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Revenge of the Fly-Over States
By Jim Gueno
The current difficulties in mortgage lending and real estate are, as you probably know, being very prominently and incessantly covered in most mainstream media. It would seem however that the resulting hysteria that’s being generated follows the “all news is local” adage. These media outlets are concentrated on both coasts and in large urbanized areas - it’s those very areas where the greatest problems are occurring. While the problems are significant and I would not diminish the severity of a very painful situation for our industry and many consumers, there are signs that much of the nation’s real estate may not be quite as bleak as you would think from media reports. Areas such as California, the northeast and Florida are where real estate has been on an unprecedented value appreciation rocket ride in recent years. Home prices in some places had become so ridiculous that a person earning the median income for the area would be unable to buy even the most basic house when compared to the same area’s median home price. From necessity, people were forced to seek out mortgage structures that provided the lowest possible monthly payments (for that’s all they could afford when faced with paying well over a half million dollars in some places for what anyone would consider “starter” housing). Loan programs like negative amortization, payment option ARM’s (with payments based on rates as low as 1%) started to proliferate. Investment bankers sought new mechanisms to get loans to fuel an enormous demand for (what everyone thought were) highly rated mortgage debt instruments by large institutional and governmental investors looking better investment yields in a low interest rate cycle. This demand was then fueling the mortgage surge that was thereby creating it’s own supply. As monthly payment amounts started to shrink and more house could be had for less paycheck, home prices began to spiral even further – in some areas by 20% or more on an annual basis. The thinking was that if your house was going to be worth twice as much in five years, then what was wrong with taking a loan where monthly payments didn’t even cover the interest and the balance was going up each month. Home prices were going up even faster and speculation in residential real estate developed into a cottage industry that even has it’s own TV show (“Flip This House” on TLC). Those same artificially low payments further inflated prices as consumers suddenly had a new standard of what their monthly payment should buy. Some even thought it was the dawn of a glorious new perpetual motion machine that made equity and profit in and of itself. Like gravity in physics, real estate economics has a way of righting itself. When the wings come off the fall is scary, but it’s that sudden stop at the end that’s most painful. Since now everyone seems to be asking if the bottom has been reached yet, it probably hasn’t. I think that this time, they’ll know it when they get there. All the while, folks in the “fly-over states” (as viewed only from an airplane window on a coast-to-coast flight by media pundits) were feeling left out. Places without beaches, 24/7 nightlife and ski slopes had yet another reason to feel like have-nots. Their real estate was appreciating at the three to eight percent it always had in good times and zero to three percent in bad. Ultimately it may be these flyover folks that are having the last laugh. To illustrate, let’s take a look at three states’ real estate markets. I picked these three at random, but substitute any trendy coastal area, desert southwest state, Colorado or New England and compare to most “flyover states” and the contrasts are striking. Office of Financial Housing Enterprise Oversight (OFHEO) Housing Price Index - Last 10 Years
Source: OFHEO Housing Price Index from Q3 1997 through Q3 2007¹
As the graphic above shows, these states started with roughly similar Housing Price Indexes (HPI’s) ten years ago. While California and Florida then went on a wild ride upward, Tennessee kept chugging along with slow, steady growth with some increased appreciation rates from the norm just in the past 30 months. However, while Tennessee is still above its typical HPI rate, both California and Florida have plummeted well into negative territory. Speculation fueled some of the run-up in Florida and California as evidenced by the percentage of new loans secured by investment or second home properties which accelerated dramatically, in some cases to rates of greater than 40% of total originations since 2003, but nonetheless was not alone the cause but rather a symptom. So what does the future hold for residential real estate and mortgage lending? I wouldn’t begin to profess the foresight to predict that, but do think that 2008 will be a year of historically critical volatility for housing and the economy in general. For one thing, I think that the 2008 presidential and congressional elections will impact this economic segment significantly. The states with the most severe real estate problems are [coincidentally?] Democratic-leaning “blue states” in the last few electoral cycles. It’s the congressional representatives from these states that have been calling the loudest for significant governmental intervention on two fronts: (a) to assist their constituents in coping with the “foreclosure crisis” precipitated by their “victimization” of having unsustainable housing debt. And; (b) to prop up the large investment and mortgage bankers from billions in losses from the “liquidity crisis” caused by the sudden realization that the debt securities created from their exotic and subprime loans are worth much less than previous valuation. There’s also a strong sentiment toward more regulation in mortgage lending to curb abusive lenders which will vary in severity depending on the political tilt of Washington in coming years. I would expect further consolidation in the mortgage industry with large depositories leading the charge via organic growth and M&A activity to buy lenders with good servicing portfolios at fire sale prices. The B of A/Countrywide deal could be a harbinger of things to come as WaMu, NatCity and several other large mortgage lenders are ailing, but have good assets currently undervalued. Recession is also a real possibility. The Fed had signaled it’s in a mood to lower rates, but energy and food sector inflationary pressures could limit their ability to do so if prices spiral in other segments. Certain “rust belt” states like Ohio and Michigan are already experiencing localized recession due to manufacturing weaknesses. To inject some pragmatism, while middle America is not now seeing drastic real estate decline, the national housing market will, over time, downgrade most everywhere. The states with the slowest appreciating home prices in boom times will also be the slowest to decline however. Bad news is that once bottom is reached they’ll have a tedious ascent back as well. There is, I believe, some pent-up demand for housing where buyers are sidelined watching events and waiting for prices and rates to bottom. For mortgage lenders, this could result in a nice surge of business around mid-year. Inventories are such that homebuilders (those that remain) would likely not see any benefit. Inevitably though, there are pockets of opportunity. Also, should inflation moderate and rates come down another 100 basis points or so, there could well be a refinance “boomlet”. Some things I would be doing now . . . · Upgrade talent by attracting the good sales producers now in the job market from the shakeout of mortgage brokers and large lenders . . . concurrently cutting loose stale sales staff unable to adapt to a market where they actually have to do a bit of selling to get business in. I would be recruiting good mortgage sales talent 24/7 and trimming non-producers at the same scale. · Rework your technology as really fantastic automation is in oversupply and now costs 20% of what it did two years ago. Same with hardware. · Dump all your residential builder/developer buddies and find some new multi-family versions. Only customs show any life and even that’s limited. Steer clear of the office market also - remember typewriters? Offices are headed that way with technology superseding the need to gather information workers under one roof anymore. · Sell more stuff. Sounds simple, but do you know how many financial products your average customer uses? Based on the cross-sell surveys I’ve seen lately 6.3 is the average number for Joe Consumer. . . between deposit, cards, savings, CD’s, car loans, mutual funds, annuities, stocks, mortgages, equity lines, recreational financing, medical financing, education financing, safe deposit, IRA’s, HSA’s, Christmas clubs, gift cards, etc., etc., etc., . . . Then there’s insurance which offers another six dozen ways to profit from each consumer relationship. Also, up to 11% of the Joe Consumers out there may also be Joe Businessmen (and women) and there’s many, many new commercial products that can contribute to earnings. Think about selling any revenue positive service or product available and actively look for new ones. Affiliate and correspondent relationships can help. Research what your customers want though - don’t just offer stuff blindly. Recognize what has net earning potential, even on smaller scales. · Know your customer! And, not just because the Justice Department says you have to. CRM is no longer optional - it’s a survival tool. Yes, it’s a pain to deploy and yes, it’s expensive. Not profiling each customer and offering the right products at the right time to the right people is ceding them to someone else who will. Banks with the best ROE’s all share the common denominator of aggressive customer profiling to increase WALLET SHARE. And with all that sage advice (most of which is probably wrong anyhow); I’ll conclude with my buzzword of the year . . . Wallet-share. Best wishes to all for a prosperous 2008 and, buckle up . . . It’s sure to be interesting. __________________________________________________________________________________________________ © 2008 James P. Gueno - All rights reserved. May not be reproduced, copied or otherwise distributed without the express written permission of the author.
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