The big news this week was the introduction of regulatory reform of the financial services industry. I hope they get it right. Calculated Risk has a great overview of the reform proposals. It contains links to many documents including the governments white paper on the subject.

We have been updating and expanding our library and knowledge base. It is a work in progress.

In the two and one-half years I have been writing for the blog, I have completed many detailed analysis posts. The complete list can be found in our Analysis section (soon to be renamed Library). The goal is to organize all of the posts into different topics so finding them is easier. Also, I plan to add links to outside posts and academic papers people may find interesting related to the topic. Another project I am working on is to document the collective wisdom of our forums. There are a number of frequently asked questions that have been discussed at length in the fourms. This library project will be ongoing, and I will incorporate additional data as I find it or generate it myself.

The vision of the IHB has always been to be a free resource providing real estate education to everyone. The development and expansion of our library is part of our ongoing committment to provide you with the information and analysis you want. If you have any comments or suggestions, please let me know.

Back when I started writing for the IHB, we used to get about 500 visits a day. Now we get about 5,000. As I was setting up the library, I came across one of my early posts that I had forgotten about. It was one of my more creative efforts, so I thought I would revisit it here today. If you missed it the first time, I hope you enjoy it. From May 21st, 2007:

The Day the Market Died

So, bye-bye, Miss American Pie
Drove my Chevy to the levee
But the levee was dry
And them good old boys were drinkin’ whiskey and rye
Singin’ this’ll be the day that I die
This’ll be the day that I die

Don McLean – American Pie

One of the hallmarks of a great song is its ability to be interpreted in different ways. American Pie is an allegory of our times, an ode to the death of our housing market.
With leverage drying up, the party is over. The last drink is for the
death of the market itself, and with it’s death, the death of the
American Dream of home ownership for thousands of overextended
homedebtors.

When a bubble in a financial market pops, it doesn’t explode in
spectacular fashion like a soap bubble, it is more comparable to a
breached levee which releases water slowly at first. Once the financial
levee is ruptured, the equity reservoir loses money at increasing
rates. It washes away the imagined wealth of homedebtors everywhere
until the reservoir is nearly empty and the torrent turns to a trickle.
Ultimately, the causes of failure are examined, the financial levee is
repaired, and the reservoir again holds value, but not until the dreams
and equity of homedebtors are washed away.

New Century Financial

Do you recall what was revealed
The day the music died?

The poster child for the great residential financial bubble of the
00’s will be New Century Financial. The date of their financial
implosion will be regarded as the Day the Market Died. The
death of New Century Financial will come to represent to death of loose
lending standards and the beginning of the cycle of credit tightening
as I described in my last post, The Anatomy of a Credit Bubble. Many people currently see the elimination of sub-prime lending as being the problem. It is much larger than that. It is the changes in behavior caused by loose lending standards epitomized by New Century Financial that will be the undoing of the housing market.

100% Financing

The most damaging change in buyer behavior was caused by 100%
financing: potential buyers quit saving. Once 100% financing became
widely available, it was enthusiastically embraced by all parties: the
lenders suddenly had a huge source of new customers to generate high
fees, the realtors and builders now had plenty of new customers to buy
more homes, and many potential buyers who didn’t have savings were now
able to enter the market. It seemed like a panacea; for two or three
years, it was.

Now for ten years we’ve been on our own
And moss grows fat on a rollin’ stone
But that’s not how it used to be

There is a problem with 100% financing (which was masked by the
rampant appreciation brought about by its introduction): high default
rates. If you want a glimpse into the irresponsible mind of a typical
100% financing borrower, go read the post and comments in Update: an FB situation 14 months later. The FB stated in the comments,

“However, I take exception to the idea that I’m taking
food out of someone’s mouth by sticking the bank with the loss. An
appraiser made the valuation, and I got a loan. No one forced New
Century to give me the loan to buy the house, but they did. They
confirmed the value, and thus, assumed all risk, especially since I
went no money down with an, at the time, 720 mid-FICO, and the wife as
well.”

This borrower signed papers promising to repay money to New Century.
He gave his word. How does it follow that New Century took all the
risk? How does the presence or absence of a downpayment impact whether
or not a borrower will live up to their commitments and
responsibilities? We all know the answer: When people don’t put their own money into the transaction, they don’t feel responsible for what happens. At one point, the FB was celebrating, “I was planning on claiming insolvency to the IRS through my job loss, anyway, but they didn’t even give us a 1099!” Does it make you want to turn him in?

The courtroom was adjourned
No verdict was returned

The more money people have to put in to the transaction, the less
likely they are to default. It is that simple. Taken to its extreme,
100% financing becomes the ideal tool for fraud. The FB from above
probably intended to repay the loan when he got it, he just didn’t feel
much of a sense of responsibility to the loan when the going got tough.
People who commit fraud have no intention of repaying the loan from the
start. Fraud is much easier to commit with 100% financing because the
bank will loan you the full amount of an inflated appraisal. It is much
harder to commit fraud when the bank will only loan you 80% of a
property’s value.

The point here is not about being irresponsible or committing fraud,
it is about defaults. High loan-to-value loans have high default rates;
this will cause 100% financing to disappear, and it will make other
high LTV loans much more expensive, so much so as to render them
useless. OC Fliptrack documented the elimination of the 100% LTV loans
at HSBC. It is all part of the ongoing credit tightening cycle.

The problem for the future housing market created by 100% financing
is that people quit saving money for downpayments. People respond to
incentives. This is basic economic theory. The availability of 100%
financing removed the incentive to save for a downpayment. People
responded; our national savings rate went negative as people stopped
saving and borrowed instead. This is going to create a huge problem
going forward: nobody has the newly required downpayments.

Elimination of Entry Level Buyers

Oh, and there we were, all in one place
A generation lost in space
With no time left to start again

People who currently own entry level housing (2 bedrooms or less and
small 3/2s) are bagholders. With the elimination of 100% financing,
they have missed their chance to sell to a greater fool. Even if these
fools were still out there (they have been decreasing in number), they
no longer have the ability to borrow all the money required to buy, and
they have no way to make up the difference. The entry level market was
destroyed the moment 100% financing was eliminated because nobody has a
downpayment.

Collapsing from the Bottom Up

The players tried for a forward pass
With the Jester on the sidelines in a cast
Now the half-time air was sweet perfume
While the Sergeants played a marching tune
We all got up to dance
Oh but we never got the chance

Housing markets collapse from the bottom up. The
first sign of a troubled real estate market is a dramatic reduction in
volume. This is particularly pronounced at the lower end of the market
for reasons outlined above. Since the lower end of the market has a
more dramatic drop in volume than the top of the market, the median
stays at artificially high levels which is not reflective of pricing of
individual properties in the market. In other words, things look better
than they are.

The graphic on the right (borrowed from Calculated Risk) shows the
problem when the entry level is eliminated. For a more detailed
analysis, please read Why the Sub-Prime Meltdown is a Problem.
As the problem at the entry level becomes more serious, more and more
transactions higher up the house chain fall out of escrow. Volume
plummets, and the whole market seizes up. That is where we are today.
There will be no summer bounce this year.

Helter Skelter in a summer swelter
The birds flew off with a fallout shelter
Eight miles high and falling fast

Eight Miles High and Falling Fast

The market will not stay seized-up forever. Many bitter renters have
complained about greedy sellers, but it isn’t the sellers who determine
market prices, it is the buyers. Think about this: what if every seller
in the market decided they would not sell for less than $10,000,000?
Would houses suddenly become worth $10,000,000? Of course not because
no buyers could afford to pay that much. Buyers determine the market
price by putting in competing bids. Sellers can decided to accept or
reject the highest bid. If all bids are rejected, there is no market
because there is no transaction.

Buyers are never forced to buy, it is always a choice; however,
sellers may face circumstances when they are forced to sell. Over the
past several years, greedy buyers motivated by rising prices and fueled
by loose lending standards were able to bid prices up to ridiculous
levels. None of them were forced to buy. The exotic financing was not a
result of high prices, it was the cause of high
prices. Those of us who are financially conservative and do not wish to
take on debt under terms which will put us into bankruptcy have been
competing with those afflicted with Southern California’s Cultural Pathology. It is a competition we were all better off losing.

Now the tables are turned. The once greedy buyers are becoming
desperate sellers, their dreams of riches from perpetual appreciation
in tatters. Many will be forced to sell due to their inability to make
their mortgage payments. Those that hang on will be homedebtors with
50% or more of their income going toward paying off an asset which will
be declining in value. It is not a set of circumstances I envy.

Prices will fall. We will see weakness at the bottom first, but it
will work its way through all market strata. It is only a matter of
time. Will you remember The Day the Market Died?

A long, long time ago…
I can still remember
How that music used to make me smile…

I can’t remember if I cried
When I read about his widowed bride,
But something touched me deep inside
The day the music died…

I met a girl who sang the blues
And I asked her for some happy news
But she just smiled and turned away
I went down to the sacred store
Where I’d heard the music years before
But the man there said the music wouldn’t play

And in the streets the children screamed
The lovers cried, and the poets dreamed
But not a word was spoken
The church bells all were broken
And the three men I admire most
The Father, Son and the Holy Ghost
They caught the last train for the coast
The day the music died