Bruce Norris is joined this week by Gary Watts. Gary is the broker and owner of Impact Real Estate. This is a private real estate company that provides consulting services to not only buyers, sellers, and investors, but also to companies affiliated with the real estate industry in California. Gary is a well-known real estate economist who began his career in 1971. Today, he and his company are called upon to advise the home industry of economic trends that will affect and effect their future impact on real estate. He also manages investment properties that they acquire for their investors.
Bruce took a look at his starting year in 1971. For somebody who pays attention to trends, that was really prior to real estate being something other than a residence. It was just lived in, and California’s median price was within 10% of the national price. All of a sudden in the mid-70s the spread happened. We have lived in interesting times. Bruce got into the business in 1980. As Gary was in the business a whole decade him, Bruce wondered about the gasoline that took the price in the mid-70s upwards of almost triple by 1980-1981. Gary said the main cause was the explosion in the baby boomers. The industry really got caught short. It was surprising because in this generation there was a shortage of diapers and overcrowding of the elementary schools and high schools. They should have known that when the colleges were bursting at the seams, these highly educated people would be coming into the marketplace.
Demographics had not been figured out yet. The big turning point was that women were graduating out of college and finding jobs. For the first time, married couples were duel income earners. What was also interesting was that interest rates were not a help. In 1972 he wrote 7% on the deposit receipt and was able to leave it there for a whole year. Now you can write 4 ½ and could leave it there for 4-5 years. What he is speaking about is anyone joining in the industry in the last 4-5 years has no experience with volatility. In 1980, the Fed fund rate changed 21 times. If you are in escrow for 45 days, you could have had three interest rate changes for your borrower.
This was probably the beginning of interest rates being monitored on a daily basis. What was interesting was we were still able to move up in price, and interest rates went from the 7 ½ range in the mid-80s to around 17 ½. When Bruce wanted to be an investor in 1981, this was the fixed rate. They had a price increase that was pretty strong until the 1980s. We were coming off of the inflation era years; and because of this in the early 80s developers were paying the prime rate of 21 ½ plus 3 points. They were paying 24 ½ percent to finance their projects. People did not seem to mind too much getting a 17% loan if the real estate market was going up 21%.
Back then, Bruce also remembered a statistic he looked up in CAR about 60% of sales in 1981-1983 not needing a new loan origination. They took over existing financing and assumed it took over subject to or was a blended rate. That was the only way that real estate market survived through the existence of low-interest rate financing on so much of the inventory that sold. Gary said we were in a recession then too, and because of that the sellers were stuck and were willing to wrap the loans and carry back paper. It was probably a big introduction to the AITDs in the other creative financing department. Bruce thought it might be a good help if they had remembered some this in 2009-2011, but we didn’t.
Bruce asked Gary what has surprised him since 2007. Gary said what surprised him in the beginning and caught a lot of this off guard was we did not really understand how Wall Street was fractionizing the loans. This is a very key point. At the time in 2007, you could have asked Bruce if he knew what a mortgage-backed security or collateralized debt obligation was, and he would have said no. He had not borrowed money in a few years and did not realize at the time. He remembered doing an interview in front of an audience and spoke to a lender. The subject was stated-income loans, and he asks where the number originates. She said in front of an audience of 400 people that they just make it up. This is a problem because the other side doesn’t care. This is the only conclusion you can make. The vehicle by which they did not care was they did not own the loan very long.
This is what threw us off since we knew the first signal was the sub-prime loan. People highly leveraged in those instruments, but they were only 3% of the market. Everyone said this was not going to affect us too much since it was such a small percentage of the mortgage market. We did not realize that Wall Street was splitting these things into all different types of tiers and selling them off to investors all over the world. When the market started collapsing and you went back to the servicing agent to negotiate it out, they could not do it. They had too many ownerships with too many different peers and responsibilities.
This is why so many homes went into foreclosure. It definitely had a domino effect to all kinds of loan programs. Whatever loan program that was affected happened because they were getting appraisals on legitimate comps. They were loaning to people even with legitimate qualifications much more than they would have had to if prices had not been pushed by this extra volume. After things hit the fan and a huge amount of foreclosures, Bruce wondered how important government intervention was. His original reaction was he hoped they would leave it alone, but looking back it may have not been a good outcome. The government can mess things up here. They had no less than 12-13 different save your home programs, modifications, HARP 1-3. It was just ridiculous.
Back in the 80s we had the S & L scandal. Those savings and loans that were operated by people that had really just gotten into the business 4-5 years earlier and did not know a lot about banking. This messed up the loans here. The FDIC came in and said they were going to clean everything up in two years. They took over the properties, sold them off, and got in and out. The government Mickey Moused the system for so long, and he has been waiting for someone to add up the total tally of the lawsuits to the major lenders, what the lenders took on hits in terms of short sales, and how much the government spent to try to save housing. We could have given every homeowner $30-$40,000 to weather through this on our own.
Bruce’s original thought was, first, there were a lot of people who exaggerated things on their application. He does not know if we have learned anything from the recent experience or if many people get on the other side of it and say it was their responsibility. He does not know if any of this has been learned. This is one of the inherent characteristics of mankind. When they started doing reviews, they found out there were teachers and gardeners making $130-$150,000 a year. We created a system where it really did not matter as long as no one held the bag at the end. We found out we all held the bag collectively at the end. This was a much bigger problem. We keep referring to this downturn as a great recession, but for our industry it was a Great Depression. When you lose almost 40% of the value of your asset, that is a Depression. Gary is in Orange County, where they have more stability and assets behind some things.
In the Inland Empire when it got to its worst, we were buying properties where lenders were taking 80% hits on their loan amounts. It was a case where they did not care if you did not want an offer. There are 20 more like it listed next door. Bruce looked at this and kept asking how you can take a $240 grand loss on a $300 grand loan. How long does it take before this puts a dent in anything? This is what was happening at the time. For notices of default, there is usually a conversion to a notice of sale a certain percentage of the time, especially when you get into bad times. Bruce was looking at where we were at the trustee sale numbers and projecting what would happen if the NODs convert. We would literally have four years of inventory in the Inland Empire in the MLS. We already had 20 months, and it was ridiculous.
When they stopped foreclosing and created other problems, they at least said they were not going to end up taking $.20 on the dollar forever until they were done. Bruce does not know if we really know the outcome since what Gary said is true. Bruce asked what the final price tag is for all of this. One of the things they have had the privilege of going back and addressing with Fannie and Freddie is loan programs for investors, which they never really decided to be generous. He got the sense even back then that he felt they were really closing, it was just a matter of time.
Bruce asked Gary if he thought they served a function or if they should downsize and get rid of them. He said he had mixed feelings about it. You cannot get rid of them unless the private sector takes over. However, these things cost so much money they are not in a position to move into that marketplace. The number starts with a T, and not a B. When you have the private funds that put together money and they want to buy 1,000 houses, the number they raised starts with a b, a billion. It was not $100 billion, but rather $5 billion. When you are loaning to residential real estate, you better have a trillion. He does not know if this is so easily replaceable. It is really a commitment to say you are not going to emphasize housing anymore. Their mantra is they are trying to shore up all their other bad loans they have, and housing is not as exciting to them as it was back in the 70s and 80s.
Bruce remembered sitting in front of one of the top guys at FHA, and he had a quote during one of his talks. He basically made an equivalent statement to our view to renting an affordable home and afford to buy one on the same level as importance. Bruce thought this was quite a change. Part of their discussion was Bruce did not think it was a good idea to do this. We do not want to say it is all the same. Gary would know this having watched people own property. He talks to people and really influences a lot of people’s decisions. A lot of realtors listen to him every year that he speaks. They have clients and literally put their presentation on his website. This was something he started doing many decades ago, so he just told them that if they wanted to use it then use it.
This is a lot of responsibility for Gary. Bruce knows he definitely cares about getting it right, and people do not get it right all the time. However, there are a lot of people who make decisions based on his conclusions. This is a heavy thing to have. When times are good, they all flock to hear what is next and thank him for making money for them. When the time is turning bad, then he can start off saying “the party is over.” Back in 1989 he said these same words, and they threw wads of paper at him. He had to tell them they were coming into another recession. What people really need to realize is that so far every decade we have not escaped a housing recession or a hit. In the ‘70s we had the doubling of the price of oil due to the Vietnam War. This led to the inflation that was discussed earlier, and this brought down housing. You then had an S & L scandal that brought down housing. In the 90s you had the defense cutbacks when the Berlin Wall came down. This really hurt, especially for Southern California region where we were getting 1/3 of all the defense contracts. When the Berlin Wall came down and the Cold War was over, they were laying those people off right and left.
These were not small employers. They were laying off 10-15,000 people in Southern California per industry. In Riverside and Moreno Valley there was a huge vacancy rate because of that. We were buying properties back then at $30 grand. This was in the 90s, and we know what happened in the 2000s. This now brings us up to what will happen in this next decade from 2010-2020. What is interesting is they have given the same result but different reasons that have always been increased in velocity as far as damage. It has come from a different direction each time. In the 70s it was just barely two years, and in the 80s it was 3 ½ years. Later in the 90s we went up to 4 ½ years. This time, we were over 5-6 years on the downsides. These seemed to get progressively longer each time. More intense to relationships on foreclosing on properties between ’81 and’84, it gets to be a certain percentage of the market and prices remain stationary.
After ’89, you had foreclosures and trustee sales that were not bought by third-party bidders. You did have gradual price increases, and this last time after 2007 they became the dominant inventory. This is really one of the things he looks at for a damage path. He sees what percentage of the inventory is not going to be able to say “I do not want this price.” In a way, this is what the market was saying. When you had 100 properties in Moreno Valley in 2009 without a kitchen, the lender could not say he wanted 300 because he is owed 340. You could give $68 grand and take it or leave it, then eventually they would call you back and say they will take it. The problem was that the appraisal world was under the gun too. Now you have 6 comps without kitchens, you fix one up, and get 20 offers for $120 grand and can’t prove it.
The government got into the appraisal business, and we can partially understand why. An in-house appraiser with an in-house lender had a lot of freedom. A lot of the listeners may not know what went on behind closed doors; and it was usually the manager who would be yelling at the people for not making more loans. It was because they could not get the appraisal, so he would tell the appraisal department to loosen up and they need money. The appraisers would get loose, the loans would flow in, and everyone was happy until the dime turned. A lot of this was self-inflicted and the industry definitely did not have its own checks and balances. The people at the top should have reigned in some of the habit. However, it is hard to do this when greed and money is flowing. You just think this is never going to end.
A lot of smart people with good intentions thought this was true. Barney Frank is on recording as saying this is someone’s house we are talking about and they are not going to lose it in huge quantities of numbers. It was almost like the end of that sentence could have been like one of those thick guns they used for races. At about that same time, it was the end. It came down to too much generous financing, which we have skewed all the way on the other side where getting a loan has been a lot more challenging and sometimes impossible. There were 100 economists who got together to talk about why real estate is still in the doldrums. He found one of their main points to be frustrating. It got back to affordability, which has naturally declined since prices have gone up and interest rates have increased. Naturally, if you look at the math people can afford less house; or if they could barely afford it before they now cannot afford it at all.
Gary said being in Orange County, they have always had an affordability problem. Decade after decade it has occurred and yet they still have the buyers. This is one of Bruce’s pet peeves because the assumption is that it is a math equation. As both Bruce and Gary know, during bull runs it is not just a math equation but also an emotional cycle. People and lenders join, drink the same kool-aid, and want one even worse than before. They also have more equity, so the affordability formula is counting on you putting 20% down. However, when you have 100% price increase, it is not very common for people to put down a little chunk. They put down a big chunk.
The nice thing about charts is they completely defy logic, and you have to ask why something happened. As affordability declines, specifically looking at 2000-2005, volume goes up every year. The same thing happened between 1986 and 1989 as well as 1976 and 1979. When you give Bruce a math equation and say why something happens, yet every chart he ever looks at says it is wrong, then you go to the other side of the equation and you see we were having to pay $8 grand to people in 2009 to induce them to buy a house. The affordability was off the charts; it had never been higher. Affordability has nothing to do with the ultimate decision to buy or sell. There has been a natural ending affordability, and this is a number Bruce respects.
When we hit a repetitive number for the state of California, he looks at it and takes it seriously. He thinks that at this point, enough lenders simultaneously say no to a very willing buyer that the market stops. When you look at charts, all the damage comes after affordability lows, but not on the journey down. When you are talking to an audience of realtors in 2003-2005, the audience got bigger and more excited and their buyers did the same thing. This is a pretty natural cycle, and this is why Bruce likes charts.
In the next segment, Bruce will ask Gary’s opinion about the future. When you go to a wrong answer and say it is the right one, you never take the time to find the right one. Tune in next week as Bruce continues his discussion with Gary Watts.