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Real Estate Leverage



In my recent housing bubble debates, the point of impasse is usually reached when I suggest that housing prices are being fueled by a binge of speculative borrowing, and my "opponent" argues that the existing demographics and demand/supply imbalances are driving the valuation parabola. In an effort to break the stalemate, I have pulled together data from the Federal Reserve relative to real estate assets and liabilities on the balance sheets of households and non-profit entities. (I could not find data just for households, but the non-profit figures are relatively nominal and they do not impact my thinking). My goal is to put some numbers behind the idea that, regardless of why prices are going through the roof, the risk proposition behind the recent residential real estate mania has created an environment where, should a bust occur, it truly would be "different".

A basic charting of the data shows that through the last 2 boom / bust periods (let's call them 1980 and 1990), absolute changes in RE values and liabilities have been fairly correlated to each other, with absolute RE Net Worth showing Y/Y increases - except for 1990 - mostly as a function of the bigger equity base relative to liabilities. It is my sense that this data - or permutations thereof - are usually at the core of the bullish argument, i.e. "there is no problem because for the last 30 years increases in RE liabilities have been more than offset by increases in RE asset values.

In my view however, such argument dances around the red flags. The more relevant question should be how the rate of growth of RE assets has stacked up against the rate of growth of RE liabilities. If asset growth results in an even faster rise in liabilities, the investment grows riskier and riskier. If one accepts this proposition, then the numbers are not nearly as rosy. From a leverage perspective, ownership of residential real estate is indeed taking the participants down a scary path.

The focus point for this risk assessment (if arguably not the most telling) is the parabolic increase in absolute mortgage debt.

I describe it as "not most telling" because it is usually paired with the chart of the absolute values of RE asset (Chart 4), which looks even more parabolic.

Nonetheless, I think we can all agree that $8 trillion here, $8 trillion there and pretty soon you are talking money. The perils become somewhat more transparent when looking at the Debt to Asset Ratio.

Aside from its steadily rising trend and its current all-time high level of 40% plus, this graph gives the first hint that the speculative leveraging that took place between 1985 and 1990 inflicted the bulk of the pain on the balance only AFTER 1990 when Asset values hit the wall. The same proposition becomes more obvious by looking at the chart below and the underlying data series, which indeed show that the pain of leverage did not manifest itself until asset prices fell out of bed.

While the above might be stating the obvious, there are qualitative aspects to today's environment that magnify the risks relative to the 1990 bust. Indeed, not all busts are created equal.

First, the 1990 debt-laden collapse was very different from the 1980 debacle, which stemmed from rising interest rates (liquidity drain) and actually resulted in a de-levering of balance sheets.

Second, the 1990 residential real estate problems, at least as I observed them from my bankruptcy practice post, were a mere by-product of the commercial real estate collapse. Toward the end of that mania people were borrowing against their homes to jump into the latest and greatest commercial real estate L.P's. The REAL leverage was in the commercial market itself, where 80/20 cash-out refis for towers in the desert were no-brainers, and where the subsequent collapse took valuations down to "bid-wanted levels". Amongst the LENDERS the desperation was such that they were opting for work-outs resulting in 50%-70% write-offs rather than being forced to foreclose on buildings which they viewed as being worth even less. Today the residential market is in the forefront of the leverage insanity, while the commercial market - from a capital structure standpoint -remains fairly healthy.

Third, the 1990 collateral damage to the residential market was somewhat contained because many of the commercial loans were non-recourse. In other words, the failure of the commercial real estate venture did not necessarily impact the individual's cash flow. Maybe 110% , No-Doc, interest only, 3-year ARMS are the precursor to non-recourse residential mortgages (except for Aunt Fannie (FNM) and Uncle Fred (FRE) of course), but so far everyone with a mortgage is personally on the hook.

Fourth, the 1990 commercial disaster was cleaned up by the government intervention through the Resolution Trust Corporation. While Fannie and Freddie are supposed to serve as the residential equivalent of the RTC, stress testing FNM's balance sheet right now may not be at the top of Elmer's retirement wish list.

Fifth, for at least the last 3 years, homes have functioned as sources of supplemental disposal income, which has served as no small crutch for the economy as a whole.

Lastly, back in 1990 10yr rates were in the 8's not 3.9% which gave the Fed a lot more "printing" room.

None of the above answers whether today's speculation is driven by debt binging or demographic shifts. And none of the above matters because right now everything is just groovy; if Hoofy and Boo can agree on anything it is that when all is well nothing matters.

But both quantitatively and qualitatively, there is little doubt that the environment is a ticking time bomb. Should property values take a dive, the absolute debt levels, the relative leverage, the sudden loss of supplemental cash, the relative instability of the government safety valves, and - in my opinion - the psychological blow of seeing "a sure thing" morph into a gigantic debt albatross, could easily result in systemic problems.

As Prof. Succo so aptly put it a while ago, we can't tell how dead or alive the "housing cat" is. But we can say with fair certainty that it has already borrowed all of its nine lives.

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