Tuesday, August 08, 2006

Fundamentals??? An 'old' perspective

I have been meaning to do a post about this for a while. I get these "Thought for the day" from the Napoleon Hill foundation. I'm sure many of you are familiar with Napoleon Hill, but for those of you who aren't, he was the author of 'Think and Grow Rich'. Napoleon Hill earned the opportunity to work with some of the best and brightest in the world of business. He was inspired by Andrew Carnegie, and became one of the greatest motivational authors in the world. From the likes of Henry Ford, John D. Rockefeller, Theodore Roosevelt to Alexander Graham Bell, William Howard Taft, and millions of successful businessmen around the world, they founded their success on Andrew Carnegie's philosophy of success that is presented by Napoleon Hill.

There were two 'Thought for the Day' in particular that I want to address here. Here is the one that arrived in my inbox about two months ago.
Thought for the Day
May 19, 2006


When considering a loan, a banker attaches great importance to three things: the borrowers ability to repay the loan, the borrowers credit history, and the borrowers character. The first two considerations can be calculated mathematically; the third requires judgment and experience. Prudent bankers have learned that persons of character are always a good risk because they take their obligations seriously while those who spend their resources on the trappings of success should be avoided at all costs. Protect your good reputation as you would protect your home, your investments, and your life. Once shattered, a good reputation can only be regained by those who have developed the courage and willpower to persevere in the face of great odds.

This positive message is brought to you by the Napoleon Hill Foundation. Visit us at http://www.naphill.org. We encourage you to forward this to friends and family. They can sign up for this free service at our web site.

Take a look at the 3 things of 'great importance' to a banker, and lets see if the 'bankers' of today follow those rules, or if they have been relaxed a bit. With stated income and no-doc loans, are you giving a banker the info needed to show your ability to repay a loan? With the explosion of the subprime lending markets, are bankers looking at a borrowers credit history the way they 'used to'? And finally, are the 'bankers' of today really looking at the character of the person they are lending hundreds of thousands of dollars?

Napoleon Hill and Andrew Carnegie worked closely with Charles Schwab. Do you think Mr. Schwab would have become the success that he was by ignoring those 3 principles? Maybe the mortgage lender Encore would still be in business if they applied Napoleon Hill's thoughts on banking to their business. Instead, they lent about 60% of their money to people with undocumented income via stated income loans. Is it really any surprise they went under? They were not the first, and they will certainly not be the last company that tries to ignore the 'old' fundamentals in favor of new ones.

People don't understand that this bubble is going to be worse than any other because never in the history of this planet has money been lent the way it has the past 5-8 years. In previous real estate boom/bust cycles, people STILL had to put money down and get a mortgage that paid down the principal (either through a fixed rate or an adjustable rate). How bad would previous busts have been had people been able to borrow 100% of the money on stated (exaggerated) income?

Look at this quote from the CEO of Toll Brothers: ‘It appears that the current housing slowdown is somewhat unique: It is the first downturn in the 40 years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors,’ said CEO Robert Toll.

The reason this is unique is because the industry completely ignored the fundamentals. Because times were good, they 'creatively' stretched the dollar so that short term monthly payments could be kept low. They have about stretched the dollar as far as it will go...50 year mortgages, 1% neg-am loans, interest only, etc. If the dollar has been stretched to its max when the times are good, what do you think will happen if we DO get higher unemployment? higher rates? a weakened economy? Combine any of those factors with the 'lawless lending' of the past 5-8 years, and what do you think will happen?

Never in the history of the planet has money been lent out in such large quantities, to borrowers with so little documentation, with such 'creative' programs, at such high loan-to-values. The stock market 'defied' the fundamentals for a while. Remember all the 'experts' saying it was a 'new economy' and that you could make money buying companies with NO earnings, that were trading at 180 times future earnings, because it was different this time. Just like the real estate experts that will tell you an 'income property' that loses over a thousand bucks a month is a 'great investment' because it will appreciate.

Once the banks start holding the paper instead of selling it on the secondary market, look for the above fundamentals to return. The free markets work, and will return to the fundamentals. The 'investors' that have been buying all these crappy MBS (mortgage backed securities) will stop buying once they see the junk they have been buying. Once these payments really start adjusting and the defaults start piling up, MBS won't be as attractive as they once were. When the banks don't have somebody else to assume the risk, they will tighten their standards because it will be THEIR money on the line, and not some 3rd party.

I will let the following 'Thought for the Day' speak for itself.
Thought for the Day
May 21, 2006


The subconscious mind makes no moral judgments. If you tell yourself something over and over, your subconscious mind will eventually accept even the most blatant lie as fact. Those whose lives and careers have been destroyed by dishonest behavior began the process of self-destruction when they convinced themselves that one slight infraction of the rules wouldn't matter. When you sell yourself on an idea, make sure the idea is positive, beneficial to you, and harmless to others. Just as negative thoughts and deeds return to their originator, so do positive ones. When you practice honest, ethical behavior, you set in motion a force for good that will return to you many times over.

This positive message is brought to you by the Napoleon Hill Foundation. Visit us at http://www.naphill.org. We encourage you to forward this to friends and family. They can sign up for this free service at our web site.

This 'Thought for the Day' could apply to any number of things in the mortgage or real estate industry...and even the stock mania of years past. It could be over-stating income, pushing the value on an appraisal, glossing over certain 'key' aspects of a loan, or not disclosing an issue with a property...just to name a few. I know that some people made conscious decisions to be dishonest, but many more don't even realize what they are doing as wrong. The barriers to entry to the mortgage and real estate industry are pretty much nil. You could have walked off the street into pretty much any broker shop and said that you wanted to 'dial for dollars' and telemarket for loans...and I think you would be surprised how often you would be accepted. Lots of places would take you in, give you a quick class or two, let you listen to some 'seasoned' brokers on the phone, then turn you loose. When you have programs like 'stated income', it just opens the door to a big 'gray area' where people can make more questionable decisions.

A loan application is really nothing more than paperwork that demonstrates whether or not a person is a good risk for a loan. If the paperwork makes sense, the loan will be made. The problem is when people look at getting a person a loan as a puzzle, or a 'problem' to be solved. Borrower A needs to make X, but they only make Y. How can I get Borrower A to income X? They are sooooo close to qualifying, I will just state their income a bit higher and they will be fine. They will get the house, and the extra 'couple hundred' a month I had to over-state their income isn't going to break them.

You have read the stories about the appraisers that are getting together because they don't like the pressure put on them to 'hit values'. That pressure can lead some people to find that slippery slope that is talked about above. If you do the right thing, you get less business. You hit a number here and there, and you become a 'go to' appraiser. Then before you know it, rounding up a few grand has turned into getting values tens of thousands of dollars higher.

Don't forget the power of the group mentality as well. If 'everybody' else is making lots of money, and this is how it is done, then it can't be wrong....right??

Lets not forget the 'mouths' of the real estate industry. The 'experts' who said that 'real estate won't go down', then changed to a 'soft landing', then to whatever crap they are spouting now days. Look at the great econoMISSED Leslie Appleton Young of the CAR (Ca Assoc of Realtors) as an excellent example of this. Facts and data be damned, real estate doesn't go down, and if it does, it is just a short term soft landing with more 'normal' appreciation for a while.

I also want to say that there ARE lots of mortgage and real estate professionals that never fell into these traps. These were usually the people that had been in the business for a longer period of time, or had some internal sense of what is right. I had the pleasure to work with quite a few people that had 20-30 years in the business. Many of these people didn't necessarily like all the 'goings on' in the 'new' mortgage industry. My whole point is to illustrate that many of the people out there didn't knowingly set out to be dishonest. In California, over 40% of the job growth in this state was real estate related the past 5-6 years. Anytime such a large number of people run into anything, there are going to be people that get lost in the 'gray areas'.

I hope this point is coming across correctly. I'm not trying to say the entire mortgage or real estate industry is this way, but it only takes a small percentage of people to influence an industry.

Look at the quality of the company that Napoleon Hill and Andrew Carnegie kept. They knew that the fundamentals were key to long term success. Who do you think will be right? Napoleon Hill and company who place a high value on the 'old' fundamentals, or todays crop of mortgage and real estate professionals who say "its different this time". The last group of stock-jockeys and financial planners that said it was 'different this time' are still looking at a NASDAQ that is less than half of its peak of 6 years ago. It will only be a matter of time to see who is right on this one...the real estate 'experts' or the fundamentals.

You know where I stand...

I look forward to the comments and feedback.


Wednesday, August 02, 2006

The 'old way' vs. the 'new way'

I know, I know, it has been too long. But look at it this way, nothing 'major' has happened yet. Most of you that have read this blog for a while know what is coming. Sure, it is 'nice' or at least 'validating' for people on the 'bubble side' of things see inventories rising, appreciation slow or even go negative, and the "oh my gosh, the market turned so fast, I wasn't able to flip for huge money" stories that are showing up more and more.

The media is doing a great job in its role of 'lagging indicator', by warning people about the pitfalls of creative financing and adjustable rate mortgages. Too little, WAY too late. But then again, if they had tried to tell people to not use interest only ARMs to buy homes they couldn't afford a few years ago, people would have laughed in their face. Real estate only goes up....duh!

That said, let's look at the 'old way' that most people used to buy property. Lets use the 'new standard' for homes/condos/townhomes in most areas...the ever popular "Starting at only $400k!!" I am going to use 'rough' numbers here to illustrate a point...so just bear with me. I am also going to assume these people have NO other debt that would figure in their debt ratio...no car payments, no student loans, no credit card bills...pretty big assumption....but it will only help make the point when you see how much most people are spending on housing.

In the 'old days', you would need an 80k down-payment to buy a 400k home. If you were an individual or family making 80k a year, if you saved 10% of your gross income JUST for a down-payment, it would take 10 years to save your 80k. I know that most people would have invested the money along the way, so let's just say they put in in fixed income because they didn't want to lose any money. So figuring in the investing, lets say it would take about 7 years for them to save the money needed for the down-payment. A $320,000 mortgage at 7.5% would yield a principal and and interest payment of $2237.48 per month. Throw in another $400 a month for California taxes, and that brings the total to a rounded off $2640 per month...and that is NOT including any HOA or association fees that most condos and housing developments have today. That 80k a year translates to $6666.67 per month (GROSS). That housing payment is 39.6% of gross income...and remember, we are NOT including any HOA or other maintenance. Throw in a $250 or $300 HOA, and we are pushing a 45% debt debt ratio, JUST on housing. That doesn't leave a lot of money to save for retirement, disability insurance, other investments. Not to mention the new Escalade payment, the Best Buy card, Visa, Mastercard, the SDG&E bill, and the gas card. That is why the 'old way' was to keep housing costs at 30-35% of gross income. To really 'afford' this house, you would need to be making at least 100k a year. If you are making 100k a year, a $3000 a month housing expense puts your housing debt ratio at 36%. That is not too bad assuming you don't have a lot of other debt.

The problem is that the median income in California is about 50k a year...well short of the 100k+ needed to really afford these 400k "starter homes". Again, crazy me was actually assuming people had some 'skin' in the game by putting down 20%. So remember that the mortgage numbers above are for a 320k loan.

With my new job, my territory consists of San Diego, Orange County, Riverside, San Bernadino, Palm Springs/Palm Desert, Temecula, and everything in between. So needless to day, I have seen most aspects of Southern California housing. From Crystal Cove and Newport Beach all the way to the 909 and Indio. Today I was driving the 'back way' from Temecula to Palm Springs. I was driving through Hemet and I was completely amazed at ALL of the housing developments that all had starting prices of "400k". I didn't spend much time there, as I was just passing through, but all I saw were gas stations, fast food, and your basic shopping center type stores. I by no means saw the potential for thousands of the 6-figure jobs that would be needed to purchase the hundreds and hundreds of homes that were for sale "starting at 400k".

These same homes are all over the desert communities. I know that there are quite a few people making 100k+, but there is no logical reason why every new home or condo should 'start' at 400k!

I know we have done it before, but let's look how MOST people are/were 'affording' these 400k starter homes. First off, most are not putting any money down. The lenders I used to work for had 80/20 combo loan programs, but they also had 100% 1-loan programs, that could be interest only as well. Take a 400k loan at 5% Interest Only (a typical rate of 2 years ago), and you get a payment of only $1666,67 per month!! Saweeeeet!!! Throw in some takes and you are about $2000-2100 per month. With the 'relaxed' lending standards, the lenders I worked for would take a 'full doc' debt ratio of 55%...and a stated income debt ratio of 45-50% depending on the loan. Take the $2100 payment at a 55% debt ratio you only need to gross about $3850 per month ($42,600 per year) to 'afford' a 400k loan. The income needed would be higher on the 80/20 loans because the 20% seconds were NOT interest only, and were at higher interest rates. I won't even get into the neg-am and other creative financing at this time. Check out the archives and popular posts for more info on those loans.

The scary part comes with the 'stated income' loans. Go to this website www.mbarl.org and click the 'facts' on the left hand side. When a recent sample of stated income loans were compared to IRS records, it was found that 60% of the loans had income exaggerated by 50% or more! Now I know that the study was only a pool of 100 stated loans, and many of you won't believe it, but from what I saw on a daily basis I don't doubt this stat one bit. There were broker offices that only did stated loans. Some brokers would laugh when I asked if the borrower was going full doc or not.

HOW else could things get sooooo out of whack from actual incomes???? Come on, I'm waiting.

During the past 5 years, down-payments have slowly faded away...but lending standards have faded into oblivion.

It will only be a matter of time until the fundamentals return. Making a low teaser payment for 2, 3 or 5 years only works when prices go up. Many people are going to have that sick feeling in the pit of their stomachs when their teaser ARM adjusts and their property is worth 100k less than they 'paid' for it....and there is nothing that the great econoMISSED Leslie Appleton-Young can say to take that feeling away.

Why save for 6, 7, or 8 years and get a fixed rate loan when you can just 'state' your income, not put any money down, and make 6-figures in appreciation a year??? Eventually you come to a point where the dollar can't be stretched anymore. You come to a point where the massive 'guaranteed' appreciation isn't there. You come to a point where the mentality shifts. Actually...we are just getting there now.

I look forward to the comments and feedback...

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