Interview with Patrick Duffy of Housing Chronicles: “Everything Eventually Reverts to the Mean.”

Today we bring you an interview with Patrick Duffy of of the Housing Chronicles Blog. Patrick is also the Founder and Managing Principal of MetroIntelligence Real Estate Advisors, as well as a former Managing Director of Consulting with Hanley Wood Market Intelligence. Below, he shares his thoughts on housing prices, loan modifications, and the pros and cons of renting, among other topics.

Mortgage Calculator: I’d like to begin by asking you about your background. What made you decide to join the ranks of housing bloggers? How would you summarize your approach to the (current) housing market, and how has your background informed this approach?

I write my blog from the perspective of an economics and market research consultant to the building industry for over 20 years who has already been through one of these boom-and-bust cycles of the early 1990s.  During my career, I’ve worked for a lender, a land developer, a homebuilder, several real estate and land use consulting firms and now have a close working alliance with a company called Beacon Economics.

Many of the housing blogs I saw back in 2007 didn’t even pretend to be objective, only focusing on the bad news that would help the authors substantiate their theory that the housing market was certainly doomed (I think in part to help drive prices down to the point that they could afford to buy something in their local neighborhoods). Since I wanted to create a blog for the long term, I specifically avoided any reference to a housing ‘bubble’ or ‘crisis,’ and instead chose the very generic term ‘Housing Chronicles.’ Over time, I’ve expanded it to include coverage not just on housing, but also on commercial real estate as well.

My regular reading list is pretty comprehensive, including most major newspapers and a variety of magazine titles related to current events, politics, general business as well as real estate development, so when I have time, I like to cite specific articles I find interesting.

Before I entered the building industry, I studied Economics and Communications at UC San Diego, and in the late 90s I took a brief sojourn into the entertainment industry, where I worked at a movie studio in their advanced technology department and then also for an independent TV production company to learn how shows are produced.  I returned to the building industry in early 2000 as the Internet was starting to really change how new homes were marketed and sold.

I started my blog in November of 2007 after noticing that almost all of the housing blogs online were focused only on the housing bubble as well as to promote my company, MetroIntelligence Real Estate Advisors.

Mortgage Calculator: It seems both the housing bubble and its bursting have been characterized by important regional disparities, so it’s not really meaningful to make generalizations on a national basis. Do you think that the recovery, whenever it cements itself, will also adhere to this pattern?

Absolutely.  The areas to recover the first will be those that didn’t participate in the bubble in the first place, states like Texas or parts of the mid-West that still have sound economies.  The next areas to recover will be those that did have price run-ups but also have relatively strong economies and have barriers to more building, which are mostly located along the coasts with the exception of Florida, which is a basket case unto itself.

What will take longer to recover are areas popular for vacation homes and those markets that have served as bedroom communities for larger job centers in places like Los Angeles or the Bay Area and require a commute.  Here in California, that means the Central Valley, the low and high desert areas and much of the Inland Empire.

But you could still see submarkets within those areas gain traction earlier, including towns welcoming retiring Baby Boomers (at least those with money), cities that have embraced the type of industrial development which mean jobs, and counties which havefocused on providing transportation alternatives to the car.  After all, who wants to drive an hour or more to a bedroom community in which there are no well-paying local jobs, home values have tanked and the neighbors park on the lawn?

Finally, you have cities that were ground central for the housing boom but aren’t close enough to global pathway cities to bounce back as fast, such as Phoenix or Las Vegas and most of Florida.  And of course Las Vegas also has the distinction of being more or less a one-industry town which depends on the willingness of people to part with their disposable (one would hope) income.

We used to do demand studies in this business, but all that flew out the window when the bonuses for building homes in the short run became so compelling that building for the long term became irrelevant.  Now I’m hearing stories that many large public builders have not learned the lessons of the past – at least not at the divisional level where the land decisions are being made.  People are getting excited about land values rising again, but it’s not like that’s been the result of job growth or a strong economy –it’s largely speculative.

Mortgage Calculator: What do you think it will take for people to accept the notion that home prices don’t appreciate much faster than the rate of inflation, over a long-term period of time?

I think a huge housing bust that totally derailed their plans for the future took care of that!  But I think also this enormous avalanche of economic news over the past few years has hopefully educated people that they should be doing their own research on the pros and cons of homeownership and not leave it up to brokers, bloggers or landlords.  A simple phrase for all assets is this:  everything eventually reverts to the mean, which means that prices for homes, stocks, gold and even tulips eventually re-align with their long-term growth rates.  So, unless you’re an expert at timing those markets, it’s best not to speculate in them.

Fortunately, I just found out that “The Economist” is the most successful weekly magazine in the English-speaking world, so clearly there are millions of folks out there who want to be informed (including me).

Mortgage Calculator: We have seen the government’s role in the mortgage market expand greatly since the bursting of the housing bubble Between keeping interest rates low (via the Fed’s purchases of MBS), maintaining liquidity in the MBS market (by subsidizing Fannie and Freddie), and helping home buyers (via tax credits, loan modification, and the FHA). In your opinion, is this a welcome development? Do you think this involvement is temporary or permanent?

If you asked me in the beginning of the interventions, I would’ve said “Oh, this has to be temporary,” and I think most economists with an understanding of the Great Depression and other economic catastrophes agreed that some type of intervention was necessary to prevent the type of economic unraveling that took place in the 1880s.  But now it seems that elements of the government support may become more permanent.

Still, at some point we’re going to have to let free market conditions take over more, especially when it comes to housing demand, and that will be based on job growth, job mobility, incomes and population/housing growth.  For example, it’s pretty clear now that the tax credits simply borrowed housing demand from the future, in part because it allowed some borrowers to use that credit for down payments, so I don’t see why people are so surprised to see dramatic declines in pending home sales.

I think given the level of damage to the mortgage markets that we’re going to need government training wheels for at least a few more years, certainly in keeping rates well below 8% to avoid another rapid price drop, maintaining liquidity and propping up Fannie Mae, Freddie Mac and the FHA.  I don’t think we’re going to see a return of tax credits, but we may see government get more involved with the issue of principal reductions to avoid another avalanche of foreclosures.  I just hope that the political infighting we’re seeing in Washington, D.C., doesn’t derail what’s best for the country.  This is no longer about leaning left or right – this is about preventing economic damage that feeds on itself.

Mortgage Calculator: The data suggests that foreclosures will continue to rise. Do you think that government programs and lender initiatives will be enough to forestall this? Do you think that strategic defaults will continue to be a factor?

I think that while the loan modification programs provided an attempt to address the issue of rising foreclosures, they’ve turned out to be nothing more than a temporary Band-Aid.  When you have something like 70% of modified loans eventually defaulting, you can’t call that program a success.

Some economists and other defenders will say the banks aren’t set up to deal with loan modifications, or the servicerscan’t break the contracts with the mortgage owners.  Well, how did they approve the loans in the first place, osmosis?  No, each of them went to loan committee for final approval.  I think the contractual argument, while valid, is also a red herring that’s masking the real issue, which is that lenders and servicers didn’t want to invest labor resources in something that didn’t make them a certain profit.   And then the banks got bailed out by the federal government, and they really didn’t have a choice.

With that said, I do applaud Bank of America’s decision to add 60% more staff this year to deal with loan modifications – which they’ll certainly need after their acquisition of Countrywide, which aggressively pushed Option ARM loans during the boom years and will continue to fail in great numbers over the next couple of years.  But what took them so long?  It’s not like we didn’t have thousands of unemployed financial professionals eager for a job back in 2008 or 2009 – did they really have to wait for the train to jump off the rails this far before reacting appropriately?

I think the reason we have strategic defaults – which according to some estimates have accounted for as much as one-fifth of all defaults (and even higher for those with high credit scores) – is because people don’t want to continue paying for an asset that’s underwater.  It doesn’t matter how cheap the interest rate is and how far out you extend the payment terms, what matters is that people need equity  to sell their homes to move to a new job, to upgrade to a nicer home in a better neighborhood or even to downsize in retirement.  And the only sure-fire way to accomplish that is through principal reductions.

Lenders hate the idea of principal reductions, because it would mean an obvious hit to their balance sheet and opens up the door to all underwater borrowers demanding them, and not just those in default.   And yet they seem content with going the way of foreclosures, which forces them to realize up to 40% or more in the loss of a loan and also drags down the prices of all surrounding homes in a self-reinforcing cycle of negative equity.   Like a rebellious teen, it’s time for lenders to grow up, take responsibility for their past actions, and think of more creative solutions to the problems they helped cause.

In an interview with HousingWire, investor Wilbur Ross, who owns American Home Mortgage Servicing, thinks the answer to the housing mess is right-sizing every underwater home – something his own company has done and been rewarded with recidivism rates far below the industry average.  Here’s how his plan works:  (1) the lender takes a principal write-down, and the related servicer takes a similar hit on the reduced value of the loan; (2) The government guarantees half of the remaining principal the lender now holds; (3) The guarantee is sold to the securitization market, thus giving the lender an income stream on that portion of the balance and offsetting some of the losses incurred upfront on the reduced principal balance; and (4) When the house is sold, the homeowner and the lender share in the profits.

While it’s certainly true there are legal complexities involved – especially related to second lien holders and subordinated investors – I think it’s an interesting idea, and the fact that it’s been proposed by someone with a great deal of skin in the game merits some consideration.

The phenomenon of strategic defaults arose in the first place because lenders weren’t properly addressing the issue, having preferred to cross their fingers and pray that loan modifications work.  But I’m not a big fan of strategic defaults for a variety of reasons.  Firstly, they’re often pitched as a simple panacea to the same unsophisticated borrowers who also didn’t understand the Option ARM loan and other non-traditional mortgages, and all borrowers need to do is wait out the hit to their credit scores and everything will be sunshine and daisies.

But lenders – as well as Fannie Mae and Freddie Mac — are starting to institute new underwriting standards which punish people who had the means to continue paying but chose to walk away.  Potential employers also are increasingly pulling credit reports before making hiring decisions, and if they’re choosing between two applicants and determine that one simply walked away from an obligation, they’re likely to go with the one which didn’t.  Data from CoreLogic has shown that in most cases, underwater homeowners recoup their losses in 5 to 7 years, so for many borrowers waiting it out may be the best option.

Unless the economy takes another serious tumble, I think the rate of strategic defaults has crested, but it will certainly be a factor as long as there is substantial negative equity.  While there are certainly many cases in which walking away from an unaffordable mortgage is the best course of action, this really isn’t a decision that should be made with the help of a simplistic Web site.  Instead, talk to a credit counselor or financial planner, and write your elected representatives to push for a more aggressive principal reduction program so you don’t have to sell at a loss or move in the middle of the night to a rental.

Mortgage Calculator: I read an interesting report that essentially blamed the housing bubble (and subsequent collapse) on cash-out home equity loans, because such borrowers were infinitely more likely to default. What’s
your take?

I’ve not read that report, but what does make sense is that the more borrowers took out, the less equity cushion they would have when housing prices fell.  Again, it depends what they used the money for.  If they used it for vacations, or cars, or to pay off credit card bills, then they’ve done nothing to invest in the home itself.  But if they used it to remodel or to add a pool or to buy a second home for investment purposes, then in many cases they’d benefit from holding on and awaiting a rebound.

Of course the lenders are also to blame for this, as it’s not very smart to lend on an asset without factoring in a potential loss in value.   But if you’re talking about borrowers who deliberately maxed out a home equity line knowing they were going to skip out when the bill came due, then to me they should be legally liable, although proving it would be difficult.

Mortgage Calculator: Do you generally believe that renting is more economical (and more sensible!) than buying, even when the ratio of rent to home prices is more in line with long-term averages?

There are definitely pros and cons to renting, and I say that as a former renter, as a homeowner and as a landlord.  Renting is great for people who need flexibility and don’t want to be tied down to a particular area of housing situation, and is usually more economical than owning.   However, in many neighborhoods – and especially if you factor in the tax savings – owning can be more economical or at least break-even after including all the appropriate expenses.

And, in the long run, owning a rental property as a landlord can be a great way to slowly build wealth and have extra cash in retirement.   Sure, you could rent and put that extra savings away in a retirement account, but how many people are disciplined enough to do that?  If the answer was “most,” we wouldn’t need Social Security, would we?

But, like anything else, it depends on the home, the neighborhood, the rents and the prices.  Thankfully, today you can easily do your own research on both prices and rents and make an informed decision.  Just make sure that your return is competitive with what you could get from other investments.

Mortgage Calculator: How would you reconcile government and seller incentives and low interest rates with the possibility that home prices could fall further, when advising someone thinking about buying their first home? Would you advise them to buy, wait for a while, or wait forever?

I think it really depends on their situation.  I personally have a very simple test, which is this:  if you can’t rent out a home to cover your costs (mortgage, taxes, HOA, etc.) or at least come close, then don’t buy it.  But if you’re planning to stay in it awhile (i.e., 10 years or more), plan to become invested in the neighborhood and, should you have to move, you can rent it out and cover your costs (and that can become tricky with some condo HOA rules), then why wait?  With that said, however, I don’t think anyone should be in a huge hurry to buy something, as when housing prices hit bottom – and they already have in some markets – they’re going to stay there for awhile.

Sure, interest rates will certainly rise down the road, but housing prices could also fall another 10% to 15% in certain markets to counteract the recent bumps resulting from government intervention.  I think you’ll get a much better picture of where the economy really stands in 2011, as it will take most of 2010 for the government stimulus dollars to work their way through the system.

Beyond 2011, I don’t think we’re going to see the type of strong economic growth that will put rapid, upward pressure on housing.   We’re in a global economy now, so the old rules about wages bouncing back after a recession don’t apply in the same way anymore. However, if you start to see inflation kicking in a couple of years down the road due to the government printing money to prevent another meltdown, then prices for all hard assets – including housing – will begin to rise, so at that point you might want to jump in.

During times of inflation, having fixed-rate debt such as mortgages is a great hedge against rising prices.  But during times of deflation, it’s a financial albatross, and that’s why the Federal Reserve will do anything to prevent the type of deflation and stagnation we’ve seen in Japan.  After all, if the economy tanks, it doesn’t matter how large the federal debt rises, because we won’t be able to service it.