Dysfunctional US housing market. Dysfunctional capital market as well?

Some insight into the dysfunctional dynamics of the US housing market. A situation that would clear in a matter of months in a free market could take decades to resolve in the Government dominated “market”.

The housing market has gone nowhere since the meltdown. Some 14 million homeowners are underwater on their mortgages. A good percentage of those people have stopped making their monthly payments.

In the initial wave after the housing crash, there were millions of strategic defaulters: homeowners who could afford to make the payments, but walked away because they believed it was the most prudent financial decision to make.

Now there are vast numbers of strategic squatters. People who could pay but aren’t. Instead of walking away, they remain in the home knowing that it may be not months, but years, before the lender will evict them. The average foreclosure now takes 728 days. In a few states, it’s over a 1,000 days. And this is after the lender has filed a notice of default. Some loans have gone 500 days delinquent before Bank of America has filed a notice to start the process.

This can happen only in a market dominated by the government. Fannie Mae, Freddie Mac, and the FHA comprise 90% of the mortgage business.

On the capital market, this comes from Karun Phillip in the US in the context of the great “fiscal cliff” debate. Critical comments from people who are more at home with this kind of thing are welcome.

Accounting is a strange rabbit-hole of a world that I had to learn from scratch, and was amazed even after doing a PhD in Engineering. Take this example: A small business may take in $5 million in revenue and have $4 million in direct costs that are considered expenses as per tax law. The supposed profit is therefore $1 million.

But there may be $2 million more in capital expenses in order to just stay in business the next few years. In normal times, the $2 million in one-time expenses is funded by bank debt, which, even at a 10% interest rate, would be $200,000 a year. But since the SEC and FASB decided to collapse the credit markets in 2007-2008, this $2 million has to come from the small business owner’s pocket.

So there it is. He/she is supposedly in the $1 million income tax bracket, but actually has to come up with an extra million and also pay higher taxes on the book “profits”.

There is a solution in that the small business can expense the capital expenses and reduce extra taxes. But then they may wreck their balance sheet and lose whatever bank credit they already have with the tightened lending guidelines. Guidelines required by a reversion to centrally planned credit after crashing the de-centralized system that existed before FAS 157.

There is more about the impact of the revised guidelines on credit and securities in his previous post.

In 2007, the SEC’s accounting arm, FASB, introduced a rule named “FAS 157” saying all these securities have to be “marked-to-market”, meaning that even if you (as a bank or investor) did not want to sell the Security you hold, you must mark it as worth what your neighbor might have sold it for. This causes you to put up a higher amount of capital to cover the security you already own and do not want to sell. It is like if your neighbor sold their house at fire-sale prices, your bank tells you that although you paid all your installments, you now have to pay more equity into the home loan immediately, or be foreclosed.

This caused what my friend Jeff Miller called the “death spiral” (do a web search on “Jeff Miller death spiral” or at http://oldprof.typepad.com/a_dash_of_insight/).

I read what he wrote in 2008 and corresponded with him, and I decided that I believed he was correct. I moved all my money to the safest places available because of the coming credit collapse, and prepared to fund my business without bank loans.

Well, Jeff was correct. A few weeks later I needed a $5000 high speed printer, which used to be routinely financed so that I could pay over 3 years, and the finance division was unable to obtain an interest rate at which they could finance a $5000 printer. Money supply (credit supply) had frozen. Fortunately, I had had some idea what was happening and just paid the whole thing up front.

Today, we have interest rates at zero, but no significant loan growth to small businesses — the creators of jobs.

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3 Responses to Dysfunctional US housing market. Dysfunctional capital market as well?

  1. Entropy

    It is like if your neighbor sold their house at fire-sale prices, your bank tells you that although you paid all your installments, you now have to pay more equity into the home loan immediately, or be foreclosed.

    This is actually a real potential problem in the Australian rural sector.

    A farmer defaults so badly (or managed to successfully fake his circumstances for so long the bank kept lending money until there is negative equity) the bank is left with no choice but to foreclose and recover at least some of the money.
    The firesale results in a devaluation of all surrounding properties, technically placing the neighbours in situation where their equity is eroded and the banks must start to consider administrative action. The rural papers are stuffed full of properties for sale, but nobody is buying because it is hard to get finance in the sector as the banks are very worried about their exposure, and the expectation property values will fall further.

    The market must correct of course, over the last twenty years land values rose well above its potential to earn, as credit was easy to obtain in the expectation of ever rising appreciation of land values. But it really sucks for those looking to expand the business in those years,who now have high debt loads and falling equity.

    As you can guess the Katter solution to this problem is for the government to step in with buckets of OPM and offer reconstruction loans at next to zero interest. For farmers only of course, because they are special. The idea could be expanded by the creation of a new state bank just like the Fannie Mae and Freddie Mac discussed in this article. What could go wrong?

  2. Pyrmonter

    carrying assets at the lower of cost or market is Accounting 1; to do otherwise involves fraud on the lender and equity holder: they don’t have access to assets of the value the debtor asserts. If you want them to share the risks, fine – tell them – ie mark to market. They might be willing to accept the risk at a price. But promoting inflated balance sheets has been and remains one of the most common large scale frauds.

  3. PSC

    I massively dislike FASB, and because of the wonders of internet anonymity I’m happy to disclose that I think the SEC are a bunch of hopeless jokes who will be first up against the wall when the revolution comes … but …

    1) The problem in the first part boils down to state law in the US. Some states have quite strict bankruptcy/foreclosure, some don’t. This isn’t a federal/agency issue. To my knowledge there’s no difference between the foreclosure times on mortgages in agency and non-agency MBS.

    2) WTF? If you’ve $2 mil of capex, you need $2 mil of cash. And if you allow everything do depreciate immediately, then your PPE will be zero, and your accounts will be a fiction, as your plant will have zero value on balance sheet.

    Blaming FASB for the credit crisis is original. They deserve a lot of flack, but the ultimate cause of the credit crisis was a bunch of people lending money to others who didn’t have the capacity to pay it back.

    3) the SEC’s accounting arm, FASB??? What is he smoking? FASB is private.

    And he’s grumpy that banks won’t lend to him. Yes, (functional) risk management departments of banks are pains in the arse. That’s their job.

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