December 21, 2007
QuickLinks: Europeans Go Holiday Shopping
In For New York
First Published: December 21, 2007 8:00 PM
Comments from "Plugged In" Readers
did anyone happen to see the article in the new york times today about foreign investors buying lots of the new condos in manhattan? with the favorable exchange rate apparently a lot of europeans are keeping some of the nyc realtors busy even in december, insulating manhattan from the slowdown happening elsewhere. i guess they're especially buying the new construction. nothing to do with somagrand really...just wondering if something similar might pick things up here.
Posted by: [andyc] at December 22, 2007 7:58 AM
i didn't see the article you are referencing andyc, but my husband is an investment banker and he told me this a few weeks ago. he also indicated that the "trend" is slowly happening on the west coast (i.e., SF and LA). another indication of how weak the dollar currently is.
Posted by: anonymous at December 22, 2007 10:48 AM
I dont think San Francisco has to worry about the strong Euro- we're a much smaller city and much further away (almost 2x) from Europe for the Dutch, Belgian, English and their cousins to come here. But those of us who havent bought a house and are waiting might have a reason to be concerned about the Japanese, Chinse and Australians.
Posted by: wont happen here at December 22, 2007 10:57 AM
Maybe you can convince them it's cheaper to rent than to buy :)
Incidentally, where is the "increased foreign demand due to weaker currency" modelled on these hilarious rent-versus-buy spreadsheets?
Posted by: dub dub at December 22, 2007 11:13 AM
"Incidentally, where is the "increased foreign demand due to weaker currency" modelled on these hilarious rent-versus-buy spreadsheets?"
In the expected rate of appreciation. I'm constantly amazed at the ignorance of so many "investors" to basic financial modeling.
Posted by: BankerBoy at December 22, 2007 11:51 AM
"Incidentally, where is the "increased foreign demand due to weaker currency" modelled on these hilarious rent-versus-buy spreadsheets?"
You're becoming a one-trick pony. Rarely a good career move.
Posted by: Amen Corner at December 22, 2007 12:15 PM
@Bankerboy: That's cheating. By your reasoning I could roll in anything not explicitly modeled. Why not be more honest and call it "emotional fudge factor" (or implied volatility :) ).
I like my models to have predictive power. Otherwise, it's astrology. I realize there are many spreadsheet-modeling fans here (the more lines the better!), but it appears SS readers with spreadsheet fet*shes are not trying to invest in these properties (where it's a more-useful tool), but to live in them.
@Amen corner: that's almost funny!
Posted by: dub dub at December 22, 2007 12:19 PM
the dollar is WEAK right now. that is a fact. in our global financial world today investors look beyond what is "close" in terms of travel. it is a business move. if an investor in europe or china sees value he will buy. keep in mind all investors are not individual, but are often corporations. as a result of the weak dollar more international money will be flushed into our economy.
Posted by: anonymous at December 22, 2007 1:15 PM
Beyond Chinese, Japanese, and the Aussies, I think many nouveau riche Russians with oil money are also buying up real estate here in SF.
Posted by: anon8mous at December 22, 2007 1:39 PM
Yes, the Chinese, Japanese, Russians, and Aussies are buying up everything left and right in SF. That's why the sales volume is so high these days.
This factor is absolutely irrelevant in terms of impact on home prices.
Posted by: anon at December 22, 2007 1:52 PM
the initial poster andyc noted that the article referenced new condos. since it is new construction it may offer a reason that we haven't seen a huge drop in prices nor a fall out of buyers for the new developments. this all remains to be seen over the next year or so as closings start to occur. it actually indicates stability in terms of those whom purchased at say infinity or one rincon.
Posted by: anonymous at December 22, 2007 2:04 PM
I'm up here at The Resort at Squaw Creek, Lake Tahoe (www.squawcreek.com), after it's snowed 3 feet up here this week! I visited the sales office, and they mentioned they had 3 recently buyers, and many more inquiries from Europeans looking for vacation homes at The Resort.
The three units purchased were 2 bedroom, 2 baths, 1,025 sqft for $1,000-$1,080/sqft. But for them, and their strong Euro, it was more like $600/sqft.
Also, I have a friend who mentioned a unit in his building: 2171 Sacramento St. #3 in Pac Heights sold for $1,057/sqft, a 610sqft 1 bedroom asking $599,000 had 6 offers, and went for $645,000 plus a free 2 month rent back to the owner (woth probably $7-8,000). So the sale price was really more like $650,000+. The buyer is a nice woman from Switzerland.
If you go to open houses, I think you'll notice the Europeans and Asians not from SF looking.
Posted by: ResortatSquawCreek at December 22, 2007 2:10 PM
Don't expect to see foreign buyers at open houses. Back when I was in the market for a brownstone in New York, I got outbid more than once by foreign offers. According to my agent, almost all of the foreign offers were sight unseen (!).
The non-domiciled East Asian SF owners I know also purchased sight unseen, although they bought units in developments that had been marketed overseas, not houses. Incidentally, I'm not sure how you'd "notice" them looking in SF - it's kinda diverse here, no? ;)
Posted by: unnoticeable at December 22, 2007 2:45 PM
"Resort" is non-credible. The condo on Sacramento was sold to a local guy, not a woman from Switzerland.
As much as I'd like it to be true, our office hasn't seen any increase in traffic from foreign buyers.
Posted by: AnonAgent at December 22, 2007 3:29 PM
AnonAgent - Oh really? Let's make a wager of your choice. End of January, you are welcome to check PropertyShark to see who the buyer is. Definitely not a man. $1,057/sqft for places at 2171 Sacramento St. now. That's a 80% increase in price/sqft since the last sale in that building in 1H03 for $586/sqft.
How much should we wager? :)
Posted by: ResortatSquawCreek at December 22, 2007 4:35 PM
People still do not realize how small the world is becoming. The U.S. and China just announced the much anticipated ADS agreement (approved destination status), which will start taking effect in 08. Chinese visitation is forecasted by authorities to reach 579,000 travelers to the U.S. by 2011, which is WAY underestimated. Of the Chinese who travel from the mainland before the ADS, only less than 1 in 100 headed for the U.S. because of difficulties obtaining travel visas.
Most of the wealthy folks in China who made their money early on are becoming more and more hesitant to invest in their home markets. In the last a few years, they have been increasingly buying things from real estate to arts in more sophisticated markets where they could easily travel to. With this ADS, we are going to see lots of Chinese buyers coming to the states to hide their money. San Francisco is one of most desirable cities because of the short flight home and the city’s strong presence of Chinese culture.
Many U.S. developers are already planning for heavy marketing in China. Here’s the thing though, these people do not buy because they can afford it. They buy because other people CANNOT. So they are not gonna come for the $600k fixers in sunset. What they want is probably a luxury condo in south beach. 2008 and on, expect to see San Francisco’s prices to spread further apart.
People can analyze all they want on price v.s income, but the luxury housings especially luxury condos in a location like San Francisco are really commodities that attract buyers from all over the world. And the truth is that San Francisco’s luxury housings are still very under-priced in comparison to other cities that carry this world appeal. Shanghai, for example, came out with this mega project of 200 something units in Lujiazui, Pudong, starting at $4mil a unit. They are not selling as well as the rest of the whole country, but they are selling. NYC’s ultra luxury market is pushing $6000psf. Check out The Mark hotel.
This is not a saved-by-rich-Chinese post. Take a look at San Francisco’s luxury condo market. Back in the summer 06 when the Infinity came out, people here were giving pages and pages of reasoning why by summer 07 the Infinity’s prices would be down 20%-30%. Well, now they are close to 90% sold. Prices are not down, but UP more than 20%. The Millennium sold more than $100mil worth of units within 3 weeks of sales. And their prices have already been raised from 5%-10%. Even with all the negativity around, we are still seeing such strong sales. The message is pretty clear if you ask me. Who knows? Maybe the city really is becoming a vacation heaven for the world. Whatever the reasons is, San Francisco has been much healthier than lots of people thought or hoped it would be.
Posted by: blahhh at December 22, 2007 5:15 PM
Blahh you may be right. But I can recall other times when rich foreigners were supposedly going to buy at the high end and make it impervious to the market cycle. Even if you're right, I'm not sure if it's a good thing or a bad thing if S.F. has certain enclaves that are part of some worldwide market fo the uber-rich. And I agree that it probably won't have too much of an effect on the average home in the average neighborhood in S.F.
I suppose it's a topic for a different site, but I find the intense concentration of wealth in the hands of a small group in virtually every country in the world (Russia, China, Saudi Arabia, the U.S., etc. ) a disturbing development. Not sure what's so great about countries minting billionaires while there is still intense poverty, crappy working conditions, and environmental disaster looming. But I suppose that it does allow us all to get a vicarious thrill (ooh, private jet! oooh insanely expensive hotel room! oooh big generic glass condo towers!).
Posted by: wonkster at December 22, 2007 6:09 PM
The world has always been that way, though. Hasn't it?
Posted by: fluj at December 22, 2007 6:45 PM
To greater and lesser extents, however. The disparity between rich and poor seems to be widening in lots of societies. Ours included.
Moreover, there are lots of things that were "the way the world is"...until it wasn't that way anymore. There was no such thing as "freedom of speech," for example, until some folks decided that it wasn't ok for the government to control what people can say (I guess China still hasn't gotten that memo...Yahoo and Rupert Murdoch seem quite ok with that).
It just seems odd that we are more concerned with how the Chinese plutocrats will affect our real estate prices than how they will affect the lives of hundreds of millions and the world our children inherit. But then, this is a real estate site, so I guess that makes sense ;)
Posted by: wonkster at December 22, 2007 7:01 PM
I guess everyone that posts here is under 50 years old. Here's a tip: the end game for the US RE cycle is always a variant of "foreign money will keep driving prices". The use of an unquantifiable but easily grasped demographic is always a useful way of unloading overpriced assets on suckers.
Posted by: Guest at December 22, 2007 10:53 PM
The “end game” has been called under all kinds of clever “tips” and reasons for a long time. And by the way bears have taken control of everywhere including socketsite lately, you can tell the bears are growing desperately impatient and frustrated that the start of “the end” is still NOT here. I don’t believe either that a single demographic group can “save” the RE market on any level because numbers do not show anything in San Francisco that needs to be “saved”. However, I do think the positive influence brought by emerging markets like China will strengthen the RE of a highly desired city like San Francisco and will make it even stronger than it already has been.
While some properties in marginal neighborhoods are taking longer to sell or seeing price adjustments, the luxury market has been selling HOT. Even with all the confusion and crisis from foreclosure to credit tightening, luxury new developments have seen price increases as much as 20% over the last year. A single development selling over $100mil of inventories after 5%-10% of price increase within 3 weeks shows how much demand there is and how underpriced the supplies still are. This is not a forecast of Chinese buyers’ influence to come, it ALREADY happened without much help from our Asian friends.
If you think the strong performance was due to developers’ luck of landing wealthy “suckers”, you’ll be surprised by how much money these suckers have to spend. Numbers support that in 2008 prices will spread further apart in the city. Developers are being very optimistic about San Francisco market in particular. The Millennium Partners is already working on their next project in the heart of down town. And word on the street is the Infinity has been selling so well that the developer is now renegotiating for better terms with the lenders as we speak. People can insist on their theories and signals. We are only a couple of months till spring kicks in. Place your bets.
Happy holidays, socketsite!
Posted by: blahhh at December 23, 2007 3:55 AM
Whether you buy in a foreign market depend on your PREDICTION on the exchange rate, not what the rate has been.
IF you are European, and you are predicting that US Dollar will rebound sometime, buying in US is not a bad idea. Same applies to Australian, Russian, Japanese, and Chinese.
(please don't turn this into a what-you-think-the-exchange-rate-is-going thread. Different people think differently, and make investment decisions accordingly)
Except, we all expect Chinese RMB to continue to appreciate against USD (and aginst other currencies), and that's why there are a lot of foreigners buying RE in China, but I have not seen any concrete evidence that Chinese are buying in US.
Posted by: John at December 23, 2007 8:17 AM
Blahh, I find your description of the San Francisco of now and the future to be quite sad. You are portraying a city solely of the rich with towers of glass down in SOMA that are never occupied (due to them being owned by investors.) (And no- I don't buy the "outer sunset" will be different argument when those houses now sell for around a million as well.)
Where is the soul of a city that looks like that?
I realize that cities change. And the "old" San Francisco of artists, writers and musicians was wiped out with the dot-com boom (and hasn't returned.)
But the vision of the city you are portraying is even more grim. It's a city with no teachers, nurses, administrative assistants, cops, fireman, waitresses.
If your vision comes to reality- then the Chinese can have San Francisco.
Posted by: Sabrina at December 23, 2007 10:13 AM
I actually agree with what you are saying. Sad is probably an understatement depending on whose point of view. However, it's not anyone's “vision” and certainly not mine. It’s more like observations gathered by many including scholars, developers, and average folks who lived through this type of transformation for some other major cities in the world. Do a search. There were quite a few elaborated discussions here on socketsite before regarding the future of San Francisco. In a nutshell, the situation goes a lot deeper than just who has the financial means to live here. And San Francisco is not gonna take a 180 degree turn over night. I think we’ve seen enough evidence lately as far as RE goes. But it’s impossible not to realize that there’s a rather significant transfusion visible in certain parts of the city.
Posted by: blahhh at December 23, 2007 10:44 AM
Are foreign investors subject to capital gains taxes upon sale? It would seem investing in US real estate would provide a tremendous tax advantage if it doesn't apply. And when you couple this with a dollar rebound, it just makes too much sense.
Posted by: TaxQuestion at December 23, 2007 10:48 AM
"Are foreign investors subject to capital gains taxes upon sale?"
Yes, they are. Foreign Investment in Real Property Tax Act (FIRPTA). Section 897 of the Code.
The botton line is that San Francisco and Manhattan are the real estate equivalents of diamonds. They are a scarce resource and there will always be demand for them. Enough said.
So to throw San Francisco and Manhattan into the discussion with any U.S. suburban neighborhood (including suburbs immediately adjacent to San Francisco or Manhattan) is just silly and impractical.
The only measuring stick there is for San Francisco's real estate appreciation supremacy at any point in time is San Francisco. And even then, it must be done over a minimum amount of years to be considered valid. a 2 year drop off in resale values is completely useless unless you're evaluating flipper profits. Every evaluation should be 5-7 year periods against other 5-7 year periods.
Posted by: rinconhill_res at December 23, 2007 9:35 PM
What will be interesting to watch this year is how responsive voters are to affordable housing and other measures to divert general fund money away from services that benefit everybody in San Francisco to "only in San Francisco" services that benefit the inebriants, drug addicts, mentally ill, chronically stupid (with money anyway), and others. I think the middle class is getting thinned out in San Francisco because they're not watching their Supervisors and cannot find the time to really do so.
Posted by: Jamie at December 23, 2007 10:49 PM
"The botton line is that San Francisco and Manhattan are the real estate equivalents of diamonds. They are a scarce resource and there will always be demand for them. Enough said."
"Always" is a pretty strong word. Within the last 4 decades both San Francisco and Manhattan had lots of cheap housing and, dare I say, "urban blight." Try not to confuse a trend with an "eternal reality". things change. You'd be surprised.
Posted by: wonkster at December 24, 2007 12:08 AM
"The botton line is that San Francisco and Manhattan are the real estate equivalents of diamonds. They are a scarce resource and there will always be demand for them. Enough said"
Yup, thought so. Average age of posters here = Gen-X & Y.
Posted by: Guest at December 24, 2007 9:00 AM
"What will be interesting to watch this year is how responsive voters are to affordable housing and other measures to divert general fund money away from services that benefit everybody in San Francisco to "only in San Francisco" services that benefit the inebriants, drug addicts, mentally ill, chronically stupid (with money anyway), and others...."
I like to imagine the voters are smarter than to fall for that. There was a hue and cry this year when Daly tried to divert a much smaller sum of money from the General Fund for his pet housing non-profits. Too many other interest groups understood that there's only so much money to go around, and that was that. But this is SF, so who knows?
Posted by: zzzzzzzz at December 24, 2007 9:41 AM
LOL Guest. Because if you're looking for a large Baby Boomer presence on blogs, you're going to be looking for quite some time.
Posted by: fluj at December 24, 2007 9:45 AM
Prices in Manhattan dropped 30% from the late 80s to the early 90s. Both buyers and sellers were writing checks at closing.
Subpar CAP rates will be a barrier to individual foreign investment in SF.
Posted by: NYCer at December 24, 2007 9:47 AM
what generation are the 40 year olds?
Posted by: james at December 24, 2007 10:34 AM
a 40 year old is still barely Gen-X. Generally if you were a teenager during the 80's you get lumped in with Gen-X. I forgot what the group before Gen-X is called, I think they lump everyone that is post Boomer but pre Gen-X together into a forgotten or silent generation.
Posted by: Rillion at December 24, 2007 11:16 AM
All it takes is one big earthquake to turn San Francisco from a diamond into a lump of coal.
Posted by: northridge at December 24, 2007 12:05 PM
I am curious as to why people think Europeans want to live in SF. NYC yes but SF or LA ? I was in a few cities in Europe last month and while most people loved coming to US for shopping no one expressed an interest in buying a second house in SF. I asked about housing and heard universally that it was better to buy in Eastern Europe, it's closer and easier to get to.
Maybe there are a ton of people in China who want a house in SF, the people my wife talks to are looking at properties in Vietnam not US.
Are there any official stats published that show foreign ownership in SF ?
Posted by: snafu at December 24, 2007 12:32 PM
Very sceptical about Europeans wanting to live in SF in any numbers, other than people who are actually working here in high tech or bio tech. NY, FL in general and LA seem to be the destinations of choice for second homes/apartments. Most Europeans associate CA with beaches and glamor and SF really doesn't cut it in that regard. I would have thought Asian money was much more likely around here.
Posted by: Amen Corner at December 24, 2007 1:25 PM
Poor Parisian or Londoner finding themselves on Mission on 8th. Hah!
SFers - look around! This is not NY, LA, even Miami -- despite the non-stop press machine which keeps cranking it out.
Posted by: anon at December 24, 2007 6:44 PM
Agree. Does anybody not travel to Europe anymore? Do you really think someone from London is going to buy here vs. even some destination areas in Southern California or Florida? I am currently in Laguna Beach (where I have a vacation property) and I have seen foreign buyers here on my own block. (Germany, an extremely wealthy couple from India that only visits twice a year, and a Canadian family) My point is, Europe already has some of the most amazing cities in the world, and when they are looking for second homes I think Florida, Southern California and NYC are where they are going to buy. When I talked to the German family yesterday and mentioned I was from San Francisco, they told me it was an "interesting place", but "very dirty".
Posted by: partimelagunaguy at December 25, 2007 8:18 AM
Merry Christmas & Happy Hollidays San Francisco,
One of the reasons our City will continue to be ranked as one of the worlds great cities is our futur.
Not only will our business community continue to be a treasurer but the redevelopment of the east side of town from Fishermans Wharf to Hunters Point has much promise.
Consider what has happened in the past 15 years and what the next 15 years hold. Entire new neighborhoods, 1,200 ft skyscrappers, high speed rail to LA and a new waterfront!!
Our waterfront could take a lesson form several of the world’s cities that have recognized how popular waterfront locations are.
The Thames has wonderful waterfront developments for miles, from Richmond (Mick Jagger's home) to the Docklands. New subways, parks and vistas. A great jog or 1/2 day walks with many sites from the Tate to the London Bridge. The various waterfront residences and boat docks are very appealing.
Vancouver has invested in its shore line with entire new residential communities, restaurants and shops.
Shanghais has redeveloped its waterfront with entire new business and residential neighbors, be sure to have dinner at the M on the Bund, great City and water views.
Our Port is about to develop or sell to developers our waterfront. We should require the Port to have a master plan for the "Sea Wall lots (Pier 35 to AT& T Park)" as once they are sold off, we will not be able to change the uses. We have an opportunity to plan for the long term and not just the Ports financial needs in 2007.
What should our waterfront look like and how should it be used for the next 100 years?
The moment is now to encourage use for open space, parks, recreation and housing, not after the Port has sold off these parcels.
With that said on my birthday, I wish Adam and all of his readers and Prosperous and Joyful New Year.
Posted by: Frederick at December 25, 2007 9:27 AM
This came via email this morning. It's a longer read, but described as the best explanation of how the housing debacle happened. It's written by Porter Stansberry of the S&A Digest.
What happened (and what is still happening) is simply leverage in
reverse, or what people used to call a "run on the bank." But... I
think a great more detail would be helpful for you to understand.
Please excuse the intricacies: None of this stuff is very easy to
understand the first time you think about it. I'll try to avoid using
For nearly 10 years, as interest rates fell from 1995 to 2005, the
mortgage and housing business boomed as more and more capital found
its way into housing. With lower rates, more people could afford to
buy houses. That was good. Unfortunately, it didn't take long for some
people to figure out that with rates so low, they could buy more than
one. Or even nine or 10. As more money made its way into housing,
prices for real estate went up 20% a year for several years in some
places. The higher prices created more equity... that could then be
used as collateral for still more debt. This is what leads to a bubble.
Banks, hedge funds, and insurance companies were happy to fund the
madness because they believed new "financial engineering" could take
lower-quality home loans (like the kind with zero down payment) and
transform these very risky loans, made at the top of the market, into
AAA-rated securities. Let me go into some detail about how this worked.
Wall Street's biggest banks (Goldman Sachs, Lehman Bros., Bear
Stearns) would buy, say, $500 million worth of low-quality mortgages,
underwritten by a mortgage broker, like NovaStar Financial. The
individual mortgages thousands of them at a time were organized by
type and geographic location into a new security, called a residential
mortgage-backed security (RMBS). Unlike a regular bond, whose coupon
is paid by a single corporation and organized by maturity date, RMBS
securities were organized into risk levels, or "tranches." Thousands
of homeowners paid the interest and principal for each tranche. Rating
agencies (like Moody's) and other financial analysts, believed these
large bundles of mortgages would be safer to own because the
obligation was spread among thousands of separate borrowers and
organized into different risk categories that, in theory, would
protect the buyers. For example, the broker (like NovaStar) that
originated the mortgages would be on the hook for any early defaults,
which typically only occurred in fraudulently written mortgages. After
that risk padding, the next 3%-5% of the defaults would be taken out
of the "equity slice" of the RMBS.
The "equity slice" was the riskiest part of the RMBS. It was typically
sold at a wide discount to the total value of the loans in this
category, meaning that if defaults were less than expected, the buyer
of this part of the package could make a capital gain in addition to a
very high yield. Even if defaults were average, the buyer would still
earn a nice yield. Hedge funds loved this kind of security because the
yield on it would cover the interest on the money the fund would
borrow to buy it. Hedge funds could make double-digit capital gains
annually, cost-free and risk-free... or so they thought. As long as
home prices kept rising and interest rates kept falling, almost every
RMBS was safe. Even if a buyer got into trouble, he could still sell
his home for more than he paid or find a way to restructure the debt.
On the way up, from 1995-2005, there were very few defaults. Everyone
made money, which attracted still more money into the market.
After the equity tranche, typically one or two more risk levels
offered higher yields at a lower-than-AAA rating. After those few,
thin slices, the vast majority of the RMBS usually 92% of the loan
package would be rated AAA. With an AAA rating, banks, brokerage
firms, and insurance companies could own these mortgages even the
exotic mortgages with changing interest rates or no down payments.
With the magic of financial engineering and by ordering the perceived
risk, financial firms from all over the world could fill their balance
sheets with higher-yielding mortgage debt that would pass muster with
the regulators charged with making sure they held only the safest
assets in reserve.
For a long time, this arrangement worked well for everyone. Wall
Street's banks made a fortune packaging these securities. They even
added more layers of packaging creating CDOs (collateralized debt
obligation) and ABSs (asset-backed security) which are like mutual
funds that hold RMBS.
Buyers of these securities did well, too. Hedge funds made what looked
like risk-free profits in the equity tranche for years and years.
Insurance companies, banks, and brokers were able to earn higher
returns on assets by buying RMBSs, CDOs, or ABSs instead of Treasury
bonds or AAA-rated corporate debt. And because the collateral was
considered AAA, financial institutions of all stripes were able to
increase the size of their balance sheets by continuing to borrow
against their RMBS inventory. This, in turn, supplied still more money
to the mortgage market, which kept the mortgage brokers busy. Remember
all the TV ads to refinance your mortgage and the teaser rate loans?
The cycle kept going more mortgage securities, more leverage, more
loans, more housing until one day the marginal borrower blinked. We'll
never know who or why... but somewhere out there, the "greater fool"
failed to close on that next home or condo. Beginning in about the
summer of 2005, the momentum began to slow... and then slowly...
imperceptibly... it began to shift.
All the things the cycle had going for it from 1995 to 2005 began to
turn the other way. Leverage, in reverse, is devastating.
The first sign of trouble was an unexpectedly high default rate in
subprime mortgages. Beginning in early 2007, studies of 20-month-old
subprime mortgages showed a default rate greater than 5%, much higher
than expected. According to Countrywide Mortgage, the default rate on
the riskiest loans made in 2005 and 2006 is expected to grow to as
high as 20% a new all-time record. The big jump in subprime defaults
led to the first hedge-fund blowups, such as the May 2007 shutdown of
Dillon Reed Capital Management, which lost $150 million in subprime
investments in the first quarter of 2007.
Since Dillon Reed Capital, dozens of more funds have blown up as the
"equity slice" in mortgage securities collapsed. Remember, these
equity tranches were supposed to be the "speed bumps" that protected
the rest of the buyers. With the safety net of the equity tranche
removed, these huge securities will have to be downgraded by the
rating agencies. For example, on July 10, Moody's and Standard and
Poor's downgraded $12 billion of subprime-backed securities. On August
7, the same agencies warned that another $1 billion of "Alt-A"
mortgage securities would also likely be downgraded.
Now... these downgrades and hedge-fund liquidations have hugely
important consequences. Why? Because as hedge funds have to liquidate,
they must sell their RMBSs, CDOs, and ABSs. This pushes prices for
these securities down, which results in margin calls on other hedge
funds that own the same troubled instruments. That, in turn, pushes
them to sell, too.
Very quickly the "liquidity" the amount of willing buyers for these
types of mortgage-backed securities disappeared. There are literally
no bids for much of this paper. That's why the subprime mortgage
brokers the Novastars and Fremonts went out of business so quickly.
Not only did they take a huge hit paying off the early defaults of
their 2005 and 2006 mortgages, but the loans they held on their books
were marked down, with no buyers available.
The failure of the subprime-mortgage structure which started with
higher-than-expected defaults, led to hedge-fund wipeouts, and then
continued with mortgage broker bankruptcies might have been contained
to only the subprime segment of the market. That's why we jumped in
during late spring and recommended the higher-quality mortgage firms,
such as Thornburg and American Home. We believed that the higher
quality of these firms' underwriting would prevent a similar run on
But... the risk spread because of the financial engineering.
With Wall Street wrapping together thousands of mortgages from
different underwriters, it's likely that hundreds of financial
institutions around the world have traces of bad subprime and Alt-A
mortgage debt on their books. Parts of these CDOs were rated AAA.
Almost any financial institution could own them especially hedge
funds. Hedge fund investors quickly figured this out and asked for
their money back.
And so, in July, liquidity fears began to creep through the entire
mortgage complex. Not because the mortgages themselves were all bad or
even because the mortgage securities were all bad, but because all the
market players knew a wave of selling, led by hedge funds, was on the
way. Nobody wants to be the first buyer when they know thousands of
sellers are lined up behind them.
The market "locked up." Nobody would buy mortgage bonds. And everyone
needed to sell. Suddenly even Wall Street's biggest banks, the very
firms that created these mortgage securities were suffering huge
losses, as the bonds kept getting marked down and hedge funds and
other leveraged speculators had to sell into a panicked market. In
this liquidation, even solid firms, like American Home and Thornburg,
were trapped owning new mortgages they couldn't sell to Wall Street.
Meanwhile their banks, worried about the collapsing prices of
mortgages, demanded greater collateral.
It's a classic "run on the bank," except today the function of the
traditional bank has been spread out among several institutions:
mortgage brokers, Wall Street security firms, hedge-fund investors,
and banks. The real problem is that the long-dated liabilities (a 30-
year mortgage) were matched not by reliable depositors, but by fly-by-
night hedge funds, which were themselves highly leveraged and subject
That's why even as the top executives in these firms believed their
mortgages were safe and sound, they can't get the funding they need to
hold onto them through the crisis. As Keynes predicted, the life of
every higher-leveraged financial institution is precarious: "The
market can be irrational longer than you can remain solvent."
The hedge funds have no solution. Redemptions will force them to sell.
They'll continue to pressure the market, resulting in huge losses.
Hundreds of funds will likely be liquidated.
Wall Street's investment firms, if they can find additional capital to
meet margin calls, might weather the storm... depending on how far it
spreads. We saw a move in this direction yesterday when Goldman
announced $3 billion in additional funding for its big hedge funds.
For most mortgage brokers, the party is over, goodnight. Something
like 90% of them will be out of business by the end of the year.
The only chance they have to survive is very conservative underwriting
(which might result in a premium for their mortgage securities) and
lots of additional funding. Delta Financial, for example, is renowned
for its very conservative underwriting, which requires a substantial
(20%) down payment. The company raised $70 million last week from two
investors (one of which is our friend, Mohnish Pabrai) to hang on to
its $5.6 billion in on-balance-sheet mortgages. The stock is up 14.5%
on the news today. Will it be enough capital? It's very hard to say.
It depends on whether or not the company is able to sell some of its
mortgages to raise cash. It depends on whether or not it is downgraded
further and the firm receives additional margin calls.
I wouldn't be surprised to see Thornburg take a similar step raising
funds from existing shareholders. But, for now, Wall Street remains
very skeptical the firm will survive. Its shares are down another 46%
As analysts, what we got wrong was how far the crisis would spread. We
thought by buying the most respected firms with the best underwriting,
we could avoid the subprime train wreck. What we didn't know was how
far the subprime sludge had been spread via mortgage securities. The
insiders at these firms made the same mistake. They assumed by
operating conservatively their businesses would retain a premium price
on their mortgage and better access to capital. But in a panic, the
baby is often thrown out with the bath water.
And... we have to consider one more thing. Nobody knows right now how
far the crisis will spread. It could certainly get worse. As these
mortgage bonds are downgraded, the financial institutions that own
them must raise more cash in order to meet liquidity regulations. To
hold AAA-rated paper, banks, and other financial institutions need
only to maintain $0.56 in capital for each $100 of paper. But as the
paper is downgraded, the amount of capital they're required to hold
goes up, exponentially. At a BBB rating, financial institutions must
hold $4.80 of capital. At BBB-, they must hold $8 of capital per $100
of asset-backed securities. Thus, as the crisis worsens, the demand
for capital from these firms could grow substantially.
We can't know what will happen. And, as we can't know, we must stand
aside when our trailing stop losses are hit. As I wrote, back in early
July, about American Home Mortgage:
Speculation on Wall Street is that "Alt-A" debt will be downgraded
next. Most of the loans held by American Home Mortgage are considered
"Alt-A" because they have adjustable rates. Even with the high credit
scores of the company's borrowers, if rating agencies downgrade the
bonds it holds, the company's solvency will certainly come into doubt.
Whether this happens or not is a moot point for us: Our speculation
hasn't panned out. We should have realized it sooner... but in a few
more weeks we might be very glad we got out while we could.
Posted by: Cary at December 26, 2007 8:04 AM
This Porter Stansberry article is eye opening.
I have a simplistic or uneducated view regarding money, mortgages and housing cycles.
Would it not be a healthier economy if the instituitions issuing the original loans had a profit motive to hold their notes? Is it the uploading of fees and profit that makes these bundled securites, over time, so valueable that any grandmother would feel fine, ripping them up and tying them to Kites Tails, ala the little Rascals?
Posted by: kathleen at December 26, 2007 10:33 AM
this was one of my favorite quotes from when i was a broker back in 91
"The market can be irrational longer than you can remain solvent."
Posted by: james at December 26, 2007 11:15 AM
And...back onto more related topic of this thread, I found out that a Chinese guy just bought an entire floor at the Millennium. This is just an example of "Asian" money we are starting to see here in the city.
Posted by: blahhh at December 26, 2007 6:07 PM
Asians will likely buy in the SF market, who knows if it will be enough to make a difference? similar to the Japanese buying in Manhattan in the 80's... the market in Manhattan still fell significantly.
I highly doubt many Europeans will buy in SF though. I lived in Europe for some time and never once heard of a person there buying here.
SF is simply too small for them, and offers them little that they can't get in their own cities... Yes, SF is somewhat "european" in nature, but if you go to Europe you'll see how little that's true.
europeans like Manhattan, Orlando, Miami, and LA, because they're DIFFERENT. (notice, Orlando isn't even a "world class" city... but it's different and thus enough for them)
as example: how many of you would want to buy a second home in Seattle? Probably very few... Seattle is a beautiful city with many attributes similar to the Bay Area (liberal, pretty, on the water, hilly, etc), but it's SMALLER. In the end, most SFers wouldn't buy in Seattle because you don't gain that much... it's simply a smaller version of here, and doesn't add that much. And when it's gloomy here, you don't want to go where it's gloomy!
It is more likley that a SFer would buy a second home in Palm Springs (even though Seattle is a far cooler place than Palm Springs), because Palm Springs is a getaway, and very different from SF. when it's gloomy in SF, you can escape to the sun of Palm Springs.
For the Europeans, SF is a cute LITTLE city with charm and character...
but there's no way they're going to fly like 10-13 hours to get here for that. especially because SF is similar but smaller for them... they're leaving gloom for gloom. not gonna happen much.
instead, they choose Miami due to the beaches, Orlando due to the parks, LA due to "glamor", and NYC because it is the only US city that is really comparable to the big Eurozone cities (London, Paris, Moscow, etc). but Manhattan is very different than the Eurozone cities with its skyscrapers etc...
SF is a beautiful city... it is world class vacation city... but definitely a step behind the big time cities of NYC, Moscow, Paris, London and so forth. and in the end, it is simply too similar but smaller than where these people come from.
it will be interesting to see what happens if/as foreigners buy... will we have a large enclave of empty high-rises in the Northeast part of the city??? that would be depressing... and certainly wouldn't support the businesses and neighborhood rejuvenation that many are hoping will come with redevelopment.
Posted by: ex SF-er at December 27, 2007 5:44 AM
Well i can only speak for myself but im buying in SF .I can think of no good reasons as a cultured Englishman(no idea what a european would do as that covers such a vast range of countries) to buy in Florida or LA ,they have nothing to offer me beyond sunshine,ghastly amusement parks and in the case of LA disgusting smog,if i wanted the former id buy in south africa and the latter china or the former eastern bloc.
Its precisely the size of SF that i love ,great opera and ballet(mediocre theatre but i can live with that) excellent food and drink easy access to Tahoe,skiing,beaches etc etc major sports teams,excellent literary scene and all in a relatively small city ,fantastic-yes its a long flight but as im going to be staying in one or two months segments thats not a problem,prices are compared to the uk cheap(even if the$ gains as i expect 10% over the next couple of years)
Posted by: bertie wooster at December 28, 2007 12:28 AM
Out of curiosity:
1. are you from The City?
2. why did you choose SF over NYC? Or do you now own in both? most cultured Englishfolk I know choose NYC because it simply has more culture than SF... but then again all the English that I know live in London
Thanks in advance.
Posted by: ex SF-er at December 28, 2007 5:28 AM
ex-SFer -- your post was very thoughtful and well-reasoned, as usual. There is no bertie wooster -- that was an obvious fake by some local RE shill (the last parenthetical about expected gains gave it away as did the strained attempt at British verisimilitude)
Posted by: Trip at December 28, 2007 6:14 AM
Sorry Trip but whatever else i am im not a local re shill (had to find out what the he.. you were talking about first though,two people divided by a common language)I dont expect the dollar to stay at two to the pound for very much longer so why should you,it historicaly hasnt been at this level for what 25 years? so on that basis if no other(lets not even take into account the uk economy for example) i would expect the $ to gain 10% over the next couple of years as for "strained attempt at british verisimiltude" sounds like someone has had a sense of humour bypass
Ex sfer,no im not from the city but have visited two or three times a year for the last twenty or so ,why not nyc,of course it has more culture than sf but its a bigger city and i dont want a place in a big city,sf is the right size and the culture it has is good enough,its more compact and manageable,i lived in London for 15 years so if i wanted a big city place id buy there(actually i wouldnt because i either use a pals place in docklands or stay at my club,but i hope you get my point)
Posted by: bertie wooster at December 28, 2007 8:08 AM
Thanks for the reply Bertie...
I often forget the European contingent from smaller cities... They would of course be more willing to buy a place in San Francisco compared to their larger city counterparts (Londoners, Parisiens, etc).
I don't doubt that some Eurozone peoples will buy in SF, but I doubt it will be a meaningful number (as I said above). The asians are a different matter IMO, they may buy a meaningful number, I'm just not sure if it will be enough.
That said, to prove the counterpoint: I've been to a few open houses in SF this year, and did hear several languages at one of the open houses in Noe Valley (all asian or indian though).
Posted by: ex SF-er at December 28, 2007 10:59 AM
bertie, i have to respectfully disagree with your currency assumption. i see no reason for our dollar to recover any time soon. your pound is still based on gold. ours is a joke. i'd seriously consider buying here if i were you for the strength of currency reason too but not unless i found a place i absolutely loved to live in while here. that way if we have lost another 10-20% of our currency next year you won't feel so bad for having pulled the trigger a bit early.
we just lost a kiwi at my company over the declining dollar denominated paycheck we were sending him. we are in trouble as a country and economy.
worst part about it, none of these clowns running for public office has the first clue what to do about it.
Posted by: james at December 28, 2007 11:59 AM
Lots of Brits live in SF or spend significant time here. Not as many as in LA (where the little neighborhood market in Beachwood Canyon has an entire section of British snacks), but SF has been romanticized in Britain by the very popular "Tales of the City" as a place of very different lifestyles and attitudes. The UK is the most common nation of birth for immigrants in 94114. Plus many Brits in technology have moved here.
I don't expect foreign buyers to save the SF housing market, but SF is a city of immigrants. It remains an attractive place for particular groups of people from around the world-- e.g., Asians, gays, English-speakers, people who don't want to drive.
Posted by: Dan at December 28, 2007 1:06 PM
I'm (originally) from the laguna area and my family still lives there. There are certainly europeans in So Cal, but considering how much larger that area is, I find it amazing how few europeans are there on a permanent or semi-permanent basis.
There are always going to be people who just like the Hollywood/sunshine California better than the golden gate California. However, among the euros I've talked to over the years that have done the SF/LA/Yosemite tour, my impression is that the majority prefer So Cal on their imported tv shows and the small city of SF in reality.
Honestly, I think the number of foreigners looking to buy a 2nd home in any of the cities mentioned that don't already have an economic reason to be here is irrelevant anyway. Nobody's going to buy in SF to go shopping, but then no one would in LA or Miami, either. And you'd be outta your friggin mind to buy in Laguna Beach to soak in the culture.
Posted by: kaya at December 29, 2007 1:10 PM