Incentives, Inventory and the International House of Pancaked Leverage

Let's talk Inventory and Leverage today

Recently, on the Motley Fool's "Macro Economic Trends and Risks" board, I wrote the following in a post.

Before I cut and paste it, I will make a point about a change in the look in this blog: from now on, when I cut and paste from and outsourced link or quote people in long form, I will no longer indent first and then change the formatting to "justified", i.e., where left and right hand margins are even.

I will no longer indent.

I will continue to highlight in blue anything taken from another source.

I will use quotation marks to help set off the cut and pasted words from a source.Then I will justify that blue print to help set it off.

Using the indent feature on this board is too time consuming, and I find I don't spend time writing when I look at the indenting and "look" of the blog as a chore.

So, to speed things up, I'll use the new look.

Here is the first use of my new look, a cut and paste from that post I left on the Motley Fool.

Sign of the Times

1. In Key West, signs of the fast fall in rents are cropping up on windows of property management companies. For the first time in my 17 years down here, landlords are tossing in "First month's rent FREE" to find longterm renters.I've seen 3 bedroom 2 bathroom houses renting for less than my one bedroom, one bath home I'm in now.

2. High priced condotel units (look at the Santa Maria) are not selling at all. To add insult to the developers injury, these higher priced rooms are always the last to rent. Usually, Sunday through Thursday, these rooms aren't even hitting a 15% occupancy. On good weekends, if all the cheaper rooms in town are rented out, then people double up and rent these expensive condos.

3. Many housing developments on the Ronald Reagan Turnpike which have been completed for two years still have a majority of their inventory unsold and unrented. Lennar and other Developer Communities are suffering from graffiti bandits and vandals tagging and destorying empty homes which haven't sold in 2 years time. It's amazing to drive by these once former "pristine" developments and see doors off hinges, windows smashed, weeds on fence lines, graffiti spray painted on the backs of brand new homes never lived in.

To make this all the more surreal, billboards are enticing people to buy homes in communities where vandals are knocking out windows, stealing fixtures, etc. The enticement is in the way of "incentives". One billboard just outside the Top of the Keys on US1 shows granite counter tops, stainless steel kitchen appliances, whirlpool baths, and enclosed pools as "incentives". You still pay the same price for your home ("In the 220s!") but you now get more than what your neighbor paid for at full price back in 2005. A brand new home for $220,000 is unheard of in the Florida Keys, but the fact that homes this cheap and cheaper exist unsold, un-rented on the tip of the mainland says volumes about how hard housing has hit a wall in Florida.

4. Signs on condos and housing developments in and around the Miami Airport, Hallandale, Cutler Ridge, Homestead, and elsewhere are showing this new leniency on rents: townhouses are renting for no money down, no security or low security deposits, and, many signs have that "First Month's Rent Free" added to the them with banners flapping in the breeze.


The Take Away

It's way too early to buy real estate anywhere in Florida, unless you fall into a deal which can be justified as a money maker today, not built on future expectations.

Rents are coming down everywhere in Florida. This is probably one of the biggest mis-told or under-reported stories of all at this time: landlords are begging for renters. And the war to get houses, condos and apartments rented is obviously heating up into a cut throat war in pricing.

Do not believe a damn word coming out of Bubblehead Economists, NAR flacks, Realtors and the like about rents going up. Know that Florida, the canary in the coalmine for the Nation's Housing woes, is now in a beginning war of Rental Pricing. There is no other way to describe what is happening in Southeastern Florida.This war will certainly spread to other areas of Florida, and then nationally to California, Las Vegas, Arizona, New York City, and elsewhere.

Sales prices are coming down quickly in used housing, but the pressure to keep up "appearances" in "new" inventory is leading to distorted median prices due to "incentives" thrown in to keep "new home" pricing higher than it really would fetch as a used home.

Despite some owners taking properties off the market to sit out this crash, real inventory continues to rise. "Hidden" inventory is not admitted to or talked about by Real Estate agents quoting the already sorrowful inventory reports of official MLS listings. This is another under-reported story by the mainstream media which will come home to roost when enough homeowner realize all these new condos, For Sale by Owner homes, repossessed homes, foreclosed homes, etc., are not being shown on the local Multiple Listing Services.

We've got hundreds of new condotel units for sale in Key West (think the new Spottswood projects) none of which are showing on the MLS. That's a big hunk of hidden inventory for sale.

And there is not only hidden inventory, there is hidden sales: Most banks down here do not list their short sales so as to freak out surrounding homeowners.

We have one Key West developer who is being sued for forcing depositers of $200,000 to either walk away form their deposits and/or either take over their finished units which were not built in time and which are worth a lot less today than they were when ordered.

These "units" . . . the cheapest ones . . . sell for only $1.2 million. The rooms are renting for $350 (the cheapest ones Monday through Thursday) to $475 on internet sites where you are looking for "deals" in hotel rooms (again I am speaking of the Santa Maria condotel project) and the parking lot sits empty during the week.

Meanwhile, cheap motel rooms a half block away for $119 to $150 a night are doing good business despite the decrease in tourism.

Question: how does any developer hope to entice buyers of overpriced condotel units which simply must command higher nightly rentals to help pay the excrutiatingly high mortgage payments in a time of diminishing liquidity and even Prime loans? How can any developer hope to "make the numbers work" for potential buyers if the market is showing consumers will not rent by the night at $400 a night averages?

Here's another Real Estate reality all over the country: sales are slowing. (You know the difference between a Realtor and a cadaver? They both make no money, but a cadaver rests in peace.)

According to a local Realtor, two years ago 600 registered Realtors worked in Key West. Today, that number is 300. Sales are slowing all over Florida. Fewer qualified buyers are able to score a loan, means fewer properties will move at current pricing.

More new inventory is coming on the glutted market. New homes sit empty all over the place still showing 2005 prices to keep up appearances on the Potemkin Village facade so current homeowners won't freak, while out back of houses for sale across the street, crews are adding swimming pools, putting in fancy add ons, and what not to keep the prices artificially high.

Think about the 20,000 to 25,000 new condos coming online in Miami in the next 18 months: who will buy one of these at 2005 prices . . . unless you toss in a yacht or a couple of Ferraris as "incentives"?


Things to Consider Before Rushing Into Florida Real Estate

1. The number one thing all people must think about before buying Florida Real Estate: insurance.

2. The number two thing all people must think about before buying Florida Real Estate: taxes.

3. The number three thing all people must think about before buying Florida Real Estate: maintenance fees.

4. The number four thing all people must think about before buying Florida Real Estate and the most important one of all: can you buy a home or condo with a mortgage, insurance, maintenance fees and taxes all figured into a nice monthly payment which could be paid for by someone renting the property from you should you need to move? If the answer is no to this question, and it usually is these days, then don't buy.

Our papers are filled with stories of Floridians wanting to move elsewhere into a home for which they've contracted, but their purchase is contingent on them selling their Florida homes at the "right price".

This Banana Republic Crash is turning otherwise sane productive adults into shells of human beings. We are turning into a Zombie Republic of Debtors. We've got a bunch of people who want to leave and who can't afford to leave . . . they are owned by their Florida "homes" or condos in which no sane buyer can make the math work.

Lastly, there is only one way to get the Real Estate market moving again in Florida: prices must fall another 25 to 50%, or incomes must double. And if incomes double, so too will consumer prices, meaning, it will cost more to buy a Big Mac, razor blades, milk and gasoline . . . things which our politicians don't know the price of and some of which are not included in their convoluted Consumer Price Index.

I think the only natural way out of this mess is for pricing to come down to the 100 year old historical median. And right now, in the Keys and South Florida t at least, we are about 100% above the median. Hence, I feel we need another 50% fall in South Florida Real Estate prices before we get back to norm.

Denver Billboards for Subdivisions Banking on Incentives Just Like Those Outside Miami

Almost 2 weeks after I posted the above on the Motley Fool's board, I found a link from Time Magazine titled

"Ground Zero of the Real Estate Bust" which sounded as though I had written the lead paragraphs.

The article (printed one day after my Motley Fool post I might add) starts out with a similar description of billboards promoting new home subdivisions. Except this is describing suburbs outside Denver, Colorado . . . not Miami.

Here's how the article, written by Barbara Kiviat, begins:

"First come the billboards. As you head north, away from downtown Denver, they flip by like flash cards, advertising houses by Lennar, KB Home and Richmond American, from the $100s, the $170s, the low $300s. What they don't tell you is that should you wander into one of the new subdivisions popping up from the prairie, you're likely to be offered tens of thousands of dollars in incentives to buy, and to buy now. At a recent conference of Colorado builders and real estate agents, one speaker counseled salespeople to stop acting so desperate. "It sends the signal that the market is bad," he said, "and to wait for the bottom."

Rock's note: I remember during the dotcom and 9/11 stock market crashes, Wall Street analysts were telling investors to keep holding onto companies with no earnings and to wait for the bottom to buy more. Meanwhile, these bastards were selling their "lockup" shares from IPOs out the backdoor like there was no tomorrow. A recent example? Check out the CEO of Countrywide Finance who has sold hundreds of millions of dollars of shares from options as he was braggin Countrywide would weather the storm.

"Yet as Denver richly illustrates, there is plenty of bottom left to wait for. It's a far cry from the days of double-digit home-price gains and mass speculation in hot markets like Las Vegas--where 40% of the houses up for sale now sit vacant."

Rock's note: I drove into a couple of brand new Homestead, Florida sub-divisions up by the Nascar track recently. What was amazing was how small the yards were. Houses were less than 12 feet away from one another. I saw home after home with no curtains in the windows, no furniture inside, and no For Sale sign out front. These are your classic "vacant" for sale homes where homeowner associations don't allow for sale signs in the yard, or, the developer is still carrying the home on inventory.

. . . back to the Time Magazine story:


The International House of Pancaked Leverage

"What's astonishing about this particular real estate bust, though, is the way the damage has pinballed across the financial universe: mortgage companies in Los Angeles, banks in Seattle, hedge funds in Australia, the European Central Bank, Wall Street investment houses and Main Street stockholders have all had the American real estate market fall on them.
Call it the international house of pancaked leverage, built on the proliferation of subprime and exotic mortgages that did away with many of the safeguards built into the classic 30-year fixed rate with a 20% down payment. Riskier loans originally designed for a narrow band of home buyers--interest only, adjustable rate, balloon payment, no documentation (of income, that is)--took off broadly in the last rising market, and Denver was one of the many areas where they were hot.

The demand was coming not so much from borrowers as from Wall Street, which packaged the loans into securities to sell to investors looking to pile into "low risk" real estate. So mortgage brokers found ways to squeeze buyers into first and second mortgages even when their finances were questionable. Consider the appellation NINJA, used to indicate a buyer with no income, no job and no assets. "Capital was made available to every Tom, Dick and Harry," says Zachary Urban, who runs the Colorado Foreclosure Hotline.

Urban is now dealing with the fallout: 18,000 calls in the past 10 months. Calls from people like Essie Kemp, who lives in the hard-hit neighborhood of Montbello. Kemp is faced with losing the home she has lived in for 23 years, since she can no longer make the payments on her refinanced mortgage. She wanted to have money to buy an air conditioner and fix her pipes. What she got was an adjustable-rate mortgage that spiked after two years. It wasn't until she went to see a housing counselor that she realized her income was listed as $4,000 a month--more than twice what she was making from a part-time job and Social Security. "I've done all I can do to keep my end of the bargain," says Kemp, "but it just didn't work."

Rock's note: in a great piece on Countrywide Finance this week, the NY Times talked about how loan officers were pushed to sell the riskiest loan schemes as these generated the highest commissions.

I hope to highlight that article later this week as it was an excellent source for discussion on Motley Fool.

Back to the Time Magazine piece:

" . . . about 25,000 people who will receive a first notice of foreclosure this year in the seven-county Denver metro area, according to the housing-analytics firm the Genesis Group. That's about half the number of people who could be expected to put their homes up for sale in a normal market. The most distressed neighborhoods are seeing foreclosure rates rivaling those produced during the state's oil and gas bust of the 1980s--except these days, there aren't mass layoffs to blame. Just flat house prices and tighter credit standards, which make it harder for homeowners to sell or refinance their way out of trouble.

Green Valley Ranch, to the east of downtown Denver, is one neighborhood having a particularly tough time. Houses are still going up in the massive multiphase development, but within the new construction lurk bus benches advertising foreclosure assistance. Many of the people who have run into difficulty are first-time buyers who jumped into mortgages they couldn't afford in the long term. Now, as they endure the heart-wrenching saga of slowly losing their homes, the whole neighborhood suffers: according to a study by Dan Immergluck at the Georgia Institute of Technology, a house loses 1% of its value for each foreclosure within an eighth of a mile (200 m)."

Now there's a formula for the ages in that last sentence.

So if 8 homes foreclose say at the Key West Golf Course (I've seen that many and more on RealtyTrac) then homes surrouding the foreclosures should lose 8% of their value right off the top. Interesting.

Some Unaffected Areas to Feel the Ripples of Sinking Developments?

"Denver is just one pin on the national map. Looking across the country, the foreclosure problem is worst in areas where house prices went wildest (southern Florida, California), where local economies are depressed (Cleveland, Detroit) and where regulators paid little attention during the go-go years (before a new law took effect in January, mortgage brokers in Colorado didn't have to be registered). But it is important to point out that while Colorado has one of the nation's highest foreclosure rates, according to property tracker RealtyTrac, many parts are doing just fine. Prices in Denver's newly hip Highlands neighborhood, a community full of bungalow homes and yuppies, were up 13% last year, according to listings data crunched by real estate agent Ed Tomlinson. And ski resorts like Copper Mountain can't build enough pricey condos.

But troubles that exist in distinct pockets can ripple outward. In the northern suburb of Thornton, Stephanie Brown is trying to sell her four-bedroom house for $445,000, just enough to break even on her investment, since she's eager to move closer to her new job. Yet in a month on the market, she's had only a single showing. On one side, she is up against home builders who are knocking $100,000 off the price of houses similar to hers. On the other, she faces a market flooded with foreclosed properties, like the hundreds up for sale at two different auctions in Denver on a recent weekend, some of which started with bids of half the estimated market value. "It's hard to sell a house if you can't even get people in the door to look at it," says Brown."

Rock's Note: Look at the highlighted sentences in that paragraph above.
Here's a woman trying to sell her home for "breakeven" yet she's up against the market dynamics of:

1. Home builders knocking off $100,000 off prices for similar homes to hers.

2. The market is flooded with foreclosed properties.

3. Hundreds of foreclosed homes are being auctioned off, some of which are receiving bids of half off current market appraisals. (Sounds familiar. We've had two auctions in Key West with similar results . . . except owners wouldn't sell for less than their minimum bid . . . none of which were hit.)

4. Lastly, the woman, slowly coming out of the state of denial says, "It's hard to sell a house if you can't even get people in the door to look at it."

Ms. Brown's comment in point 4 tells me she hasn't dropped her selling price enough to compete with points 1 through 3.

It's like this: Say I owned shares of American Home Mortgage before they went bankrupt. Say I woke up one morning and saw the share price had opened 25% down from yesterday's close.

Question: If I needed to liquidate my holdings and I wanted out, what do I do to sell my American Home Mortgage shares?

a) Click in an order to sell at a "limit price" 10% above where American Home Mortgage shares were at the moment?
or
b) Sell at "market prices" wherever they are, take the loss, and clap my hands together than I had something to show before a further fall in American Home Mortgage's fall in share price?
Holding onto a home or condo in a crashing marke

It is similar to Chinese Water Torture. The drip, drip, drip of depreciating value cannot be stopped without underselling all your competition.

Look at it this way:

I'll guarantee a buyer can be found for any Key West home today if only the seller will cut his price by 50% for just one day only.

In Capitalism, there is a right price for everything.

Supply and demand.

If supply is too high, the only way to move inventory is to drop prices like a Macy's Basement Sale. First 10% off. If that doesn't work 15% off. If it still won't sell, try 25% off. I've seen stuff in department stores marked down 7 or 8 times til it ended up in my shopping cart.

All of us know the drill.

To move inventory, prices absolutely must come down.

On the other hand, if demand is too high, sellers can adjust condo and home prices by the hour as people camp out in lines before ground has broken. (How Realtors must long for those heady Bubble days of 2003 through 2005.)

Smart buyers never buy in a mania and expect to make big gains.

I don't care if its stocks, coins, cars or houses, smart people don't buy simply because someone they know, like their cab driver from the airport, tells them how he has made millions buying and flipping Key West condos.

How a Chase for Huge Gains Stoked the Insane Leverage in the Credit and Housing Bubbles

"This local malaise, repeated in city after city, has ballooned into trillions of dollars in losses around the world, thanks to the magic of Wall Street's financial engineers. Blame it on one of the Street's recent innovations, the collateralized debt obligation, or CDO. The recipe: buy home loans, blend them, then slice up the result into different securities (reflecting different levels of risk) to sell to investors. Many such securities carry AAA or "investment grade" ratings despite subprime mortgages being in the mix. From there, things get really complex--CDOs created from other CDOs, synthetic CDOs crafted from credit-default swaps, none of which had experienced a down market. "The problem is that CDOs were untested. There was not much history to suggest CDOs would behave the same way as AAA corporate bonds," says Richard Bookstaber, a hedge-fund manager and author of A Demon of Our Own Design, who views market palpitations as a predictable by-product of complex financial products like CDOs. (For the author's take on the subprime disaster, go to

time.com/bookstaber.

Now that the foundation is shaking, there are scant buyers for the lower-grade issues built on top of the pooled mortgages, and the values of those CDOs have plummeted. Losses in the subprime market drove Bear Stearns to declare two of its hedge funds, once topping $1.5 billion, all but worthless, and banks as far afield as Germany and France have frozen funds or received bailouts because of exposure to U.S. mortgages."

Will 2008 be worse than 2007 for Housing?

Last week, Countrywide Finance CEO Angelo Mozilo was interviewed by CNBC. Mr. Mozilo called the current credit crunch “one of the greatest panics I've ever seen in 55 years of financial services.” He also said we will most likely see the whole country slide into a Recession due to these problems.

Time Magazine's article is in synch with Mozilo's new gloomy look.

The Looming Disaster

"FOR REAL ESTATE, NEXT YEAR COULD BE EVEN worse if interest rates don't fall. In 2008, some $680 billion worth of adjustable-rate mortgages are due to reset, according to Bank of America. That's $165 billion more than this year, and of those loans that are likely to carry higher rates, nearly three-quarters are subprime. Since many adjustable mortgages change rates after two or three years, the loans due for reset would have been written in 2005 and 2006, the years underwriting standards were bent the most. "It's clear that the performance of loans will be worse," says Mark Adelson, recently departed head of structured finance research at Nomura Securities, "but it's not yet clear how much worse."

One way to think about it is to consider how much more homeowners will have to pay to keep their mortgages current. According to an analysis by First American CoreLogic, a firm that tracks real estate and home loans, a typical subprime first mortgage that was originated in 2004 to 2006 will face a monthly increase of $407, and a typical teaser-rate loan, the type often sold to people based on their ability to pay the introductory rate and not the reset, will see monthly payments jump by $1,512."

Rock's Note: How does any sane Realtor, CNBC Bubblehead, Lender or Homebuilder make the economic assumption Housing is bottoming now?

How does a taxi driver, hairdresser, waitress, bartender, deejay, etc., suddenly find $407, or $1,512 or even $3,250 extra a month to stave off the Mortgage wolves at his/her front door if wages and salaries are not increasing quick enough to meet the new realities of a reset mortgage?

Will Florida or the US Congress Take Colorado's Lead and Make Lenders Do More Due Diligence?

"Back in Colorado, people are reacting. This summer, three laws went into effect that, among other things, require anyone selling a home loan to make a reasonable inquiry into the buyer's ability to repay it. In recent years, as a growing percentage of loans have been generated by brokers rather than the banks that ultimately owned the mortgages, best interests have been at odds: brokers can make more money with higher-rate loans, even if buyers qualify for a better deal. And that doesn't even touch the lending arms of home builders, which come with their own special conflicts of interest once you consider pressure from shareholders to get people into houses and book those profits. Establishing a fiduciary duty for mortgage sellers, which Congress is considering as well, is meant to realign interests. In the meantime, many banks are working with homeowners to renegotiate loan terms to avoid foreclosure. Still, the EZ Credit addiction is tough to cure. Drive through Green Valley Ranch, and you still see signs for 0 DOWN PAYMENT, 100% FINANCING.

In early August, American Home Mortgage, a mortgage lender with little subprime exposure, declared bankruptcy, stoking speculation that troubles are bound to spread to securities backed by higher-quality mortgages. It didn't help when lenders Countrywide and Washington Mutual subsequently issued dire warnings about losing liquidity because so few people want to buy mortgages on the secondary market right now.

"One of the most interesting things is, we don't know who's going to suffer," says Karl Case, a housing economist at Wellesley College. "Obviously, the people who get foreclosed against suffer. That goes without saying. But who bears the losses ultimately is really complex." We can start with the stock markets around the world, which have surrendered $3 trillion in value over the past month, thanks in large part to the mortgage monster beginning to come undone.

But houses don't trade like stocks, so when it comes to correcting the system when it gets out of whack, we're talking years, not weeks. "Real estate," says housing economist Thomas Lawler, "is a slow, tedious process." In July, after the two Bear Stearns hedge funds first ran into trouble, bond guru Bill Gross of Pimco wrote a foreboding investment outlook, pointing out that hedge funds tied up in trading are the top layer of the problem, not the root. That can be demonstrated in the Mile High City and, as Gross wrote, "in the Summerlin suburbs of Las Vegas, Nevada, and in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida." It's a big problem. How big, we're still waiting to find out."

To which I will add one last tip to the reader of this blog: Bill Gross has recently called for government bailouts of 2 million Americans who bought housing at the wrong moment in time.

I am totally, 100% against any government bailout of corporations, farmers, stock shareholders and yes, homeowners.

I would waste words explaining myself about my new disrespect for Bill Gross, but no one has written about this better than Michael Shedlock, aka "Mish", on his blog.

Read Mish's

"Bill Gross Wants PIMCO Bailout" for an excellent analysis of Bill Gross's crocodile tears for two million American homeowners who might face foreclosure. Like Jim Cramer, his real tears are for the well heeled, especially himself.

Mish knocks this one out of the park and I hope all small shareholders of PIMCO funds or bonds take time to open this link to learn how Gross has piled on risk in the past few years in his chase for better gains.

I also hope you will open up some of the 256 comments this post of Mish's has elicited.

I'll give you some from the top to show you how investors are feeling about PIMCO, Gross and bigwigs calling for bailouts:

Mish -- great write up. I use to respect Gross but now I see he was waddling around in some of those 6 inch stilettos along with everyone else. He should pull up his shirt and show us his tramp stamp. If you are going to be crying for money to the poor, I think you should indicate that a big chunk of it is going to you. All, I can say is this is getting to be so typical. Makes me puke.Like this comment? [yes] [no] (Score: 17 by 17 votes)

LJ, I agree with you 100%. As I stated before, he was one of the only traders I thought made a good deal of sense. However, it seems like Gross has just shown himself to be a selfish little piggy just like the rest.Like this comment? [

yes] [no] (Score: 5 by 5 votes)Liberal JohnFriday, August 24, 2007[delete]

And Gross hires Greenspan. Message to Bernanke: I'll pay you a tidy little sum to be my advisor, too, once you retire for a Bernanke put.Like this comment? [

yes] [no] (Score: 3 by 3 votes)HappyThoughtsFriday, August 24, 2007[delete]

He wants another RTC? I lived through the RTC when I lived in Colorado Springs. The result was that the home owners were out on the street, but the big defaulting developers got to buy their properties back from their real estate agent buddies, who handled business for the RTC, for dimes on the dollar. Simply put, the big guys defaulted, and then got their properties back for less than half the value of the loans they walked away from, thanks to tax-payer subsidies. Of course, this time around, because we have a much more honest government, there will by no crony capitalistic deals with any government created bail ou organization. So please, just tell me where I sign up. I want to be in the front of the line when the feeding trough opens.Like this comment? [

yes] [no] (Score: 5 by 5 votes)threadkillaFriday, August 24, 2007[delete]

if there is a bailout i'm gonna be one pissed off mofo!!!Like this comment? [yes] [no] (Score: 2 by 2 votes)Dr StangeloveFriday, August 24, 2007[delete]

Excellent piece Mish. Very good work. I used to like Gross but this behavior by him is criminal to say the least. Does make you wonder just how bad things really are though to get this desperate. He's been on the inside for a very long time. He has to know the criticality of the situationLike this comment? [yes] [no] (Score: 1 by 3 votes)