mortgage mess perspective from january 2009

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The Mortgage Mess:Where To From Here?

Where are we?

Where are we going?

How are we going to get there?

How long?

Winston Elton

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What is the problem?

• Jack and Jill went up the hill, to fetch a pail of water• Jack fell down and broke his crown, And Jill came tumbling after• Who is Jack, who is Jill, what is the water?

• Current Situation• U.S. and other major G7 nations now in recession-Germany, Britain, Italy, Japan, Canada• Major financial institutions crisis - Bear Stearns, Wachovia, USB, HSBC• Major mortgage providers in retreat or on the ropes - Countrywide, GMAC• Major losses in GSEs, Fannie, Freddie, multi billion dollar losses, taken over by Feds• Real estate markets across country at very low levels - SD - 44 sales in November• -layoffs, bankruptcies, business contraction, many industries• -retail, transportation, manufacturing, airlines, tourism, auto related• Unemployment increasing - S.D. County 5.9% in August, 6.9% in December• Inflation moderate - 3%; “stagflation”?• Energy price increases - 35% - 40% higher in last year, impact on entire economy• Growth in GDP - 2Q 2008 - 1.9%; 3Q 2008 down .5%; 4Q 2008?• Mortgage foreclosures continue to increase at accelerating rate• More pain yet to come in major financial institutions

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Perspective• 303 million people in U.S., growing at 1% per year; 3 million per year

• Ongoing population growth fundamental economic demand driver for housing and the rest of the economy; basic 1% growth per year

• 129 million housing units in U.S.; should grow at about 1.3 - 1.5 million units per year

• 18 million vacant, 2.3 million for sale; 4.1 million for rent, 2.9% owner occupied vacant– Highest vacancy rate in past several decades

• 110 million occupied houses; approx 32% are rental units; 33 million rentals, 85% of rentals are apartments

• Approximately 68% of occupied units are owner occupied, approx 75 million owned homes

• Total value of all owner homes in U.S. approximately $20 Trillion, down by $2 -$ 4Trillion

• About 20-22+ million homes do not have mortgages - almost 30% of total single family homes

• Homes without mortgages were $5 Trillion of total home value - all equity, now <$4 Trillion

• About 52 - 55 million homes have mortgages - just over 70% of total homes

• Total value of homes with mortgages - $15 Trillion, total mortgages $10.8 Trillion; 67% LTV

• Equity in homes with mortgages - was up to $5 Trillion, now <$4 Trillion

• Current federal budget about $1.6 Trillion, $500 billion dollar deficit (spending over revenues; 3.3% of GDP)

• Current total federal debt, about $9.5 Trillion, almost equal to total residential mortgage debt

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Case-Shiller Home Price IndexPrice Drop From Peak - late 2006

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

AZ-Phoenix

CA-Los AngelesCA-San Diego

CA-San Francisco

CO-Denver

DC-Washington

FL-MiamiFL-TampaGA-AtlantaIL-ChicagoMA-BostonMI-Detroit

MN-MinneapolisNC-CharlotteNV-Las VegasNY-New YorkOH-Cleveland

OR-PortlandTX-Dallas

WA-SeattleComposite-10Composite-20

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QuickTime™ and a decompressor

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Larger Homes More Likely to Have Mortgages

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Amount of New Mortgages per year

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Magnitude

• Worst areas for foreclosures - Las Vegas, Phoenix, Florida, California - Texas not as bad– San Diego is 15 on list; Stockton #1, Riverside-San Bernadino in top 5

• California - average home prices down 30% - 40% from peak in 2005 - 2006

• Average home price appreciation since 2000, up by 75% - 90%; SoCal down to 2004 prices

• National index shows now down to 2005 prices

• Most upside down homes bought or refinanced since 2004; pre 2004 homes not affected unless refinanced: 2007 mortgages worst default rates, then 2006 mortgages

• 90% of all homes still paying their mortgages as agreed; most will continue, – Including the owners with no mortgages, nineteen out of twenty homeowners are not affected

• 45+ million homes with mortgages not directly/immediately affected by this mortgage crisis/downturn

• The 90% who don’t have the problem don’t want to be paying for the 10% who do, BUT– The 10% who have the problem are having a major negative effect on the 90% who don’t– All ships fall with a falling tide

• Renters (32% of occupied households) don’t want their tax dollars paying for a bailout of 10% of homeowners who are overextended

• However, the problem is now affecting the rest of the market in a major way– No one else can sell until cheaper mortgage foreclosure homes have sold and off the market

• Tipping Point - past a point of no return

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Mortgage Foreclosures

• Total of all mortgages in U.S. - $10.5 - $11 Trillion• Total number of all mortgages - 55 million +/- (up to 3 million private mortgages)• Total foreclosures in 2006 - 500,000• Total foreclosures in 2007 - 1.5 million• Total foreclosures in 2008 - 2.5 - 3 million (projected)• Total foreclosures in 2009/2010 - 3 million plus (unknown but possibly increasing)• Total foreclosures since downturn started in late 2005/early 2006 4 - 5 million, up to 8-10 million• Currently up to 7% of all mortgages in default or pending, could rise to 10% (tipping point)• Total foreclosures as percent of total mortgages - up to 10% of mortgaged households• Some projections claim up to 13 million homes “under water” - value less than mortgage• Could go to 15 million homes, 16% of housing stock, if prices drop 20%• Could go to 20 million homes, up to 25% of housing stock, if prices drop 30%• To date, less than 30% of “under water” or “upside down” homes have gone into foreclosure

• “Walk-aways” increasing - mail keys to lender; can buy back similar home for 25%-30% less• Average foreclosure 15 months from first missed payment to selling home - average loss 20%-

30% of mortgage principal plus missed payments and foreclosure costs• Up to $200 - $300 billion in unrealized losses (writedowns) due to foreclosed mortgages; could

go much higher– 5%-10% of total mortgage value e up to $11 Trillion in total mortgages

• Five states (including California) suing Countrywide for “Pushing consumers into loans they couldn’t afford”; possibly more; class action, etc. It ain’t over ‘til it’s over

• Notices from Countrywide, GMAC

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Prices

• Foreclosure distressed prices set price level for all other houses– Other houses won’t sell until cheapest houses on market have sold - foreclosures

• Current price levels significantly below replacement costs – no new homes built in many areas - national starts down 25% - 40%, San Diego off over 50%

• Prices SoCal fallen from $250 - $275 psf in 2006 to $150 - $175 psf today, still falling

• In San Diego, 2,500 square foot home off from peak of $600,000 - $700,000 down to $400,000 to $500,000 today; many homeowners have lost $200,000 - $300,000 in value, many have fallen below total mortgage obligations

• Foreclosures (10% - 15% of mortgaged homes) having major effect on remaining 85% - 90% of other homes which prior to now did not have a problem

• Freddie Mac CEO estimates overall price drop of 18% - 20% price drop peak to trough

• If 20% price drop, may be largest single erosion of capital value in history, $4 Trillion loss

• $4 Trillion is 40% of all “home equity” across country

• “Wealth Effect” - erosion of households single largest asset, consumer constraint on spending

• Consumer spending is 63% of all economic activity; significant drop causes economic downturn

• Effects on commercial real estate - office vacancies from 12% up to 18%

• No new office construction for next 2 - 5 years; impact on construction industry,

• Construction unemployment has increased drastically; construction employment normally 4% - 5% of total jobs, in hot market up to 10% of jobs, now employs less than 5% of total jobs; major cause of increasing unemployment is construction unemployment

• Retail - markets changing - from enclosed malls to big box super stores

• All types of real estate affected - Residential, Office, Retail, Industrial, Recreational, Hotels

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Fannie, Freddie• Fannie Mae (1938) and Freddie Mac (1970) currently hold or insure about $5

Trillion of total U.S. mortgage debt, about 50% of total, increasing market share• Up to 10% of the Fannie and Freddie loans are in trouble• Fannie Mae $2.3 Billion Q2; $2.2 Billion Q1, total losses over $9 Billion• Half are losses from higher risk Alt-A loans (between sup-prime and prime)• Fannie Mae CEO “Worst market in 70 years”• “GSEs” - Government Sponsored Enterprises ; private companies but with

federal government support and oversight, but operated as private entities• GSEs own $1.4 Trillion in loans directly, guarantee/insure another $3.8 Trillion• Freddie Mac high $67, low $4, now at $8, $35 Billion negative swing in equity,

down 88%• Fannie Mae high $70, low $6.68, currently $9.50, down over 85%• Office of Federal Housing Enterprise Oversight (OFHEO) regulates GSEs, more

oversight• GSEs owned by foreigners ($1.5 Trillion out of $7.4 Trillion), commercial banks

($929 Billion; 15%); life insurance companies ($390 Billion; 6%); state and local government retirement funds $317 Billion 4%; mutual funds $566 Billion 8%; asset backed securities $387 Billion 20%; self owned $718 Billion; who owns GSEs? We do, through retirement funds, insurance, stocks and bonds

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Fannie Freddie New Program

• Recent Housing act authorized $300 billion in new Fannie, Freddie loan funds;• New funding is less than 6% of total Fannie Freddie funding• “TOO LITTLE, TOO LATE?” or should it be done at all?• 400,000 homeowners could be helped, but 4 - 5 million in foreclosure, helps less

than 10%• Must prove paying more than 31% of income for mortgage (now up to 38%),

banks to check incomes; will likely impact only lowest levels; no help for middle or upper priced homes or most higher priced areas

• Current housing bill will not even come close to addressing the magnitude of the problem, covers less than 10% of foreclosed mortgages

• Bulk of mortgage problem will have to be worked through without help from GSEs

• “Hope Now” alliance helping in refinancing restructuring mortgages• $4 Billion to help communities clean up derelict neighborhoods affected by

foreclosures - delinquencies, defaults, vacancies - 1% of the problem• Morgan Stanley brought in to advise GSEs, how to implement federal

involvement• Unprecedented involvement in private sector by federal government

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Energy

• Currently world consumes approximately 85 million barrels of oil per day (mbpd)• U.S. consumes approximately 21-22 mbpd - up to 25% of world total; • U.S. produces approximately 22% of total world goods and services with <5% of world’s

population• U.S. produces up to 5 - 7 million barrels per day, balance 14 - 15 mbpd is imported• Major suppliers are first Canada, second Mexico (over one third of oil imports)• $600 - $700 billion per year to buy imported oil, one third paid to neighboring countries• Prices set by international cartels, OPEC• Largest single producer is Saudi Arabia at 9.5 million bpd, second is Iran, U.S. currently

fourth or fifth largest producer of oil• Major producers include Iraq, Venezuala, Russia (self sufficient),• Major new find in offshore Brazil, northern plains in U.S. have potential• Oil shale may have as much potential as all of Saudi Arabia• Tar Sands in northern Alberta may have more than all the rest of world combined

• Three countries, U.S., Japan and Germany are over 40% of worlds total economic activity - China gaining fast, productivity depends on energy availability

• China and India are fastest growing economies in world, between them they are one third of total world population

• Largest market for SUVs in world is now China, no effort at energy conservation• Largest consumers/importers are now China and India, their demand drives prices

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Solution: What, When

• Ultimate solution is restoration of economic confidence, bring buyers back into market– Buyers not come back until they perceive that prices have bottomed out; I.e. don’t

want to buy just to have prices drop– Restored mortgage confidence - mortgages much harder to get and qualify for, many

players have left the market, never to return; much more stringent mortgage approval requirements, documentation, income and asset verification, higher credit scores, only the very best can currently get mortgages, severe limitation on market

– Very little new inventory to chose from; no new houses being built, major homebuilders on the rocks, sold off major land holdings at pennies on the dollar to “vulture funds” who buy low and hold land for 3 - 5 years into future

– Ongoing very negative press becomes self-fulfilling prophecy; buyers remain on sidelines

• Work through current economic cycle - Four stages: Growth, Decline, Recession, Recovery; currently still on negative downward recessionary part of cycle

• Major economic stimulus could be a full court press on achieving energy self-sufficiency: develop all forms of energy at same time: current drilling, enhanced recovery, off-shore, Gulf, Alaska, natural gas (plentiful), oil shale (Colorado, Wyoming, Utah), Tar Sands (Alberta, Saskatchewan in Canada), major pipelines, coal, wind, solar, conservation technologies without sacrificing economic growth potential

• Full court press on energy could be the largest economic stimulus in history over next 5 - 10 years

• Would restore and create many new jobs and industries, “Full Employment Act”, result in increased tax revenues to states and federal government, rapidly expanding economy, careful not to overheat

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S.W.O.T.: Strengths, Weaknesses, Opportunities, Threats

• Strengths - U.S. still the strongest economy in the world, most productive, largest market; has availabl resources, worldwide influence

• Weaknesses - lack of political will, political disarray, weakening economy

• Opportunities - maintain economic strength, become energy self-sufficient

• Threats - continued reliance on foreign oil, economy dependent on exterior forces, declining economy, losing ground to emerging economies, slow recovery from current financial malaise

• Obstacles: environmental resistance and blockades, legal challenges, will require major about face on part of federal government likely including legislation regarding the extent to which environmental concerns can block energy development

• Where does money come from for economic incentive programs? (Spring 2008 $165 Billion, more?) - from taxpayers

• Housing and concomitant mortgage financing are the result of, not the driver of, real economic growth, job creation, growth in GDP, real productivity increases

• When current overhang of unsold inventory begins to lessen, housing and mortgage markets will rebound accordingly; not until then. Unsold inventory won’t start to move significantly until overall economic confidence is restored.

• When? Current election cycle, high gas prices driving more energy development, full court press will revitalize economy, drive oil and gas prices down, create jobs, ancillary development, housing, mortgages

• In the meantime; more pain to come, it will get worse before it gets better; the shortcut or bridge over the ravine is an immediate economic stimulus via way of energy self-sufficiency; the fatal trap door is the lack of will to become energy self sufficient, environmental extremists, legal roadblocks

• Alan Greenspan - it will not end until consumer confidence is restored and the excess inventory is burned off

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Types of Spending - Milton Friedman

• Issues are: Getting Good Value, Amount Spent• Type I - My Money on Me - I take myself to lunch, want good value, concerned

with amount• Type II - My Money on You- I take you to lunch, I am concerned with amount

(it’s my money), not as concerned with getting value (I’m not eating your lunch)• Type III - Inverse of Type II - you take me to lunch, I’m not concerned with

amount (it’s your money), but would like to get good value (I’m eating it)• Type IV - Spending Somebody Else’s Money on Somebody Else -

government; not as concerned with how much is spent, or with getting good value

• The mortgage bailout is Type IV spending - the government spending somebody else’s money (the taxpayer) on somebody else (other taxpayers); the first “somebody else” is us, the taxpayers

Types of Spending

My Money Your Money/

Somebody Else’s Money

On Me Type I-get good value

Concern with amount

Type III-value, not care about amount

On You/ On

Somebody Else

Type II-concern with

amount

Type IV-little concern with value or amount

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What has happened since then?• July 2008 - Oil Price Shock - $4/gallon gas, $145/barrel oil - rumored to be the end of the world as

we know it - Oil company hearings in Senate - ripoffs, gouging• September 2008 - Bailout - $700 Billion - URGENT - NOW - VITAL - or COLLAPSE!

– To preserve financial institutions - Troubled Asset Relief Program - “TARP”• Treasury to buy nonliquid, difficult to value assets from banks, financial institutions• Purchase whole loans, direct equity investments in banks• Buy Collateralized Debt Obligations (CDOs), improve liquidity, balance sheets, re-

capitalize banks• Two sections $350 Billion in September; $350 Billion pending (this week)

• What has happened to the first $350 Billion?– $250 Billion to bank equity infusions - government now owns banks?– $40 Billion to AIG – UAW wants to use TARP to bail out auto industry - $15 - $35 Billion– Dec 19, Bush lifted limitation to banks, authorized for any purpose necessary

• Troubled Asset Relief Fund (TARP) has not worked as planned;– Banks liquidity has not been restored, credit freeze is still on

• Give a teenager an unlimited credit card? Who pays the bill?

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Appraisal Issues– HOW DO YOU PRICE A TROUBLED ASSET? WHAT IS THE VALUE?– NEW APPRAISAL ISSUES, PARTICULARLY REAL ESTATE AND BUSINESS VALUES– VALUE YESTERDAY, TODAY, A YEAR FROM NOW, TWO YEARS FROM NOW– WHAT ASSUMPTIONS DO YOU START WITH

• - ECONOMIC RECOVERY? WHEN? HOW FAST? WHAT WILL CAUSE IT?

– USE OF CURRENT COMPARABLES AN ANOMALY? OR THE NORM?– SELLERS WANT YESTERDAY’S OR TOMORROW’S VALUES– BUYERS WANT TODAY’S VALUES - BUY IN THE DEPTH OF THE TROUGH

– WHAT WILL TODAY’S VALUES DO TO THE OVERALL VALUE OF ALL ASSETS IN A CERTAIN CLASS ACROSS THE COUNTRY AND AROUND THE WORLD?

• I.E. RESIDENTIAL REAL ESTATE - HOME VALUES DOWN FROM $21 TRILLION TO $15 - $18 TRILLION

• WHAT WILL HAPPEN IF ALL HOME VALUES DROP TO $11 TRILLION I.E. THE VALUE OF ALL THE OUTSTANDING MORTGAGES IN THE COUNTRY

• WHAT WILL HAPPEN IF THE VALUE OF BUSINESSES DROPS BY 25% - 50%, OR TO LESS THAN THE VALUE OF THE OUTSTANDING DEBT ON THE BUSINESS I.E. BANKRUPTCY

• THE VALUES WILL BE DIFFERENT 12 - 24 MONTHS FROM NOW - LOWER OR HIGHER?

– WHAT DO WE DO AS RESPONSIBLE MEMBERS OF THE ECONOMIC SYSTEM TO STEM THE TSUNAMI OF RED INK? WHERE DOES IT ALL LEAD TO?

– STRICT ADHERANCE TO USPAP; ARE THERE OTHER DUTIES?

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How Will It End?• The new lexicon:

– Emergency Economic Stabilization Act - EESA - $700 Billion

– Troubled Asset Relief Program - TARP - administers $700 Billion • Was to buy troubled assets from Banks - gave money to banks, used it for something else

– Office of Financial Stability - OFS - purchase Mortgage Backed Securities (MBS)• Buy shares in banks - re-liquify balance sheets

• Another $800 Billion - $1 Trillion + Economic Stimulus Package• Alan Greenspan - "The current credit crisis will come to an end when the overhang of

inventories of newly built homes is largely liquidated, and home price deflation comes to an end. That will stabilize the now-uncertain value of the home equity that acts as a buffer for all home mortgages, but most importantly for those held as collateral for residential mortgage-backed securities. Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the U.S. economy, and the world economy more generally, will be able to get back to business.”

• WHEN?

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Where will it end? When? How?• We are in unexplored territory. The current downturn is unprecedented in modern

history. The combination of events has created the Perfect Economic Storm– Collapse of fundamental financial institutions - central banks, and largest public banks– Erosion of $12 Trillion of personal and household wealth - from $65 Trillion to $52 Trillion– Total bailout costs so far $8.5 Trillion (back up for FDIC, TARP, other)– International effects - public and private wealth affected around the world– Upside - U.S. is attracting foreign capital as “Save haven”, still best game in town– Re-trenching of personal households - peeling off debt, more conservative spending– Consumer Confidence lowest in 50 years; unprecedented impact on consumer spending– Consumer spending is 65% of total economic activity– Over 500,000 jobs lost in December; national unemployment now 7.2%, will rise in 2009– GDP expected to fall for next 12 - 18 months

• No single entity has the solution - not U.S. Federal government, nor any other nation• 1930s is not a reliable precedent, different situation• World economies interlocked, interdependent, China also slowing due to U.S. decline• What will turn the tide? We will.• Chaos Theory - Non-Linear dynamics - short and long cycles• Order tends to disorder or disequilibrium, creates transition periods to new order• Mini-cycles within larger cycles - the outcome is unknown and unknowable• Enjoy the ride

mortgage mess perspective from january 2009

Real Estate