Time to Buy?

Yes and no.  I think there are two types of buyers who can make it in this market.  The first is the investor with experience who is picking up cosmetic fixers from the bank and turning them quickly.  The second may surprise those of you who know that I have not been counseling many people to purchase over the past three years.  I think that now is a very good time for buyers who have some stability in their lives (you need to be thinking 5-7 year minimum hold) who are tired of renting.  It’s not that I think we are at the bottom yet (I don’t), but I think that interest rates could be extremely volatile over the next 2-3 years.  Let me explain.

First of all, I think that Southern California real estate is going to be no lower than it is today in 5-7 years.  That is why I think that if you have that time horizon, you are not likely to get hurt (if I am wrong, odds are I’m doing something else in 7 years anyway so you won’t have a chance to tell me about it).  So, let’s say you have been paying rent for a couple of years wishing you had purchased years ago when your friends did, although now you are glad you didn’t and are looking a lot smarter then they are.  Let’s look at a hypothetical buyer:

Joe makes $60,000 a year and has a car payment of $500 a month.  He has no credit card debt or student loans.  To qualify Joe, a bank is going to say he can have roughly 40% of his income in debt (including housing).  This means that after his car payment, Joe can spend $18,000 a year on his housing.  If Joe uses an interest only loan at 6% (lenders, I am using 40% debt ratio and an interest only loan because the math is easier – it makes the same point as an absolutly accurate scenario) the bank would qualify him for a loan of about $250,000 (assuming $3k a year in property taxes, etc.) 

Now, let’s say that we are at the low point now and prices go up.  Joe is obviously going to wish he had purchased now.  But what happens if the market keeps going down?  Well, Joe’s $250k will buy him more house.  Or will it?  What about interest rates?  Let’s say the price of Joe’s home falls 10%, how much would interest rates have to rise to offset the drop in prices?  The answer is not much.  If interest rates rose from 6.0 to 6.67% and the price of Joe’s home fell 10%, he would be able to buy the same home.  However, if interest rates rose to 7.5%, Joe’s home would have to drop 20% for him to still afford it.  Am I predicting rates will go up to 7.5%?  No.  But with the Fed pumping as much money into the economy as they are, inflation is bound to heat up and the Fed likes to raise rates to control inflation.

That is why, if you are planning on being in a home for 5-7 years, now might be a very good time to make a purchase and stop giving your paycheck to your landlord.

Blame the Republicans or the Democrats – Yes

I spent a good part of the weekend doing research to get a better understanding of what caused this train wreck that necessitated a $700B (minimum) bailout.  I found that there is enough blame to go around to everyone, but two pieces of legistlation are the primary enablers.

First of all, I found the Community Reinvestment Act.  This was legislation passed in 1977 to eliminate red-lining.  At that time, banks actually had maps with areas highlighted in red in which they would not lend money.  These areas were shown to be very heavily populated with minorities.  The idea behind the CRA was to force banks to invest their money back into the neighborhoods where the deposits came from.  In my opinion it was a good effort that had a small effect until 1995 when it was revised.  Under the revisions, banks could be punished for not making enough loans to low income people and businesses.  However, low income people could not meet the qualification requirements for most loans available at that time, so “creative” loans were created and insured by Fannie Mae and Freddie Mac.  The program seemed to work as more lower income people were able to purchase homes.  Since the programs were working, they were expanded to not only low income people but investors.  Your friend who bought five investment homes in two  years on a $80k income?  This is why he was able to do it.  Nobodys saw any problems seen with this, as enabling more people to buy homes pushed up housing prices and drove the economy.  People who did not have a large income were making money from home appreciation.  As their home value went up, new loans were created to allow people to pull money out of their homes to buy other things.  This drove the economy as a buyer with no money, purchased a home, waited a year to refinance and then bought a new car, new toys, took vacations, etc.  All of a sudden, having no money or not having a good job didn’t seem important, just lie on a loan application, buy a home and use it like an ATM.  The American Dream of working hard to own a home where you can raise your family was hijacked by well meaning interest groups and turned into a dream of getting a free home (if you consider that the mortgage paid was equal or lower to rent, the home purchase was basically free)  and using its appreciation to gain wealth rather than putting in an honest day’s work.  (This wasn’t limited to low income people, friends and I used to joke that we made more money going to bed at night than we did working – but nobody complained).

This instant and easy wealth had a hidden cost.  Historically, housing has tracked inflation, but after the CRA was revised in 1995, housing took off.  The reason is simple:  if more people can qualify to by a home (or homes), the more that home (or homes) will get bid up in price.  For over 10 years there was no problem with this.  Since housing prices kept going up, everybody could refinance if their rate adjusted the wrong way.  Plus, as prices kept going up, we used our homes as ATMs to buy things and drive the entire economy.

Sounds too good to be true?  It was.  When prices started to rise and the economy slowed down, people had to pay more money for food and gas.  Paychecks got squeezed.  Especially low income paychecks.  Paychecks that couldn’t have qualified a buyer to buy a home now had no chance to pay the mortgage.  Low income people (and it expanded to the middle class) got their dreams crushed by reality. 

Could this have been avoided?  Maybe, but the political pressure was too strong.  Fannie Mae paid lobbyists and polliticians huge sums of money to keep the affordable housing madate going.  Reform was tried in 2003 and 2005, but was killed in committee by politicians friendly to Fannie Mae.

The second piece of legislation originated after the Great Depression.  I wasn’t around for it (I’m going gray, but not that gray), but one of the causes of the Depressioon was that banks were speculating and crossing into areas that were conflicts of interest.  Now, I don’t know exactly what happened (that part of US History was too boring at the time), but it was decided to impose tighter regulation on banks.  The law that was passed to do this was the Glass-Steagall Act.  For the purposes of this discussion, the most important part of the Act was that it prohibited Banks (or companies that owned banks) from also owning other financial companies.  This separation kept banks from owning investment companies and insurance companies that would be a conflict of interest.  Of course, this also kept a cap on their profits which they did not like.  So, for about 30 years, banks have lobbied to be rid of this regulation, and in 1999 they were successful with the passage of the Graham-Leach-Bliley Act.   

It is not an accident that the housing boom (which had started prior to this) gained momentum with the passage of Graham-Leach-Bliley.  This Act allowed banks to issue loans and create securities and market them – making a profit each step of the way. 

The reason this is important is that it created incredible demand for investment products that were created by packaging mortgages – subprime mortgages.  If the banks that were packaging these loans were also the same banks selling them to investors, there is a huge conflict of interest (is an investment banker going to tell an investor that the bundle of loans created by the investment bank’s new sister mortgage company have been issued to borrowers with low income and that many of them will fail)?  Since the market kept going up, the demand for these packages kept going up and more sub-prime loans had to be given to feed that demand.  Everybody made money.  Homeowners got free money from appreciation, mortgage brokers made money with every loan they made, the banks who made the loans made money selling them, Freddie and Fannie made money insuring them and investment bankers made money trading them  No wonder nobody wanted it to end.  It was a feeding frenzy – and then we ran out of food.

I asked a friend of mine who is in the financial management world how this could happen, and he had a great explanation:

Any time you get incredibly smart people who are also incredibly greedy people and you don’t regulate them, you are going to have a problem.

So, my conclusion is that we had too much government involvement in one area:

• Forcing banks to make loans to people who could not reasonably pay them back.

And too little government involvement in another area:

• Regulation brilliant, greedy people who had the power to move markets.

Why did this happen?  Politics and Politicians.  On one hand making it possible for poor people to own homes and making it possible for all people to earn more money on home appreciation than by having a good education and job is appealing to voters.  On the other hand, getting support in the form of campaign contributions and lucrative post government jobs from the financial sector is just as appealing.

I looked at a lot of sources this weekend.  Here is a list of some of the better ones if you are interested:

Gramm-Leach-Bliley

http://banking.senate.gov/conf/grmleach.htm

http://www.ftc.gov/privacy/glbact/12cfr225_28.htm

http://www.ftc.gov/privacy/glbact/12cfr225_86a.htm

Community Reinvestment Act

http://www.federalreserve.gov/newsevents/testimony/braunstein20080213a.htm

http://mises.org/story/2963

http://economistsview.typepad.com/economistsview/2008/04/yet-again-it-wa.html

http://www.youtube.com/watch?v=RBWPk5Yk_AM&feature=related  – this is a political presentation from the Democrat side

http://www.youtube.com/watch?v=3EyKiOE78yU&feature=related - this is a politcial presentation from the Republican side