The Pig in the Python
The title of this post may sound like a fable told by Aesop, but we assure you it’s not.
We spent the early part of this week in Dallas attending the 3rd Zelman & Associates Housing Summit. The conference was attended by CEOs of housing and housing finance companies, senior officials in various government agencies and regulators, as well as numerous economists and investors, thinkers and forecasters. Today’s post is a brief summary of one of the more interesting narratives that wove through many of the panel discussions: shadow inventory and moving the problem loan pig through the python.
Ms. Zelman and Director of Research Dennis McGill opened the conference with a discussion of where the housing market stands, and where we are likely to go from here. They started with the good news. To name a few important points:
· New home inventories are relatively lean by historical standards
· Home prices have fallen far enough that they are now back in line with historical relationships to incomes and rent
· Investors have been attracted to the market, with all-cash purchases making up about 34% of all purchases on average
However, affordability alone won’t be enough to spur a rebound in housing activity. There are several factors mitigating the effect of lower prices and mortgage rates: a poor labor market, borrowers with negative equity in their homes, and tighter credit standards (higher down payment and credit score requirements, for example). This leads us into the negatives for the market:
· Excess supply of homes, especially vacant ones
· The multifamily market will begin to take share as more households decide to rent
· A large and growing shadow inventory is hanging over the market
Now we can begin to explain our title. Zelman closely watches the problem loans (the pig) that need to be moved through the long foreclosure and REO process (the python), so that the houses can be put out onto the market and absorbed. The government has chosen to deal with the problem loans first by trying to turn them into non-problem loans, through the various foreclosure moratoriums and modification programs. Why have these programs been so ineffective in relation to the size of the problem? Listening to a panel of mortgage servicers gave some important insights. The mortgage servicers are on the front lines, responsible for dealing with delinquencies, modifications and foreclosures. It’s no surprise that this was one of the more downbeat panels at the conference. The consensus is that life has been much harder for the servicing industry since the government has stepped in with modification and foreclosure-avoidance programs like HAMP and HAFA. These programs aren’t working because many borrowers don’t qualify, and the ones that do are often very hard to get in touch with. A common statement from the panel was that, without the credible threat of foreclosure, borrowers have no incentive to come to the table in the first place. They will continue to live in the house, ignoring phone calls, door knockers, and fancy envelopes sent in the mail. The performance of HAFA, which offers foreclosure alternatives like short sales, has been worse. One servicer stated: “Offering a short sale to somebody living in the house for free, it’s a tough sale. They know the foreclosure process takes a long time.”
Most of the borrowers who could be helped by these programs have already been helped, and it appears that servicers are finally able to begin to move the pig through the python again. The government seems to be leading the charge:
As you can see in the chart above, REO portfolios of the GSEs and the FHA are growing, and the rate of dispositions is picking up. This is a painful (and deflationary) process, but the housing market can’t establish a firm foundation for future growth until we deal with problem loans and the shadow inventory overhang.
We should close on a positive note. For all of the government programs developed to assist the housing market, the conference showed us one private sector solution in action: REO investors. We spoke with a panel participant who told us the story of his family’s privately-owned home building business. As the market rolled over, the company paid off their relatively small amount of debt and mothballed the building business. Instead of playing golf until the market turned around, they decided to pursue an interesting opportunity. The company purchases REO properties from banks, uses their existing building crews to renovate them, and then resells the homes. The business model is simple: buy at a discount, put a few thousand dollars into the house, aim for relatively modest margins on a quick resell, and repeat. The return on invested capital has been more than adequate. This anecdote is a great example of how smart people running a conservatively financed business can adapt to a tough environment. It is also a private sector-driven way to help work the pig through the python.
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