This post first appeared in the June edition of: Cirios Trends: Finding Real Estate Opportunities.

There is no ambiguity about the goal of current US government policy when it comes to housing: Prevent home price depreciation at all cost.

As such, this month’s State of the Markets was going to discuss shadow inventory, diving into the numbers to see just how long we’ll have to live with looming supply of bank owned homes. At current repossession rates (around one million per year according to Lender Processing Services), it will take around four years to work through all loans that are more than 90 days delinquent. Morgan Stanley agrees, pegging 47 months as the time required to work through the backlog of distressed loans. And those figures assumes no additional loans get added to that severely delinquent bucket.

Sobering stuff, and evidence that foreclosures are going to be a dominant market force for the foreseeable future.

But as we dug through the data, something wasn’t adding up. Many are fearful that supply will flood the market as banks push through foreclosures. Housing bears often cite this inevitable inventory spike as evidence housing is in for a second leg down.

This is a very valid concern, and in order to remain ahead of the curve, Cirios closely monitors real time foreclosure and new listing data, watching out for early signs of a supply shock.

Our antennae were tripped in April as Trustee Sale activity began to ramp up and repossession levels began rising. Nervously, we waited for the natural increase in listings that were sure to follow. It never came. It still hasn’t come. Something isn’t adding up.

When banks take back homes, the next step in the process is to list those homes for sale. But that wasn’t happening. Banks were foreclosing on more homes but the trail stopped there.

So we went to the tape. Since 2000, the average increase in new listing activity from April to May was 2.9% on the Peninsula and in the South Bay, while over in the East Bay, new listings rose almost 5.5%. During good times, the typical increase is a bit higher, while during bad times new listings in May can actually decline. In fact, they have declined in each of the past three years.

But this year, throughout the Bay Area, new listing activity in May plummeted relative to historic norms. East Bay new listing activity fell 15.8% while Peninsula and South Bay activity dropped 12.8% - both the highest on record. So what gives?

Without sounding like conspiracy theorists, we’d like to put forward the following, very logical thesis: Imagine you are the government. The tax credit expires, the economy starts to sputter, Europe begins to melt down, the Gulf is literally full of oil and the job market turns out not to be on the mend after all, and you have a stated policy of propping up home prices, what would you do?

This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Over the past several weeks, the federal government’s increased scrutiny of Goldman Sachs has brought complex financial securities at the heart of the housing market collapse back into the government’s crosshairs. We thought an attempted explanation of not just the case against Goldman Sachs, but of how these instruments in question, CDOs, actually work would be valuable.

On April 16th, the Secuities and Exchange Commission, or SEC, filed a civil suit against Goldman Sachs, and late last week it surfaced that the Justice Department was conducting a criminal investigation into the company’s trading practices.

Both departments are focusing on Goldman’s involvement in setting up collateralized debt obligations, or CDOs. The charge, and one that on the surface sounds like a slam dunk for the folks at the SEC, is that Goldman colluded with a hedge fund to create a security designed to fail, then peddled it to unsuspecting investors while the hedge fund placed huge bets the security would fall in value.

During the boom, investment banks like Goldman Sachs bought up thousands of individual mortgages and packaged them into mortgage back securities. These securities aggregated monthly cash flow payments from individual borrowers, then distributed them to investors based on their risk tolerances. Risk-averse investors (pension funds, big banks, insurance companies, etc) were paid first while more risk hungry investors like hedge funds, were paid second if there was enough money left after the first group was paid.

For taking on the risk of being paid second, investors were paid a higher rate of return.

CDOs function similarly, but rather than aggregating individual mortgages, they group together mortgage-backed securities (stay with us).

CDOs aggregate the payments of individual securities, whose cash flow is determined by the mortgages that make up each one. Investors in the CDO get in line for payments and are compensated based on their place in line for cash flows.

The Goldman security in question, called Abacus, takes this one step further. Abacus was hatched using a collection of what are known as credit default swaps, or CDS, and is thus known as a “Synthetic CDO.”

CDS, for all their complications, are nothing more than insurance policies. Let’s say you own GE bonds, and even though GE is a solid company, you’re a little nervous GE may run into trouble and not be able to pay back its bondholders. To alleviate this concern, you could buy a CDS that guaranteed your investment in the event GE couldn’t make good on its bond payments. The seller of that CDS (think insurance company) only has to pay if GE stops making its payments. So, if news were to break that GE were running out of cash, the insurance would go up in cost (value) since bond holder protection would be in high demand.

An investor in a synthetic CDO is paid from premiums collected from CDS buyers who want to bet that the securities protected by the CDS default, thereby increasing the value of their investments in the CDS (get all that?).

So, here you have two sides of the trade. Synthetic CDO buyers hoping the underlying securities keep paying and that CDS buyers keep paying their premiums vs. CDS buyers who hope the underlying securities fail, thereby pushing up the value of their protection.

Since CDS contracts do not require that the insurance seller (or buyer) own any of the underlying securities, these devices were essentially high risk gambling devices, where many gamblers made large sums of money at the expense of other gamblers. Clear as mud, right? It’s easy to see how these often opaque securities got out of control.

At issue is if Goldman, as issuer of the security, made proper disclosures to buyers about the nature of the security and who designed it.

And while it’s easy to cast the case in the “Evil Wall Street Greed” category, investors too deserve their share of the blame for blindly buying what they were told was good quality.

What ever happened to Caveat Emptor?

This post first appeared in the May edition of: Cirios Trends: In Search of Real Estate Opportunities.

Silicon Valley Defies California Gloom
(Silicon Valley Business Journal)

Even though consumer confidence in California has fallen to a historic low, Silicon Valley residents remain some of the country’s more optimistic folks. California’s Index of Consumer Sentiment registered an all-time low of 68.8, five points lower than last April’s 73.8 tally. Silicon Valley, on the other hand, came in at 75.9. Just 14% of the state’s residents believe they are better off now than they were a year ago. On the flip side, only 13% believe they’ll be worse off next year at this time. So, even though Californians think the current situation generally stinks, by in large we don’t think it can get much worse!

(Read more here: http://tinyurl.com/ciriostrendsmay1)

Calls for a Bottom in Commercial Real Estate Ring … Softly
(Cornish and Carey Commercial Real Estate)

A growing consensus is emerging that despite fears of a collapse in commercial real estate, the market may be quietly healing itself. In its latest quarterly survey of San Francisco commercial real estate activity, brokerage Cornish and Carey reported that Class A asking rents inched up by 0.4% from the previous quarter. A smidgen indeed, but this marks the first Q/Q increase since the market peaked in Q2 2008. Even though unleased inventory still appears massive when you look at the data, most of it is concentrated in vast, empty swaths of space. Smaller chunks and premium view space are in limited supply and deals are on occasion seeing multiple bidders. Recovery? Not yet, but investors are licking their chops.

(Read more here: http://tinyurl.com/ciriostrendsmay2)

Are Mortgage Backed Securities Back?
(San Francisco Business Times)

For the first time in almost two years, investors placed bets that mortgages not backed by the government were a good investment. Redwood Trust, a Mill-Valley based real estate investment firm, issued and sold the first private label jumbo mortgage backed security since 2008. The deal, small by bubble-craze standards, consisted of 255 mortgages issued by Citigroup for a total deal size of $222.4 million. The secondary market for mortgage backed securities not insured by Fannie Mae or Freddie Mac has been literally non-existent, as investors have proven unwilling to buy debt without Uncle Sam’s implicit (or explicit) stamp of approval. The deal, adding more fuel to optimists fire, was over-subscribed.

(Read more here: http://tinyurl.com/ciriostrendsmay3)

Foreclosures Continue Steady March Upwards
(San Jose Mercury News)

For all the signals that the housing market may actually be improving, that nasty fly in the ointment, foreclosures, just won’t go away. Despite hundreds of billions of dollars thrown at the problem, foreclosures in Santa Clara County rose 72% from a year ago. This trend is being echoed around California and indeed the country, where foreclosures, the market clearing mechanism everybody loves to hate, continue to plague local economies. One bright spot, however, is that investors are stepping into the market. 4,000 homes were sold directly to investors at auctions - up almost 4-fold from 2009.

(Read more here: http://tinyurl.com/ciriostrendsmay4 )

This post first appeared on Minyanville.

The Obama Administration’s latest salvo in the war against foreclosures, Home Affordable Foreclosure Alternatives, or HAFA, is but a week old and already America’s real estate establishment is trying to cash in.

HAFA aims to step in where Home Affordable Modification Program, or HAMP, fails. In other words, when borrowers are so far behind or upside down that a modification doesn’t make sense, HAFA tries to provide an alternative. Whether it be through Short Sale, where lenders let borrowers sell their homes for less than the amount of the outstanding mortgage, or “deeds-in-lieu,” where homeowners hand their lenders the keys in exchange for absolution of the debt, Washington wants to make getting out from under crippling mortgage debt a little bit easier.

Realtors are licking their chops.

Short sales are notoriously tough to get done, since voluminous requests have bogged down the back offices of big banks like JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC). Approving short sales can take months, and real estate agents lose commissions when buyers walk for lack of patience or if they find another deal. As a result, short sales sell at as much as a 10%-15% discount to regular sales or even bank-owned homes, simply because most buyers (and agents) don’t want to deal with the headache.

HAFA wants to fix all that. By providing cash incentives for interested parties (lenders, loan servicers, and borrowers) to push through short sales, Washington has devised yet another way to try and help distressed homeowners. But as I wrote last week in The Unintended Consequences of Treasury’s HAFA Program, these payments may be too small to push a material number of short sales through the system.

When a buyer makes an offer on a short sale, it first must be approved by the homeowner, then sent on for approval by the bank. More often than not, sellers place the asking price as high as possible in hopes that an offer will be good enough to get the bank’s attention. And more often than not, overpriced short sales get stale as buyers move on in favor of better, lower-priced homes.

But in the few days since the Treasury Department announced HAFA, a strange thing has started happening. Short sale prices are being slashed and buyers are stepping in. The logic makes sense: If you were an underwater borrower (or his or her Realtor), why not slash your asking price to well below the amount you owe, grab an offer, and send it through. You never know what you may get. After all, the president effectively announced that he’d be asking lenders to take it in the shorts for the common good. So banks, eager to keep their names out of the papers as uncooperative, may be eager to fill their government-mandated quota for HAFA short sales and approve just about anything that comes in the door.

And, of course, Realtors then get to collect their commission. A commission which HAFA mandates must be higher than the going rate for distressed sales.

This post first appeared in the April edition of: Cirios Trends: In Search of Real Estate Opportunities.

For 12 months now, the Case Shiller Home Price Index - the most widely watched home price indicator - has been hinting that the housing market has at the very least stopped getting worse. In February’s Cirios Trends, we examined housing’s relationship to the stock market and how last April’s nadir coincided with lows in equities. (For more on home prices and stocks, flip to the charts in the back of this month’s issue for some interesting graphical analysis.)

But back to the data. This month we also received two more signs that the economy, at least on paper, is doing a bit better. First, last week’s employment report showed a meaningful jump in non-farm payrolls for the first time since the recession began. Second, that same Case Shiller Index registered a year-over-year change of nil, the first time prices didn’t slip from the previous year in more than four years.

And looking below at the state of office vacancies, despite hitting the highest level since the 1990s, the rate at which office space is going dark appears to be slowing.

So is that it, are we out of the woods? Not exactly.

Data is easily manipulated and subject to bias, even when its collectors have the best intentions. Let’s look at Case Shiller and dig into just what the data tell us.

Case Shiller looks at paired sales to determine home price changes. In other words, researchers compare sale prices of individual homes in a given month to the last time that house sold. Add in a bit of statistical wizardry and you have a pretty good metric for home price changes over time.

Case Shiller is also considered a value-weighted measure, as it weighs more expensive homes more heavily than cheaper ones. This makes some sense, since otherwise the relatively small number of high priced sales would get lost in the mix.

The implications of this is that an increase in the Case Shiller Home Price Index could either indicate true appreciation, or a shift in data where if more higher priced homes started selling, prices would look like they were rising when in fact, it was something else entirely.

Case in point: Livermore, CA - one of the cities we highlight in this month’s Talking Charts. By measuring price per square foot, which we use as a broad proxy of value, it appears that prices have flat lined for the past 12 months or so. Meanwhile, looking at median prices (a metric commonly used by the National Association of Realtors), prices are up 13.4% in the past 12 months. Quite a difference.

As we edge forward, keep in mind that there is more going on underneath the data than it appears. Always look at trends on as defined a level as possible. Look at cities not countries, zip codes not cities, neighborhoods not cities. Only by drilling deep into the data will it truly help you make better real estate decisions.

This post first appeared in the April edition of: Cirios Trends: In Search of Real Estate Opportunities.

Every six months or so, Washington’s political will seems to coalesce in support of the only issue where there is true agreement across party lines: The housing market is still broken. Sadly, in our view, the Treasury Department’s Home Affordable Foreclosure Alternatives Program, or “HAFA,” is simply the latest in a series of flawed legislation aimed more at pacifying popular outrage rather than offering real, tangible solutions to the challenges facing the US housing market.

On April 5th, HAFA will become law, representing the Federal government’s latest assault against the depressed residential housing market. HAFA aims to provide options for homeowners unable to qualify for loan modifications through the Home Affordable Modification Program, or “HAMP,” which was the last government-backed foreclosure prevention initiative.

Indeed, the foreclosure epidemic in this country remains a pressing issue, as recent data indicate that more than five million households are behind on their mortgage payments, with almost three million households 90 days or more delinquent but not yet in foreclosure.

HAFA attempts to step in where permanent modification via HAMP is not a viable option, offering incentives to lenders, servicers and distressed homeowners in the hopes that foreclosures can be cut off at the pass. The primary mechanisms HAFA promotes are short sales, where the lender allows the homeowner to sell his or her home for less than the mortgage amount, and deeds-in-lieu of foreclosure, or “DILs,” where the homeowner hands the lender the keys cooperatively in exchange for the lender agreeing not to pursue back payments. These alternatives are believed to be less damaging to a homeowner’s credit.

While some homeowners will be assisted by HAFA, each group affected by the legislation could see unintended consequences that mitigate the program’s good intentions.

1. Distressed Homeowners
HAFA’s primary goal is to help distressed homeowners. Noble enough, but will the program be effective? First, to incentivize homeowners to cooperate in short sales, Uncle Sam (read: taxpayers) is offering a $1,500 payment for “relocation assistance.” This payment is on top of cash assistance lenders often provide short selling homeowners.

From our experience, however, the decision to short sell is not typically one that is easily swayed by $1,500. If the government wants to help homeowners start over, every little bit helps, but if the aim is to encourage more short sales, this amount of money is but a drop in the bucket and successes will be few and far between.

Second, and almost more important, it’s not even clear short selling truly benefits the homeowner in all cases. Even though the IRS revised rules which previously treated the forgiven loan as taxable income, many states are behind the ball. For example, in California, if a homeowner short sells his home for $400,000 with a $500,000 mortgage outstanding, at year end he could face $100,000 in additional taxable income. A proposed amendment to this law is in limbo because Governor Schwarzenegger has threatened to veto due to an unrelated provision in the bill. For those seeking to enter a short sale, tread lightly and seek tax counseling before agreeing to anything.

2. Lenders / Mortgage Servicers
HAFA also tries to further incentivize lenders and mortgage servicers (who collect payments and administer modification and/or foreclosure proceedings on behalf of lenders) to avoid foreclosure. Lenders and servicers receive a $1,000 bonus for each short sale and Uncle Sam (read: taxpayers) will cough up $1,000 to second lien holders in order to get them to play ball. Second lien holders can gum up short sales by demanding payoffs first lien holders aren’t willing to make. Washington hopes this token payment will encourage second lien holders to cooperate, but in reality a mere $1,000 may not be enough to coax second lien holders’ to take their lumps.

In addition to making short sales more palatable, HAFA makes the foreclosure process even more onerous than it already is. Additional notification to borrowers, a required HAMP review of each file and other hurdles to completing foreclosure aim to push more lenders in the direction of short sales or DILs.

3. Non-Distressed Homeowners
Some of HAFA’s major impacts, to the extent it is successful of course, will be felt by homeowners seemingly untouched by the legislation: Non-distressed homeowners.

While the government wants to delay foreclosures, short sales flooding the market could put downward pressure on home prices. For each successful short sale or DIL, that is one additional home dumped onto the market. Currently short sales are viewed by many buyers as not worth the hassle and that they should not be treated as true supply. If word gets out, however, that lenders are actually cooperating, short sales may lose their negative stigma and start to more strongly impact prices.

Mortgage-paying homeowners could see their property values continue to fall thanks to government efforts to speed short sales to market.

4. Once Again, Taxpayer Loss is Realtor Gain
No analysis of HAFA would be complete without mention of the National Association of Realtors, or NAR, which continues to demonstrate it’s lobbying prowess.

In addition to supporting the legislation because more short sales means more transactions and more commissions for Realtors, the NAR lobbied aggressively for the inclusion of a provision preventing lenders from lowering a Realtor’s commission in a short sale below 6% of the sales price. In distressed transactions, a 5% commission has become the defacto rule, a trend which, much to the NAR’s chagrin, is causing commission compression across even non-distressed housing markets.

Thus, HAFA hands lenders, servicers and homeowners taxpayer dollars, even as it mandates that real estate agents earn more money on each transaction.

So how will it all end? Ultimately, the aforementioned effects will only be felt to the extent the program is an actual success. Will small handouts across many transactions cause actual change?

Will HAFA promote Washington’s stated policy of propping up home prices? Will flooding the market with new short sales add to the backlog of distressed homes working their way through the system or fail and further delay the inevitable normalization of the market?

Time of course will be the true arbiter of the debate, but we’ll be monitoring the program’s successes … and failures.