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Incredible India: A Bubble About to Pop?

February 19th, 2010 6 comments

Can you imagine being able to rewind time and watch the U.S. real estate bubble as it’s about to pop? While none of us has the ability to time-travel just yet, I did have the opportunity to witness something remarkably similar to the U.S. real estate bubble while on a recent trip to India with my family.

Just like tech stocks were the talk of the late 1990′s in the U.S. (everyone from your barber to the grocery store clerk had a winning stock pick and was a market expert), real estate is the current hot topic of conversation in India. This in itself, in my opinion, is indication that a growing bubble is afoot – when everyone from the professional investor to the gardener is talking about how to make lots of money in a particular asset class, the prudent investor should start looking for an exit.

Another factor supporting the not-so-distant decline in Indian real estate prices is the excess leverage in personal balance sheets. Just as we saw in the U.S., residents of India are now taking out mortgages that they can just about afford. The availability of credit and the shifting mindset in favor of borrowing (traditionally Indians like to pay for everything, from groceries to housing, with cash; this trend is rapidly changing with the younger, more affluent middle class opening up to mortgages and credit cards) is creating demand for housing, and pushing up prices. The opening up of credit is actually a good thing. The issue is that people can barely afford their mortgages. So, when the Indian economy slows a bit and people lose jobs, their mortgages will immediately be at risk, just as was the case here.

Excess foreign invesment also plays a significant role in Indian real estate prices. It’s a well known fact that investable assets chase returns. In this instance, NRI (Non-Resident Indian) assets that had, until recently, been invested in the U.S. and European stock markets, are migrating to India. This is natural; older Indians living abroad have accumulated a lot of wealth, which was parked in cash, gold, and financial markets. With the collapse of equity markets around the world and the drop in interest rates, there aren’t many good places to park cash. In such an environment it’s no surprise that these assets flow into housing “back home” in India. The older Indian population applies the following logic: “Should I chose to move back home once my kids are settled, I’ll have a place to live. If I choose not to move back home, I can always sell the investment in Indian real estate for a handsome profit since the market is so hot”.

The net effect of these factors is that real estate prices in India have about tripled over the last three years. This is an alarming rate of appreciation given that I see no sustainable demand for real estate. Yes, it is true that many corporations are moving to India and the economy there is growing at a brisk rate. However, the jobs created by these actions aren’t enough, in my opinion, to support the kind of national real estate price appreciation India is experiencing. Rather, I’m concerned that there are too many speculators in the market, which will result in an inevitable, and painful crash. In addition to the foreign speculators I mentioned above, there are also the domestic type – those buying a house with the hope of selling it in the next six months to a year and turning a profit (much like what we saw in the U.S.). In one conversation I learned that about 40% of the purchasers in a new subdivision that was being built were investors; they wouldn’t actually be living in the house. 40%! That’s huge! 4 out of 10 homes will sit empty when built – either awaiting immediate sale by a domestic speculator, or awaiting an NRI family that, in a few years, may live there or, in the more likely scenario, will sell the home to turn a profit.

The risk of this speculation is clear. As soon as the Indian economy slows and those young, affluent borrowers face difficulty paying the mortgages they can barely afford now, there’ll be panic, fueled by memories of what happened in the U.S. This panic will be further exacerbated by the immediate dumping of homes by investors who fear the loss of capital experienced in 2008-2009, creating a snowball effect in the decline of real estate prices. Though I can’t say for certain when this will happen (if I could, I’d have made millions on it), my intuition is that it’ll be within the next 3-5 years.

Though the issue in India is certainly not identical to what happened in the U.S. (high risk mortgages aren’t as prevalent as they were in the U.S. and the secondary mortgage and derivatives market is no where near as large as it was in the U.S.), there are many alarming similarities. That being the case, the prudent investor should be mindful of the similarities and be aware and history can very well repeat itself.

Cash for Clunkers

September 23rd, 2009 No comments

By now the Cash for Clunkers program is well behind us. Before the chaos of this financial crisis, I had never thought that the government would introduce such a program, and I’m not sure I’ll ever see another one like it in my remaining years. Given that, I’m glad that we (specifically, my parents) were able to take advantage of the program. Based on my experience, a few thoughts:

The government’s objective was the lift vehicle sales; there’s no doubt that they were successful. About 700,000 vehicles were sold under the program, resulting in a total of $2.87 billion paid out by the government. In addition to this, we should add the cost of processing the applications and any additional infrastructure needed to execute the program. The cost still comes in under the $3 billion the government had budgeted. This was a great thing for car dealers, for people who were able to take advantage of the program, and for the auto industry in general (production was ramped up and thousands of people were put back to work). However, my concern is about the short-lived nature of the program. I’m afraid that in the books of history, this will be but a blip. Now that the program is finished, we still have extremely high unemployment, we still have lack of desire for American cars, and we still have no evidence of improved American cars (in terms of quality and reliability). So, what will happen to the auto industry and all the workers who were put back to work over the next six months? I hate to say it, but it isn’t looking pretty – auto sales are down again, and I feel like it’s only a matter of time before production stops again. We need a more permanent solution to this problem…

Buying a car through the Cash for Clunkers program was quite an experience. Firstly, finding a car was an issue. Many dealer lots were empty and inventory was scarce. Dealers couldn’t really get cars from other dealers since the problem was systematic. We pulled the trigger pretty quickly – I spent a couple of days reviewing candidate cars, did my usual email blitz, and then ended up deciding where to go. We bought on the Saturday of the final weekend (the program was to end on Monday and Illinois law requires dealers to be closed on Sunday, so we effectively bought on the last day of the program). We visited two dealerships and I’d never seen dealerships so busy. Both dealerships were swarming with people – in the showrooms, on the lots, and in the tiny cubes doing paperwork. Sales people were juggling 4-5 deals at a time. Normally a sales person is asking what they can help you with within minutes of your entering a car dealership. Now you could be looking at a car or trying to get someone’s attention for over a half an hour before you finally got to talk to someone. It was taking about 5 hours to get a customer from agreeing on a price to out the door with a detailed and inspected vehicle (when normally it shouldn’t take much more than an hour or two). I asked the sales guy at the dealership what time they close and how their day yesterday went. He told me that the were supposed to close at 9pm the previous day (a Friday), but couldn’t. They had new customers walking in at 8:55, and ended up staying at the dealership until 1am. They returned to work at 5pm the following day. There was an immense buzz and excitement in the dealerships – something I’d never seen before, and unfortunately am not likely to see in the near future.

The Cash for Clunkers program created interesting distortions in the auto industry. Prior to the program dealers would do anything to get a car off the lot. In addition to rebates, the dealers were willing to pass along any marketing incentives they were given by the manufacturer, as well as part of any volume discounts they got. Basically, if they could make a couple of hundred dollars on a deal (or less!), they’d sell you the car. Heck, it was difficult to understand the quotes you’d get for a car – they’d be below the invoice less all available discounts – a price that just made no sense! As far as choice goes – you could get almost any color with any options – there was so much inventory either on the lot or with nearby dealers that you got whatever you wanted. After the program, things couldn’t be any more different. Cars were scarce – the only color available at all the Chicagoland Honda dealerships we spoke to but one was black. You’d be lucky if you could get pricing any lower than $50 below MSRP or so (I even received a couple of quotes OVER MSRP!). From an economics point of view the government incentive created a surplus for the consumer. However, much of that surplus was consumed by the dealers. As incentives disappeared and demand went up, prices went up by thousands. Of the $3,500 or $4,500 the government gave you, it wasn’t unusual for the dealership to take more than half (as a result of the higher prices). At the end of the day, this gives a double bonus to the dealers, and only a slight incentive to consumers. Dealers win because they reduce inventory and get MSRP for the vehicles sold. Consumers are told they’re getting $3,500 or $4,500, but in reality are getting much less since they paid much more for the vehicle than they would have paid before or after the program.

Another interesting dimension of the program is that the government didn’t put any restrictions on re-selling vehicles bought under Cash for Clunkers. What prevents someone from buying a new car at a steep discount and then turning around and selling it? Granted that after factoring in taxes and the dealerships’ higher prices this idea isn’t too lucrative, but depending on the situation (getting the full $4,500 and buying one of the less popular vehicles), one could make $1,000 or more doing this. Not preventing this from happening results in car prices (both new and used) falling (since there would be several new clunkers cars hitting the used market with less than 1,000 miles). Practically this may not be doable for most people since they’d lose the use of the vehicle (i.e. if I used my clunker to get to work everyday and then traded it for a new car, I can’t exactly sell my new car since I will no longer be able to get to work!), but I do find it interesting that the government didn’t limit this behavior.

Finally, one unfortunate side effect of this program is the cost to people who were in the market to buy a vehicle but don’t have a clunker to trade in. Because of the spike in demand, car prices shot up. If you had a clunker to trade, that was fine since the government rebate more than accounted for the increase in prices. However, if you didn’t, that $13,000 car you were looking at just jumped to $16,000 with no recourse for you. If you can delay your purchase until the program is over, inventory is sufficiently replenished, and demand has slowed again, you may be able to buy that car for $13,000 again. However, hopefully manufacturers learn from their mistakes and don’t create so much supply this time, keeping prices high. Even if prices to fall to the pre-clunkers level, the annoyance and inconvenience of not being able to buy for months is still significant.

I’m glad that I was able to be involved in a Cash for Clunkers transaction – it was great to see a buzz in dealerships that I’d never seen before. Getting $4,500 for our old van (which was probably worth no more than $500) didn’t hurt either. However, I’m not sure that in the long term the program will be as effective as the administration had hoped…

Categories: Economics Tags: , ,

Would you like some cheese with that whine, Wall Street?

June 17th, 2009 No comments

Yes, I realize the title is very cliché, but I think it’s quite fitting – it’s used often when dealing with toddlers and young children who whine because they can’t get their way, and, in my opinion, that’s exactly what Wall Street is doing!

President Obama unveiled his administration’s plan to overhaul the financial industry today, and Wall Street isn’t happy about it. One of the points that has them throwing a tantrum is a measure that requires firms to “retain 5 percent of credit risk” whenever they package loans into bonds. A statement from the American Securitization Forum, which includes Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Citigroup, says this condition creates “undue restrictions” that may hamper “consumer and business lending via securitization” and “impair broader economic recovery”. Oh, puuhhleeeez!

To take a quick step back: most banks that issue loans (whether they are mortgage loans, credit card loans, home equity loans, or car loans) will take a bunch of loans they’ve issued and lump them together into a security that’s then sold to other investors. These securities are called mortgage backed securities (in the case of mortgages) and asset backed securities (in the case of the other loans types I mentioned). These securities then have a variety of payment structures – either they pass the payments from the loans directly on to the people that bought the securities (after the banks take their cut of the profit, of course), or have other exotic payment structures that are pretty complicated and aren’t really the point anyway. The point here is that the bank issued the loan, and then sold it as part of a pool to other investors. So, who’s really holding the credit risk (the risk that the borrowers won’t pay back the loan)? The investors. Since the banks themselves aren’t holding any of the risk, and since they collect fees for both issuing loans and selling the securitized product to investors, the banks are incentivized to issue as many loans as they can, regardless of credit risk. This is a part of what led to the whole mortgage problem in the first place – banks blindly turning an eye to whether the borrower is likely to repay the loan or not in the interest of earning fees.

So, the President’s plan would require banks to now hold 5% of the credit risk of these loans. Note, this doesn’t mean that banks have to hold 5% of the loan amount on their books, but just that they have to hold 5% of the risk exposure – a technicality that isn’t relevant here. The point is banks are unhappy because they can no longer blindly pass the risk on to others and collect fees. Now they will have exposure to the risk too (and it’s certainly debatable whether 5% is the right number or not).

What a minute, doesn’t this seem like a good thing? Well, I think so. Having the banks on the hook should result in them being more careful in who they issue loans to and thus result in fewer defaults, which ultimately protects the investors and homeowners since there would be fewer foreclosures. Sounds like a good structure to me, if you believe in the welfare of all over the profit of the banks.

It is true that there will be indirect costs to this. Loan processing costs may go up due to the additional scrutiny of each application (though I would argue that banks were already charging high fees and weren’t really doing any loan processing – having them do their jobs shouldn’t cost consumers more), and many people may not be able to buy homes. However, that may not be a bad thing. I’d rather pay a slightly higher cost (whether it’s buried in the interest rate or in up front fees) that is structured and known, rather than pay the very high costs associated with the financial distress we’ve seen for the last two years. It’s also sad that not every American can but a home, but then I don’t think every American should buy a home. If one can’t manage their credit or doesn’t have enough income to support the home they want, then they have no business buying the home and ultimately costing everyone else more when their loan defaults. I’d love to drive around in a Ferrari and have a Rolex glistening on my wrist, but I can’t afford it and so I shouldn’t have it.

So, yes, bank profits may fall a bit and yes the risk on bank balance sheets may go up a bit (though that’s debatable too – if banks are on the hook for the credit risk they are likely to be much more careful in which loans they issue, which in turn reduces the overall risk of the loan pool). But, Wall Street, I really think you should quit your whining and accept this gladly since it benefits all Americans, and ultimately you (since the banking sector is clearly benefited by a stable American financial system). And to those who would argue that such a measure is against all that capitalism stands for, I say: “so what?” Yes, this may be a bit socialistic. But I counter that a purely capitalistic society is not optimal for all its members. When people are motivated by profit alone, others suffer – that’s the bottom line.

Besides, such sweeping reforms were passed after the Great Depression and they were a boon to the country and helped us emerge ever-stronger. I think it’s hard to argue that such a social safety net would choke off capitalism.

Categories: Economics Tags:

Housing Defaults: The Next Wave

June 11th, 2009 No comments

So, as you’ve probably read or heard in the the news, evidence that the American housing market is stabilizing is beginning to present itself. Data from the National Association of Realtors showed that the number of signed contracts to buy previously owned homes climbed 6.7 percent in April (granted that not all signed contracts will turn into closings since financing could fall through, it’s still better to have more contracts than fewer). Furthermore the Mortgage Bankers Association’s index of applications to purchase a home gained 1.1% in the week ending June 5th (though total mortgage applications fell and refinancesdropped off with the now higher interest rates). Finally, the fact that rates are higher itself suggests more confidence in the housing market – if there was no demand for loans, rates would keep falling. So, we’re on the path to real estate recovery, no? Well, no. Not so fast.

We have all heard of the recent run up in foreclosures that started two years ago. One would think that with all the economic turmoil we’ve had over the past two years and the fact that we’ve seen so many foreclosures already, maybe we’ve flushed most of the bad loans and things get better from here. In fact, as the chart below shows, we are indeed experiencing a steady decline in the number of subprime mortgage resets (and thus foreclosures since not all borrowers who reset will be able to afford the new payment) – the blue line.

From March 2009 to December 2012

From March 2009 to December 2012

 However, what should be a cause for concern are the yellow and orange lines – Options ARMs and Alt-A loans, respectively. Many people are familiar with Alt-A loans (they’re basically loans that are riskier than conventional mortgages, but not as risky as subprime mortgages). However, not as many people are as familiar with Option ARMs, which is of particular concern since they could be the next wave of foreclosures.

An Option ARM is something like a negative-amortizing mortgage. A negative-mortgage is one in which rather than the loan amount being reduced with each payment, it’s actually increased. For example, suppose you borrow $200,000 and your mortgage payment is $1,000/month. In a typical mortgage $800 of that $1000 may be for interest and the other $200 would pay off principal. Now consider the situation where someone wants to buy a house but can’t afford the $1,000/month mortgage payment. As an alternative, they get into an Option ARM that allows them to make payments of $250/month (yes, the difference between a conventional and option ARM mortgage can be that much!). What’s actually happening here is that they still owe $800 in interest, but since they’re only paying $250/month, the remaining $550 of unpaid interest gets added to the balance of the loan, bringing our hypothetical loan to $200,550 after the first month. Now, since the principal balance is higher, the interest due will be more than $800 next month. But, the borrower still pays $250, so they add an amount greater than $550 to their unpaid balance the following month.

Whereas in a conventional mortgage you pay down the loan a little bit each month, with the amount of pay-down increasing each month, an option ARM results in you increasing the loan a little bit each month, with the amount of the increase, increasing each month. You can see how this can turn into a troublesome situation very quickly, especially in an environment of falling home values. Our borrower continues to happily make his/her $250/month payment (usually completely oblivious to the fact that their loan balance is increasing) until one of two events occurs: 1) they go a certain amount of time specified in the loan agreement at which point they’re forced to start repaying principal, or 2) their loan balance reaches some predetermined amount (think 150% of the original loan balance – in our example $300,000) at which point they’re forced to start repaying principal. Either way, even if interest rates haven’t moved (heck, even if they’ve come down), since the loan amount is so much larger and they now have to pay the complete amount of interest and principal, their payment will radically spike – let’s say from $250 to maybe $3,000. So now the family that bought the home but couldn’t afford the $1,000/month has to pay $3,000/month. In most instances their income is not likely to have gone up enough to make this new mortgage affordable.

So, the family has a higher payment than they can afford, has experienced depreciation of their home, and has a loan balance that’s much higher than where they started, and likely much higher than the value of the house. They’re screwed, and this story does not have a happy ending.

As the chart above shows, the number of Option ARM resets will significantly increase until about the end of 2011. This means that there will be many properties that have depreciated (or even have had the good luck of not depreciating), but are married to loans that are considerably larger than they were at closing. This will most certainly result in more foreclosures, and thus further downside pressure on housing prices.

I certainly wish the worst were over in terms of housing, but unfortunately that just doesn’t seem to be the case. This is yet another example of creative financing, greedy lenders after fees, and uninformed consumers causing considerable damage.

Categories: Economics Tags: , ,

Housing Woes

May 15th, 2009 No comments

Okay, so we all know that the bursting of the housing bubble is one of the main catalysts of the current recession. Lenders got sloppy with their lending standards in an effort to make a quick buck on fees, home prices were bid up supporting lax lending standards (if the collateral to the loan – the home – appreciates really quickly, then a borrower with very little-to-no equity will all of a sudden have ample equity to support the loan), and people were leveraging themselves more and more by taking out loans against the equity they had in their homes. What no one saw coming was the fact that though borrowers may rapidly develop equity from home appreciation, if their incomes can’t support the low interest, adjustable rate mortgages when the rates go up, there will be mass defaulting, as we see today (and have seen for about two years now).

So, the metaphorical earthquake has already happened and we’re still watching the dust settle. The government is also trying to kick start the rebuilding, by kick starting the housing market. Home prices are down over 25% nationally from their high in fourth quarter of 2006 (see here for supporting stats). A lot of people have lost money in their homes as well as other investments (the S&P 500 is down about 45% from its high in October, 2007), and many others have lost their jobs. There is a glut of homes on the market, and no one wants to buy them for either: 1) not having the money or financial stability to support buying a home and paying a mortgage, or 2) persistent uncertainty about whether home prices have bottomed yet or not – after all, who wants to buy an asset that may still drop in value?

So, what does the government do to incentivize people to buy homes and try to turn this mammoth economy around? Well, first we drop the interest rate on mortgages to make home buying cheaper (it’s ironic how one of the main causes of the housing bubble itself was the availability of cheap credit and record low interest rates for too long a period, and that same thing is now the solution), and second we give people money (via the $8,000 tax creditfor first time home buyers) to make their decision to buy a home cheaper. Of these two solutions, I find the first - the artificial lowering of interest rates – to be the most worrisome. Though I understand that the government is trying to make borrowing cheaper so more people buy homes, I think it’ll have an unwanted side effect. Interest rates are at record lows now. Let’s suppose that Americans take advantage of this and buy homes (as the government hopes). This causes home sales to increase now, and for the economy to appear to be turning around. All is well and everyone is happy. Now, fast forward 10 years or so. Given that rates are at historical lows, they only have one direction to go from here – up. (Some argue that given all the financial stimulus the government has engaged in recently, they’ll have to inflate away some of the debt, causing rates to rise even faster than they otherwise would). So, ten years from now when the average American family goes to buy a new home, they’ll be faced with an unpleasant surprise: the rise in mortgage rates will be very prohibitive to buying a new home. Suppose they pay $100/month for their mortgage. Borrowing the same amount of money with higher rates will cause them to pay much more than $100/month. Couple that with their likely desire to move into a larger, more expensive home, and the whole proposition becomes very scary. Thus I would expect future home sales to fall relative to where they would have been had there not been such a large difference between the natural interest rate then and the artificially low rate now.

So, my conclusion  is that we may stimulate home purchases now by lowering rates to record lows, but this comes at the expense of housing sales in the future. So all we’re really doing is pushing the problem from now, into the future. Though that may be welcome for many right now, as investment portfolios are in tatters and many are unemployed, I would argue that if I have to suffer, let me do it now while I’m already suffering, not later after I’ve gotten over the bad times and am looking forward to enjoying prosperity. I can’t help but wonder if it wouldn’t make sense to just let interest rates float to their natural level right now and just give the economy time to work its way thorough the excess inventory of homes. Yes, this process will take longer than the lowering of interest rates approach, but at least we won’t have to deal with much more expensive homes in the future. Besides, I can’t help but feel that a lot of the economic issues we face now are the result of our band-aiding things so we don’t have to “face the music”. Maybe it’s finally time to live within our means, buy as much home as we can afford (which may be much less than what we may want), and build a strong financial and economic foundation for our children. Of course, that won’t get me votes with the public if I were running for any kind of office…

Categories: Economics Tags: , ,