Waiting for a sucker from Oz

My recent post on the wisdom of Australians buying up $600 million of US foreclosed properties has provoked a few interesting comments and questions by email from readers, so I thought it warranted a quick follow up. Firstly, here is what one concerned Californian reader had to say:

Aussies planning to be millionaires by buying anything in California should think about this. There are literally hundreds of thousands of knowledgeable CASH buyers who are NOT buying. What do we know, that Aussies don't know? First if ANY house is going to be sold, at least 5-6 insiders will get a first shot at the deal..and they will buy in hours. Any property that you see on a list...is OLD, and probably a bad deal....

There is a small house across the street from me. In 2005 it cost USD $380,000...today it is for sale for $120,000. They have an auction every day. NO BUYERS! Why aren't people buying? The prices are TOO high! If you buy and rent out...what is to stop your tenant from giving notice and moving next door to the next empty house for LOWER rent? Nothing! So how many months can you handle no tenants---no rent money? Tenants are not stupid...

I look outside my window and see five For Sale signs ---all "good deals", but why haven't they sold? They were from $750-899,000 only 4 years ago. One of them wants $450k....and has been for sale for 2 years. The asking price drops every month. Why buy TODAY...when the house will be cheaper next week? I have seen some houses go through 4 buyers and sellers in 5 years. All the buyers thought they would be rich. Now you tell me why they sold? Rents are dropping every month...and my county has 22% unemployment. More than one in five adults has NO JOB!

You want to be rich? DO YOUR HOMEWORK. NO ONE wants to live near gangs. Gangs are attracted to low rents and vacant houses to squat in. Gangs move in and all house prices drop in the area. I saw an ad for the 888 company showing a newer house near Atlanta Georgia to sell to Aussies. I called a friend who lived nearby the house. There was a gang murder - two people shot one block from the house. Police have no suspects. People in gang areas will not talk...or they will be killed next.

You can see the listing on the 888 website. It's on a corner lot, in a suburb of Atlanta, Georgia....waiting for a sucker in OZ land. 

I think this comment speaks for itself about some of the risks involved in buying US foreclosed properties. In another recent post, I discussed an additional risk that any Australian buying US foreclosed properties needs to be mindful of: the possibility of lawsuits from previous owners of the property claiming that they have been wrongfully evicted. In response to this, one reader asked if it is possible to protect yourself from such risk through title insurance.

I'm far from an expert on these matters, but the answer to the question seems to be: "Yes, but...". The problem here is that some insurance companies have started to shy away from insuring foreclosed properties. And even with those that are willing to insure properties, you can't entirely rule out the risk of getting caught up in a complicated legal mess if the foreclosure is challenged in court. From one recent article in the Washington Post:

The title insurance industry is maneuvering to protect itself from losses if courts rule that banks have played fast and loose with the foreclosure process. But people who buy foreclosed properties from banks may face some degree of loss despite having a title policy.

Fidelity National Financial, the largest title insurance company, is leading the industry in demanding that lenders warrant that they have followed all legal procedures in the handling of foreclosures and indemnify the title insurers if a court decides otherwise.

"They are putting on record that it is absolutely the bank's responsibility," said Susan Wachter, professor of real estate at the Wharton School of the University of Pennsylvania.

But Wachter said buyers of these properties risk getting caught up in litigation among title companies, banks and possibly other entities if the foreclosure is overturned by a court. "There is still uncertainty," she said. "It's a question of litigation; it's a question of transaction costs."

In other words, title insurance should protect you, but there is so much legal uncertainty surrounding foreclosures right now that basically nobody really has a clue what is going to happen. And this is my point. Is the average Australian investor that is buying US properties sufficiently educated about these risks?

To conclude, yesterday's Wall Street Journal had a truly bizarre story about how residents of Salem, Massachusetts are turning to witches to exorcise the demons from their foreclosed properties. If you are hellbent on buying a property in the US, maybe you'd better look into this.

SALEM, Mass.—There's a certain look and feel to a foreclosed home, and 31 Arbella St. has it: fraying carpet, missing appliances, foam insulation poking through cracked walls.

That doesn't faze buyer Tony Barletta since he plans a gut renovation anyway. It's the bad vibes that bother him.

So two weeks before closing, Mr. Barletta followed witch Lori Bruno and warlock Christian Day through the three-story home. They clanged bells and sprayed holy water, poured kosher salt on doorways and raised iron swords at windows.

"Residue, residue, residue is in this house. It has to come out," shouted Ms. Bruno, a 70-year-old who claims to be a descendant of 16th-century Italian witches. "Lord of fire, lord flame, blessed be thy holy name...All negativity must be gone!"

The foreclosure crisis has helped resurrect an ancient tradition: the house cleansing. Buyers such as Mr. Barletta are turning to witches, psychics, priests and feng shui consultants, among others, to bless or exorcise dwellings.

What can I say?

Why foreclosure-gate matters

In my last post we took at look at Australia's latest investing fad: buying up foreclosed properties in US states like California, Nevada and Florida. We've already examined how anybody who thinks this is a good idea probably needs their head checked, but there is one additional risk that I didn't even mention: the risk of getting sued by the previous owner of a property that you've bought if he or she claims that they were wrongfully thrown out of their house.

On this front, a Massachusetts court delivered a very important decision last week that could have huge implications for the US housing market and mortgage securitization. From the NY Times:

The highest court in Massachusetts ruled Friday that U.S. Bancorp and Wells Fargo erred when they seized two troubled borrowers’ properties in 2007, putting the nation’s banks on notice that foreclosures cannot be based on improper or incomplete paperwork. Concluding that neither institution had proved it had the right to evict the borrowers, the Supreme Judicial Court voided the foreclosures, returning ownership of the properties to the borrowers and opening the door to other foreclosure do-overs in the state.

To explain why this is important, we have to go right back to the root of the global financial crisis of 2008, which can be found in the securitization of US subprime mortgages.

During the boom years leading up to 2008, American banks packed together millions of mortgage loans, and sliced and diced, or "securitized" these into thousands of securities called MBS. To create an MBS, the banks would first sell the loans to a trust, which then sold bonds backed by those mortgages to investors all over the world. But there was a minor problem. In their rush to issue as many of these securities as possible and pay themselves gargantuan bonuses, the bankers didn't bother to do the paperwork properly, and now it's unclear who actually holds the mortgage notes. Oops. 

Of course, at the time these loans were made nobody ever thought this would be a problem because, as we know well in Australia, house prices double every 7 years and borrowers never default on their mortgages. Now, a few years later, there are millions of Americans delinquent on their loans.

"Foreclosure-gate" started brewing late last year when it became evident that having stuffed up the paperwork, many of the banks had hired thousands of "robo-signers" to write false affadavits claiming that they had reviewed the loan documents (which they hadn't even seen). These affadavits were then being used to evict people who had stopped paying their mortgages. 

So, the court case above puts an end to this kind of nonsense from the banks, at least in Massachussets. Until they get their paperwork in order (if that is even possible) they will have to stop turfing people out of their homes. The real estate experts cited here here say that this delay in the processing of foreclosures would be a good thing for the housing market.

If the slowdown continued through this month and into the spring, it could be a boost for the economy. Reducing foreclosures in a meaningful way would act to stabilize the housing market, real estate experts say, letting the administration patch up one of the economy’s most persistently troubled sectors. Fewer foreclosures means that buyers pay more for the ones that do come to market, which strengthens overall home prices and builds consumer confidence in housing. 

This is the optimistic view. If it becomes harder for lenders to foreclose, then they might become more willing to restructure loans instead (for example cutting the interest rate on the loan and/or reducing the principal that has to be repaid), which is probably the only eventual way out of this mess. At the end of the day, the banks are going to have to take a hit for making stupid loans that were never likely to be repaid.

But loan restructurings are tricky, because if the lenders offer attractive loan modification terms to delinquent borrowers, then even people who are able to pay their mortgage will start "strategically" defaulting in order to become eligible for debt forgiveness. And this would probably make some lenders insolvent. On top of this, securitization makes the whole process even more complicated because there are so many parties involved. In an MBS deal, there are strict contractual limits on loan modifications, which usually can't be changed without the consent of 100% of the MBS holders, who could number in the thousands and are usually spread all over the world. Obviously getting all these parties to agree is pretty much impossible.

In the meantime,  there could be enormous potential for chaos, because the Massachusetts legal decision is going to be followed by waves of lawsuits in other states all over America. Felix Salmon of Reuters has a great post addressing this issue which I will quote at length from:

The legal craziness that this decision sets in motion is going to be huge, I’m sure. Anybody who was foreclosed on in Massachusetts should now be phoning up their lawyer and trying to find out if the foreclosure was illegal. If it was — if there was a break in the chain of title somewhere which meant that the bank didn’t own the mortgage in question — then the borrower should be able to get their deed, and their home, back from the bank. This decision is retroactive, and no one has a clue how many thousands of foreclosures it might cover.

Similarly, if you bought a Massachusetts home out of foreclosure, you should be very worried. You might not have proper title to your home, and you risk losing it to the original owner. It might be worth dusting off your title insurance: you could need it. And if you ever need to sell your home, well, good luck with that.

Going forwards, every homeowner being foreclosed upon will as a matter of course challenge the banks to prove that they own the mortgage in question. If the bank can’t do that, then the foreclosure proceeding will be tossed out of court. This is likely to slow down foreclosures enormously, as banks ensure that all their legal ducks are in a row before they try to foreclose.

What’s more, courts in the other 49 states are likely to lean heavily on this decision when similar cases come before them. The precedent applies only in Massachusetts for now, but it’s likely to spread, like some kind of bank-eating cancer.

If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain.

The big losers here are the banks — of course — as well as investors in mortgage-backed securities, including of course Fannie and Freddie, a/k/a the US taxpayer.

 This could get very ugly.

On Australians buying US property...

With Australian property prices looking very toppy and the Aussie dollar going through the roof, the latest delusional investing fad in Australia appears to be snapping up foreclosed US properties. I've been hearing stories about this a while now, so I thought I'd look into it a bit. Firstly, in case you missed the story in The Age last week, here's a little extract to set the scene:

AUSTRALIAN property investors risk losing hundreds of millions of dollars after snapping up thousands of US housing bargains at forced-sale prices, experts have warned.
Emboldened by the soaring local dollar, Australians invested about $600 million on US residential property last year, according to the Washington-based National Association of Realtors, as overseas buying of US housing doubled.

But consumer advocate Neil Jenman predicts that thousands of Australians will lose their money after unwittingly buying undesirable property.
''It's going to be a calamity, for sure and certain,'' he says.

Another article from The Age tells the story of the following couple:

CLEANERS Ana and Miguel Canepa never imagined when they fled to Australia as refugees they would one day be landlords of four rental homes. But the residents of St Albans in Melbourne's outer north west are living the Australian dream, having last week signed contracts to buy their latest investment property. And it only cost them $A44,117.

That is because the three-bedroom house is in the US city of Phoenix in Arizona.
The couple, originally from El Salvador, have never been to Phoenix. But they already own two other homes purchased there this year for $A41,000 and $A52,100, as well as a fourth rental asset in Melbourne.

Real estate specialist Kevin Walters, who arranged the Canepa's purchases, will next month lead a shopping tour for 10 Australians and a tax firm that advises self- managed superannuation holders. They will visit Phoenix and Las Vegas, the foreclosure capital of the US.

''You can buy a house in the US for the cost of a deposit here,'' he says. ''Clients can purchase property in just two days, it's that easy. The only exception is that we don't have a lender for them at the moment, so they buy in cash.'' Mr Thomas says he gets rental returns of 16 per cent on his US assets, compared to about 3 per cent for his Australian properties. ''It doesn't seem a risk at all to me,'' he says.

What could possibly go wrong?

The Age quotes a Byron-Bay based buyers agent called 888 US Real Estate, which according to its website charges a "committment fee" of $380 and then a commission of $3,420 for each property purchase it handles for the Aussie battlers trying to realise their dreams. But 888 US Real Estate is just one of a handful of organizations that are sprouting up like weeds to flog US property to unsuspecting Australian buyers. Here are just a few of the ridiculous sales pitches made on some of these websites.

• "It's no secret: USA property investment gives you a 10-20% net return... Even after your expenses are paid you will still make money with My USA Property"
• "Once American banks start lending again, the USA market will recover. So you’d be wise to invest in an undervalued market now since every Australian dollar buys more"  (My USA Property)
• "When you say “Go!” you set the wheels in motion for an exhilarating ride as your property grows in value giving you the possibility to create enough cash to fund the rest of your life in a few short years. Call us now!" (888 USA Real Estate)

Now, before you leave to throw up, I'd like to note that the statements above would be illegal if these guys were stockbrokers. But apparently in property land it's OK to promise fantastical rates of return without pointing out any of the risks involved in the investment strategy. Speaking of the risks, we'll get to that later.

But for now, we should concede that some of the claims they make are accurate. It is indeed true that in many parts of the US today, you can buy a house for less than the price of a new car in Australia, or for less than the average deposit on a house in most Australian cities. Which raises another question. There are a lot of very smart American investors with a lot of money to burn. If properties in the US are such a bargain, why is it that many of these American investors still don't want to touch the property market with a ten foot pole?

Miami Vice
I'm not going to go into detail about what an absolute debacle the US property market is today, but let's just take a look at an interesting graphic in a recent report from the ratings agency Moodys. Moody's notes that there is still a massive surplus of housing inventory on the market, and that foreclosures and defaults are still skyrocketing in many parts of the country. You can see below that there are significant parts of California, Nevada, Arizona and Florida, where Moody's doesn't expect the housing market to fully recover until 2030. Yes, that's still two decades away.

And guess where the property spruikers are trying to talk Australians into buying investment properties? You're right. Places like California, Nevada, Arizona and Florida. Here's are a couple of listings in Florida from My USA Property:

Now, on the surface, property prices in Florida look like a real bargain, since they've already fallen around 45% in Miami and more than 40% in Tampa, as you can see below.

Source: www.data360.org

Unsuspecting Suckers
But there's no guarantee that prices are ever going to return to these peaks again, at least for a very long time in some of these areas. In fact, one recent study (which I might examine in more detail when I get the chance) argues that the housing bust may have created new types of "declining cities" across the USA -- certain cities which grew rapidly in the boom, attracting huge population inflows and investment -- but which are now facing the prospect of decades of stagnation thanks to a vicious circle of falling house prices, declining populations, rising vacancies, and increasing crime rates.

Some Australian investors are already finding this out the hard way. From the above story in The Age:

Sydney woman Kathy Graffiti bought three properties in upstate New York in 2005 and estimates she has lost between $300,000 and $400,000 on her investment. She bought two properties in Rochester and one in Buffalo for a total of $250,000, expecting rental yields of between 22-23 per cent.
The rental income stopped in 2007 and Ms Graffiti was forced to sell two of the properties at a significant loss. She has been offered $10,000 for the third property. 

According to Neil Jenman, the consumer advocate quoted in The Age above, Buffalo, NY is one of the many areas where American "flippers" are buying up properties at fire-sale prices and then selling them on to "unsuspecting Australian suckers" at much higher prices.

Typically, the American promoters work in tandem with Australian property spruikers who Jenman says are the "same rogues" who used highly questionable tactics when selling residential property on the Gold Coast and in the outer Melbourne suburbs.

Jenman says some Australians paid $50,000 for US houses with expectations of extraordinary rental yields and now can't sell the properties for $25,000. And he knows of an Australian who paid $80,000 for a house and now is unable to sell it for $40,000 – the best offer has been $10,000.

Dumb Things
Without a doubt, there are going to be some good investment opportunities in some parts of the US. But how the hell are you going to identify them from Australia, and can you really trust the clowns at places like 888 US Real Estate to pick the winners for you?

And that's not to mention the myriad of other problems involved with buying property in the US, which the property spruikers gloss over, but include:

• Significant foreign exchange risk
• Major tax complications including the necessity to pay income tax in the US on any rental income
• Stronger legal protections for tenants in the USA and a greater likelihood of lawsuits which can significantly raise costs for landlords compared to in Australia (see here for example)

Finally, you may have wondered how Australian investors have been financing these purchases. The answer is that American banks generally refuse to grant loans to overseas property investors (they're having enough trouble dealing with all the dumb subprime loans they made to Americans), so the majority of purchases are being made in cash. And where is this cash coming from? Usually, one of two things. Either a line of credit based on the equity in their Australian property holdings, or cash from their self managed super funds. Does this sound like a smart idea to you?

It's time to wrap this up. Let's end with an appropriate Aussie classic from Paul Kelly.

A double whammy from The Australian

Just a day after its revelation that there is dissent within the Australian Treasury about the government and RBA's view that Australia does not have a property bubble, we have an article today claiming that the Reserve Bank "deliberately intervened in the political debate over the property boom to stop governments releasing more land."

The bank feared the release of land would cause traffic gridlock, environmental problems and potentially a US-style housing slump. The move, detailed by a senior RBA official in documents obtained under Freedom of Information laws, is a rare example of how Australia's independent central bank is prepared to act to protect its monetary policy decisions.

Now, there are several interesting revelations in this article, but I was perhaps most struck by this passage:

Even if Australia had lifted supply-side restrictions, she said, and "became Phoenix or Las Vegas", there would still be significant price cycles... Ms Ellis, who, like Mr Stevens and Wayne Swan, has pointed to the more recent contribution of supply-side issues to higher prices, believes government restraint on housing supply helped avoid a US-style slump.

I find this interesting because it is, to put it mildly, totally at variance with the facts. There is very strong evidence that the US states that had the most "government restraint on housing supply" -- such as California and Florida -- had the biggest price rises when the market was booming, and are now suffering from the biggest crashes. It's hard to believe the RBA is not aware of this evidence. See the chart below.

Source: Carpe Diem

Important to note is that Texas, the second largest US state, has managed to almost entirely escape the housing crash. This article has a nice summary of the arguments. 

Throughout the past decade, Texas has experienced far smaller house price increases than in California, Florida and many other states. During the bubble, California house prices increased at a rate 16 times those of Texas, while Florida house prices increased 7 times those of Texas. As a result, after the bubble burst, subsequent house price declines were far less severe or even non-existent in Texas... Unlike Texas, all of the markets with steep house price escalation had more restrictive land use regulations. 

So back in the real world, the evidence suggests that supply side restrictions do nothing but intensify the boom-bust cycle and worsen the fallout when the music stops. Am I the only one disturbed that even the RBA is utterly unable to face up to reality?