Is The Housing Recovery Real?

true false From John Grant, Market Adviser...

By most accounts, the housing market is lurching toward a recovery. The evidence most often cited by experts and the media is the rise in home prices, especially in markets ravaged by the foreclosure crisis. Their facts are correct, home prices are ticking upward, but their conclusion that the uptick corresponds to a reality-based housing recovery may be optimistic.

The rise in home prices directly corresponds to new valuation methodology implemented several months ago by Fannie and Freddie to obtain a “fair” price for bank-owned or real estate owned (REO) properties. Previous methodology valued foreclosed homes as a percentage of broker-price opinion (BPO). In other words, a broker would submit an estimate of the value of a foreclosed property, and distressed buyers would usually pay between 80-85 percent to take the property off the hands of Fannie and Freddie.

New methodologies put in place by Fannie and Freddie have scrapped the BPO model and replaced it with a more fluid model that takes into account local market conditions and credit availability among other factors. In theory, this new methodology makes much more sense especially for communities most impacted by the foreclosure crisis, because the BPO model failed in areas where prices were in a freefall.

In reality, at least the reality at Fannie and Freddie, the new methodology for pricing foreclosed properties has led to an artificial inflation in home prices. Neither taxpayer-financed institution will dispute the fact that now, instead of taking a loss on foreclosed properties, they are actually making a profit in many cases. Before taxpayers rejoice, there are a few caveats that should be weighed.

A basic tenet of the housing market, or any market for that matter, dictates that a distressed asset sells for less than a non-distressed asset. If something must be sold, it sells for inherently less than its identical, non-distressed counterpart. Fannie and Freddie categorically deny this, and have successfully warped a market truism into a myth. The market reality of a distressed asset discount has been redefined as an “REO stigma”, as if calling it something else evaporates market realities.

The new REO valuation methodology could be utilized to provide Fannie and Freddie flexibility in an effort to sell off toxic assets. Instead, Fannie and Freddie are using the revised methodology to effectuate their own delusions that there are no such things as distressed assets and the housing crisis was just one big misunderstanding.

But the real question is who would buy enough foreclosed properties at an inflated value to actually tick the meter on the overall home price index? Or more simply, who is the sucker?

Enter Wall Street. Wall Street’s expertise on housing issues is best quantified by the $700 billion taxpayer bailout needed to keep the firms in business because of bad bets on the housing market. These institutions are now hungry to buy all the foreclosed properties they can and rent them out, an investment with no discernible exit strategy and fraught with additional substantial risks.

Washington’s shift away from failing government programs toward private market solutions to save homeowners, protect taxpayers, and create an organic housing recovery is a good thing. The inflation of REO valuations is not. A “recovery” based on inflated prices purchased by institutions in $100 million tranches cannot be considered real.

Inflated REO valuations are having an impact on small bulk buyers and small business that rehab houses. They are forced to overpay, and after refurbishing the properties, some banks are restricting when they can resell.

A recovery begins with a free market, free of price rigging and free of resale restrictions. But the most obvious and most pervasive risk of inflated valuations falls on taxpayers. If there is a market downturn or a broader economic dip, Wall Street will be stuck with over-priced housing inventory that it cannot unload.

Sound familiar?

While the new valuation methodology is not inherently flawed, its implementation as it pertains to REOs is myopic and may create a larger threat to the overall market. Congress should also study potential systemic risks posed by large institutional buyers of residential properties in order to protect taxpayers from another meltdown.

The Federal Housing Finance Agency (FHFA), which oversees Fannie and Freddie, has implemented several important new programs to help distressed homeowners and protect taxpayers. FHFA may wish to examine how the new methodology is being implemented as it balances short term taxpayer benefits with long-term taxpayer exposure.