The Great Bank Bailout

I chose the title “The Great Bank Bailout” as it reminded me of one of my favorite movies “The Great Bank Robbery” except this time it’s more like the Burger King advert where “the King” reverse pick pockets by putting money back into your pocket.

Financial Institution just got a cool $700 billion bailout. In terms of the bailout a financial institution can sell its non-performing assets to the federal government. In theory this will recapitalize the lenders, remove the credit squeeze and restore confidence in our financial institutions.

I can’t tell you if it will work or fail so I’m going to limit this article to discussing what the bailout is and how it will affect us as real estate investors.

The Bailout Plan

The bailout is more properly known as the Emergency Economic Stabilization Act of 2008. It was signed into law by President Bush on October 3, 2008. In terms of the plan the Treasury Department is authorized to spend $250 billion dollars to insure and purchase non-performing assets, can draw down on another $100 billion immediately and will be required to get congressional approval for the remaining $350 billion.

Most non-performing assets have already been packaged and resold as Mortgage Backed Securities (MBS). A mortgage backed security is a complicated financial instrument that allows lenders to split, compile and package mortgages into commercial paper that is purchased by the secondary market. It also allows for the creation of derivatives and other financial instruments. This is important because unlike the Savings and Loans crisis of the late 1980’s and early 1990’s where the actual assets of the failed companies were seized, it is very difficult to identify and value the Mortgage backed Securities that the Treasury will be asked to purchase.

The decision on how to spend the money lays in the wide discretion of the Treasury Department and is basically a blank check for Treasury Secretary Henry Paulson. The Treasury has 45 days to come up with a plan to spend the money.

The Treasury has set up a new division to handle the money, called the Office of Financial Stability. The Office of Financial Stability will contract outside asset managers to help it insure, buy and sell the non-performing assets. Who will get the asset manager contracts? Probably Wall Street insiders!

The Treasury also has the power to insure Mortgage Backed Securities against default. At this time the Treasury has no experience, no plan and no proposal as to how it will enter the insurance business. Will the Treasury adopt the Federal Housing Administration (FHA) model and use HUD to auction the homes?

The bailout plan has specific language aimed at helping homeowners facing foreclosure. The Treasury is obliged to try to modify troubled mortgages that it acquires in terms of the bailout plan. This means that the Treasury must try to work with loan servicers to modify loans, including reducing the monthly payments, lengthening the loan term and even reducing the principal balance owed on the mortgage. The Treasury can use loan guarantees and credit enhancements to encourage the servicers to modify loans. The Treasury must also encourage the redirection of the loans to the Hope for Homeowners program that was set up to refinance troubled loans into lower fixed rate loans. (Note for real estate investors – this provision is very vague but very important).

Finally, the bailout plan included a provision to raise the FDIC limits to $250,000. This measure is aimed at restoring public confidence that their money is safe in a bank. It’s important because it helps prevent a run on the banks by individual depositors.

The National Foreclosure Market

The real estate industry continues to be dominated by foreclosure properties that have created a downward push in home values.

The Standard and Poors / Case-Shiller 20 City Index, which measures home prices in 20 major U.S. cities, fell 16.3% from July ‘08 from July ‘07.

“There are signs of a slow down in the rate of decline across the metro areas, but no evidence of a bottom,” said David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s, in a press release issued to announce the numbers. “Little positive news can be found when cities like Las Vegas and Phoenix report annual declines as large as -29.9% and -29.3%, respectively, and all 20 cities are still in negative territory on a year-over-year basis.”

The National Association of Realtors (NAR) reported that the median home sale fell 9.3% to $203,000 in August 2008.

The Mortgage Bankers Association reported that an estimated $500 billion in Adjustable Rate Mortgages (ARM’s) remained in the market representing over 1.4 million houses. Statistically, the highest class of defaulting mortgages are ARMs so it is likely that a significant number of the outstanding ARMs will default when they reset in the near future.

The National Foreclosure Map

RealtyTrac reports that foreclosure filings continue to rise with over 200,000 filings in July 2008. State foreclosure filings were led by Nevada followed by California, Arizona, Florida and Colorado.  Stockton, CA led the nation in metro foreclosure filings with Denver in 23rd position.

The Colorado Foreclosure Market

Let’s take a look at the current Colorado foreclosure market.

Colorado rates 5th in the number of foreclosure filings, behind Nevada, California, Arizona and Florida.

RealtyTrac reports that “despite a nearly 15 percent quarterly decrease in foreclosure activity in the second quarter, Colorado posted the nation’s fifth highest state foreclosure rate — one in every 129 Colorado households received a foreclosure filing during the quarter. Second quarter foreclosure activity in Colorado was still up more than 50 percent from the second quarter of 2007.”

The majority of Colorado’s foreclosure filings were along the Front Range with the Denver/Aurora Metro posting over 10,800 filings for the year to date with an estimated one in every ninety five homes in foreclosure.

The S & P / Case-Shiller 20 City Index reported that Denver home values declined 4.7% for the year ending July ‘08 from July ‘07.  It was the third smallest decline behind Charlotte and Dallas in the 20 City Index. Most interestingly, Metro Denver home prices increased 1.5% in June and 0.8% in July, signs that there is some recovery in the local market.

What Does This Mean For Real Estate Investors?
The short answer is “I don’t know”. All I can do is encourage you to think about what will happen and position yourself to take advantage of the situation.

Here’s what we do know.

Real Estate Owned (REO) real estate brokers have advised me that there has been a significant decrease in REO listings that they receive form lenders. In particular, in the last month they have received very few REO listings and they attribute this to the belief that the lenders knew this bailout was coming and have taken a wait and see approach.

Foreclosure investors have advised me that there is increased competition for foreclosed properties. Most new foreclosure listings receive multiple offers and are put under contract in about ten days.

The general consensus in the market is that supplies of foreclosure properties will dry up through the end of 2008.

The $700 billion question is “what will happen to all the foreclosed properties related to the bailout plan?”

I think there is a fundamental flaw in the entire bailout plan. The flaw is that the plan bails out financial institutions that hold the mortgage backed securities. It doesn’t bail out lenders who make mortgage loans. The lender has little incentive to work with the Treasury and modify loans as they no longer own the loans. The loans were sold to the secondary market (Fannie and Freddie) and the lender’s role is simply to service the loan. Before the bailout plan the lender had the right to modify the terms of the mortgage loan but they rarely did because it was simply too complicated for administrative reasons. Nothing has changed to make it any easier.

Remember also that the Treasury can insure or buy the Mortgage Backed Security. This means that the Treasury is not buying the actual house. This complicates things as the Treasury doesn’t have the right to dispose of the house. During the Savings and Loans crisis, the Federal Government was able to dispose of the actual house, which it did through its own asset manager, the Resolution Trust Company RTC).

The one good thing about the bailout plan is that it makes it easier for the financial institution holding the Mortgage Backed Security to consent to discount the value of the asset. In theory this should make it easier to get agreement on a short sale or a reduced REO price.

So here are the questions you need to ask yourself:

•    Will loan servicers actually modify the loans? They won’t do it now so why do we think they’ll want to do it in the future?
•    Will lenders continue to approve short sales and REO sales or will they sit back and let the financial institutions who own the MBS sell out to the Treasury?
•    Will the Treasury set up a company like the Resolution Trust Corporation to dispose of the homes or will it use the FHA or HUD?
•    Will the Treasury modify every troubled loan and effectively reduce the number of foreclosures?
•    Will the Treasury take steps to acquire the physical homes and then hold them until the housing market recovers?
•    Should we turn our focus away from short sales and REO’s to getting the deed and the public trustee auction?

Right now the Treasury doesn’t have a plan. It’s wait and see time.

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