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October 25, 2008

Roebling was a Distant Relative

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Originally uploaded by Oliver Ryan.

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Posted by oliver at 04:50 PM

Visiting the Brooklyn Bridge

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Originally uploaded by Oliver Ryan.

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Posted by oliver at 04:48 PM

Sonali and Alexander Visit from Brussels

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We went to the New Museum to see the Elizabeth Peyton exhibit.
Originally uploaded by Oliver Ryan.

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Posted by oliver at 02:23 PM

October 17, 2008

A Borrower and a Lender, Be!

The following was originally published in the spring of 2004. At the time, I was in my final semester at the Columbia Journalism School, and taking a magazine writing workshop with John Bennett, the grumpy, wonderful veteran New Yorker editor. For the class, we had to do one long piece, and I chose to focus on the then-booming real estate market, and the question of a looming "housing bubble." John didn't seem overly enthralled by the piece at the time, but, looking back, I'm quite proud of how (for better or worse) my thesis has stood the test of time. Some of this is dated, but should you still be fuzzy on what's going on in the global economy, the following could actually prove helpful. To spice things up a bit, I'm inserting a chart of consumer credit outstanding in the U.S. since 1943. -OHR

The B Word

Nothing is esteemed a more certain sign of the flourishing condition of any nation than the lowness of interest. --David Hume, Essays, Moral Political, and Literary

It was David McWater who got me thinking about it. I was standing in his office on the first floor of an Avenue A walk-up near Houston street.

"It's a craze," he said. "It has taken the place of IPOs." By this, he meant the technology stock boom of the late 1990s.

"What's going to happen?" I asked.

"I'm pessimistic for the industry," he said.

McWater owns buildings and bars in the East Village, places with names like Doc Holiday's and Nice Guy Eddie's. He calls them gin joints, and I thought from the start that he was pretty sharp. Though only in his thirties, he's an active member of his local Community Board, and seemed to have his feet on the ground. He was talking about the "fanaticism of refinancing," and telling me that New York's real estate market was going to collapse.

"Like the rest of America," he said, "the city has been unduly influenced by extraordinarily low interest rates." He said he expected there to be a lot of vacant store fronts when the recent wave of would-be "lounge" owners went out of business, and their deeply mortgaged landlords weren't able to find anyone else willing to pay the "jacked up" rents. Naturally, I was hooked.

So, I called my childhood friend Whit Quillen. We always knew Whit was smart, but when he was racking up DWIs as a teenager, nobody expected he'd turn out to be quite such a big success. His first big score was the parking lot in Bridgeport that serves the Port Jefferson Ferry. Who knew? He bought the lot for a song, and it's been throwing off piles of cash ever since. The rest looks obvious in retrospect. He borrowed money to buy tenement buildings in the East Village in the early 1990s when New York real estate was sluggish and before that neighborhood had officially exploded. Now he runs his own firm called Gravitas and has a plush office on 73rd street. When I got him on the phone, he apologized in advance for possible interruptions as he was in the middle of some trades. I imagined the Bloomberg terminal next to the phone.

"I may regret it later," he said, "but I'm selling everything." Whit put the odds at "fifty-fifty" for an "utter collapse" in real estate. When prices go down, he said, "I can always buy them back."

Of course, I knew something was going on in the real estate market. For at least a year, my child-of-the-Depression father had been calling to point out that mortgage rates hadn't been this low since the late '50s when he bought what is now my mother's home. I also knew that housing prices were high. My friend Adriaan, with his Harvard MBA and fancy hedge fund job, regularly complained that he and his wife Dorothy couldn't afford to buy a home in Boston, where they now rent. If they can't afford a home, I thought, who can?

The answer to that question, I would soon discover, was anyone willing to move to Rochester, where homes are currently selling for $30,000. The catch is that there aren't any jobs in Rochester. That's what you get when your hometown businesses are titans of the analog era such as Xerox and Kodak. But Rochester was the exception.

In Manhattan, I found a general consensus that low rates and a hot real estate market had helped "soften the landing" following the stock market "correction" in 2000 and all the subsequent economic troubles. Savvy people, however, seemed divided on the "bubble" question.

"I call it the "b-word", said Ellen Bitton, the President of Park Avenue Mortgage Group. "There is no bubble." Bitton has been in the mortgage brokering business since the early 1980s and appears regularly as a market analyst on CNBC. Sitting in her Park Avenue office with picture of herself and former President Clinton behind her on the wall, she fielded phone calls impatiently while consuming a fried egg and a V8 and watched Alan Greenspan testify on CSPAN. She said her average loan was around $1.5 million. According to Bitton housing prices are high, but the market is "healthy."

"I would venture to say that there's been an exponential increase in people's wealth," she said.

Actually, median household incomes in the United States have remained decidedly flat in the last several years. But, in one sense, Bitton was correct. People are spending money as though their incomes were increasing.

***

In the summer of 2000, shortly after the NASDAQ began to plummet, the Fed Funds rate reached a nine year peak of 6.54%. The Fed Funds rate is the one thing that Alan Greenspan controls, and he had been pushing it up slowly for years in an attempt to dampen the enthusiasm of the late 1990s stock market. Higher interest rates mean that money costs more to borrow, so, all other things being equal, individuals and companies tend to borrow and spend less. Conversely, when Greenspan wants to push the economy along, he cuts his rate. By December of 2000, the NASDAQ had lost half of its springtime market capitalization, and Greenspan got busy cutting. Today, the Fed's rate is at 1%, a level that revered financial columnist James Grant calls "the interest rate equivalent of the 100 year flood." As my father rightly noted, mortgage rates followed suit. The average rate on your garden variety 30 year mortgage in 2000 was 8.02%. Now it hovers around 6% and, for much of 2003, it was closer to 5%, lower than it's been in almost 50 years.

Knowing a good deal when they saw one, the American people began borrowing and buying at record levels. In 2001, 6.2 million homes sold in the United State, the most ever in a single year. In 2002, the record was reset at 6.5 million. Despite a recession, enormous losses in the stock market, and the attacks of 9/11, housing prices climbed to record highs, not in Rochester, but in destination cities like Boston and New York. Having already increased without interruption since the mid-1990s, the median home price in New York City rose another 65% from 2000 to 2003, reaching $353,000. In Boston, where Adriaan was looking, the median price hit $406,000. Perhaps most breathtaking, however, were prices in the San Francisco Bay area. By the end of 2003, the median Bay Area home price reached $574,000, higher than it had been at the apex of the technology boom in 2000.

Analysts, including those at the Federal Reserve, attributed part of the run up in prices to an increase in immigration and the limited housing supplies in urban centers, but it's hard not to give a lot of the credit to Americans' growing coziness with debt and the basic mathematics of declining rates. Simply put, when rates drop by 40%, a buyer can afford 70% more house. Or, perhaps more to the point, the buyer can pay 70% more for the house they want.

By mid 2002, the b-word had already surfaced. Edward Leamer, the Director of UCLA's Anderson Forecast Center released a report in June entitled "Bubble Trouble," in which he pointed to the alarmingly disconnect between home prices and average rents in San Francisco. Later in the year, The New Yorker weighed in with a feature entitled "The Next Crash," in which writer John Cassidy highlighted the escalation of home prices in middle class neighborhoods like Levittown, and quoted one analyst who suggested that "in places like Manhattan and San Francisco, prices could easily drop forty or fifty per cent."

The mounting concerns eventually prompted a response from Greenspan, who, several months later, publicly reiterated the conventional wisdom among economists that the U.S. housing market was fundamentally not susceptible to a speculative bubble. Greenspan pointed out that to sell a home, "one almost invariably must move out," and this fact alone prevented people from the excesses of stock market investing. He also argued that U.S. real estate was not monolithic, but instead comprised of many independent regional markets, a fact that made a national collapse unlikely.

"It is, of course, possible for home prices to fall as they did in a couple of quarters in 1990," said Greenspan. "But any analogy to stock market pricing behavior and bubbles is a rather large stretch."

If Greenspan was not overly concerned about housing prices, he did acknowledge that 2002 was "surely one of the most memorable years ever experienced by the home mortgage market." As it turned out, 2003 proved even more impressive. In the 3rd quarter of 2000, a relatively typical quarter before the Fed cuts, $312 billion in mortgages were issued in the United States, of which 16% were re-financings. By comparison, in the 3rd quarter of 2003, $1.2 trillion in mortgages were issued, of which 68% were re-financings. Such has been the frenzy of borrowing and refinancing, in fact, that the value of mortgages issued in the last three and a half years is greater than the combined value of all mortgages issued in the 19990s. Virtually all of the $7 trillion in mortgage debt that was outstanding in 2000 has been refinanced.

And, in some ways, this is unsurprising. When rates drop, it makes good sense to refinance. What is surprising, perhaps, is the financial system's capacity to handle so much activity, more or less without breaking a sweat. It is a virtuoso macro-economic feat that would not have been possible until relatively recently. Indeed, it represents the highwater mark of an expanding system of secondary credit markets and related government agencies like Fannie Mae and Freddie Mac that emerged in the 1970s and have had a profound, though often unheralded, impact on the basic economics of American life. Interestingly, most of the people working at the front of the lending system, not to mention the borrowers, are only dimly aware of the secondary markets' existence. Ellen Bitton jokingly says that, after the closing, loans are sent to "the great mortgage gods in the sky."

***

The "great mortgage gods" actually descended upon the U.S. financial system in 1970, before which time mortgages were simply held in proprietary portfolios by the regional, and decidedly mortal, banks that issued them. The bank-centric system worked, but had two obvious weaknesses. First, not having infinite reserves, the banks were limited in the total value of loans they could make, a constraint that effectively pushed up the rates they offered and tended to limit capital to lower risk borrowers. In the absence of a national market, high growth regions -- and marginal borrowers -- were perpetually cash starved, while capital in prosperous, slower growth areas remained, relatively speaking, idle. The second problem was that regional banks were unavoidably over-invested in particular geographical areas. Instead of being able to provide liquidity during regional economic slumps, they were forced to become more conservative, often aggravating downturns by contracting the local money supply. No doubt the banks would have preferred to diversify their loan portfolios prior to the 1970s, but individual mortgages were both too small and too risky to be of interest to institutional investors.

The solution to this problem lay, simply enough, in aggregation. Looking for ways to expand homeownership, the Government National Mortgage Association ("Ginnie Mae") began pooling thousands of loans with similar interest rates, maturities, and risk profiles into large funds. Thanks to the law of averages, the aggregate cash flow from the pooled loans could be accurately predicted -- even taking into account the varying propensities of borrowers to pre-pay. Instead of selling individual loans, then, Ginnie Mae sold shares in the funds, known as "mortgage backed securities."

"Securitization" set off a revolution, opening up the mortgage market to enormous sources of capital, such as life insurance companies and pension funds, that had previously confined their debt investing to corporate and government bonds. Today, virtually all forms of consumer debt, from credit card balances, to student loans, to car lease payments are "securitized" and sold in a dizzying array of ever-more sophisticated "collateralized debt obligations."

And, as it was intended to, the system made it easier to get a loan. The greater supply of capital drove down rates, while increased competition triggered a wave of bank mergers, which, in turn, resulted in more efficient and decidedly more aggressive national lenders. Lower income families were able to qualify for loans in greater numbers than ever before. An influential Harvard study in 2002 pointed out that "mortgage companies specializing in sub-prime loans had made astonishing gains, increasing their share of home purchase mortgages from just 1 percent in 1993 to 13 percent in 2000."

Today, high profile, national lenders like Ditech.com -- actually a subsidiary of General Motors -- advertise relentlessly, offering 24x7 services both online and over the phone. Through the likes of Ditech, it is now possible to apply for a million dollar mortgage at midnight on a Saturday night, and receive the money within a matter of days having never met anyone face to face.

Not surprisingly, the explosive growth of the credit supply has had a not-so-subtle impact on American attitudes with regard to their credit demands. If you look at a graph of total mortgage debt in the United States over the last 50 years, what you'll see is a curve that creeps along the bottom of the graph in a linear sort of way for the first twenty years or so, and then, in the early 1970s, begins an impressive exponential climb. Such is the growth, that big deal events such as the run up in interest rates in the late 1970s (the 30 year mortgage almost hit 17%) and the early 1990s real estate slump appear only as the slightest of inflections in the steepening curve.

In 1968, the total outstanding mortgage debt in the United States was about $201 billion. In the fourth quarter of 2003, that number stood at $9.5 trillion, an increase of roughly 2,300%, a rate that is clearly unrelated to underlying trends in population or inflation. Indeed, one possible interpretation of the current frenetic activity in the housing market is not that it represents a short term speculative bubble in home prices, but rather it represents the emergence of a bubble in consumer borrowing.

Of course, higher levels of debt do not inherently pose a problem. The key to the stability of the new, more expansive credit system is the quality of the underlying loans -- that is, the likelihood that the payment schedules will be met over time.

On the street, I found at least some people who are skeptical of that quality.

***

Matthew Haines stumbled into the real estate business after being laid off by Deloitte & Touche in the wake of 9/11 while in the middle of purchasing a home in Harlem. He now runs a website called www.propertyshark.com, which, among other things, lists property foreclosures in New York City.

"Banks are shoveling money out the door," said Haines. Recently, Haines sold a condo in New Jersey to a New York City bus driver. When he heard that the bus driver was considering an adjustable rate loan for the purchase, he insisted that the real estate broker communicate his horror at the notion.

"I think there is irresponsible lending going on," he said. "More and more I see loans being pitched with one month adjustables." Mentioning Enron and Tyco, Haines said "if rates go up, two to three years from now, we'll be seeing the same sort of scandals."

People like Haines are most alarmed by two aspects of the recent lending boom. First, many homeowners and even commercial property owners take the more convenient than ever refinancing opportunity to borrow more than the value of their old mortgages. This is called a "cash out refinancing," and, thanks to the low rates, the borrowers can pay off their old loans and keep the extra cash without increasing their monthly payments. In many cases, borrowers sensibly use the cash to pay down outstanding credit card balances with higher rates, but significant numbers also use the found money just to live a bit larger, thus reducing their financial cushion in the event of problems.

Second, many people have replaced fixed rate mortgages with "adjustable rate" mortgages. As the name suggests, payments on these mortgages are "adjusted" up or down with prevailing market rates, usually after some initial fixed rate period. Since the only place for rates to go these days is up, it seems inevitable that some homeowners will have trouble making their increased monthly payments. Experts, like Fannie Mae CEO Frank Raines, however, discount the possibility of widespread defaults as a result of adjustable rate mortgages.

"Do rising rates create a housing bubble problem?" Raines asks in a statement on the organization's web site. "Not likely, because if interest rates are rising, it's usually because the economy is improving, which means incomes are rising too."

As witnessed by Rochester, though, the economy can be growing on average, and yet not be growing in a specific location. Since adjustable rate mortgages are sold everywhere, it seems that, at a minimum, they could aggravate downturns in particular areas. Then too, there is the specter of the late 1970s "stagflation," when interest rates were high and growth was low, a result that was brought on, in part, by the 1979 oil price shock -- an event that certainly doesn't seem out of the question today.

Haines put me in touch with Brian Dougherty a real estate attorney who has been in the business since 1991 and deals with both residential and commercial properties. Dougherty's office was on the fourth floor of a battered building in the thick of the Japantown district on West 32nd. Bulging manila file folders were stacked along Doherty's office walls, and a cluster of five inch New York Mets figurines on a cabinet next to his desk under an old public-school style wall clock. His partner sat on the other side of a glass wall, and a young Japanese assistant sat just in front of their doors in a cluttered, overlit space -- the general scene conjuring something out of Raymond Chandler. Dougherty said he had never wanted to be a part of a big corporate firm.

"We don't answer to anyone," he said, and he agreed with Haines' assessment the system was overheated.

"I think the way buyers are analyzing is completely out of whack," he said referring in particular to the commercial market. "I now have people telling me that standard rent roll analysis doesn't apply. Once you throw out that, then it's all hogwash and you have tulips in Holland."

Doherty said one potential sign of trouble was the general "lack of attention to detail." He said that the increased turnover in the market combined with the wave of bank consolidations has made it difficult for record keepers to keep up. Sloppy administration, he argued, create a fertile atmosphere for sloppy lending.

Later, at the Manhattan offices of the New York City Register, I got a tour of ACRIS, the city's new web-based system for home and mortgage-related filings. The system was installed last year, and, without it, one official told me the city wouldn't be able to keep up. Even still, there is a one month backlog on new filings, and more for "mortgage satisfactions," the documents which confirm that old loans have been paid off. The official said that the backlog in Westchester and Nassau was six months. Another big issue for Doherty, Haines, and others was the apparent collusion between mortgage lenders and appraisers.

"The industry that has been tainted is the appraisal industry," Haines had said. Appraisers are hired by lenders to establish a market value for a given property on which to base the size of the loan. Theoretically, appraisers look at historical prices for comparable properties and establish a value at which the bank would very likely be able to sell the property in the event that the borrower defaults. In boom markets, the appraised value is generally lower than the market value, and the appraisal step is part of the system of checks and balances that ensures the quality of loans.

The problem, of course, is that the bank -- not to mention the mortgage broker and the real estate agent -- makes more money on bigger loans, and the appraisers work for the bank. The standard designation for a professional appraiser is "MAI," which stands for "Master, Appraisal Institute." Peter Mickle, a long time Manhattan real estate agent explained to me that the common joke around town is that the "MAI" designation really stands for "Made As Instructed."

"They'll give you any kind of number you want," says Mickle.

Without objective appraising, of course, the size of bank loans move in lock step with the market, constrained only by the buyer's immediate income and/or credit history, and swept along by the momentum of the credit markets. In general, Haines, Doherty, and Mickle feel that lending constraints have loosened, and they all point to the upsurge in 2nd mortgages and home equity loans.

"Five years ago, people were not doing that," said Doherty. "Now everyone has a credit line."

"We're up to our asses in debt," said Mickle. Doherty feels there will be a price to pay for the sloppy lending.

"When it bursts, it'll burst hard," he said. "They have to be making errors in judgment." But at the same time, he acknowledged, "I don't see distress yet, and, quite frankly, I'm shocked."

***

Normally, lenders are incented to make good loans as they hope to get paid back. In the modern market-system, however, there is a greater detachment between those making the loans and those funding them, a fact that could lead to greater "agent risk." In other words, the incentives for those on the front end of the process favor more and bigger loans, but given their arms length relationship to the secondary market, they may be less and less accountable for the quality of the loans they generate.

Certainly, the refinancing boom has been an unprecedented windfall for many of the "agents," including the spamming hordes hawking cut rate credit via email. Mortgage brokers, appraisers, title insurance companies, and, importantly, municipalities all see a cut of the transaction revenue when mortgages are created. An official in the Register's office told me that New York currently books roughly $200 million in mortgage taxes and filing fees each month, nearly double the pre-cut levels. Yet another indication of the profitability of the lending business has been the run up of the stock prices of major lenders. Dan Ackman, of Forbes.com, reported in a December that several major, mortgage lenders had "seen their share prices roughly double in the past year."

To some extent, cracks are showing in the system. Harvard's omnibus "Joint Housing Center Study: 2003" study pointed to "the dramatic jump in the number of homeowners spending more than half their incomes on housing," as well as the "predictably higher default rates" on subprime loans. The study also notes that such loans were highly concentrated in minority areas, and worried that any sustained downturn in the economy could threaten "the stability of entire neighborhoods."

Ultimately, however, lenders are held accountable at some level. Mortgage brokers that issue "bad paper," will quickly lose the confidence of their banks says Ellen Bitton, and banks that underwrite bad loans eventually lose the confidence of the secondary market which would quickly put them out of the business. Still, even Greenspan admits to some uncertainty.

"Borrowing against home equity has been a staple of household finance for decades," said Greenspan in his March address. But, "it has been only in the past decade or so that such practices have been encouraged by lenders," and "we need to far better understand the economics of this major addition to household finance and its impact on the economy."

At Fannie Mae, however, the drive to push greater credit is only picking up steam. Frank Raines, who, in fact, has been mentioned as a possible running mate for presidential candidate John Kerry, has established a $2 trillion initiative called the "Mortgage Consumer Bill of Rights," which he describes as the "cornerstone of Fannie Mae's American Dream Commitment." (This latter phrase, it should be noted, has been registered as a trademark by the quasi-public agency.)

Raines discounts the possibility of system failure. He says that thanks to stress testing and planning for hypothetical disaster scenarios, the organization is rock solid.
"Fannie Mae not only poses little systemic risk even in a calamity," he writes. "We are built to withstand shocks and even reduce systemic risk."

But the fact of the matter is that no society has ever existed with the complex secondary markets for debt and the pervasive use of credit currently the norm in the United States, and it's not entirely clear what, if any, the systemic problems might be. It is clear that many people are uneasy with the new culture of easy credit. Dr. Robert Manning, the author of a book called Credit Card Nation argues that the culture of easy credit and instant gratification has ruptured "the cognitive connection between earnings/saving and credit/debt that has traditionally shaped consumer behavior." Very likely, some of this distrust for the new lending system derives simply from a fear of the unknown, and experts like Raines and Greenspan will be proven correct in their conviction that the current markets represent a historic achievement and are tethered to dependable economic reality.

In the East Village, McWater's bars carry the names of a bygone debt-averse era. With a name like Nice Guy Eddie's, you might expect to get a boiled egg at the bar with your whisky. McWater is distinctly not a member of the credit card nation. He keeps the mortgage payments on the buildings he owns low, and he avoids paying high rents.

"I'm pessimistic for the industry," he said, "but I'm optimistic as a businessman. "When they go out of business, I'm going to buy up all those places."

Posted by oliver at 11:11 AM | Comments (0)