The Right Place

From tiny plankton grow. . .; Beginning of food chain holds clues to market
By Sally Duros

A long, long time ago it seems, I worked in a large gray stone
government building with long, marble echoing hallways, and frosted
glass doors that opened into lots of nooks and crannies and bureaus
that constituted many balkanized fiefdoms.

It was said that getting things done there was like pushing a feather through honey, and it was. Even more frustrating than the push back of the honey was the fact that even when you were doing one thing with the best of intentions, you were unwittingly doing something different. And as it would often turn out, what you were actually doing was not what was actually required, although nobody would actually say that.

It was your job to somehow sniff out the correct direction to go in, and woe be it to you if you messed up.

I'm sensing a similar dynamic in the real estate market these days as regulators, the press and industry players try to figure out what the fallout will be from the subprime mortgage market.

There are many crannies in this nook, and it is difficult, perhaps even foolish to talk about one without talking about all of them. But unless you are an economist and given to dismal utterances, how do you talk about them?

Nationally, we saw March sales of existing homes dropping a dramatic 8 percent. Here in the Chicago area, sales of existing homes fell 22 percent from the year earlier period, a sales level that looks a lot like 2002. But what does it mean? How far will it go?

What's been missing for me is a unifying theory that brings these pieces together so we can see from the balcony how important the numbers are.

Luckily, a wise friend forwarded to me a copy of a newsletter by John F. Mauldin (JohnMauldin@Investorsinsight.com) that offers a theory for better understanding the subprime mortgage market.

The article, "The Plankton Theory meets Minsky," by Paul McCulley, explains why many investment professionals think the problems arising from subprime mortgages and the housing market slowdown will affect our economy in a significant way.

The article begins this way:

"The Plankton Theory, like life itself, begins and ends in the ocean. Plankton, of course, are almost microscopic organisms that serve as food for higher life forms. . . . Logic would suggest, therefore, that in attempting to forecast the well-being of the Great White Whale, Jaws, or even Jaws II, that one of the factors to consider would be the status and future outlook of the plankton. "

These words were written by PIMCO bond expert Bill Gross in 1980. He then goes on to describe the dramatic escalation of housing prices at that time. And he states, "In the case of real estate, the plankton would be the first-time buyer with a desire to own their own home but with very little capital to carry it off."

And we come to understand that the great white whale would be the economy.

That's where Minsky comes in.

Hyman Minsky was a Harvard University economist. "A fundamental characteristic of our economy," Minsky wrote in 1974, "is that the financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles," according to the Wikipedia. Economist Henry Kaufman said that Minsky showed that financial markets could move to excess, ie. move to a bubble.

Now here's how Minsky meets the plankton.

In extremely oversimplified terms -- and I apologize to McCulley and for nuances that I butcher here -- Minsky says that there are three types of players in a market. First, those who have sufficient cash to meet their contractual obligations. Second, those who are speculative, who can only make payments based on "income account," and must issue new debt to meet maturing debt. And third, Ponzi agents with insufficient cash who can only sell assets or borrow.

McCulley says exotic mortgages -- subprime, interest only, pay-option -- and their lenders are examples of Minsky's speculative and Ponzi units. But Minsky's theories say that by the market's nature, this game must end and Ponzi borrowers will cash out. That is what we are seeing now.

So we are back to where we began: These mortgages are the food of the Plankton -- the first-time homebuyer -- and as Gross says: "when the time comes that the plankton can't pull homeownership off, then the "plankton" would disappear, and the rapid escalation in real estate prices would ease as well."

Says McCulley: "The ongoing meltdown in the subprime mortgage market would not matter, except for those directly involved, except that it marks the the unraveling of Ponzi finance units that on the margin were the plankton of the bubbling property sea of recent years." You can read the entire article at http://investorsinsight.com/otb_va.aspx?EditionID=485.

blockquote>What a year! But Chicago rolls with the punches
December 30, 2007
BY SALLY DUROS Sun-Times Real Estate Editor

Surprise -- it's the eve of 2008, and what a year 2007 was!

In early 2007, we and the Sun-Times business section reported on a series of events unfolding related to HB 4050, the Illinois Predatory Lending Database Pilot Program.

The purpose of that law was to stem a tide of subprime lending in certain neighborhoods in Chicago. In the events of the day, that bill was pulled back, revised, and will be rolled out again in 2008.

The purpose of that law was to stem a tide of subprime lending in certain neighborhoods in Chicago. In the events of the day, that bill was pulled back, revised, and will be rolled out again in 2008.

That story was a harbinger of more dramatic events to come that ultimately called to order Federal Reserve Chairman Ben Bernahke, sent Wall Street lenders gasping for cash streams, grabbed President Bush's attention, and contributed to a financial credit crunch worldwide.

As we reported then, the original HB 4050 was revamped in the unresolved clash between home buyer advocates and lenders. Home buyer advocates wanted to flush out the predators and prevent suffering caused by inappropriate subprime loans, while lenders wanted to preserve the robust cash streams from the legitimate sub-prime market.

So here we are! The bubble has burst --finally! -- and it's ugly out there.

Except in Chicago where we have developed a few warts but can still look at ourselves in the mirror with pride. Although our home prices might be backsliding a bit, we on the third coast are holding our own much better than the bubble-iscious coasts of California, Florida and New York.

To prove a point, the latest data from Standard & Poor's/Case-Shiller home price index shows home prices falling nationally in October for the 10th consecutive month, posting their largest monthly drop since early 1991. But here in Chicago, home prices dropped only 3.2 percent in October 2007 from October of 2006. This was less than half the record national rate at 6.7.

"If you go back a year ago and look at the stories, and look at what the lending community was doing, [the problems do] tend to unfold more slowly in places like Chicago that are more stable," said Ellen Seidman, executive vice president at ShoreBank Corp. and the director of the Financial Services and Education Project at the New America Foundation. Seidman was director of the Office of Thrift Supervision between 1997 and 2001.

"I think we will see a slow rollout in Chicago in 2008 of problems," she said, "[but] fortunately we have a healthy economy."

While President Bush's plan to freeze rates on certain subprime mortgages continues its public vetting, the Federal Reserve announced stronger lending standards with the goal of being a "comprehensive set of protections to consumers."

Seidman says the goal of these proposed revisions to regulations under the Truth in Lending Act is to realign relationships in the mortgage business so a good mortgage is the outcome.

The proposed rules, Seidman said, would apply to all mortgage lenders and others (such as brokers, independent mortgage bankers and appraisers), not just to banks, thrifts, and credit unions.

The proposed regulations would "require lenders to lend based on the borrower's ability to pay at a fully indexed, fully amortizing rate, verified by independent third-party documentation. Escrows for taxes and insurance would be required (for at least the first 12 months the loan is outstanding), and prepayment penalties would have to expire at least 60 days before the first payment change," Seidman wrote in an OpEd piece in the American Banker.

The proposed regulations also address abuses in brokerage, appraisals and servicing, as well as advertising abuses, such as calling a loan fixed when it's not. Lenders would also be required to provide borrowers with information about payments, finance charges, and interest rates early in the shopping process, and before charging any application fee.

"The proposed law is pretty far-reaching," Seidman said. "There are several pieces of it that would cover all loans."

"I know how hard it is to hold on to the pro-consumer stuff that you've done when the comments start coming."

Seidman says that some areas are left untouched by the regulations. These include nationwide licensing, testing and registration of mortgage brokers; liability -- beyond the initial creditor -- for violations of standards; requirements for pre-foreclosure counseling and modification attempts; and bankruptcy law changes to permit judges to modify home mortgage loans that are "underwater."

"The Fed will try hard to hold tight," she said. "To some extent the comments by the Democrats on the Hill are a combination of wishing the Fed would go further and wishing the Fed will not go backwards."

She said, however, that "The Fed rules will not make a major change to the fact that property values are out of line. "

"2007 was not by any means the end of it," she said.

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