be taking higher than normal risk when you buy one of his funds due to its concentrated bets. But given its past record, although there is no guarantee for the future, I would probably still lean towards buying any CGM funds.

I currently have no holding, but I’m really going to seriously consider CGM funds (not necessarily CGMRX), especially after I’ve missed the entire ramp-up in the most recent real estate bull market (which has probably turned into a bear market already).

Its CGMFX Focus Fund returned 24.7% from 1/3/06 to 4/9/07, and 17.9% from 1/3/07 to 4/9/07, very good this year, but not so good last year. This uncorrelation to the general market is an excellent choice for asset allocation.

I found this quantitative matrix for the lending mortgage interest rate as a function of your FICO score and the LTV (Loan-To-house-Value) ratio. I have saved a copy here just in case the link is no longer available.

The matrix (in A1) makes total sense to me. If I am a mortgage investor, the mortgage interest rate should be dependent on the risk that I would take, which could be roughly measured by FICO & LTV. Although I don’t really understand the difference between A1, A2, B1, B2 tables, the more important message to take home here is that if your lender is not giving you a better interest rate on a lower LTV, your case is probably adding to his or her bottomline. For a FICO of 700, there is a 0.30% interest rate difference between 80% LTV and 65% LTV. A 0.30% on the mortgage rate can translate into a lot of “current” money.

By the way, this matrix is from the recently bankrupt ResMae on 2/13/07. This subprime lender was asked to swallow back $300 million loans purchased by Merril Lynch. Time after time, lenders just don’t realize that you cannot make a deadbeat to pay up when he just doesn’t have any money. You can sue and win, but you will simply lose more money in legal fees.

On the last note, I don’t know whether these lenders who use this matrix has ever thought of the “monetary value” of a FICO score. Anything that you can “quantify” (like a FICO score) you can fake too. Between walking away from a upside down loan worth of $100K and a perfect FICO score, which one would you choose? Despite my strong ethical sense, when $100K increases to one million dollar, I think I may walk away too. If I do that, I would have just “quantified” the monetary value of my ethics/FICO score, worth of a million dollar unpaid debt.

In reality, you can almost always put a monetary value to everything (sorry to be a little cynical here). But of course, I’m glad that my ethics won’t put myself in this situation of owing 1 million today’s dollar of mortgage in the first place.

I do hope that the “monetary value” of my ethics will grow bigger as I grow. But I do know for a fact that when given a real choice, the “monetary value” of people’s ethics is smaller than both the creditor or the debtor thinks. At least, I think this applies to me.

Fremont General just announced that they will not do piggyback loans (80/20). It’s another proof of LTV is a better safeguard than FICO scores.

As I have described how a financial bubble progresses and deflates in my previous posts at My 1stMillionAt33.com: Comparing Bubbles in Real Estate and Stocks, and Best Example of the Real Estate Bubble, this “small cap” and “big cap” phenomenon is repeating itself over and over again. CNN Money news again confirms my observationa and theory.

Another way to visualize the progression and deflation of bubble, think of all individual units as either small cap, mid cap or big cap, with the big cap at the center, while the small cap at the furthest out, all in a circle. The hot money is like a force, lifting and concentrating its force at the center, the big cap goes up first. When the force is sufficiently large, the upward momentum starts to propagate out and lifts mid and small caps. In the last stage of a bubble, the small cap may have the biggest percentage rise-up, but the rise and fall may come very quickly and is not guaranteed. Once all the monetary forces dissipates throughout too big of an area, the upward synchronization cannot continue and breaks down. Since majority of the force is still in the center, the big cap will fall last. But the small cap and mid cap will suffer first. It is not guaranteed that the big cap will suffer a complete breakdown at the end of the bubble deflation. But such breakdown in the big cap will suffice to create the final panic and despair needed to mark the end of a financial breakdown.

You can take my words or trash them. But I still think that although real estate may not be falling down hard in the absolute non-inflation-adjusted price, it will not go up for the next five years with a very high probability. Anyone who is not in hurry can wait and put their money into the next forming bubble. So far, it appears that the markets like to make stock market the candidate. Don’t let your money sit idle or going down in real estate.

Posted by “Frugal” at My 1st Million At 33.com.

This appears to be the beginning of the vicious cycles. Lax lending standards have resulted in loan buybacks and losses. Now they are forced to tighten up the lending standards, which will decrease the loan volume, which decreases profits, etc. This year of 2007 just started, and still a trillion dollar of refinance to go….

Here are some of the symbols that I watch.

Symbols Percentage Dn/Up on 2/8/07 at 8:30am
CFC -2.70%
CTX -2.51%
HBC -2.42%
KBH -2.76%
LEN -2.48%
LEND -8.17%
MTG -3.71%
NEW -36.21%
NFI -11.12%
PHM -2.37%
XHB -2.52%

Housing market is the big elephant in the room that every stock bull wants to pretend not seeing, and won’t talk about.

And what did Fed governor said? “[Interest] rates may have to go up”. Yeah, right! Notice that gold and oil investors are gradually tuning out on the Fed babbles.

In an earlier post (at InvestMiddleWay), I wrote about how the stocks of home builders and mortgage lenders are diverging from the actual weakness in the residential market. In this post, I want to concentrate on the “real” aspect of the residential real estate market. I’ll start off by commenting on a lifetime home purchasing plan from iTulip and discuss my own view of housing valuations afterward.

For those of you familiar with Eric Jansen or his iTulip website, advice on buying homes is probably the last thing you expect. Indeed, iTulip first made its name by calling the tech bubble correctly. More recently, it has been calling for a popping of the housing bubble, such as this article in 2005. To me this actually makes them more credible as the source is free of the usual biases and ulterior motives. At any rate, I found the advice practical, prudent and well thought out. Here is an excerpt:

Step 1: Buying your first home*. Buy a modest house as soon as you can. That means a house that’s not as nice as the one you grew up in, and one that needs some work. But you’re young and smart. Swing a hammer. Slop some paint. It’s one that you can afford using the 20/28/36 mortgage rule… Consider a variable rate mortgage that doesn’t adjust for seven years. You may find it cheaper than a fixed rate 30 year mortgage. You’re going to move in four to six years anyway–this house is just a way to get to the house you want but can’t afford yet. No, not some suicide loan with a teaser rate that adjusts after the second full moon in the first year of the dog or whatever. If you are smart enough to be reading this but can’t understand a loan you’re offered then it’s garbage. Don’t buy it. Good loans are easy to understand.

Buy in a town with a good school system if you can because the price will tend to hold up better during inevitable real estate downturns. Don’t buy a house at the top of the market in a lousy neighborhood…

Step 2: Buying your second home. Four to six years later, sell the modest house and use the profit as a down-payment on your first good house. Again, look into an adjustable mortgage that stays fixed for seven years.

Step 3: Buying your third home. Four to six years later, sell the good house and use the profit as a down-payment on a great house. Take out a 15 year fixed rate mortgage and pay if off in ten years.

Using this method, by age 50 you’ll own a great home free and clear, while riding the real estate cycle up and down and without having to win the lottery.

What not to do:
• Nothing. Wait for money to fall out of the sky. As you can see, the process takes time. Starting a 20 plus year process works better when you’re 25 than when you’re 40. (See caveat*, below.)
• Buy more house than you can afford using the 20/28/36 mortgage rule…
• Purchase a suicide loan, liar loan or other horrific loan product. (These are soon to be nixed by regulators, anyway.) If you can’t afford a home with a fixed rate mortgage or a seven year adjustable on the 20/28/36 rule, look for a smaller house or condo or wait until you’ve saved more money and your income is higher.
• Consume your home equity…
Just as there is no more ludicrous form of slavery than the one we can impose on ourselves using unsecured debt to purchase depreciating assets like cars, there is no greater freedom than owning a home clear of a mortgage. Getting there isn’t rocket science.

Housing Bubble?
Of course this being the iTulip, there is a caveat:

* Note on Step 1, Buying your first home. We are early innings in a real estate bust cycle. These tend to last five to seven years but this one may last as long as (ugh) fifteen years, due to the extreme of the housing bubble. This boom peaked around the middle of 2005, and may not bottom until 2010 or even 2015.

Obviously, iTulip believe we’re still in the early aftermath of a housing bubble. Whether to call housing a “bubble” is just semantics, but it’s plain as day that prices have increased significantly in many coastal markets. The following article contains a table of 5-year (to Q1 2006) appreciation rates for 275 metro areas compiled by the Office of Federal Housing Enterprise Oversight (OFHEO). The gains range from a meager 8.32% for Lafayette, IN to a blistering 146.4% for Madera, CA.

The key question to ask at this juncture is what kind of appreciation is reasonable? I use a simple rule of thumb based on Robert Schiller’s work that in the very long term, home values only keeps up with inflation. For inflation, one can assume 3% per year if one wants to used the government CPI number; 5% per year is probably more reasonable if true living cost like food, energy or insurance are included; or one can use 7% based on M3 growth. I’m feeling generous so let’s use 7% for now. In five years, it gives an “in-line” appreciation rate of 1.07^5 -1 = 40.2%.

To appreciate how much home value have increased across the country, note that if we rank the 5-yr appreciation rates as compiled by OFHEO from the lowest to the highest, 40.2% (my in-line figure) corresponds to 151/275, 80.4% (2x in-line figure, getting warmer) to 213/275, and 120.6% (3x in-line figure, hot, hot, hot) to 255/275. 12 of the top 20 gainers are in California, the rest in Florida. Although more than half of the nations market appreciated less than the “in-line” figure of 40.2%, the value of the homes in the hottest areas are much higher. Consequently, the mortgage backed security market is dominated by issues from those areas.

If I were in California or Florida, would I start the long term home purchasing program as outlined by iTulip? No way! Had I been in one of the cheap locals? Absolutely! How about something in-between? As an example, let’s consider the city of Philadelphia that had a 5-yr appreciation rate of 74.29%. My quick rule of thumb says it was 1.7429/1.402 = 24.75% overvalued as of Q1 2006 as opposed to over 70% overvalued in Madera, CA by the same methodology. The answer here is not so clear cut. There are a number of other factors to consider:

• House values can revert to the mean via a combination of price decline and inflation.
• There are tangible psychological benefits to being an owner provided household finances are not stretched.
• Price and availability of rentals
• The length of time one intends to stay in the home

In the end, I can see a rational person going either way.

Obviously my rule of thumb is just that: a quick estimate based on a single variable. It assumes all housing markets are fairly valued five years ago and doesn’t take into account housing quality or other specifics. The OFHEO data paints a bleak picture for RE in the formerly hot markets in California, Florida and possibly Arizona and Las Vegas. Lenders and builders in those markets will be under pressure but the majority of markets across the nation will not be affected much. While it’s too early to call for a housing bottom or a soft lending, we will not have a great depression either.

Due to the recent blow-up in subprime mortgage companies, it is no surprise that subprime borrowers are facing tougher qualications for mortgages. The interest rate has gone up by at least one percentage point, besides tracking the recent increase in the treasury market.

Reading from the above link, and checking with my friend in mortgage business, it is still very surprising to me that the current lending standards are not as tight as I think it should be:

Higher credit scores. Previously, borrowers with a FICO credit score as low as 570 (out of 850) could qualify for a single loan financing 100 percent of their home purchase, Carmona said.

“Now, across the board, it’s jumped up to a 600 FICO score for an 80/20 loan,” Carmona said, in which a second loan has to be taken out to finance the remaining 20 percent of the home value

A loan with no down payment has zero buffer zone for a borrower whose net worth is close to zero to mail back the keys to the bank, especially when

1. the mortgage payment is higher than repaying ability,
2. or the mortgage payment is higher than rent,
3. or the equity in housing is a big negative number.

Such is a get-rich-quick dream turning into a destruction of one’s own credit report file, and the bank will need to eat up all the losses from the fall of housing market, PLUS any difference between the appraisal and the actual housing value.

I think 600 FICO is really low by my standard. To think that a 600 FICO score is worth some $20K to $50K or more in the lender’s mind is a little bit ridiculous. Even though the bank can theoretically sue to get back the money due on the 20 portion of the 80/20 loan, how are you going to find the missing money of $50K when the person just doesn’t have it?

Here is a list of subprime mortgage lenders going bust or reducing operations. All of which went down because the investors of the mortgage loan demand buy back on the EPD (Early Payment Default) or that their packaged loan has become toxic that it is NOT investable:

1. OwnIt (partialy owned by BofA) closed door on 12/7/2006.
2. Option One (owned by H&R block) for sale, cutting workforce by one third, and earning forecast by 25%.
3. Equibank / Wachovia, an immediate shutdown.
4. MLN temporarily stop funding loans.
5. Metropolitan Mortgage in criminal suit.
6. Mandalay Mortgage shut down.
7. Kirkland Mortgage in Seattle shut down.

For more fireworks in the subprime mortgage land, you could visit the Implode-Meter.

Frugal at My 1st Million At 33.com

Welcome to the carnival of real estate, hosted at 1stMillionAt33. There are over 30 entries. Plenty of readings for anyone interested learning more about real estate. The entries are listed mostly in the submission order by the categories. Please check out the articles that interest you.

My personal pick of the week for carnival of real estate is Timeshares: Good Investments or Travel Scam? from Queercents.

TheLandJournal.com presents Rural land pricing will never look this good again to buyers, expect huge sales.

Getting Green presents The Many Faces of Mortgage Fraud & Rip-offs.

Investment Property Insider presents A Roadmap For Commercial Real Estate Syndication, Part 1.

Aridni presents Real estate that saves your wallet, but not much more.

Searchlight Crusade presents Vampire Properties.

Realty Thoughts presents Niche Real Estate Blogs.

YoChicago today presents Olympic Village is coming to Chicago, games or no games.

Chicago’s Home Weblog presents Urban Legend, The Top 10,000.

The Real Estate Guide presents Don’t Try To Time The Market.

Dorky Dad presents Trying to get it right: Ben Stein is wrong about Real Estate Investing.

Queercents presents Timeshares: Good Investments or Travel Scam?.

BloodhoundBlog presents The Right Time to Buy: An Investor Perspective. With interest rates creeping up and home values creeping down, is now the time to make a large purchase?

RealProspex presents Commercial real estate buyers: 8 ways to find the right deal without searching

Yahoo! Search blog presents Home Search Update Now with Schools.

Moneywalks presents 5 common homebuyer mistakes you want to avoid.

Big Time Real Estate Listings presents Rocker David Grohl buys 3rd home in Oxnard.

1SiliconValley.com presents How Much House Can I Afford? (Part 2 of 2).

No Down-Payment Home presents No Down Payment Home – How I Did It.

Leslie Pandey at Zillow Blog presents Hollywood’s Heartbreak Homes.

Salt Lake Real Estate Blog presents Housing Panic Disingenuous?.

Reasoned Audacity presents Are Children at Risk in Red States?

360Digest presents Shack Prices, referral fees, cherries and designer dresses…

1031 Exchange Lowdown presents 77 Surefire Ways to Increase Your Home’s Value.

Mike’s Corner Web 2.0 For Real Estate Pros presents How Podcasting Impacts Local Search Relevancy.

Altos Research Real Estate Insights presents MeeboMe as Killer Real Estate Marketing Tool. Instant Customer Service & Lead follow up with Meebo

Real Estate Convergence presents Housing Glut Gives Buyers Upper Hand.

Mortgage Home Loan and Real Estate News presents Mortgage Loans presents: Mortgage Loan Shopping: LendingTree, E-Loan or Quicken Loans?

Renthusiast presents BrightSale defines what it means to be 2.0. Online Estate Agents BrightSale.co.uk give their definition of a 2.0 value system and why they feel ready to change the way the UK buys and sells property.

MiOaklandCounty.com presents The Answer to Everything Can Be Found On The Internet!!

Mike’s Corner Web 2.0 For Real Estate Pros presents Interview: Ken Brand – Exceptional Leadership Through RE Blogging.

The Most Opinionated Mortgage Broker presents Wanna be a Trust Deed Broker?

Clifford Jacobson presents Real Estate 2.0: High Tech, High Touch, or High-Tech Touch? Thoughts for Agents about Real Estate 2.0, High Tech and High Touch.”

Overseas Properties presents Bets on Brazil property as future favourite.

Transparent RE.com presents Cyberhomes and its future.

Thanks to all those who have participated in this carnival. Past posts and future hosts can be found on our blog carnival index page.

I just read this story from LaTimes.com. Some guy had an equity of some $275K in his home, and he spent through it all. Here are some interesting excerpts from that link:

In the first eight months of 2006, even as the real estate market began to weaken amid fears of a downturn, the appeal increased again. Nearly 1 in 3 California loan applicants are now choosing them. The state boasts about 580,000 active pay option mortgages, about half the U.S. total.

Hertzberg’s home equity paid off his credit cards, financed trips around the world that allowed him to indulge his passion for photography, bought a $32,000 Toyota Avalon and enabled some lousy investments. He bought dot-com stocks and lost money. To recoup those losses, he bought commodities — and lost money faster.

But the day of reckoning is arriving early. By paying the minimum, Hertzberg has increased the size of his loan in a little over a year from $320,000 to $332,616. His lender, Calabasas-based Countrywide Financial Corp., recently sent him a letter warning that when his loan hits 115% of its original size he’ll run out of credit with the company.

The article said that his “life line” will run out in two years. But my calculation shows that it should be another four years (about 3% every year). Maybe I’m not using the correct current interest rate. In any case, such loans get recast every five years. So looks like he delayed his time bomb to 2010, assuming that he can get through annual 7.5% increase in the minimum payment year after year.

If you think his case through, don’t you wonder where the funny money comes and goes? It’s a house in 1995, and it’s the same house, but older in 2006. Just the valuation of the house has changed, but no economic productivity has increased. The flood of cheap money is coming from Asian savers and central banks, while Americans spent thru it. When Asian savers retire and start to withdraw money from the system, where will the “money” which is already spent come from?

When the wealth of a society is created primarily based upon a higher valuation of the assets, the wealth can go away as easily as it comes (when the valuation changes).

I’m guessing that at the end, the creditors/savers cannot get their saved (paper) money back, since the debtors/spenders would either have no money to pay back, or print more worthless ever-depreciating paper money for the savers.

As far as the real estate market goes, I’m still in the camp of slowly unwinding from the height, since the lending standards have not tightened much (this guy Hertzberg was able to refinance last fall). The housing market may rise up again if

1. wage income inflation catches up with the past housing inflation, or
2. long term interest rate falls even further, hard to imagine, but that’s the current forecast by the bond king Bill Gross (down to 3%).

I’m guessing that scenario #1 is more likely, if $US undergoes an orderly decline. But the outsourcing trends will probably cap the wage increases.

I don’t believe that scenario #2 will happen. I believe that along with the turn of housing market, the bond market has also turned. The sentiments among foreign central banks have turned, and diversification out of $US has been the key messages.

After many thoughts about this home, the sticking point has really been the second-rated school district (but still better than probably 85% of the schools in California). Despite that the performance of a school district changes year from year, I just can’t make myself commit to it.

However, one really positive point about that home is that at the next door lives my nice friend from Church. It would have made baby-sitting so easily between the two families that I think my wife’s childcare burden will be reduced by at least some 25%. I keep thinking whether this positive would outweigh the negative.

I called the listing agent myself again this Thursday to check on the status. I thought the home must have been sold. Surprisingly, I heard the exact same story again:

There are two offers on the house. You should make your offer in the next couple of days before the bank approves those loan terms.

Not sure what’s the real story behind. But my agent certainly have delivered the words from listing agent verbatim. Looks like it was probably a trap.

After some research, I also found out that the price of my own residence has fallen further, now by some 10% from the very peak. I will update my net worth at the end of year to reflect this change (although I have assumed a more conservative price when calculating my net worth). In my own community, the homes that are sold or still active have gone through an incredible number of days on market (DOM):

• The active ones have DOM of 160, 125, 21, 50, 97, 84.
• The ones that have recently sold had DOM of 43, 131, 65, 59, 176, 17, 13, 31.

This housing market is getting REALLY slow. If I made a non-contigent offer on the home, I probably will have DOM of 150+ with either the similar pricing or lower.

I keep thinking to myself that maybe next summer I will have a lot more choices when more homes will come to the market. The slow housing market is making any house move to be difficult.

Many thanks to all who have responded last time. Your inputs gave me more angles on the issues. Waiting now should be to my advantage. And I can’t really spend $600K in just 1 week.

In the past few days, my mind is focused on whether I should be buying this home:

1. Built in 1995, 3 bedrooms, 2.5 bathrooms, 1940 square feet, detached condominium (just like single family home, but with some legal differences).
2. Price is $600,000. Annual property tax + Home owner association dues + Insurance is about $10500, not including any amount of mortgage payment. Part of the $10500 is tax deductible.
3. School district is not one of the best, but second rated (actually one of the worst around that particular area).
4. Current owner bought it for $680,000. Still haven’t paid 2005 property taxes of some $5000. Apparently, it is not working out for him.
5. This property has been on the market for about 160 days total, after probably a couple of rounds of price reductions.

Before my vacation I think the price was $635000. After my vacation, the price is $600000. My agent told me that there are now 2 full price offers. My agent probably is not lying to me, but I don’t know whether the listing agent is telling the truth. I was told that if I don’t make an offer this Friday, I would lose this home. If the seller doesn’t find and accept an offer, he will go into foreclosure.

Dear readers, shall I fork over my money and make a non-contingent offer? I plan to sell my current residence if I buy this. But in this slow housing market, it will probably take a minimum of 3 months if not 6 months to get it sold.

Any advice is appreciated. Thanks.

I just discovered that you can search for foreclosures in addition to regular MLS listings on Yahoo! Real Estate. It was completely new to me.

For example, in my zip code, when searching for a 3+/2+ single house, I got 44 MLS listings between $350k and $450k. Checking for foreclosures, I got 6 entries, all entered on Oct. 11-12. Half of the entries had auction dates prior to October so I suspect the foreclosure feature wasn’t available till then or it wouldn’t be very useful. Looking at other zip codes, I found houses in all stages of the foreclosure process, from “notice of default” to “foreclosure sale”.

Each of the 6 foreclosures has an associated price that varies wildly from $129k to $423k. Further investigation indicates they are merely “estimated bid amounts”. The “More information” button leads to RealtyTrac which offers a 7-day free trial. The membership gets you the standard property information plus detailed loan information including the default amount, the last payment and the name of the owner (see the screen shot below).

Not knowing much about the foreclosure process I’m not sure if the average home buyer can really take advantage of this information (Would someone at the NOD stage be a “motivated” seller? More likely they are in default in the first place because they are “under water” on the mortgage.) On the other hand, the number of foreclosures is an indication of the health of the local housing market (e.g. 305 listings in Sarasota, FL).

If you know more about foreclosures or how to take advantage of this information please leave a comment. TIA.

California is one of the biggest state in the USA. The dynamics in CA can been seens as a microcosm of the entire US (actually CA is almost 1/6 or more by GDP). Since I’m most familiar with the state of California, my discussion will be mostly drawn from events in California, even though similar dynamics is playing out in other regions.

Currently, there are two obvious trends, all hitting the headline of the newspaper:

1. Sale volume in housing market is down dramatically. Housing market is no longer rising on the average.
2. Residential rental market is picking up steam. Rents are rising at a much faster clip, many at 6% to 7% annual increases.

All these come as no surprise to me, since I have specifically stated different strategies for different people in my Unconventional Strategies in This Housing Market back in June, fully expecting this unfolding scenario.

If one can understand how things are the way they are today, one can better anticipate what could come next.

The sale volume is down big because there is certainly a change in the sentiment of the participants, especially in the overall real estate investing segment. A very significant part of the sale volume is due to second home buying, and purely investor buying. The exact number is hard to tell, but my guess is probably 20% to 35%. Some of the CA real estate investors have gone out-of-state for better values. Some of the investors are stopped by rising short-term interest rates. The late investors are bleeding cash probably on the monthly basis, which is forbidding them to flip their last home trade for a profit. It’s one “trade” gone bad, and the game is slowly over for them. Some certainly pocketed good profits previously, and can get out less scathed, or have a better holding power. But many of them may have spent significant portion of the profits that were earned in previous trades, and a trade gone back means no more home-flipping income.

In any case, whether it is because of voluntary or forced retreat, investors no longer participate in the same fervish way as before. This is the most obvious from all the national home builders reporting dramatic rise in the cancellation rates (cancelled by home-flipping investors, and/or cautious would-be home owners). What’s left in the housing market is the remnant of new stupid investors and normal home buyers. However, with volume going down, it pretty much means that price cannot be pushed up through a more fervent buying process anymore. Prices will be determined by other factors.

That is the current price environment. However, price alone does NOT tell the whole story. If you buy any stocks, you know that there are really three prices: transaction price, and bid/ask. In the real estate market, the asking price is the most visible. Transaction price come out with maybe two months lag. However, only sellers can see the bidding price. In the stock market, market makers will balance the bid/ask, and try to facilitate the marketplace by putting out a transaction price closer to the dollar-weighted price of all bid and ask prices. In the real estate market, the real estate agents and brokers perform the same function. They won’t get paid if there is no transaction, and therefore, first and foremost, they want to bring the buyers and sellers to come to the same term in price. Why is NAR telling sellers to tone down sellers’ expectation in price? Because the bidding price is actually WAY LOWER on the average than the asking price, and these agents can only make transactions happen by bringing down the price (and not the other way around). Even the new homes are having all sorts of incentives and discounts which in effect lower the actual asking price.

So what is happening is that ask price is probably slightly down to 10% higher than last year, while very few transactions go thru to the advantages of sellers because of greater fools and never-ending lies from real estate agents, and increasingly more transactions go thru in the advantage of buyers. There are not more transactions because there is a BIG spread in the bid/ask price. If you have such things happening in the stock market, you will call that as “illiquid” or less liquid market, which also translates into lower transaction volume.

Once you take the average of all completed transactions, the price is about flat, since the sellers were expecting 10% to 25% higher in price than last year.

Rents were depressed partially because of more new homeowners who “shouldn’t” be homeowners due to zero down payment or extremely low mortgage payment from the negative ARM or interest-only ARM. Now the same factor is working in reverse to the advantage of the rental market. For the first-time home buyers, it is becoming tougher for them to either come up with a hefty down payment or qualify for a higher mortgage amount.

Besides, the bulls in the real estate market is right all along in that both job market remains strong, while population (+ all new immigrants) growth is steady. By default, it means housing demand. And if the housing demand is not going into the housing market, then it must go into elsewhere, in this case, rental market. Many places, like Southern California, have rental vacancy rate of less than 4% (or 96% filled). It practically means that it’s all full since you are always bound to do some cleaning up inbetween move-ins. And what that means is Pricing Power for the residential rental market.

Yes, rents are going up more. And unfortunately, they will keep going up at a faster rate than general inflation rate or CPI. It will go up until two things happen (forget about factors due to housing market for now):

1. People start to move out of California.
2. Business cannot find their employees at the salary wage that they want to pay, and start to move out of California.

I’m not saying that both of the above will happen. What I mean to say is that the growth of both population and job opportunities will probably go down to match what is happening in the rental market. Essentially, all markets will find their equilibrium point. It is hard to say what is the final equilibrium which is a dynamic balance anyway. However, things will only happen slowly. Average people’s ability to forecast the future is limited. When there is some change, they simply ignore them, and expect things to stay the same, until the change becomes a consistent trend. I don’t expect most people to move out of state, but rather coming in less, or through attrition due to various reasons.

At the same time, for the expanding business and the new business coming into California, they may be in for a surprise (if not already). It will become harder and harder to find skilled workers (or even unskilled workers for that matter) willing to accept the same salary level as before. Workers will demand a higher pay because of a higher rent, either because of necessity or because of expectation. Turnover rates will be higher. Competition for workers will be tougher. So for the businesses, they only have two solutions: pay more, or move out. Some of them will definitely pay higher, while the ones that cannot afford to pay more will move out. It is like Darwinism, survival of the fittest.

In the meantime however, workers will trench down first and take up the rental rate increases on their face, while businesses will simply expand slower with lots of unfilled job slots (until they raise the wages). The bulls in real estate market are right about the growth. But the markets ADJUST. And the adjustment is certainly that growth will be forced to slow.

In the two previous posts in this series (here and here), I discussed a basic allocation plan using stocks and bonds. The current article examines some alternative asset classes that may boost the return without much additional risk.

REITs
Real estate investment trusts are a very popular sector in the past five years along with the bubblicious housing market. REITs (and other income trusts, MLPs) can be thought of as straddling both stocks and bonds. They are ultra long maturity fixed income plays that also reflect the value of the underlying assets. You will not find them in the portfolios at Fund Advice, but they are included in many other plans including that of Index Fund Advisor. A typical allocation would be in the range of 5-10%. There are at least four ETFs of REITs (IYR, ICF, VNQ and RWR) as well as numerous mutual funds available. Current yields of the ETFs are 3-4%.

My thinking on REITs has been evolving. I have been wary of the housing bubble as I have written elsewhere; therefore, it was natural to be concerned about the value of the underlying real estate. On the other hand, REITs are not the same as residential housing, there are apartment/commercial/nursing home/forestry REITs that may be quite resilient. The price action certainly supports the latter view. The chart below compares IYR (iShares DJ Real Esteat Index ETF) with ^HGX (Philly housing index, mostly home builders). You can see that IYR has been steadily increasing with little volatility since 2003 even as the home builders peaked last summer and the apparent deflation of the housing bubble.

More information on REITs can be found here and here.

MLPs and CANROYs
Master Limited Partnerships (MLPs) are similar to REITs in that they do not pay income taxes, and their shares trade on the major stock exchanges just like regular stocks. However, REITs and MLPs are different in structure. Unlike REITs, which are a special type of corporation, MLPs are partnerships. MLPs get special tax treatment. An MLP does not incur income taxes. Its income is allocated among all partners in proportion to their ownership interest. To qualify for the tax benefit, 90 percent of an MLP’s income must come from activities in real estate, commodities, or natural resources such as mining, timber or energy production and related activities. However, MLPs may not be suitable for IRAs and other tax-sheltered accounts.

CANROYs stands for Canadian royalty trusts. More often than not they are oil/gas operators which ties into the commodity theme below. They grabbed dividend investors’ attention during 2003/2004 because many of their payouts were equating to 15% to 20% yields. Now, because so many investors are on to them, share prices have gone up, dropping yields for most to the 6% to 12% range.

Frugal has written on both topics:
Master Limited Partnership – Great Dividend Savers
List of High Yield Dividend Stocks (Up to 18.6%)
Royalty Trusts – Get Paid Royalties w/o Paying (Much) Taxes

Commodities
“Commodity” is a wide-ranging term encompassing hydrocarbon fuels (oil, gas, coal), metals (precious and base), soft goods (grains, sugar), etc. They tracked by at least three major indices: the Commodity Research Bureau (CRB) index, the DJ/AIG commodity index and the Goldman Sachs Commodity indices. All have shown tremendous appreciation since1999.

If you have been following my other articles, you would have known that I’m heavily over weighted in precious metals (PMs) and the energy complex. One attraction of PMs is their lack of correlation to either general equities or bonds according to this study by the highly regarded Ibbotson Associates. I have yet to write a big picture overview for the PM sector, but I urge readers to visit the PM related sites I have linked to in the side bar.

Anyone had to fill up gas in the last two years would understand my preoccupation with the energy sector. I subscribe to the “peak oil” theory which basically states that the world’s reserve of cheap oil has already/is going to run out soon. Again, this is a topic deserving of at least several posts of its own, and I won’t go into much details here.

Hot Commodities : How Anyone Can Invest Profitably in the World’s Best Market Jim Rogers was the best selling author of Adventure Capitalist and Investment Biker. He was also partner to Soros in the legendary Quantum fund. “Rogers also offers practical advice and information for beginners, including the best resources, how to read the commodities reports in the newspaper or on television, the various ways to open an account, information on index funds (such as Rogers’ own index fund that he started in 1998), mechanisms, terminology, and other vital details people must know before investing. Clearly written and entertaining.” — Amazon review

There are two ways to gain exposure to commodities: buy the commodities themselves, or buy stocks in the commodity producing (including exploration) companies. In the first category, the Pimco commodity real return strategy fund (PCRDX and family), the newly launched Deutsch Bank commodity index ETF (DBC) and the more recent iSharies GSCI trust (GSG) are convenient ways for participating through the commodity futures market. For PMs specifically, there are three index ETFs (GLD and IAU for gold, SLV for silver), and a close end fund (CEF, the Central Canada Fund) for both gold and silver. For crude oil, there is USO. Buying the actual commodity eschews individual company risks and may offer short term trading opportunities.

Stocks in the commodity producing (or exploration) companies are more volatile, usually carry some political and management risk, but also offer a healthy leverage to the underlying commodity as they come to be more and more valued on their secure reserves. There are many mutual funds and ETFs available in this area. For precious metals, ASA, GDX and GGN are traded on US exchanges; XGD is traded in Toronto. Gold mutual fund performances in various time periods can be viewed here.

I have spill the most ink in this section because in my view its lack of representation is the biggest weakness in Merriman’s portfolios. Currently, my own target allocation is 30% general domestic equities, 30% general international equities, 10% commodities and 30% bonds. In my actively managed accounts however, PM and energy shares are weighted much more heavily.

Municipal bonds, foreign bonds/currencies, income producing closed-end funds
I’m lumping all these together under the big umbrella as alternatives in the fixed income category. A great site to do research on them is ETFconnect.com.

For individuals in high tax brackets and whose bond allocation are in taxable accounts, municipal bonds offer superior return as the income is tax free at the federal and state (if bonds are from the state you reside in) level. There are closed-end funds that offer very respectable yields (5-6% with leverage).

The US$ has been trending downward since 2000, although the decline was interrupted since the beginning of 2005, longer term it would have to lose value (against gold and Asian currencies most probably) in order to pay for the Social Security and Medicare obligations. It won’t happen in a linear fashion or overnight, but diversification into foreigh bonds or currencies seems prudent and consistent with the basic tenets of asset allocation.

The Dollar Crisis: Causes, Consequences, Cures , Revised and Updated Posterity may remember The Dollar Crisis as a seminal book in the field of 21st century economics. Indeed, rarely has a book offered such a grim yet, well argued view of the current economic situation facing the world.”– Steven Irvine, FinanceAsia

“Duncan writes like a man who’s already seen tomorrow.” — James Grant, Grant’s Interest Rate Observer

One can purshase foreign bond mutual funds. I currently own OIBAX ( it has a front load). Some no load alternatives are PSAFX (has ~15% PM, my wife owns), BEGBX, PFBDX, PEMDX, LSGLX, etc. There are plenty of closed-end funds in this area, again the best bet is to do a search on ETFconnect.com. Yields of high single digit can be expected. On the currency side, Everbank offers foreign currency CD’s (single currency CD’s with a minimum of $10k, index CD’s from 20k) that are worth looking into.

I found this term when surfing one of the financial sites over the weekend and thought it an apt term for my thinking at this time. Just to clarify: I’ve been writing about asset allocation which normally calls for being fully invested at all times. However, only about half of my assets are invested that way. With the other half, I try my hand at stock picking as well as market timing.

A big part of my approach is top-down, macroeconomic based. Frankly, I see the US and to a lesser extent, global economy on very shaky ground. A central theme of our economic system strings together (over)consumption of the US consumer, Asian and Middle Eastern trade surpluses and recycling of these surpluses into US debt instruments. A crack in this chain would bring painful adjustments for everyone involved.

I see the US consumer as the weak link in this symbiotic relationship. Unless you spent the last year in a cave, you are well aware of the drastic slowdown in the housing market all around. But a “soft landing” remains the current consensus. Although many home builder stocks have lost 50% or more from their peak they have stabilized since July. I, however, count myself in the camp that thinks the unwinding from this historic housing bubble is far from over. The next phase of decline, may well involve lenders and mortgage backed securities (MBS) such as this latest news on bonds from Countrywide Financial suggests. [Disclaimer: I’m shorting BZH and LEND.]

“What a load of crap!” I can hear you say, “What about the Dow’s daily new highs?!” I admit I didn’t see that one coming. I have some positions in bear market funds. Even though I’m net long the market, watching this relentless upward march in the major indices has put a knot in my stomach the size of which I never imagined possible.

So it finally brings us to the term “ideological bear” which to me is a state of being bearish, yet gored by this bull too many times to go seriously short. Funny, maybe, unless you are in the same shoes. After much soul searching though, I still see this rally fueled by liquidity akin to the post Y2K “melt-up”. Of course, if we’re closer to 1995 than 1999 there will be a tremendous opportunity lost. Alas, only time will tell.

I’m sure everyone understands the difference between a positive cashflow and a positive earning, right? This post is just a brief summary for investors, and a friendly reminder for the real estate investors out there.

On Stock Market Investing

When you look at the financial reports of any public traded companies, there are income statement, cashflow statement, and balance sheet. The cashflow statement indicates how the company manages its cash, while the income statement tells you how the company is earning/losing its money. Normally, you would like to see both good positive earning and cashflow. However, both cases of a positive earning with a negative cashflow, and a negative earning with a positive cashflow are possible. And it is important to understand the difference.

A positive cashflow simply means that incoming cash is greater than outgoing cash. It means that the entire process of the business has enough cash to self-sustained itself. However, how much it earns from the process is an entirely different story. The earning or income is the actual real profits assuming that all booked entries can be collected from customers. It is all of your revenues minus all of your expenses. So when the collectibles pile up without any trend of going down, or that the revenues are generated through vendor financing, it is a big sign of danger ahead for possible big “extraordinary” write-off of past booked revenues. Such booked revenues are of low-quality revenues which usually don’t translate into positive cashflow. Some companies do this kind of extraordinary write-offs of past booked revenues regularly, and it’s almost like a regular recurring expense. You should never invest in such companies.

On Real Estate Investing

In the case of real estate investing, if you can generate both positive cashflow and positive earning, it is a great investment indeed. But if you generate positive earning with a negative cashflow, I think it is still pretty good. Such scenario can arise when the rent you collected cannot cover the all the expenses including mortgage. Since mortgage payment has two components: principal and interest. If your collected rent covers beyond the amount of interest charge, but does not cover fully the principal paid down, I think it is still very good real estate investment. The only downside is that you will be forced to put your saving away into the principal balance of this mortgage. You should also account for tax reduction that you can get properly. It’s best if you file a W-4 to reduce the your withholding amount if you work full-time, but is also a part-time real estate investor. Otherwise, you should manage the cashflow carefully on an annual basis (for tax refund), instead of monthly basis.

But if you are a real estate investor who uses negative amortization loan to improve your cashflow, while counting on housing market to go up 7+% every year, I advise you to look at your “income statement” carefully. A positive cashflow does NOT equal to positive earning. Your net earning is reduced by the amount of additional interest debt accumulated. I assume that you understand the difference between payment rate and interest rate in a negative amortization loan. Any advertised rate that is below 1% + 10-year treasury bond yield (about 1+4.7% now) is most likely a payment rate, not the actual interest rate. Payment rate is the teaser rate you will be paying initially. It’s not the interest rate at which you are charged for. To find out your net earning, you should probably use the interest rate and simply calculate how much you would earn on a presumed interest-only loan without any principal paid. When your net earning is not positive, I would only advise positively on such deals under two kinds of scenarios:

1. A very good reason to believe that your collected rent can soon catch up to produce a positive earning.
2. A very good reason to believe that the housing price can keep going up to make up the shortfall of your negative earning.

Usually, it’s not that easy to predict either the rental or housing markets with very high accuracy. I’m more conservative, and therefore my suggestion for most circumstances whether to invest in a real estate deal is when you can produce a positive earning or breakeven right from the beginning, and not relying on the increases in either rental or housing markets. Or at the minimum, your breakeven collected rent should not be more than 5 to 10% of your starting rent. At 10%, you will need to increase your rent by 5% for consecutive two years to get to the breakeven point. That may be quite a lot to ask from your tenants.

Many real estate workshops or books emphasizes two points: No Money Down and Postive Cashflow. I can understand why those are their key selling points, because to sell to the mass who may have money/cashflow problem themselves, the two points are music to their ears. I’m not saying that those two points are not important. But I think a positive earning is the MOST important thing than anything else.

And the last important thing that many real estate investors don’t account for is calculating the cost of down payment. Some people don’t even pay attention to down payment. They think if they put down more and borrow less, they can make a real estate deal to be earning-positive. That is certainly a wrong perspective. The more down payment you put down, the less loan you borrowed, but the more invisible opportunity cost you pay. You can use my Rent vs Buy Calculator to determine how much opportunity cost you are paying. It accounts for the opportunity cost by allowing you to enter your own assumed investment return and your own tax rate. It will accurately account for the opportunity cost that you will pay (using your own assumption). You can put in your assumed collected rent to find out whether the deal will positively earn you money (along with assumptions of rent & housing inflation).

Sorry, I just don’t have respect for someone who does not do his job according to his duty, and then tries to clean his act up, and keeps playing this confidence game by words: “the worst of housing correction may already be over”. Housing boom due to global integration and the collapse of Berlin Wall? Say what? Are you telling me that you didn’t know what you were doing? Who played words on deflation scare in 2002/2003 to drive long term bonds to ridiculuously low level while deflation was nowhere to be seen? So it makes no difference for homeowners and investors to have a short-term interest rate at 6.5% or 1.0% (for 1+ years)?

If US ever goes into a hyper-inflationary depression, one of the root causes will be due to actions and inactions from Greenspan and Bernanke. The game and fruits of inflation are very sweet while the bitter ones has not come yet. A revered Fed chairman? We will see how history judges Greenspan. If he lives long enough (20 to 30 more years?), maybe he will just see how things unfold for himself.

With current interest rates well below 5.0%, I suspect that Fed has probably bought enough 10-year and 30-year treasury bonds (by printing money) to drive down the interest rates for ARM resets and propel the stock markets higher. More money, more inflation. Since all of these money won’t manifest its inflationary power for quite a while, it’s just the right medicine for the right time. And better yet, the more US inflates, the better it is for all the debts. As long as US can keep its image of a strong (military) country with vast resources, all the Asian and Middle East people who don’t live in the US will not have any ideas about why music CDs costing $10.99 several years ago are now costing $15.99, or why a $10 haircut is now $15. Hey, they don’t live here. How would they know? As long as they are willing to fund the US spending style, we get to spend the money and send them more IOU papers. It’s a happily consuming nation. Remember Bush always said, we will defend our democracy and lifestyle? Don’t mean to take his words out-of-context, but a war if for oil will be indeed a war for the lifestyle.

Yeah, a lower interest rate definitely helps the housing market without a doubt. I even saw two houses that were on the market for 100+ days recently sold after long term interest rate plunges under 4.75%.

What exactly is a Liar’s Loan? A Liar’s Loan is another term for the low-doc or no-doc loan. It’s also called stated income loan. Here is the quote from LA Times:

Industry insiders have a nickname for low-doc and no-doc mortgages: liar’s loans. The phrase reflects the suspicion that many of the borrowers who get such loans don’t have the income or assets to qualify the old-fashioned way.

Who in their right minds will opt for paying higher interest rate instead of documenting their income? Unless they are like self-employed businessman who may have a hard time for documentation, they are probably unqualified liars.

What’s some statistics of lying on such loans? Only about 10% of people were telling truth in an example.

One lender recently compared 100 stated-income loans with the borrowers’ tax returns and found that only 10 of the borrowers were telling the truth about their wages, according to Mortgage Asset Research Institute, a division of data firm ChoicePoint Inc.

Sixty of the borrowers had exaggerated their incomes by more than 50%, according to the institute, which didn’t identify the lender.

I don’t know what’s the percentage of self-employed, but I bet that there cannot be one third of Californians all self-employed and need such kind of loans?

As the state’s boom went on, the mortgages became so popular that they now account for a third of new loans, according to data tracking firm First American LoanPerformance.

So it goes without saying that a significant percentage of these loans most likely will crumble down at the expenses of others, when the boom turns bust.

Our American values have sinked so low that not only lying on the loans is perfectly okay for many people, but getting free rides from loan applicants makes perfect business sense. I contacted a homebuilder designated lender once. The lender gave me a higher interest rate quote, and told me that they only do no-doc loans. But the lender asked me whether I can document the loan. I said yes. And then, the lender dared asking me whether I can document the loan for them, even though I don’t need to document it. And I said NO. I asked the lender, “why should I document my income for you while not getting a better interest rate?” Apparently, most newhome buyers have being taken advantages without knowing it.

For the poor renters who have been leap-frogged by such homebuying liars or “investors”, I can share with you a trick. This is just what I heard, and I did not verify this. In the state of California, the state laws favor tenants than landlords (this is a fact). I heard that someone was simply paying rent every other month, effectively cutting the rent price in half, and the landlord couldn’t get him out for a very long time because he was making partial payments.

Californians in the golden state? Liars against cheaters? Is this the state that we’re in? I guess if Californians can sell their FICO score of 680 for some fraud housing ATM money of half of a million dollar (or probably less), they will all flock to do it. Have you read this from Housing Panic blog? A 24-year old kid lied through all the loan doc and has over two millions in real estate, but his networth is negative $200K. Think hard about who is going to take up the tab, about what ramifications these incidents have on the society? Who will be the real losers when the housing bubble bursts?

Do you choose money or your values? You don’t need to let me know. I’m certain you know about it, and if you don’t know, don’t worry. God knows all about it.