Saturday, December 29, 2012

Hong Kong Revisited -- Risks Presented by Low Cap Rates

View of Hong Kong Central from Kowloon, November 2012

Returning to Hong Kong 18 months after my previous post, I found residential prices had increased 23% this year alone as of October, and 87% since 2007, causing the Hong Kong Monetary Authority (Hong Kong's central bank) to worry that “the disconnect between property prices and economic fundamentals” presents “macro-financial risks” to the Hong Kong economy. has reported rental property capitalization rates in Hong Kong have declined to a range between 2.2 and 3.6%, and as low as 2.13% in The Peak neighborhood, and The Economist has reported an estimate that Hong Kong homes are 69% overvalued when compared to the rental income that they can produce.

Ultra-low real estate capitalization rates in Asia, such as in Hong Kong, present a bubble that lasts only until interest rates return to normal levels. Hong Kong already has a history of these bursting bubbles, such as the office market in 2004, declining 30% the following year, or the residential market in the Asian Contagion of 1997, when average prices declined 63% from peak to trough.

The Hong Kong government has already taken measures to discourage speculation, such as lowering loan-to-value ratios on mortgages and imposing stamp duty taxes of 15% on home flippers and foreign buyers, but such measures also send signals that housing prices are still headed upwards.

A Barclay’s report this year shed some light, though, on the gain in housing prices, reporting that the proportion of investor-buyers increasing to 70% and that 60% of homeowners have no mortgage. This points the reason for the price gain in the direction of foreign buyers, particularly the Chinese mainland, who often do not occupy their Hong Kong homes but treat them as “safe haven” assets.

With home affordability in Hong Kong at historic lows, any events that call in to question Hong Kong’s “safe haven” status, such as an interest rate shock, could cause it to suffer the fate of most of the second home markets the world over, although there is always a need for a safe haven somewhere. London, New York and Dubai have been recent popular destinations for foreign buyers with this aim in mind.

Hong Kong benchmark interest rate history -- HK Monetary Authority
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Tuesday, December 25, 2012

Perverse Executive Compensation Schemes Instigated the American Mortgage Crisis

Last month I had the opportunity to watch my former boss on trial. On December 7th, he and his two co-defendants were found liable by a jury for $168.1 million in damages to the FDIC (U.S. Federal Deposit Insurance Corporation) for the failure of IndyMac Bank, the costliest failure to date for the FDIC, causing an estimated cost to taxpayers of $12.8 billion. This case was known as FDIC v. Van Dellen, Koon and Shellem. The basis of this lawsuit was that the defendants departed from safe and sound lending practices in order to score personal bonuses based on loan volume.

IndyMac executives Shellem and Koon

Eleven years ago I was the chief commercial appraiser for IndyMac Bank in Pasadena, California, reporting to the chief credit officer, Ken Shellem, who was one of the defendants in this case. I started my position there with the naïve expectation that this new bank wanted to follow all the rules. It took me 3 months to figure out that IndyMac was in the business of breaking rules to enrich its senior management, and this corruption led to the top of the organization, the Chairman of the Board, David Loeb.

Chairman David Loeb was best known as a co-founder of Countrywide Home Loans than in his other role as a Nevada land developer. While Federal Reserve Board Regulation O severely limits the amount of money that can be loaned to officers of a regulated institution, Mr. Loeb had found what he thought to be a loophole. He pushed through bank loans to developers who were buying his land in Nevada. As the chief commercial appraiser, I was told that I would be fired if I held up any appraisal supporting one of these land loans, and I was prohibited from ordering any appraisals. All appraisals were ordered by loan officers on sales commissions.

I worked mainly with the Bank’s Home Builders Division and was surprised to find that its own senior credit officer was on commission. As a result, there was no loan proposal that he didn’t like. After 3 months, it was made plain to me that my job was to approve every salesman-ordered appraisal report with a review report bearing my signature. This concerned me, because I found a few of the reports to be biased with false inspection reports, absurdly optimistic income projections, or appraised values well above the simultaneous purchase prices.

I tried to hold on to my job as long as possible without approving the fraudulent reports. I certainly did not want to be fired, but neither did I want to be prosecuted or sued some day for participating in loan fraud. It would be better to be unemployed. I was fired roughly 6 months after I started.

I blew the whistle to the regulators (OTS), and shortly afterwards there were some personnel changes at IndyMac, including the sudden retirement of Chairman Loeb and the termination of the COO and Senior Credit Officer of the Home Builders Division. Loeb died five months later, the Kenneth Lay of the banking industry. Most of the ringleaders kept their jobs, however, including the defendants named above.

I launched a wrongful termination lawsuit against the bank and two of the same defendants named above – Ken Shellem, my boss and chief credit officer, and Richard Koon, the chief loan sales officer, who worked hard to persuade the bank to fire me. At a court-ordered mediation the case was “settled to the mutual satisfaction of both parties.” A non-disclosure agreement prevents me from saying more.

The problem with the whole mortgage industry

In the mortgage industry meltdown of 2007-2008 it could be asked why so many of the best and brightest financial minds were so wrong again so soon after the savings and loan fiasco of two decades ago?

It’s the compensation

One explanation is that financial executives were gaming the system in response to unsound executive compensation systems commonly used by public companies.

Earnings can often be booked at loan origination, regardless of loan soundness. During the good times, these unsound loans can be sold off to sit in mortgage pools or portfolios as ticking time bombs, to be dealt with long after the senior executives have received their bonuses and exercised their stock options. Many mortgage industry executives succumbed to such a compelling enrichment scheme.

IndyMac Bank and Washington Mutual

Two of the largest savings and loan institutions in the U.S., IndyMac and Washington Mutual, were respectively seized by the FDIC in July and September of 2008.

Both were fast-growers who were rewarded by Wall Street with high price-earnings multiples and soaring stock prices. Those in the mortgage lending business know, however, that such rapid growth is inconsistent with prudent lending.

Many mortgage-lending institutions rewarded their CEOs and COOs with incentive-based compensation that dwarfed their annual base salaries and encouraged them to do whatever was necessary to increase the stock prices of those institutions. Stock prices moved in tandem with reported earnings.

IndyMac CEO Mike Perry, for instance, had an annual salary of one million dollars per year, but his incentive-based compensation (bonuses and stock options) was many times as high. Perry earned over $32 million by selling IndyMac stock from 2003 to 2007, in addition to performance bonuses which were typically 75 to 100% of his base salary.

An IndyMac press release on September 22, 2006, “IndyMac Signs Long-Term Contract with High-Performing CEO, Michael Perry,” plainly explains the radical difference in future (year 2007) compensation to Perry under various scenarios, with his total compensation limited to $1,250,000 for EPS growth of less than 5%, but compensation of $8,943,000 for EPS growth of 17%. With a compensation structure like this, it was no wonder why rapid growth was pursued at all costs. Making and selling unsound loans would be the easiest way of meeting such a financial goal.

Kerry Killinger, CEO of Washington Mutual (WAMU), was also paid a base salary of $1,000,000 in Washington Mutual’s last full year of existence, and he was incentivized with stock options that brought his total pay package to more than $14 million. The New York Times reported that he received $38.2 million in performance pay ($7.6 million in cash and the remainder in stock) between 2005 and 2008. WAMU”s mortgage-related losses of $8 billion in 2007 and 2008 wiped out all of its earnings in 2005 and 2006.

World Savings

As reported on CBS’s Sixty Minutes, Herb and Marion Sandler safely and soundly managed World Savings for years before finally succumbing to such temptation, receiving millions of dollars in the sale of their doomed institution to Wachovia Bank, so badly damaged that the federal government had to force its sale to Wells Fargo.

Fannie Mae

Franklin Raines, the CEO at Fannie Mae, received $52 million in compensation between 1999 and 2004, with $32 million from an incentive plan generating big bonuses for Fannie Mae achieving certain performance yardsticks, such as 15% annual growth in earnings. Mr. Raines was accused of falsifying the reported earnings to gain his bonuses and was therefore terminated, leading to a $9 billion profit restatement covering years 2001-2004.

These CEOs have faced multiple lawsuits, some of which have not yet been resolved. Mike Perry, IndyMac CEO, settled with the FDIC (last week) and the SEC and faces class action lawsuits from investors.

Renowned law professor and former regulator William Black has recently made similar comments as follows:
Widespread appraisal fraud by mortgage lenders optimizes accounting control fraud.  The fraud “recipe” for a mortgage lender (purchaser) has four “ingredients.”
  1. Grow like crazy by
  2. Making (purchasing) really crappy loans at a premium yield (interest rate) while
  3. Employing extreme leverage (very high debt to equity ratios), and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)
George Akerlof and Paul Romer wrote a famous article in 1993 entitled “Looting: The Economic Underworld of for Profit.”  They agreed with the central finding of competent financial regulators and white-collar criminologists: following this recipe produces a “sure thing.”  More precisely, following the recipe produces three sure things.  The lender (purchaser) will report record (albeit fictional) profits in the near term, the controlling officers will promptly be made wealthy by modern executive compensation schemes, and the lender (purchaser) will suffer severe losses in the longer term. 
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Thursday, December 13, 2012

The “Colonias” at the Mexico-Texas Border

Colonia in Cameron County, Texas

While working on an assignment near Brownsville, Texas, which was a proposed subdivision with no entitlements or development plan, it reminded me of a different type of illegal subdivision which has been a scourge in the Texas Rio Grande Valley.

The word “colonia” has an often undesirable connotation in Texas, unlike other areas of Latin America, where it generally refers to suburbs or other human settlements. In Texas it refers to illegal residential subdivisions lacking the basic utilities (water and sewage treatment) needed for human habitation. Residents also sometimes have to poach electricity from the closest power line, as often done in India. These colonias are some of the poorest communities in the U.S. (60% of households earn less than $1600 per month and average household size is 4.1) and are estimated to contain as many as 500,000 residents in Texas. A University of Texas study indicates their greatest prevalence in the border counties of Webb (Laredo) and Maverick (Eagle Pass) and the Central Texas counties of Travis (Austin) and Bastrop.

Photo from P.A. Lassiter

When one crosses north from Mexico to Texas, the landscape and culture have a less defined boundary than the border itself, as the Texas border is porous and the border fence has unguarded openings for vehicles (although vehicles can’t cross the Rio Grande at those points). Extended families sometimes live on both sides of the border and cross freely, and the vast majority of residents on the immediate Texas side of the border are ethnically Mexican.

Texas governments have traditionally had a laissez-faire (“anything goes”) attitude towards real estate development. There are no zoning laws governing land outside city limits, and even the city of Houston has no zoning code.

Some unscrupulous land developers have previously taken advantage of this laxity by subdividing rural land, building or allowing substandard housing on it, and failing to install water or sewers. This was done illegally, and per Texas Local Government Code section 232, all residential subdivisions must now be approved by county government and show that they have water and wastewater removal prior to development. Lack of zoning is not the same as having approval to build. The law allows almost any piece of rural land to be subdivided and developed, but the development has to meet local standards, which include water and sanitation.

Because these communities live outside the conventions of the modern American financial system, colonia residents cannot obtain mortgage financing for their land or homes. Instead, their home purchases are typically financed through “contracts for deed” issued by the original property owner as “pay-to-own” contracts, and are often informal and handwritten, charging interest rates as high as 20% per year. This leaves homeowners without proper title to their properties, not being recorded in official land registries, and burdens homeowners with tremendous risk that they cannot claim or sell their ownership rights.

In 1995, the Texas state government was becoming increasingly concerned about living conditions and exploitation of poor homeowners in colonias and enacted legislation to discourage “contract for deed” transactions and assure that all residents have water, sanitation, and electricity. This will prevent future colonias from being developed, but has not necessarily corrected existing colonias, as there has been no budget for enforcement.

Colonias may undergo similar life cycles to conventional neighborhoods, starting simple and uncrowded, than densifying to horrific proportions, and then finally being recognized and brought under the control of local authorities and even provided with modern infrastructure. The top 2 photos are colonias I saw in Cameron County, which has made progress in getting colonias under control. I searched in vain in Cameron County for a horrificly overcrowded colonia, so I turned to another blogger for the third photo, one of many on her own blog.
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Friday, December 7, 2012

Waterfront Land Appraisal in Puerto Rico

This was a 1000+acre combination of fee simple (freehold) and leasehold interests in land around a scenic bay in Puerto Rico, and the lease agreement also had an option to purchase. A developer was acquiring these interests for an already approved project to build hotels, villas, and a cruise ship port. This mixture of interests meant that I had three tasks to do:

1. Determine the market value of the fee simple parcel, whose purchase price had been set in year 2000,
2. Determine the market rental rate for the remaining parcels and compare to the contractual rental rate to determine if there is a positive leasehold value, and
3. Determine if the option price was above or below market value in order to determine if the option had any value.

In my background check on the borrower, I found that he had pled guilty a year ago to a criminal charge of mortgage fraud and was also being sued by the FDIC. This became troubling to me as he required a quick closing on the loan and was using an unknown escrow company, yet had no signed, valid contracts as of my visit or several days afterward. What was also suspicious was that the price kept on changing with each new contract version he sent, all of which were in MSWord and easily alterable.

The ground lease was to another unaffiliated LLC who was supposedly going to assign its interest to the borrower after the lease was signed, but despite my requests, I never received a document of this assignment of leasehold interest. Moreover, the lease had a clause which rendered it null and void if anyone in the tenant’s company had had a criminal conviction.

The fee simple parcel had an abandoned sugar mill, and there was no environmental report to inform me about possible contaminants. Common sugar mill contaminants include bagasse (from boiler fuel), pesticides from the sugar liquid and residue, and metal oxides from the rotting of the structures. This site had an estimated 50,000 tons of scrap metal, much of it rusting, placing iron and zinc oxides into the soil.

The bay’s water was as turbid as New York Harbor and unlike the clear blue water one would normally expect in the Caribbean. The problem was agricultural runoff from the farms upstream, making the bay very silty, compounded by incoming wave action from the Caribbean Sea. The waterfront of the fee simple site, moreover, consisted mainly of bulkhead and mangroves, making it unsuitable for a beach. Beaches are one of the principal attractions of Caribbean resorts.

Moreover, the bay’s maximum depth was only 29 feet, whereas most cruise ships have drafts (distance from waterline to bottom of keel) of more than 25 feet and need another 6 feet of depth for clearance. The bay would have to be dredged first and periodically thereafter until the continuing river silt deposits were under control.

Sales of large parcels of entitled land had not occurred in several years in this part of Puerto Rico, but a look at listings of property for sale indicated asking prices below the sales prices of several years ago. An adjacent, waterview parcel entitled for 100 hotel rooms and 50 villas is listed for sale at just $35,000 per acre or $10,000 per UBV (“unidad basica de vivienda” or “unidad de vivienda basica”, meaning “basic housing unit”, a unit of measure uniquely created by the Reglamento de Zonificacion de Puerto Rico, the zoning regulation for Puerto Rico). One UBV is equivalent to a 3-bedroom dwelling. A 2-bedroom dwelling counts for .8 UBV. A one-bedroom dwelling counts for .6 UBV, and a hotel room counts for .4 UBV.)

The purchase option was based on a price close to $100,000 per UBV, ten times as high as the neighboring property, so the purchase option was considered to have no value.

Because the ground rent was in steps leading up to a stabilized rent equivalent to 8% of the purchase option price, and no ground leases were found as high as 8% of value, the leasehold interest itself was also considered to have no value.

The only parcel that was considered to have value was the fee simple brownfield parcel, so there was insufficient collateral to support the large development loan requested by the borrower. Furthermore, he never showed the ratified, valid contracts that would show that he was really closing these transactions (with my client's funds) on the day he specified, with his chosen escrow company. (I always advise my clients to use nationally known escrow companies.) I suspected a scam.