Elgonemy, director of acquisitions at San Francisco-based private equity firm Equinox Hospitality Group, shares his observations on real estate finance in his new book, ‘Skin in the Game.’ MortgageOrb spoke with Elgonemy about real estate finance's recent past, rocky present and uncertain future.
Q: Your book discusses ‘the impending risks in the U.S. financial system.’ But haven't U.S. investors already learned their lesson from the 2008 crash?
Elgonemy: The impending risks should be viewed as ‘tail risks,’ or those that are lingering in the U.S. economy and have an indirect effect on real estate. Unfortunately, memories of U.S. real estate cycles are short, and some of the lessons are never taken on board at all. For example, American International Group is already looking to get back into the mortgage-backed security game, even after being at the center of the recent financial crisis and causing U.S. taxpayers some $182 billion.
The 2008 crash had many similarities to the savings-and-loan fiasco of the late 1980s, in which a banking system welcoming deregulation decided to capitalize on a massive, debt-financed real estate boom without much concern about the downside. That's because the players expected the government to intervene when financial hell broke loose.
So the question is whether we're smart enough this time around to use what happened and actually learn from our mistakes. Time will tell.
Q: Your book considers the state of the Federal Housing Administration (FHA) with a section called ‘Our Big Fat FHA Dilemma.’ What is the FHA's dilemma, and how can it be fixed?
Elgonemy: With U.S. banks still reluctant to make loans to riskier home buyers, the government is using the FHA to make home mortgages more accessible. However, in doing so, the government is insuring billions of additional housing debt with potentially disastrous effects.
The danger of relying on the FHA to prop up the shaky housing market by facilitating mortgage originations, modifications and refinancings to less-than-stellar borrowers will only result in more subprime loans being stockpiled on the Fed's balance sheet. Eventually, delinquencies could overwhelm the FHA, and the hoped-for floor in residential real estate pricing could be prolonged.
The FHA's 3.5% down-payment loan, known as the Section 203(b) Mortgage Insurance Program, is the crux of the dilemma. This type of 30-year fixed financing is funding approximately 23% of all FHA-insured, single-family loans in the U.S. today. So first-time buyers in the U.S. can purchase homes with FHA-backed loans with very little down.
It sounds great, but is this really a smart idea? Isn't the lack of down payments one of the reasons we have so many owners being foreclosed upon today? Buying with practically nothing down is not good public policy, not good for lenders, dangerous for mortgage investors, and very risky for borrowers.
Should Americans worry about FHA loans with little down? Yes, of course they should worry, because buying with hardly anything down does not suggest dealing with purchasers who have good financial capacity. If something goes wrong, such buyers can quickly be underwater. Moreover, when there's little or no equity, the option of selling without a loss is gone.
In addition, borrowers applying for an FHA-insured mortgage with a minimum 3.5% down payment are required to have a FICO score of only 580 (even though 580 is considered high-risk). Common sense dictates that the FHA is enabling too many people with shaky finances to get loans and, in effect, indirectly contributing to a potential repeat of the errors that caused the financial crisis.
With only 3.5% skin in the game, can homeowners be protected from the potential risks of negative equity if home values decline? Does just a 3.5% equity stake instill pride of long-term homeownership? Has the paraphernalia of the credit bubble not taught U.S. regulators any lessons? Without serious reform related to sufficient down payments, it could soon be a case of ‘here we go again.’
If there is one collective lesson to learn from the past, it is that excessive leverage is lethal. Increasing the amount of equity that banks have to hold is one way of keeping down the amount of debt that easily finds its way into real estate. The best way to limit the damage from a property bust is to exercise more direct control over the amount of debt available to property owners and developers, whether that is through discretionary interventions or standing rules.
Q: When do you believe the residential housing market will begin to see signs of recovery?
Elgonemy: The rise in home prices and supply were extremely high, so the fall was very steep and the recovery will be lengthy. A conservative estimate would be at least three years in most U.S. markets.
There are just too much shadow inventory and foreclosures in the market. Also, the increase in renting in the U.S. is putting a damper on the housing recovery.
Q: What solution would you propose for reforming Fannie Mae and Freddie Mac?
Elgonemy: The mortgage finance debate is highly contentious because it requires a complete re-examination of whether the government should subsidize homeownership. But I think that the optimal solution is to fully privatize the U.S. mortgage guarantee business, meaning that Fannie and Freddie would be completely dismantled.
Existing banks and mortgage lenders, as well as new lenders, would step in and undertake all conforming (core or with loan-to-value ratios lower than 80%) mortgage originations. This would take time and would need to be done gradually, so as not to cause any shocks to the financial system.
Q: And looking at the other half of the industry, how would you categorize today's commercial real estate market?
Elgonemy: It can be categorized as a market of ‘haves’ and ‘have-nots.’ That is, we are already in an upturn comprising of well-occupied commercial properties in primary markets (Class-A trophy assets). Pricing for trophy assets in gateway markets (New York and San Francisco) have increased significantly, but on the other hand, pricing for most Class-B and Class-C properties in secondary and tertiary markets continues to decline, but at a much slower rate than before.
There are still several threats to the fragile stabilization of the commercial-property sector. First, delinquency rates on commercial mortgage-backed securities have reached record highs. Second, massive amounts of commercial real estate debt will be coming due by 2015.
Third, refinancing options are still limited, despite historically low interest rates, because many of these loans are higher than the original balances. Fourth, renewed strain on credit conditions may materialize from loan losses due to delinquencies, forming higher capital and liquidity requirements in the context of new international banking regulations (such as Basel III).
Risks continue to revolve around the exposure of financial institutions to commercial real estate, especially by small and midsize banks, which are major providers of credit to small and medium-size property owners. In addition, continuing weakness in private-label securitization markets is limiting the ability of banks to offload commercial-property debt risk from their balance sheets. In other words, and given the mixed signals emanating from the markets, the commercial real estate sector is not out of the woods yet.
The outlook for U.S. commercial space has clearly improved, but any enthusiasm should be restrained by the challenges that remain.