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