Wisest of the crowds

I keep getting asked what will happen to home prices with the Federal Reserve lowering rates to banks. The question implies:

1. What is the relationship of cost of money to prices?
2. Can we identify trends and/or turning points based on this macro-economic variable?

The sub-prime crisis was not born of a real change in cost of money. Rather, it folded under its own weight as artificial borrowing conditions expired and came head-on with artificially inflated home prices. The recovery, on the other hand, may very well be born of a change in cost of money (at least the Fed Reserve is hoping as much).

I believe the past relationship of cost of money and prices is fairly strong and so we should probably consider it. However, the mortgage market is based on long-term MARKET rates (5 year, 10 year, and 30 year US Treasuries) and not DIRECTLY related to the short-term cost of money. Having said that, banks typically borrow short-term and lend long-term and so decreases in their short-term borrowing costs generally will lower mortgage rates - particularly if they WANT TO BE COMPETITIVE. Recently they have not wanted to lend and so lower rates just means increased banking profits. In essence, the Fed is using rates to improve the capitalization of banks. This will eventually flow back into the economy and hence to mortgage borrowers but the immediate impact is less clear.

A couple of things I read this weekend are reinforcing something that I have been thinking about the contrasts of old-school business models and (the promise) of new school businesses. I don’t want to quibble about who is “old” and who is “new” but I guess the test is this: “Do you make a truthful promise to your customer?” Take at a look at theses facts, as an example, below:

- 50% of sub-prime borrowers could have qualified for prime rates, according to Fannie Mae

- “Yield Service Premiums” (kickbacks from lenders to mortgage brokers) are present in 85-90% of sub-prime loans.

- US Dept of Housing and Development estimates that 1 in 9 middle income and 1 in 14 upper income families have sub-primes

Are you kidding? As my kids would say “Sheezamageezza!”

This is old school businesses doing its thing of false promises (of their product or service) and lies (not disclosing dangers or conflicts of interest). Someone posing as an “agent” to a mortgage consumer “advises” that a specific product is “best” and the naive consumer accepts this as fact. Even corroboration with another mortgage broker may not yield substantially better terms because, well, the incentives are the same. The “agent” can sell 6.5% loan and make $3,000 or the 9.5% loan and make $15,000. Easy choice for the “agent”.

The issue is this: consumers are directly or implicitly promised one thing and given another. Bait and switch. Unfortunately, false promises are devastating people everywhere - like in the in sub-prime loan sector. Sadly this isn’t new - this is how business has been done forever and this still happens everyday. Think about all those commercials for processed food claiming to be healthy. This cereal or that snack bar. What do you think when you see this?

The company’s website says “symbols of quality, great taste, and nutrition”. Yet if you look into the ingredients you will see:

Its all crap yet somehow people trust that Quaker is a trusted source of nutrition. The brand promise is improved health and the delivery is poor health. The mortgage broker category promise is best rates and the delivery is, for some, the worst rates. False promises and lies - everywhere.

The business people I meet everyday don’t conspire against consumers but rather are reacting to and responding to duplicitous commercial behavior. This is a market response that will win - eventually.

Interestingly there are others looking at this as well. One the one side are those, like Greg Swann in this wordy post, that believe that regulation should be replaced with personal responsibility and free market solutions as it relates to, for example, real estate agents.

On the other hand, there are those like Elizabeth Warren, a Professor of Law at Harvard Law School, that make an argument for more regulation in a post entitled “Unsafe at Any Rate” referencing the dangers of various consumer financial products and services.

Swann makes the argument that there should be no licensing requirements for real estate agents and that the industry is using regulations to benefit themselves rather than consumers. I agree that the there is a false promise made to consumers with the agent “licensing” scheme but am undecided if removing licensing makes sense for the very same reason that the sub-prime market is a mess - consumer ignorance and bad actors (although not necessarily illegal actors) yield substantial problems. Matters of health and safety are basically the governments job and so just where the lines of safety end is very debatable. Should financial safety be elevated to bodily safety?

Warren thinks so. Her argument is basically that consumers are subjected to too much complexity - complexity meant to trick consumers or keep them ignorant. For example, most people need not scrutinize consumer products at an engineering level because the government sets saftey guidelines and requires clear saftey disclosures. Yet for financial products it is essentially caveat emptor. Consumers must do the equivelant of engineering (and law) to understand the products they are buying and the risks that they are taking. Adding conflicts of interest, common in the mortgage brokerage and payday businesses, makes consumers that much more vulnerable.

The free market rebuttal to Warren is that a market solution will evetually emerge, which I agree with, but the issue really is how many people must suffer in the interim? How many false promises and lies must people endure before a market solution kicks in? What is an acceptable casualty rate?

The Washington Post has a hilarious (but real) article discussing the inside of New Century Financial - the sub-prime mess to end all messes that is now bankrupt. I first read about the article at Inman blog, entitled You WILL play ball. Below is a WP sampler:

“The stress in that place was ungodly. It was like selling your soul,” said Hardiman, who worked for New Century in 2004 and 2005. “There was instant notification to everyone as soon as you rejected a loan. And you dreaded doing it because you paid for it. Two guys would come with a bat, and they were all [ticked] off because you cut their deals.”

I have posted several times about the conflicts between the appraisers, lenders, and agents here, here and here. Bottom line is that it may be time for buyers to hire their own appraisers. This doesn’t represent a new expense but rather a disaggregation of a current expense. If a buyer uses cash, rather than having the costs buried in other transaction costs, than the buyers can control quality and appraiser can get on with their jobs with conflicts.

Also, we might consider the conflicts from the lending side as to communicating affordability to consumers. Does it make sense to expect a lender, who is commissioned based on the number of closed transactions, to actually protect the customers side of the equation? I suppose the logic is that its the banks money but in truth, lenders sell loans and loan agents get new jobs. So the buck gets passed, Wall Street just play the odds (and gets a commission), and the financially illiterate get stuck holding the bag. Nothing new from “big business” but certainly NOT something part of the new business models powered by the internet - including ours.

The solutions to these and other vexing consumer problems are being addressed by market forces. Entrepreneurs like us see this problems as opportunities to add value to people by being open and transparent about our businesses. We put people at the center of our model and drive everything to satisfy this focus. Gone will be the days when trapping and or tricking a customer into a piece of business is THE model. Gone will be the oligipoly’s upon which many incumbent industries are based. Power is being pushed down to people and the economics will follow. Selling your soul in sub-prime, or any other industry, is a dinosaur waiting to happen. A lot of other charts will look like the one below over the next few years.

Today, Easter Sunday, the New York Times takes advantage of its prominence in the psyche of the educated and well read by putting Real Estate front and center. The first article sits in the right hand column of the front cover and discusses the impact of the housing contraction on State tax revenues.

Entitled “Housing Slump Pinches States in the Pocketbook”, Abby Goodnough’s article was thorough, some highlights follow:

Florida is projected to have tax revenues drop for the first time since the energy crisis of the 1970’s.

-NJ could have a budget shortfall of $2.5 billion by mid-2008

-California could have a $2 billion shortfall this year and next

-16% of Floridians and 30% of californians use home equity loans to buy cars

The second article, from a NYT regular (and a personal favorite), Gretchen Morgenson, is on the cover of the business section. Entitled “Home loans: A nightmare grows darker”(premium), the article discusses the sub-prime mess and suggests that well intended social engineering led by the Clinton administration is the cause of the mess. Highlights:

• Sub-prime accounts for one-eight’s of mortgages and 60% of foreclosures

• -President Clinton and HUD Secretary Cisneros encouraged the private & non-profit sectors to find solutions to increase homeownership. Outcome: ownership rose to 69.2% from typical range of 60-65% but was built on mis-leading “innovations” such as teaser interest rates that are resetting substantially higher, extending maturities out to as much as 50 years, interest only loans , and discontinued use of escrow accounts to collect real estate tax and insurance expenses.
• -Best quote: “We’ve created a society that loves the term homeownership, yet we can’t allow people to understand that they are being taken advantage of by the term” - Josh Rosner, MD at Graham Fisher.

On a local front, the Real Estate pull-out of the SF Chronicle Examiner’s lead story entitled Boom and Gloom by Marni Leff Kottle

• -Places like San Francisco, Palo Alto, Marin County are doing well while cities further out are doing poor

• -2.2 million Americans could wind up losing their homes to foreclosure over the next several years.

• -Quote: “People are paying a lot for schools and for shorter commutes on the west side of Silicon Valley and up the Peninsula toward San Francisco,” said Mark Burns, president of the Silicon Valley Association of Realtors

Real estate markets are hyper-local and now that the bloom has come off, this will become more and more apparent. Sub-prime versus Super-prime. City center versus suburb. SOMA neighborhood versus SoBe neighborhood. Bush Street versus Jackson Street. The house at148 Jackson versus the house at 156 Jackson. Talk of a “market” needs to be cleaned up and better described because it doesn’t really exist as a market.
Having said all that, there are common touch points that make real estate a market from a macro-economic perspective: Cost of money, local employment and income, demographics, and population changes. Of course one of the biggest is buyer and seller psychology of the future prices.

Will CFC (Country Wide Financial) be a reasonable indicator that the sub-prime market is truly spilling over to the whole housing market? If you believe that the markets are the best aggregators of information and are forward looking, then keep your eye on the stock. It looks like a break of $30 dollars a share could indicate that investors believe that the housing landscape is still working its way through the mess and that the much discussed resetting of ARM’s may get uglier. This, in the context of a broad consensus that the Federal Reserve will lower fed funds - hence making ARM’s cheaper - is a staggering thought. Take a look at the chart below to get a sense of how well CFC has done over the last 8 years.