Insider Report on the Credit Crunch

I just recently read that foreclosures are starting to cause trouble beyond the confines of the subprime mortgages.

To investigate this phenomenon, your erstwhile blogger recently met a disguised banker in trench coat and dark glasses in a shady roadside diner. How, I asked, did all this happen, and what's the likely effect.

The banker whispered over to me ... "I can tell you, but I have to speak in code. Here, you can use this keyword code card afterwords to figure out the analogy I'm about to give you."

"Our money wizards assured our bank executives that this new lending would be like driving a new CAR, and that we'd be FASHIONable everywhere. We were even handed a nice clean MAP.

Unfortunately, it seemed like we ended up driving too fast, and a CRASH ensued. We looked around, and there was nothing but a WRECK left.

In the end, my friend, I don't want to tell you what our balance and income statements will look like, because I respect you too much to BORE you with all the details."

The banker glanced around, and quickly stole away. I was left scratching my head, until I remembered the keyword code card he'd handed me. I looked at it:

• CAR = Careful Assessment of Realty
• FASHION = Forward Appreciation Stereotyped High In Our Nation
• MAP = Mortgage Applicants Poor
• CRASH = Crisis Revolves Around Suspect Homeowners
• WRECK = Wobbly Realty Eviscerating Capital Keepers
• BORE = Bank Owns Real Estate

Now it all made sense ... reporting from the front lines of the credit crunch, I remain, yours truly, the Confused Capitalist.



JW

The Confused Capitalist

Credit Markets for Dummies / Bankers

Last week, I was complaining about the idiocy of the CEO's of the major banks in their sub-prime and general end-of-cycle lending practices. Although I thought that these folks should be smart enough to understand cyclical risk in mortgage lending, apparently it has escaped them.

While your servant is just a humble real-estate appraiser in his real life (and a former branch manager for Household Finance), I didn't think understanding changes in real estate values or basic credit lending (and hence, value at risk for a bank) was too complicated.

Apparently, though, I was mistaken. Hence, my new class, Credit Markets and Residential Real Estate Values 101. Now, I want the heads of Citibank, Bank of America, et.al. to stop goofing off, and sit at the front desks here.

Prince! Up Front!! What? You've been canned? (oops, "resigned under pressure") Well, all the more reason to sit up front here. Now pay attention!

This is pretty simple.

1. First of all - don't lend to people who can't afford to repay you - yes, over the long term - not just based on the teaser rates!


2. Check their references - i.e. confirm their income, debts, payments, etc.


3. Medium-to-longer term changes in real estate values (which is really what the bank's security is predicated upon) is based almost completely on just three factors. Pay attention to those factors, since they can affect values!

The three factors affecting the medium-term plus value of real estate are:

a. Changes in population in an area;

b. Changes in after-tax income;

c. Changes in interest rates.

Prince, note that unsustainable changes or trends (as an example, interest rates at historic or near historic lows, eg 2001-2005) will have the effect of exagerating short-term property values. Meaning, in the context of real estate values, circa 2002-2007, they are likely to become OVERSTATED due to "c" above. And thus impair balance sheets.

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No one could have predicted this? I pull some narrative commentary from my own appraisals dealing with values in 2003 ...

"... the local housing market continues to set records, fuelled by both low interest rates, and a relative shortage of product."

... in 2004 ...

"Lending rates remain at near-historic lows, and continue to support economic activity of all kinds, but low rates are well-known to provide significant boosts in pricing and activity in the housing sector."

... and in 2006 ...

"Lending rates remain at near-historic lows, and continue to support economic activity of all kinds, but low rates are well-known to provide significant boosts in pricing and activity in the real estate sector."

Prince, Prince!! Pay attention.

JW

The Confused Capitalist

Editorial: Why a Responsible Fed Won't Lower Rates Anytime Soon.

Notwithstanding the perceived subprime "crisis", a responsible Fed can't lower rates anytime soon. Why?

Because the consumer is finally being told, in no uncertain terms, to smarten up, stop spending more money than you have, and save a little bit. With this message, (and a puncturing of the home-ATM cash-machine) inflation will finally begin to get tamed.

Any loosening of the money supply at this point, while mitigating the short-term damage that will soon become evident in bloated housing markets, will only move that day of reckoning into the future. A future time which which would then have bleaker, more uncertain and more unstable fundamentals, from which to try making essentially the same maneuver.

No, dear readers, this is the medicine that great-great-grandmother used to force down great-grandmother's throat: a nasty-smelling, foul-tasting, herbal concoction that nearly gagged the dear girl. But medicine that helped the patient recover sooner, and more robustly.

To lower interest rates at this time is the equivalent of turning up the heat in the house, so that the feverish patient may feel comfortable. Foolish. Understandable to some, with the child whining so loudly but, all the same, foolish.

And a responsible Fed just won't do that.


JW

The Confused Capitalist

Real estate values still to be knocked down ...

There's an interesting report on the value of housing in America, updated this month. The Global Insights/National City report suggested, based on 21 years of data, that of 317 metropolitan areas around the US, covering 84% of the housing stock, only 88 markets are currently undervalued (by any amount).

Against that, there are some 71 metro markets - covering 39% of the housing stock - that are "extremely over-valued", meaning that the valuations are at least 34% above what their model projects as correct values. The report further notes that as recently as the first quarter of 2004, only three metro markets were "extremely" overvalued.

And for those that think the housing market is due for a rebound (and prices aren't yet statistically showing up as falling much), the report states that the median correction in overvalued markets in the past 21 years is 17% and that it lasts 14 quarters. That's three and a half years folks. To those that like the seemingly cheap valuation metrics of home-builders and development companies, may I suggest .... patience.

In Canada, however, things are different as the good times appear to roll on for as far as the eye can see. Although there's no apparent signs of a real estate bubble here, perhaps some leading edge indicators suggest that a bubble may be in the early stages of forming.

ReMax just reported that sales of high-end luxury houses are booming across the country, with sales volumes up year over year by 31% in Toronto, by 90% in Vancouver, and by 124% in oil-rich Calgary.

Another five or ten years of this, and we might end up in the same boat as the US market is!

JW

The Confused Capitalist

Canada: What Housing Bubble?

Well, apparently unlike the US housing market, even after a strong five years of house price gains, housing in Canada remains undervalued.

According to recent research by Merrill Lynch economist David Wolf, the Canadian housing market is, on average, undervalued by 10-20%. Mr. Wolf ran his model based on average incomes and the cost of debt, and in only one (Victoria) of the 15 major markets measured, was the housing over-priced - and even then it was just a modest 4%.

To check his model accuracy, he ran current prices and incomes in the major US cities (yes, most were over-priced, according to his model), and also ran it against the frothy 1990 Canadian markets (again, his model suggested they were then, in fact, over-priced).

One of the more surprising findings was that even in oil-rich Alberta - after years of very strong gains - the major cities of Calgary and Edmonton were amongst the most-undervalued cities in Canada.

According to Mr. Wolf, Canadian prices can rise by an average of over 4% annually for the next four years before they'll achieve full value.

In the meantime, those worrying about a Canadian housing bubble can relax ... relax ... relax ... relax ...


JW

The Confused Capitalist

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