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Sunday, October 15, 2006 10:47 PM

Kool Aid & Krispy Kremes

Mish Moved to MishTalk.Com Click to Visit.

I asked Mike Morgan at Morgan Florida if he had an update for us.
Here it is. It is something quite different too.

Mike Morgan:

With so many “experts” out there singing the praises of the housing market, I think it is time for me to once again poke my head out. I had an email exchange this week with Jim Cramer, and it was hard to believe he is as bullish as he is. I hear from too many analysts and Wall Street gurus that don’t take the time to get out of their offices and get on the front line here in Florida, as well as Arizona, Texas, California, Virginia, etc. I also hear from the analysts and hedge fund managers that are visiting the corporate offices of the big builders. Unfortunately, they’re drinking the Cool Aid. It’s potent stuff that clouds rational thinking and it is probably just what is needed to wash down a few hundred stale donuts.

Do you remember my analogy of housing to donuts? A year ago I said this was like the room of 1,000 donuts. Even if they are warm Krispy Kremes, how many can you eat? Three? Maybe four? And even if you come back the next day, and the donuts are now half price, how many can you eat? Same thing with housing. We only have so many people in the US. But builders built houses like donuts. They sold houses to non-users. They sold houses to the greedy masses that bought multiple houses to flip. Now we have the inventory, but there are not enough people to occupy these homes. Moreover, with interest rates rising and mortgages becoming tougher to obtain, we have less and less people that can buy these homes, even if they want to.

Since my recent article in Barron's, I have received dozens of calls from builders, bankers, buyers and investment groups perched like vultures. Let me give you a sampling of a few calls.

Public Builder - Called me to find them bulk buyers with the ability to buy out all remaining units in developments they cannot sell. They are willing to sell at cost. I told them they were about 10% over the current distress market, and they didn’t even hesitate. They said, fine. Drop the price 10% and we’ll pay a 5% commission to you. Just help us get rid of this inventory.

Condo Developer - They have a 600 unit project that is 100% up for resale. This means no one is going to close when the building is completed in January. Every single buyer will walk from their 20% deposits. The developer will simply going to turn the keys over to the bank. And the bank will take a massive hit that will have the Feds on top of them in the blink of an eye.

Townhome Developer - Asked me to resell 132 units that they had sold a year ago for an average of $400,000 a unit. All of their buyers have notified them that they will not close. Unfortunately, even a year ago in the heated market these units were only worth about $250,000. Now, the units will not command more than $175,000 . . . if they’re lucky.

Real Estate Agent - She sold 10 of the 132 units I just mentioned to her friends, family, banker and co-workers. They’re all going to walk away from their $40,000 deposits, so they don’t lose $250,000. The developer will be stuck with 132 units that are not worth what it cost to build them.

Homeowner - This one really hurts, and this is the next wave of the massive tidal wave hitting this industry. As surfers know, the third set is the biggest. This homeowner purchased her home for $390,000 plus $15,000 in closing costs. It is now worth maybe $300,000. Their interest only ARM is scheduled for refinancing. The bank told them they need to come up with additional cash to cover the drop in equity. But they don’t have the $75,000 the bank wants. And even if they sell for $300,000 and clear $280,000, they can’t pay off their $390,000 mortgage balance. You see, their mortgage was 100% and it was interest only. They are going to walk away from the house and give it to the bank. The bank, if they are lucky, will sell the house for $300,000 less commissions and expenses. Maybe they will net out at $280,000. The math is simple. The bank, at best, will lose at least $110,000 on a $390,000 mortgage. That’s a 28% loss . . . IF they can sell at $300,000. Back to the donuts. Maybe they can sell a few of these homes at market prices, but as foreclosures mount, prices will drop further.

The Third Wave - This massive tidal wave will effect all aspects of our economy. Some banks will fail. Other banks will suffer the worst liquidity crisis since the Depression. And there is no way to stop this wave. This wave not only effects current mortgage holders who can no longer afford to live in their homes, but it devastates the new home market. Buyers with contracts are finding it tougher to qualify for mortgages. We can’t forget that rates are also up about 18% from a year ago, so buyers cannot afford the same home they could have a year ago.

I will wrap up with a statistic from a recent FDIC presentation.

“Bank exposure to mortgage and home equity is now at peak levels, having risen dramatically. If you look at 1998, the total exposure to mortgage and home equity loans was about 25 percent. In the last quarter, the third quarter, it had risen to 37 percent.”

And here’s the why this tidal wave is a killer. The 25 percent exposure was during a period of rising home prices and low inventory levels. The 37 percent follows the first two tidal waves of the highest inventory levels in the history of the United States and prices falling with equity disappearing daily.

I sold three homes last week for one public builder. Each of these homes sold for 40% less than the same homes sold a year ago. How about all of those neighbors when it comes time to refinance? The appraiser is going to look at current sales prices, and the bank is going to ask for additional funds to meet the equity requirements. Ouch. Where’s the Kool Aid?
Let's take a look at Scenarios for the Next U.S. Recession, a PDF put out by the FDIC in conjunction with Meredith Whitney, Executive Director, CIBC World Markets, a subsidiary of Canadian Imperial Bank of Commerce.
Bank Exposure to real estate.

Bank exposure to mortgages and home equity is now at peak levels, having risen dramatically. If you look at 1998, the total exposure to mortgages and home equity loans was about 25 percent. In the last quarter, the third quarter, it had risen to 37 percent.

Yes, the above chart is slightly out of date but the accompanying text was not. All in all the article is one of the best reads on the current mortgage mess you can possibly find.

The conclusion to the article is that we will have a "segmented consumer recession that will impact 10% of U.S. consumers". I dismiss such a limited impact because it does not address a rolling cascade of layoffs that I believe are coming as a result of the housing slowdown. Nonetheless the case is presented extremely well along with charts and data that everyone can use to draw their own conclusions. Time will tell which scenario is correct.

Mike Shedlock / Mish

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