Doug Duncan with Fannie Mae #243

Norris Bruce

Bruce Norris is an active investor, hard money lender, and real estate educator with over 30 years experience. Bruce has been involved in over 2,000 real estate transactions as a buyer, seller, builder and money partner.

Norris Bruce
September 16, 2011

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On October 14th, 2011, The Norris Group returns with its award-winning event I Survived Real Estate. An expert lineup of industry specialists join Bruce Norris to discuss current industry regulation, head-scratching legislation, and the opportunities emerging for savvy real estate professionals. 100% of the proceeds support the Orange County Affiliate of Susan G. Komen for the Cure. This event would not be possible without the generous help of the following platinum partners: Foreclosure Radar and Sean O’ Toole, Housing Wire, The San Diego Creative Real Estate Investors Association and President Bill Tan, Investors Workshops, Invest Club for Women and Iris Veneracion and Bobbie Alexander, San Jose Real Estate Investors Association and Geraldine Berry, Real Wealth Networks, Frye Wiles Web and Branding, MVT Productions, and White House Catering, who will provide the 3-course meal for this black tie event. Visit iSurvived2011.com for more details.

Bruce is joined this week by Doug Duncan. Doug is Fannie Mae’s vice president and chief economist. He’s responsible for managing Fannie Mae’s strategy division, economics, and mortgage market analysis groups in this leadership role. Doug provides all economic housing and mortgage market forecasts and analysis and serves as the company’s thought leader and spokesman on economic mortgage market issues. Prior to joining Fannie Mae, Doug was senior vice president and chief economist at Mortgage Bankers Association. Doug was recently named one of the country’s top four most accurate economists in 2010 by Wall Street Journal. He was also named one of Bloomberg’s Business Week’s 50 most powerful people in real estate.

It was back in 2005/2006 that it first occurred to Doug when he looked at the real estate market that things were going to unsustainable. In one of the first conversations he had back in late 2005/early 2006, he was talking with the commerce secretary in a business group, and he asked Doug what he thought about house-price bubbles. He told him he was in the Don Ho camp, Don Ho being the recording artist who recorded the song “Tiny Bubbles,” but it turned out the bubbles weren’t so tiny. However, there were some tiny bubbles, and one of the keys that he had an inkling of but didn’t really comprehend was after the end of the 2003 refinance boom when they had expected to see a downturn in employment in the industry. They had forecast about 85,000 layoffs as the Feds started to raise rates in January 2004 through February and March. At this time there were about 30,000 layoffs, which was right along their forecast path. It turned around, and employment started increasing even though total volumes were falling. They puzzled over this for a while, and it took about a year to figure out it was really the growth of the subprime business and this was going to provide support for price appreciation. They were a little slow to figure it out and saw the trigger did not completely comprehend it.

At the time it was not possible to understand the products that were being used, such as the mortgage backed securities and the CDOs. You would have really had to realize that at the moment you had lenders that did not actually care if they were loaning to people that could pay them back. As the discussion of CDOs and other derivatives came to the forefront, they tried to understand them. He recalled someone asking him to give an explanation of them in a public setting in a Q and A session, and he told them that he was reasonably good at math but he could not figure out how you could take the B tronches from ten different securities and put them together into one new security and then rate the top 80% AAA. Doug said at the time this was something he should have paired more concretely with the change in the employment structure, thought about the products, and done a better job of vetting it. It was clear that there were problems, and one thing they did was properly called “the peak of momentum in the market.” What they did not call was the degree of downturn and the breadth of impact it would have on the overall economy. In the October convention of MBA in 2005, they believed that in June of that year the peak of momentum had passed. This came from their observation in the condo market. In condos, a much lower proportion of people who own them live in them as their primary residence. The biggest transaction cost in real estate is actually moving out. This does not show up in financial metrics, but from the human perspective this is the biggest issue. If you don’t have to move out and you can sell it, the price is more sensitive to market movements.

In June of that year, for the first time in four years, the year-over-year price appreciation in condo existing sales was less than non-condo existing sales. They watched in July, and the same thing happened in August; so they concluded that was an early signal that momentum had peaked. The average house price continued to rise through 2006, but condos were falling. The sales peaked in new homes, which are always the second to go. This started to decline in October, and by January of 2006 they were also in decline in terms of the number of units. In about July of 2006, average house prices started to go as existing home sales started to fall. They did call the peak properly in terms of the momentum in the marketplace, they just did not get the degree of magnitude of disruption it was going to be or the degree to which house prices were going to decline, even though they knew they would. It was unprecedented, no one can fault somebody for not picking up that this was the Great Depression of real estate and is pretty much what we’re living through right now.

A survey was conducted back in 2003, the time when you would not have seen much change between this year and 2005 because people were using the products which ended up being destructive in some cases. The pace of appreciation had them frightened that they wouldn’t have gotten access to housing. They were using these different products which had payment characteristics that ultimately proved to be unsustainable in some cases and of course got caught in the downdraft of prices and other cases. It was because the price appreciation was so strong they thought they would not be able to get onto the wagon. In the 2003 survey, people said when asked about the safety of housing as an investment, they even ranked it over insured deposits, which is nonsensical. This could be a warning sign for someone in Doug’s business who is looking to the future when somebody perceives absolutely no risk when signing up for something so large. It should have been another early signal to put things into perspective. Things have changed a lot from 2003 to what the recent survey from August 2011 showed. Clearly they have changed for the worst in general across the whole survey. Even from 2010 we have had some significant movement in attitude, even seeing a dramatic shift in the last two months. If you summarize all the information from the surveys, the public is basically saying they like the economy’s direction less today than they liked it a year ago. More people have seen their expenses go up than their incomes. They don’t expect interest rates to go anywhere, but they expect house prices to actually decline. They expect rents to go up, and they wonder why anyone would think now is a good time for them to make the biggest financial commitment of their life. When you aggregate that on the most recent quarter when they recently asked how people felt about the stability of their job, 26% of employed people were worried about the stability of their job. If you add that to the 9% unemployment rate, you have 35% of all the employable people in the country that are worried about the stability of their job. This is not a good sign for demand for housing.

As Bruce mentioned earlier, when you had a mood that was euphoric that took us too far, you now have a mood that is almost depressed and probably doing exactly the same thing in the other direction. The percentage of people who say they would rent if they were to move in the next twelve months is rising. The percentage who says they would own has been falling. In particular, for anybody that is delinquent, their view of next-time ownership has degraded significantly. In this case, you are talking about one’s desire to own, but now you have to pair this with capability of qualifying. When someone says they are delinquent and might not want to own, they are not going to be able to own. There are a lot of firsts in this downturn, and this is one of them. California has several mixed areas, and Riverside County is one of the harder hit areas. 65% of all of the sales are either short sales or REOs; which means that when someone closes 1,000 sales, they are only producing 350 potential repurchasers. 65% of the inventory is going to go vacant and be bought by an investor or bought by somebody migrating to an area that has 15% unemployment. They would need to find 650 people per 1,000 houses, which is a unique problem. This is one of the reasons when Bruce was talking about investor financing it seemed obvious they were probably going to have to participate.

To find out the significant mood change in the market in the last two months, Doug asked several categories of questions. They asked about their attitude about the direction of the economy, their confidence and changes in the nature of their personal financial situation, interest rates, prices, and rent vs. own. The main question they asked was whether or not they liked the direction in which the economy was going. In the last two months, the percentage of people who feel it is going in the wrong direction has increased by 14 points. In the most recent survey, 78% of the people who took the poll said it was heading in the wrong direction. If you go back two months to the debate over the debt ceiling combined with the re-emergence turmoil in Europe, they concluded that consumers were watching with one eye the debate in Washington for clues as to whether there was going to be a serious addressing of the longer term fiscal health of the United States. They came away from the debate dissatisfied that it had really solved the problem. With the other eye, they were watching Europe with in mind that that was a potential future for us if we don’t get our fiscal health in order. This is an inference that they weren’t asked to articulate. However, when you look at the changes in their attitude about all the other things related to their personal situation and their housing choices, it seems to be a reasonable conclusion to draw what was aforementioned. There were not other significant events at the time that would have driven so big a change in attitude.

It seems like just the idea of buying a house has become more complicated just because people are being forced to consider some of the other factors involved. If one thinks they are just going to buy a house in California and see if they make enough money, it’s not that simple. They also have to not only think about if their job is going to be stable, but also factors like whether or not countries like Greece will pay their debt. It’s a lot to think about. Also, the size of both the deficit and the debt that we are accumulating make it more apparent to people that somehow it’s going to have to be paid for and that it is people and households that ultimately pay for that one way or another. You’re seeing a continued financial conservatism on the part of households as they attempt to get their household balance sheets back in order, reducing debt, and increasing savings. All of that is a demand-side problem for housing. What is hard to imagine is that there is hesitancy buying a property when the financing is something like 3. To become an investor, Bruce refinanced his house that was almost free and clear at 17 ½% fixed in 1981. Doug just bought a house in Florida, and on 15 year fixed money it was 3 ¾%. It’s an amazing thing, and people recognize that. When they ask them in the survey whether or not it is a good time to buy a house, a very high percentage say it is a very good time to buy a house. What they are not saying is it is a good time for them in particular to buy a house.

Bruce mentioned the front cover of Time Magazine and how it really bothers him because of its description. Its title is Rethinking Home Ownership: Why Owning a Home May No Longer Make Economic Sense. This drives Bruce crazy because he is thinking that going forward they are probably going to have some inflation. No one that owns a rental is going to let somebody tie up a fixed-rent for 30 years. If you get to borrow money at something that starts with a 3, you will have a real hard time convincing Bruce that it is a bad economic decision ten years later when your neighbor is renting for twice your house payment. This is one of the things that is a practical attribute of homeownership that gets lost and is one of the reasons that there is a difference between how households behave with their mortgage and what we teach in introductory finance classes in college. There is a practical attribute to the mortgage, which is as long as you make it through the first three or four years of that mortgage successfully, typically it is with a growing income. After a while your income grows away from that fixed obligation and becomes less and less significant; whereas to Bruce’s point as economic conditions’ rents change annually and don’t have the same attribute as the fixed lending. If you don’t own in the future, the housing bill will always take the majority of your income. If you are able to buy and lock in a fixed rate, it will become less and less a part of a percentage of your budget. You will have spendable money and will be able to absorb higher tax levels where it will still leave you with a lifestyle with which you are okay. The difference in the cash flow also allows you to diversify your investments and increase your overall financial strength through other diversification of ownerships.

The biggest hurdle to a normal housing market is employment. Going back to the survey, with 26% of the people saying they are worried about whether their job is stable and another 9% unemployed, this means 35% of the employable market is worried about their job. On that side of things, stability is really critical. Doug and Fannie Mae have tried to fix employment without having construction be a participant, but he said this slows things down. Typically, about 10% of new jobs are in the construction space in any expansion. When housing is not a contributor, then it is much slower. It would seem like we would have to resolve a backlog of homes that are below replacement cost before we get to somebody building a significant amount of homes. The pile of properties that would be called shadow inventory would still be a significant issue. It is both a current issue and will be a longer-term issue with regards to price appreciations. There are folks who would like to sell their house but know that they cannot get the market price that would make it make sense for them to sell unless they are under pressure. There are also folks who have had to sell; and with prices falling and lots of distressed sales, investors have appropriately stepped in to assist. Some of the investors will take a long-term buy and hold strategy for the investment value, both for the capital gain and also for the cash flow returns. Others will be helping make the market as it transitions to absorb the supply and will put them back on the market as price appreciation sets in. The implication of that is that price appreciation for sometime into the future would be slower than what folks have seen in the past. If you look at the instances where there was a significant regional price decline in Los Angeles in the late ‘80’s or even in New England in the Boston area. The pattern that you see with a precipitous decline is in a very long and slow recovery period, something along the order of a decade.

Right now we have the risk of a recession as a coin toss. The triggering event is usually a surprise when it occurs, but sometimes you can get it right. One of the things that could cause another leg down for housing would be a major bank failure in Europe, which could lead to a layman type of event in Europe. They are our biggest trading partner, so that would definitely be a hit to the U.S. economy, both in terms of trade and general economic activity. However, we also have significant interbank relationships in our financial system with them. This is the thing Doug and Fannie Mae are watching most closely today. If something was to happen and we were to go into another recession, there would be additional downward movement in prices. The degree would depend on the degree of the recession.

Doug Duncan will be on the panel for I Survived Real Estate 2011, taking place on October 14th. The Norris Group would like to thank their gold sponsors for the event: Adrenaline Athletics, Coldwell Banker Pioneer Real Estate, Conaway and Conaway, Delmae Properties, Elite Auctions, Inland Empire Investors Forum, Keller Williams of Corona, Keystone CPA, Kucan & Clark Partners, LLC, Las Brisas Escrow, Leivas Associates, Mike Cantu, Northern California Real Estate Investors Association, Northern San Diego Real Estate Investors Association, Pacific Sunrise Mortgage, Personal Real Estate Magazine, Realty 411 Magazine, Rick and LeaAnne Rossiter, Southwest Riverside County Board of Realtors, Starz Photography, uDirect IRA, Wilson Investment Properties, Tony Alvarez, Tri-Emerald Financial Group, and Westin South Coast Plaza. Visit isurvived2011.com for more details.