As the economy improves, lenders will start to liquidate their inventory. When they do, the lending cartel will collapse, and prices will get pushed lower.
Despite the huge backlog of inventory of both bank-owned properties and shadow inventory, the banks are in no hurry to liquidate. It is classic cartel behavior.
When OPEC first formed, a group of oil producers had an idea: if they all agreed to restrict production, it will drive up prices and make them all rich. When they first put their plan into motion in the 1970s, it worked. The member countries curbed production, and prices went up. Once prices were high, each member country had incentive to cheat to obtain more income at the higher price, so the cartel weakened, and many argue it has little or no power today.
Similarly, the heads of all the major lenders today are like minded: they all agree that processing foreclosures into a weak job market will lower prices and reduce the value of their holdings. They all came to this conclusion in 2008, and during 2008 and 2009, they stopped processing foreclosures and restricted the inventory on the market to keep prices high, and it worked.
As the economy pulls out of this recession, each of the members of the banking cartel will change their opinions about the economy and the market. Some will evaluate their procedures and determine changes are in order, and some will evaluate the amount of inventory they must chew through and determine they better get going or they will own real estate for the next 20 years.
The 2:00 problem
Years ago I attended a seminar where the speaker was Kevin Haggerty, 7-year head of trading at Fidelity Capital Markets. He described what is known as the 2:00 problem.
When mutual fund managers want to buy or sell stock, they call the trading desk and place an order. Since these orders are often very large, it may take quite some time to get their orders filled. Let's say the trader was asked to fill a 100,000 share order, and at 2:00 he has only accumulated 60,000 shares. He informs the head of trading who calls the fund manager. The fund manager has to make a choice: (1) either wait and get the order filled tomorrow, or (2) have the trader fill the order regardless of what it does to the stock price. Filling a large order at the market can cause a major change in price.
The banks have a 2:00 problem... almost. It is only 12:00 in their world. They have only filled a tiny fraction of their original, market-clearing order, and they feel no urgency to fill the order through lowering price... yet.
Two o'clock is coming. When the economy starts to recover, banks will get pressure from regulators and stockholders to clean up the mess on their books. Lenders are not synchronized, and each one will hit 2:00 at a different time. The volume necessary to clear the garbage is simply not going to happen at current price levels. The price-income mismatch makes that impossible. At some point, the pressure to liquidate will force them to impact the market.
Ever since the housing collapse began, market seers have warned of a coming wave of foreclosures that would make the already heightened activity look like a trickle.
The dam would break when moratoriums ended, teaser rates expired, modifications failed and banks finally trained the army of specialists needed to process the volume.
But the flood hasn't happened. The simple reason is that servicers are not initiating or processing foreclosures at the pace they could be.
It really is that simple. I see uninformed shills write that there is no shadow inventory and other nonsense that realtors tell their customers to dupe them into a false sense of security. The fact is that shadow inventory does exist. It is very large, and eventually banks are going to have to liquidate this inventory. This liquidation will be the collapse of a cartel and may not be the orderly flow they are hoping for.
By postponing the date at which they lock in losses, banks and other investors positioned themselves to benefit from the slow mending of the real estate market. But now industry executives are questioning whether delaying foreclosures — a strategy contrary to the industry adage that "the first loss is the best loss" — is about to backfire. With home prices expected to fall as much as 10% further, the refusal to foreclose quickly on and sell distressed homes at inventory-clearing prices may be contributing to the stall of the overall market seen in July sales data. It also may increase the likelihood of more strategic defaults.
I have pointed out on many occasions that lender policy is encouraging strategic defaults.
It is becoming harder to blame legal or logistical bottlenecks, foreclosure analysts said.
"All the excuses have been used up. This is blatant," said Sean O'Toole, CEO of ForeclosureRadar.com, a Discovery Bay, Calif., company that has been documenting the slowdown in Western markets.
Banks have filed fewer notices of default so far this year in California, the nation's biggest real estate market, than they did 2009 or 2008, according to data gathered by the company. Foreclosure default notices are now at their lowest level since the second quarter of 2007, when the percentage of seriously delinquent loans in the state was one-sixth what it is now.
Let that sink in: banks have six times as many delinquent borrowers, but they are foreclosing on less of them. What do they expect to do with all these squatters?
New data from LPS Applied Analytics in Jacksonville, Fla., suggests that the backlog is no longer worsening nationally — but foreclosures are not at the levels needed to clear existing inventory.
The simple explanation is that banks are averse to realizing losses on foreclosures, experts said.
"We can't have 11% of Californians delinquent and so few foreclosures if regulators are actually forcing banks to clean assets off their books," O'Toole said.
Officially, of course, this problem shouldn't exist. Accounting rules mandate that banks set aside reserves covering the full amount of their anticipated losses on nonperforming loans, so sales should do no additional harm to balance sheets.
Within the last two quarters, many companies have even begun taking reserve releases based on more bullish assumptions about the value of distressed properties.
That is mark-to-fantasy accounting. The banks are using bullish assumptions that can't possibly come to pass given the huge inventory that must be liquidated.
Now there is widespread reluctance to test those valuations, an indication that banks either fear they have insufficient or are gambling for a broad housing recovery that experts increasingly say is not coming.
Banks did not choose the strategy on their own.
With the exception of a spike in foreclosure activity that peaked in early-to-mid 2009, after various industry and government moratoriums ended and the Treasury Department released guidelines for the Home Affordable Modification Program, no stage of the process has returned to pre-September 2008 levels. That is when the Treasury unveiled the Troubled Asset Relief Program and promised to help financial institutions avoid liquidating assets at panic-driven prices. The Financial Accounting Standards Board and other authorities followed suit with fair-value dispensations.
These changes made it easier to avoid fire-sale marks — and less attractive to foreclose on bad assets and unload them at market clearing prices. In California, ForeclosureRadar data shows, the volume of foreclosure filings has never returned to the levels they had reached before government intervention gave servicers breathing room.
Some servicing executives acknowledged that stalling on foreclosures will cause worse pain in the future — and that the reckoning may be almost here.
"The industry as a whole got into a panic mode and was worried about all these loans going into foreclosure and driving prices down, so they got all these programs, started Hamp and internal mods and short sales," said John Marecki, vice president of East Coast foreclosure operations for Prommis Solutions, an Atlanta company that provides foreclosure processing services. Until recently, he was senior vice president of default administration at Flagstar Bank in Troy, Mich. "Now they're looking at this, how they held off and they're getting to the point where maybe they made a mistake in that realm."
Did you catch that? That is the beginning of the end for the lending cartel. Once they lose their like-minded action, once some of the cartel members begin to liquidate, prices will fall, and the cartel will crumble.
Moreover, Fannie Mae and Freddie Mac have increased foreclosures in the past two months on borrowers that failed to get permanent loan modifications from the government, according to data from LPS. If the government-sponsored enterprises' share of foreclosures is increasing, that implies foreclosure activity by other market participants is even less robust than the aggregate.
"The math doesn't bode well for what is ultimately going to occur on the real estate market," said Herb Blecher, a vice president at LPS. "You start asking yourself the question when you look at these numbers whether we are fixing the problem or delaying the inevitable."
I am amazed that anyone involved really thought the bailouts and false hopes would actually solve this problem. There was never any chance. Those programs were obviously delaying the inevitable.
Blecher said the increase in foreclosure starts by the GSEs "is nowhere near" what is needed to clear through the shadow inventory of 4.5 million loans that were 90 days delinquent or in foreclosure as of July 31.
LPS nationwide data on foreclosure starts reflects the holdup: Though the GSEs have gotten faster since the first quarter, portfolio and private investors have actually slowed.
"What we're seeing is things are starting to move through the system but the inflows and outflows are not clearing the inventory yet," he said.
I find it surprising that the government is actually leading the collapse of the cartel. Don't be surprised if the GSEs stop their foreclosure activity under pressure from banking interests that would rather see us become Japan than see themselves forced out of business.
Delayed foreclosures might be good news for delinquent borrowers, but it comes at a high price.
Stagnant foreclosures likely contributed to the abysmal July home sales, since banks are putting fewer homes for sale at market-clearing prices.
Moreover, Freddie says a good 14% of homes that are seriously delinquent are vacant. In such circumstances, eventual recovery values rapidly deteriorate.
Defaulted borrowers were spending an average of 469 days in their home after ceasing to make payments as of July 31, so the financial attraction of strategic defaults increases.
One possible way banks are dealing with that last threat is through what O'Toole calls "foreclosure roulette," in which banks maintain a large pool of borrowers in foreclosure but foreclose on a small number at random.
O'Toole said the resulting confusion would make it harder for borrowers to evaluate the costs and benefits of defaulting and fan fears that foreclosure was imminent.
For as cold as Sean's idea is, it would probably be effective. Random violence is an effective method of generating terror, and what Sean is suggesting is that lenders become terrorists.
Is that what this has devolved into? Are lenders going to resort to terrorist tactics to compel people to pay for lender's stupid lending mistakes? Are we going to allow lenders to do this? When will the government act for us rather than for the lenders?
The idea that lenders could and would do this makes me want to see them die.
The cartel in action
I am featuring a property today that demonstrates the macro-economic concept I discussed in the post. I originally featured this property back in January in Foreclosures Ravage Irvine’s High End.
This property was built with a $4,300,000 loan from Fullerton Community Bank. Loans like this inflated high-end pricing, and their absence has created a huge vacuum that no lender is every going to fill. Evidence of the precarious nature of high end properties is evident with $2,650,000 losses in Irvine real estate.
Back in January, they were asking $4,500,000. A wishing price. They are now down to $4,195,000, and no buyers are to be found. It is 12:00 in their world. They are still in denial. Despite the obvious evidence of long-term weakness in this market, they are holding out for that one buyer who could bail them out. Unfortunately, so are hundreds of other desperate sellers at these price points.
Eventually, it will be 2:00, and they will have to make a decision about liquidation. Either they will mark it way down to sell it, or this may be REO until 2018 when their asking price is market. Which do you think they will chose?
Home Purchase Price … $4,300,000 Home Purchase Date .... 5/10/2006
Net Gain (Loss) .......... $(356,700) Percent Change .......... -8.3% Annual Appreciation … -0.5%
Cost of Ownership ------------------------------------------------- $4,195,000 .......... Asking Price $839,000 .......... 20% Down Conventional 4.50% ............... Mortgage Interest Rate $3,356,000 .......... 30-Year Mortgage $819,853 .......... Income Requirement
$17,004 .......... Monthly Mortgage Payment
$3636 .......... Property Tax $792 .......... Special Taxes and Levies (Mello Roos) $350 .......... Homeowners Insurance $500 .......... Homeowners Association Fees ============================================ $22,281 .......... Monthly Cash Outlays
-$2068 .......... Tax Savings (% of Interest and Property Tax) -$4419 .......... Equity Hidden in Payment $1398 .......... Lost Income to Down Payment (net of taxes) $524 .......... Maintenance and Replacement Reserves ============================================ $17,717 .......... Monthly Cost of Ownership
Cash Acquisition Demands ------------------------------------------------------------------------------ $41,950 .......... Furnishing and Move In @1% $41,950 .......... Closing Costs @1% $33,560 ............ Interest Points @1% of Loan $839,000 .......... Down Payment ============================================ $956,460 .......... Total Cash Costs $271,500 ............ Emergency Cash Reserves ============================================ $1,227,960 .......... Total Savings Needed
Property Details for 63 CANYON Crk Irvine, CA 92603 ------------------------------------------------------------------------------ Beds: 6 Baths: 7 full 1 part baths Home size: 9,600 sq ft ($437 / sq ft) Lot Size: 23,183 sq ft Year Built: 2009 Days on Market: 248 Listing Updated: 40404 MLS Number: S599824 Property Type: Single Family, Residential Community: Turtle Rock Tract: Shdc ------------------------------------------------------------------------------ According to the listing agent, this listing is a bank owned (foreclosed) property.
Bank Owned Estate presented in distinctive Andalusian Style, this custom designed and built home artfully balances grand scale spaces with an extraordinary attention to detail. Numerous viewing decks and a courtyard entry pay tribute to Old World traditions, while graceful archways, hand turned balustrads underscore the architectural theme. With 2 of the 5 bedroom suites & an office on main level, this 9600sqft home offers optimal flexibility.Oasis like landscaping with various waterfalls enhance the villa appeal of this magnificent residence. Subterranean soaking pool, sauna, home theatre/game room/ bar and a temperature controled wine cellar with custom racking and table seatings of 8 or more. Optional Elavator.
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