Tuesday, October 27, 2009

Bulk REO, Fact vs. Fiction: Part IV, "A Possible Solution"

Economics 101 tells us that supply and demand determine market value. When supply goes up, and demand goes down or remains level (thereby increasing supply) prices come down. And when demand goes up and outstrips supply prices go up as well. It’s a pretty simple formula. But what happens when either the supply side or demand side are artificially manipulated? Artificial Booms and Depressions.

That’s what we have right now. For years due to cheap capital and almost non-existent regulation (fraud) in the mortgage market, the demand for housing in this country went through the roof. The manipulation with FNMA (Thank you Barney Frank and Company) set up a scenario where “anyone with a pulse” could get a loan for a home. And with this raging demand came the housing boom. New construction of homes and condos proliferated. Whole new cities were built. New condo construction in most major cities exploded out of control. Apartment buildings by the 100,000s of units were converted to condos. The supply side of the equation was attempting to keep up with the “demand”. But as we now know that demand was artificial, manipulated, and false. And a large portion of those “buyers” are now in default, and losing their homes. (I left out the entire scope of how mortgage backed securities and derivatives trading helped drive the demand for and creation of mortgage products that pushed this demand even higher but suffice it to say Wall Street played a large role in this current crisis).

What we are left with are millions of homes and condos vacant, or going into foreclosure and soon to be vacant.

So what’s the solution? Simply, all that supply that the artificial demand generated needs to be absorbed. One smart broker emailed me from my last post and suggested that if the banks were to “dump” their entire inventory onto the market, it would create such an oversupply of product that it would further depress prices. Well I have to agree, except why is that a bad thing. Until the Real Estate market establishes a true “floor”, a true base line of home values based on supply and demand, all transactions now and in the future are and will be based on “artificial values”. For how can someone buying a home today, and getting a mortgage based on an appraised value, do anything but lose money, and lose equity, if there is still so much inventory, and thus still a built in “value killer” in the market.

As I see it, the only way to solve the housing crisis is for the banks to release their entire REO inventory to the private sector. The large funds out there will over the next year or two (or 5) buy up most if not all the banks inventory at a nice discount. This at once will set the floor for housing nationwide. Yes in the short term it will depress current home values. But once that inventory is bought from banks, and the floor is established, those private firms will begin selling those homes, for a profit, and home prices will begin to steadily rise, based on supply and demand, back to a REAL value level.

Like a sponge, the only way to get more water in it, you first have to wring out all the water that currently resides. So until this entire surplus inventory is “wrung out” of the system, we can never see a true recovery in the Real Estate market.

How many more foreclosures and REOs are being created right now by banks loaning money on a “false floor”.

Think of it like this. If one steps on a foreign body, and then gets an infection in their foot, they can soak their foot everyday, and take antibiotics all they want, but until that foreign body is removed, that foot won’t heal.

So the excess inventory the banks currently have needs to be put out there for the market to truly correct itself. This will not be popular in the short term, but as I see it, the only way a long term, real recovery, can ensue.

What do you think?