Brains, Greed and Despair - Part III

Published on November 13, 2007 in Economic, Funding, Risk and Risk Analysis. 48 Comments

Part III will review what has taken place within the financial markets and how Wall Street’s great brian trust has unknowingly, or maybe knowingly, screwed things up.

Transferring Risk

A financial market is a place where investors can go to buy and sell (trade) financial instruments such as  stocks and bonds. It is a place where companies can go to raise capital, generally with the help of investment bankers.

Financial markets also offers a place where one can go to transfer risk to someone else. And that brings up an interesting question. If a lender has a way of transfering the risk on a loan to another investor how concerned will the lender be in making a risky loan?

It is important to understand that there are many different financial markets and each market can impact other markets including the housing market. Most of us are quite familiar with Capital Markets including the Stock Market and the Bond Market. We also know something about the Money Market and the Commodity Market. But perhaps few of us understand the Derivatives Market where financial risks are being transferred from one investor to another. This is the subject of Part III of Brains, Greed and Despair.

A Simple Example

Many years ago, in a one bank town, the Town Bank would use funds from its depositors (from savings accounts) to help others purchase homes and place a lien on each home to protect the bank. If everyone in town wanted a home, however, the Town Bank with limited funds could sell bonds in the Capital Market (part of the Primary Market where new instruments are sold) or borrow short term funds from the Money Market.

The bank could also enter the Secondary Market (where existing or old financial instruments are sold) and sell some of its own mortgages to investors looking for future cash payments secured by liens placed by the bank on homes.

Securitization

The process of selling a package of secured loans in the secondary market is called securitization. Two of the largest firms securitizing loans today are Fannie Mae and Freddie Mac. Most of the loans Fannie Mae and Freddie Mac handle are fairly straight forward - but given the opportunity of borrowing short and lending long coupled with the ability of passing risk on to other investors has resulted in some questionable loan programs.

Securitization generally includes:

  • Transformation of Illiquid Assets that are hard to sell into liquid assets which are easy to sell.
  • Creation of Asset Backed Securities(ABS) that provide a future stream of payments secured by other assets such as our homes.
  • Reduction of Risk by (1) pooling a large number of loans and (2) breaking down loans into various classifications of risk and seperating risk into layers called tranches with higher risk loans subordinated to loans with a lower level of risk.
  • Structured Financing which is a nice way of saying that risk is transferred by using a complex set of legal manuvers along with various corporate entities called Special Purpose Entities (SPE’s) or Special Purpose Vehicles (SPV’s) with the expressed purpose of (1) conforming to regulatory rules; (2) meeting tax objectives and (3) providing a shield against possible default or bankruptcy.
  • The Use of Credit Derivatives which are another type of financial instrument the value of which depends upon (1) the credit worthiness of third parties and where (2) the seller provides some type of protection to the buyer against a list of pre-agreed events.

Just How Much Risk?  

The point in listing the above is to get across the fact that this is pretty heady stuff and not that easy to understand. And that is the problem. The great brains of Wall Street, through financial manipulation and engineering, have come up with ways that allow lenders to offer loan programs at a reduced rate and then sell them as transformed securities at a higher price based on the perception that risk has been lowered. In addition, it is very difficult for investors to ascertain the level of risk when purchasing derivatives that include sub-prime loans.

Credit Crunch

All good things come to an end. A few months ago investors realized that these high-yielding instruments where worth less than they thought as the housing market began to tank. And then things began to snow ball.

The default rate of sub-prime adjustable rate mortgages began to accelerate from 3.3 percent two years ago to 6.5 percent in the first quarter of 2007 and this was just the beginning. Reports suggest that approximately 56 percent of America’s outstanding mortgages were packaged through securitization including two-thirds of all sub-prime loans issued in 2006.

Major players in the market began taking hits. Last month Merrill Lynch reported its first quarterly loss in six years with write-downs totaling $8.4 billion. Other players including Morgan Stanley, Goldman Sachs and Bear Stearns have similar problems.

Sophisticated lenders are finding it difficult to sell sub-prime loans without taking a loss. Hedge funds, with their masterminds, are having difficulty determining the level of risk in the credit market. And experienced investors, who thought they were holding liquid assets, are finding that their assets are not so liquid after all. The end result of all of this is a major credit crunch that will take time to work out.

The Fed’s are trying to fix the problem by cutting rates which is not a quick fix. In the mean time families are having a hard time making higher payments, companies are become insolvent and those that depend directly, or indirectly, upon the housing market for a living are looking forward to a bleak Christmas.

Enough Despair For All Of Us

Too much greed, too much brain power, and not enough wisdom and good judgement has brought about enough despair to go around for a long time to come until things begin to stabilize. Maybe in the future we will be a little bit smarter, with a little less greed and use some good old fashioned common sense.

Brains, Greed and Despair - Part II

Published on November 6, 2007 in Foreclosure, Housing, Short Sale and Sundry Items. 0 Comments

Short Review of Part I

Previously, in Part I a brief rendition of John and Mary’s plight was given. The story began with a purchase of a home in Queen Creek followed by a car accident; the loss of employment; the continued decline in the value of their home; increased mortgage payments after an inital teaser rate; and finally the inability to refinance or sell their home without taking a heavy loss. Part I was not just a story about John and Mary, but rather a story of what is taking place across the country.

During the third quarter of 2007 approximately 447,000 homes faced forclosure - almost a 100% increase from the the third quarter of 2006. Reports are coming in that Arizona has the dubious distinction of ranking seventh in the country for the highest foreclosure rate with 22,750 foreclosures during the third quarter of 2007. This represents a shocking rate of one foreclosure filling for every 112 households according to RealtyTrac. These stats represents a humungo amount of despair.

So who, or what, is responsible for all this grief and despair?

That Little Dirty Word - Greed

Included in the title of this post is the word ”greed”. That is a dirty little word that has a dark connotation suggesting something sinister or wrong. Perhaps greed is just part of human nature, to have an unquentable desire for more. Desire in and of its self is not always bad. I strongly believe in capitalism which is driven by desire.

Some of the ingredients that make up greed include: (1) motivation, (2) judgement and (3) action. We all need a little motivation but we do not always use good judgement. Do we realize there is a difference between what we “need” and what we “want”? Do we seek after the good things of life or are we becoming to materialistic? Do we strive after power or status without concern for others?

Generally it is the “action” we take in obtaining what we desire that causes problems. Do we always act with honor and integrity? Do we try to follow the golden rule or do we believe that the end justifies the means? Are we motivated to help others or do we have a hidden agenda that feeds our own selfish desires?

Pointing Fingers

Limited to the scope of our discussion regarding despair within the housing market I’m using the pronoun “we” to refer to any and all that have participated in creating this debacle resulting in foreclosures, short sales, lack of liquidity, a credit crunch and insolvency.

  • Borrowers

As borrowers we sometimes bring grief upon ourselves. If we want something bad enough our thought process seems to move beyond reality and we lose any semblance in judgement. We rationalize that things can only get better; that our income will only improve; that we will leave our foolish ways and follow a tighter budget; that nothing can prevent the employment of both spouses so we can get that larger house on a bigger lot with all the upgrades being offered by the builder.

It’s a no brainer when borrowers falseify income or current employment or the amount of debt or the source of funds for the down-payment or even their intent regarding primary residence. If a borrower flat out lies on the loan application then he or she should be willing to buck-up and take the consequences.

  • Lenders and Loan Agents

There has been a lot in the press lately regarding predatory lenders. Lenders that pray upon the less fortunate have certainly contributed to the problem. At the same time there seems to be an epidemic with mortgage fraud. This invoves a “material” misrepresentation or omission to deceive the lender in making a loan that provides funds beyond what is necessary to purchase a property. Excess funds may benefit the borrower, the loan agent or even the real estate agent. Generally this requires a joint conspiracy between with the borrower, the loan agent, and possibly the appraiser and other parties that directly or indirectly benefit from the transaction.  A major outcome of such practices is a skewed perception of market value which ultimately affects all of us.

The primary problem, however, with lending practices may be the wide variety of loan programs that get borrowers in trouble over time. Because of greed and/or the lack of judgement individuals, families and financial institutions are placed at risk.

  • Builders and Developers

On the supply side of the equation builders were more than happy to build homes, run raffles and crank up prices as far as the market could bear. Marketing was directed not so much in selling homes but selling them for at a higher price to further improve profit margins. By providing adjustable rate mortages through their preferred lenders they could demonstrate how a family could get the larger model or acquire additional upgrades where the profit margin is the greatest.  

  • Real Estate Agents

Real estate agent have the responsibility to act professionally at all times and place the clients needs first. Unfortunallty that does not always happen - weather it’s intentional or not. Among other things agents should have a fair idea as to how much a client can afford. I’m not saying that an agent should become a financial planner or police the actions of their client, but there should be some dialoge regarding qualifications for a loan and financial prudence.

I may get some flack from other brokers that it is not the role of the agent to get to into the personal life of a client - but on the other hand we keep talking about real estate agents becoming professional advisers and not just transactional minded sales-persons. I feel the lack of professionalism on the part of real estate agents (with some, not all) is part of the problem we are currently facing in the housing market.

  • General Market Conditions

Many factors have caused a downturn in home values. It was only a few years ago when investors from California, Nevada and elsewhere realized that Arizona homes were undervalued (at least relative to their home states). Credit was easy and interest rates were attractive. Investors flocked to Arizona and the feeding frenzy began.

Agents found that listings were hard to come by. Anyone could sell their home with a ”for sale by owner” sign or just by word of mouth. Agents also had difficulty finding product to sell. Homes were on the market for days, not weeks or months. A buyer had to make a quick offer above asking price with no contingencies. All cash worked best if you wanted to buy a home. The general feeling was if you want to get a home you had better do it today because tomorrow you may be priced out of the market. Desire rampant and greed began to flourish.

As home values continued to climb it became apparent that neither rent nor wages could support inflated prices and investors began to move out of the state leaving a wake of destruction behind. As the smoke clears it appears that greed and a lack of judgement played a major role in our current housing crisis.

Final Installment - Brains or the Lack Thereof

Part III, the last of this trilogy, will cover some of the esoteric elements of the financial market. We will get into financial engineering, risk management, securitization, financial derivatives and how a “special purpose entity” is used to offer lower rates to borrowers and at the same time reduce the level of risk to the ultimate investor that purchases a pool of loans. 

Brains, Greed and Despair - Part I

Published on October 31, 2007 in Disposition, Foreclosure, Funding, Housing, Risk and Short Sale. 1 Comment

  • A Story of Despair

A few weeks ago I received a call from a concerned mother over a situation that many are struggling with. She informed me that her son and his wife had purchased a home in Queen Creek and wondered if I might be of assistance. The next day I spoke with her daughter-in-law who recounted a story that has become all too familiar in recent times. 

Her story began a few years ago when they moved to Arizona. Her husband had secured a new six figure job and life was good. After looking around they decided on Queen Creek as the place to begin their Arizona adventure. Mary (names are fictitious) shared the excitement they felt as they located the perfect home to raise there young family. The market was hot and they had to wait, week after week, for their name to be drawn from the builder’s weekly raffle. Each week they watched as the Builder raised the sales price of each model. The day finally came when the Builder notified them that they were one of the chosen few - with the great honor of paying top dollar for a home.

Time went on, the home was built, and they moved into their new surroundings. John worked hard and found he had to be on the road a great deal of the time. Mary was left to get the kids to school and manage the home. Then, without notice, their dream fell apart. While travelling along Hunt Highway Mary was seriously hurt in a car accident. John eventually had to leave his job to take care of his wife and kids. Things became tight and they decided to move back with the folks to cut expenses. Home values were going down and it was not the time to sell. They rented their home to help make monthly payments.

Today things are still tight. In November their house payment will increase substantially since their friendly Builder had persuaded them to work with a “preferred lender” who was pushing a loan program with a teaser rate.

  • Coming Up Short 

What do you tell this couple when they are are underwater, that is , when the value of their home is substantially less than their loan?

They are having a hard time making ends meet and they are ready to sell (particularly since their renter is slow in making payments). Mary has tried a number of times to contact her friendly lender to come up with a workable soultion - but since they are not yet behind in payments the lender has no reason to work with them. Do you the couple to quite making  payments to get the attention of their “friendly” lender? I don’t think so.

If we put their home on the market - the listing will have to spell out that this is a ”short sale”. Before doing this the following ramifications need consideration: 

  1. Would the lender accept something less than what is due? Unless the home is already in forcelosure (or at least if no payments have been made for several months) the lender will flat-out deny the request. Well, that is, unless the they are willing to pay the difference as a personal obligation.
  2. Before the lender approves a short sale sufficient documentation will be required to: (a) justify that this is the only course of action that can be taken and (b), that a short sale would be advantageous for the lender.
  3. Speaking of documentation, they will need to make sure in writing that the lender will not subsequently go after the shortfall.
  4. They will need to understand that a short sale results in “relief of debt” and, therefore, the unpaid amount will (not maybe) be treated as income for tax purposes. I just love the IRS.
  5. The purchase contract will need to be contingent upon a short sale - the language of which will need to be acceptable to both the lender and the buyer.
  6. Then, when all is said and done, the their credit score will take a big hit.

Mary and John thought perhaps their Renter could purchase the home by taking over the loan.  Again, a few things come to mind:

  1. The only way to convey ownership is by paying off the loan or by having someone take over the loan (with lender’s permission). A seller needs to be careful with an “assumption” of the loan. An assumption is when the buyer has the primary responsible for making payments - but should the buyer fail in making timely payments the seller has the ultimate responsibility.  
  2. To be removed from any future responsibility on the loan there would have to be a substitution on parties on the loan (known as novation) and of course the lender will have to approve this and we know the Renter has been slow in making rental payments.
  3. Also, why would the Renter (if he had good credit) take over the couple’s loan which exceeds the market value of the home? Why not just purchase a similar home at a lower price. The loan would be much easier to qualify for since the loan would be supported by the value of the home, payments would be less, and the Renter (now buyer) would not be upside down.

So what else can John and Mary do?

First, they can try to hang on (and if they can the lender won’t allow a short sale anyway) until the market turns around, or until they are ready to move back into the home.

Second, they might see if the lender will consider a “Deed-in-Lieu of Foreclosure” but they must reside in the home and be in default at the same time.

Finally, they can walk away from it and let their friendly lender deal with it.

  • So Who is at Fault?

Part II of “Brains, Greed and Despair” will try to answer this question from several different perspectives along with some background on lending practices and degree of professionalism on the part of builders, lenders, real estate agents and their brokers. And, of course, the buyer has a responsibility as well.

Arizona - A Magnet for Growth

Published on October 27, 2007 in Arizona, Market Place and Sundry Items. 0 Comments
  • Growth is Not Such a Bad Thing 

If you have not noticed lately there seems to be more people living in our State. Just try and make a left hand turn without the benefit of a traffic light during rush hour. Perhaps it’s because of my background in development - but I like to see growth. With growth comes opportunities and, of course, a few challenges that need to be addressed along the way.

I remember moving to Thousand Oaks (a bedroom community in California) back in the late seventies. Thousand Oaks was taking off like a rocket. It was one of the fastest growing communities in the country. The locals (except those that had land) were not happy with all the changes that were taking place in their town. There were arguments over air quality, traffic congestion, community services, inflated home values and alot of newsprint about those rotten, greedy land developers that were raping and plundering the land. To many growth represented everthing that was bad or ugly.

We lived in Thousand Oaks for sixteen years and raised our family there. And yes there were some growing pains but in the end Thousand Oaks became one of the most desirable places to live in Southern California.

  • Arizona - A Place to Move To, Not From

I bet the locals here never dreamed of the day Phoenix would become the 5th largest city in the country. Arizona has become one of the fastest growing states in the Nation. Between 2000 and 2005 the State’s population increase by 20.5% and during the same time period Maricopa County was the fastest growing county in the U.S. with 696,000 additional residents. The overall population in Arizona went from 5,131,000 to 6,305,000 - the second fastest growing state during the five year period.

Where are all these people coming from? Well, a good part of them came from my native state, California - 30% according to the records. We know that more people are moving to Arizona than out Arizona, but here is something interesting - the U.S Census indicates that Arizona experienced a “positive net migration” from each of the states in the Union with the exception of Nevada, Georgia and Arkansas during the year 2000. We had some good friends that moved to Arkansas a few years ago and now they are talking about moving back! So much for Arkansas.

  • Why Arizona?

My wife and I moved here because we wanted to be near our grandchildren. Now that in and of its self does not say much for Arizona - but we also wanted to live in a clean, family oriented community near ample restaurants, shops, theaters and a major airport. We had no desire to live where it snows, nor did we want to worry about hurricanes, flooding, earthquakes or even wildfires which California is known for. It does get warm here, alright so it gets down right hot, but its a “dry heat” and we love it here. At first we thought things looked a little bleak when it came to vegetation, but it’s amazing how things grow here. We also miss the beach, but we love the many scenic areas through out Arizona. If someone doesn’t think this is a beautiful state they need to take a look at a few issues of Arizona Highways and then get into a car and take an adventure.

Our two sons, and their families, moved to Arizona for affordable housing (particularly compared to California) and a bright future - a natural outcome of a robust economy. Between 2000 and 2006 Arizona’s Gross Product increased by 36.6%; retail sales increased by 48.1% and the value of building permits increased by 82.7%. No bad if you ask me.

As far as the future is concerned, I’m very optimistic and that’s why I believe Arizona is a great place to  invest in real estate. Based on recent projections the state’s population will increase from 6.3 MM to 12.3 MM by the year 2030 and that may be conservative if our State leaders take the appropriate steps to prepare for the future. now that may be the sixtyfour dollar question?

Maiden Voyage

Published on October 25, 2007 in Acquisition, Agent, Apartments, Budgeting, Cash Flow, Cities, Commercial, Comparative, Contractual, Disposition, Due Diligence, East Valley, Economic, Exchange, Funding, Gifting, Goals, Housing, Investment Analysis, Investment Vehicle, Land, Legal, Light Industrial, Management, Market Activity, Market Place, Marketing, Multi-Family, Negotiations, Objectives, Office, Ownership, Personal, Phoenix Area, Planning, Portfolio, Property, Purpose, Raw Land, Records, Retail, Return, Risk, Risk Analysis, SFD Homes, Structure, Sundry Items, Tactics, Tax Issues, Taxation, Timing Issues, Trends and Why Real Estate. 1 Comment

This is my maiden voyage with Word Press -  so this is more for me than for you. This is an attempt to see how Word Press works by experimenting with categories, formatting text, using headings, etc. and at the same come up with a game plan for future posts.

Will start with a list of general topics each of which is further broken down into specific areas of concern or interest. Hopefully this will  provide some form of organization for future posts and at the same time place a list of categories on a sidebar. If all goes according to plan this blog will eventually become meaningful to real estate investors and professional colleagues who provide assistance to investors.

Future Topics May Include:

  • Planning Considerations - Perhaps the primary reason investors have a negative experience with any type of investment, and particularly with real estate, is a lack of planning. If an investor has a goal in mind it is generally vague, usually unmeasurable and possibly irrelevant to the task at hand. We all remember Alice in Wonderland asking the Cat:

“Would you tell me, please, which way I ought to go from here?” “That depends a good deal on where you want to get to,” said the Cat. “I don’t much care where–” said Alice. “Then it doesn’t matter which way you go,” said the Cat. “–so long as I get SOMEWHERE,” Alice added as an explanation. “Oh, you’re sure to do that,” said the Cat, “if you only walk long enough.”

Without a goal its difficult to know if (or even when) you have reached your destination. With an investment in real estate you have reached your destination  when you are satisfied your goal has been reached and/ or the property in no longer useful. Along with goal(s) a set of objectives needs to be in place. Objectives outline the steps that need to be accomplished over a specified period of time. Moving forward towards a goal without any objectives is like traveling to a far off land without a map to find your way.

While we are under the general topic of planning lets include tactics (or logistics) which can be defined as the employment of available means to accomplish a given objective.

  • Investment Vehicle - To follow along with this ”trip” metaphor one has to chose the vehicle or means of travel to get from one point to another. If you are looking to invest in securities you may decide to purchase individual stocks; or you may invest in mutual funds; obtain an annuity, or what ever. The list goes on and on. The world of real estate also has may alternatives or vehicles to select from. In future we will discuss the various aspects of housing including SFD homes, multi-family and apartments. On the commercial side we will consider office, retail and maybe even light industrial. For the adventuresome we can take a look at the art of real estate development including the development of raw land (for those with a passion for risk).

  • Market Activity - Under market activity we can focus on housing activity, commercial activity and the level of demand for land for various market segments. Supply and demand are reflected in price (both in the asking price, closing price and the amount of spread thereof), rent being obtained and level of activity in terms of sales and the swing in inventory levels.

  • Market Place - Each real estate investment is unique, primarly due to its location. We have all heard it said time and time again, ”the three main factors to consider in real estate are location, location and location”. We will try to cover these three factors in terms of: (1) the Phoenix Metropolitan Area; (2) East Valley which comprises Scottsdale, Paradise Valley, Fountain Hills, Tempe, Mesa, Chandler, Gilbert, Apache Junction and Queen Creek; and (3), specific local neighborhoods primarily within the Town of Gilbert and the City of Chandler.

  • Timing Issues- There is a time to buy and a time to sell. Timing is always a critical factor whenever we invest our hard earned money. Relative to timing I’m going to break the topic down into three broad categories: (1) economic factors that drive the real estate market; (2) general trends that impact the value of real estate and (3), personal factors that impact our lives as we progress through the various stages of life.  

  • Investment Analysis - It’s all in the numbers “provided” you make reasonable assumptions and have sufficient detail incorporated in the model you are using. Unfortunately most of the analysis I have seen just cuts the surface. Part of the reason is majority of software available has been designed for the general practitioner (generally a real estate agent that is transaction oriented) that does not have the time or inclination to do an in-depth analysis. On the other side of the coin, the majority of investors want to cut to the chase. They are not interested in a ten to twenty page report (excluding charts and graphs). But its that an indepth analysis that helps investors better understand the wide range of factors that can affect the outcome of an investment. Since analyis is a dry subject, at best, I will try to keep things as simple and straight forward as possible. Over time we will get into cash flow analysis, budgeting, various ways to measure return and  comparative analysis.  We may even get into the differences between analysis for investment purposes vs. analysis as a component in the planning of a long term project.

  • Acquisition - As part of acquiring property we will discuss ownership and control, due diligence, contractual issues, tax considerations and funding. Another aspect of acquiring real estate in the manner in which a deal is structured along with the art of negotiating.

  • Management - Management has never been my cup of tea. It is an important aspect during the holding period. It is also the reason why may do not invest in real estate other than a home to live in.  Under management we can get into property management, risk management and portfolio management. Then there is another exciting aspect management, record keeping.  Perhaps to add a little spice under the management we may discuss why real estate vs. other types of investments.

  • Disposition- Since we are getting towards the end of general topics and subtopics will keep this short. Under disposition of real property we can get into marketing, selecting an agent or broker, tax deferred exchanges and the gifting of real property.

  • Sundry Items- This is a catchall for anything that does not logically fit into a topic listed above along with things that have nothing to do with real estate (I do have a life outside of real estate).

Well that does it. Over time I hope to add something meaningful to each of the topics that are underlined above. For now I’m just trying to work out the mechanics of Word Press.