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August 1, 2008

A Housing Bottom?


Earlier this week, Merrill Lynch announced an $8 billion write-off of high risk mortgage assets. These assets were sold to a private firm for 22 cents on the dollar. I believe this action could potentially precipitate a housing bottom, which will likely occur in about 18 months.

The reason for this is because we are closer to purging high risk mortgages than we were six months ago. For too long, banks held onto foreclosed homes and bad debts hoping to get a break-even investment from them. A real signal that this housing crisis has bottomed would be a collapse in prices great enough to increase demand to a level equal of that of supply. Basically, with lower prices, buyers would enter the market and begin to buy up homes at a faster rate than foreclosures. Not only that, we would need to see a rash of refinancing for troubled homeowners who with better terms, can responsibly pay off their mortgages.

Here’s what I believe is going to happen:

Merrill’s 22 cents on the dollar pricing of risky mortgages will set an industry standard of pricing bad debt. Banks, wanting to be rid of the credit crisis, will begin purging off these bad loans as quickly as possible. Private lenders and equity companies will buy these high risk debts for under a quarter of their value. These private firms can then attempt collections, and still make a profit if they are only half successful.

Furthermore, if homeowners refuse to pay, these private firms can evict them from their homes, and either sell them “as is” for 50% off, or renovate and sell them at 25% off of their valuations. This would deliver large profits for sellers and good deals for the buyers. However, there are still some challenges in the way of bottoming the housing market.

Time & Uncertainty.
It will take 12 to 18 months for the market to transfer, attempt collection, refinance (when necessary), purge, and renovate homes (and mortgages) before Wall Street can call a bottom in the housing market. As we know, even some of the best economists have a difficult time looking beyond 6 months to forecast economic conditions as a whole. An unknown event or catalyst between now and the end of next year could drive the bottom lower and further into the future.

Inflation. As described in a previous blog, inflation raises interest rates. Higher interest rates makes borrowing more expensive thus restricting the issuing of new loans. This will have a negative effect on the housing market and could drive the market lower if inflation continues to be a problem into 2010.

Financing. Even without inflation, banks are going to have a tough time stabilizing their ability to finance. If home prices do plunge due to the purging of bad mortgages and increases in the supply of existing homes, buyers may finally decide to hit the market in stride. If they do, who’s going to lend to them? Wachovia? Key? IndyMac? Many banks are still realigning their balance sheets and may not be able to produce the mortgages to meet the demand generated by a dramatic drop in price.

All in all, a bottom is always called about six months after it happens, but I believe that Merrill’s write-off can spur the trigger needed to end the housing recession. Just as many saw a problem when banks were issuing $0 down mortgages and lending to suspicious homeowners, we can now look at the recent events as the possible light at the end of the tunnel.

1 comment:

AaronIL said...

Well, I tend to look at that as a desperate move, more than something that will suddenly jump-start the housing market again. You listed a couple of the main variables (uncertainty, interest rates, and lending), but you also have to consider the economy as a whole. Even if prices drop significantly, if the unemployment rate continues to rise, people just won't have the money (or will believe that they do not have the money) to make big purchases like this.

Also you forgot to mention how gas prices and other expenses on consumers also play into the equation. If the consumer has to pay double to heat their home, the market for large homes probably will drop, due to less demand. I actually think a lot more houses will eventually foreclose, as people try to figure out a way to get out of their McMansions and back into a reasonable house.

The housing market works pretty much the same as any other market. Price is determined by supply and demand. The current market is grossly oversaturated, which is one reason why so many people are defaulting on their mortgages. Also, I am curious as to the percentage that builders/speculative sellers make up the total foreclosure numbers. I live in town rich with tear-downs, and many of the new homes sit on the market for over a year, leaving the builder with one heck of a mortgage payment.

I guess I'm just not seeing how we can expect to see a bottom this soon, when you have so many people losing this much money.

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