Watch out: Home real estate is back in the sights of Capitol Hill tax reformers.

The staff of the nonpartisan Joint Committee on Taxation has proposed new options for closing the "tax gap," the difference between federal taxes that should be paid under current tax rules and the amounts collected by the Internal Revenue Service. Recommendations from the committee staff carry substantial weight with members of the Senate and House, and frequently get included in tax legislation.

High on the list of methods to collect more of what is owed is to tighten up on homeowners’ billowing write-offs of local and state property taxes, which cost the government about $20 billion a year in revenues.

Under the federal tax code, local real estate taxes on homes generally are deductible. But they are not deductible if the tax payments cover commonplace special assessments designed to pay for improvements that directly benefit taxpayers’ real estate. Examples include local "user fees" for water mains, sewer lines, sidewalks, trees and trash collections.

The problem, according to the tax committee staff, is that current federal law does not require local governments to tell the IRS about property owners’ mixes of regular taxes and nondeductible special-benefit levies. Local governments often provide annual property tax statements to residents with breakouts of assessments. But many homeowners simply deduct the bottom-line taxes paid.

As a result, according to the committee, homeowners get to write off hundreds of millions of dollars a year for tax payments that are not legally deductible. In a 1993 study, the Government Accountability Office estimated that $400 million of that year’s $11 billion in property tax write-offs claimed by homeowners were improper. With deductions this year running nearly double that amount, wrongly claimed write-offs could be in the $700 million range or more.

The committee proposes two possible solutions: Require local governments to provide copies of homeowner tax statements to the IRS with breakouts distinguishing between regular and special-benefit assessments; or require mortgage lenders and loan servicers to report details of homeowners’ property tax escrows with similar breakouts.

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This is a topic that seems to come up fairly often and I think is worth exploring: Does the rise of Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) represent a true “paradigm shift” in how risk is decoupled from mortgage originators/lenders and transferred to individual investors and taxpayers? Is this a temporary trend soon to follow unprofitable Dot.coms into the dustbin of history, or a true revolution in risk transference?

MBS/CMO goal: Privatize profits, socialize risk

We have often derided those in the REIC over the past year or so who have claimed that the unprecedented run-up in housing prices over the last 6 years was a “new paradigm”, i.e., a permanent, historic shift in severing the traditional relationships between incomes, rents and RE prices. But what if there’s a kernel of truth to this?

We must remember that MBS/CMOs are what have made issuing NAAVLPs and I/Os profitable, even with tiny risk premiums, because of that oh-so-critical risk-transference. Even the most toxic option-ARM is profitable to the originating lender –in fact, the fees & points (profits) are far higher on toxic loans than they are on traditional 15/30-year FRMs or amortizing ARMs. If you’re a lender, why wouldn’t you want to take boat-loads of risk-free (for you) money? You’d have to be crazy not to, right? Of course, there’s always the possibility of repurchase agreements or class-action lawsuits if things get really bad, but, hey that’s for some other guy to worry about. You’re in it for the short-term profits and couldn’t care less about the long view, right?

The new MBS/CMO risk transfer model has been working SO well for lenders that I fear only a complete economic meltdown (resulting from it) would deter banks from voluntarily continuing its use in the future. And, as Randy has pointed out, the current anti-regulation/pro-banking bias in government is so strong, involuntary regulations (with real enforcement) are pretty much out of the question –for now.

I believe our best hope where toxic loans are concerned is for MBS investors to begin to recognize that the underlying risk has been severely under-priced and demand greater premiums and/or risk disclosure. This should result in higher mortgage interest rates and the return of “quaint” things like full-documentation, which in turn would deter widespread use of these loans. Of course, this would require FB defaults on a massive scale, something we could expect to see beginning next year, and continuing in waves for several more years.

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RodgerRafter

Sub-prime mortgage lender Accredited Home Lenders issued an earnings warning yesterday morning, citing three main reasons for their disappointment:

"Origination volume and loan submissions have not increased as much as the company anticipated and continue to be adversely affected by a combination of pricing competition and product contraction that has been prevalent in the market throughout 2006.

Whole loan premiums and securitization returns are under more pressure than previously anticipated, caused a decrease in whole loan investor appetite for certain products, as well as changes in credit standards and equity requirements promulgated by the various rating agencies.
-Delinquency from production periods in 2005 and 2006 has risen above previous expectations, which requires the company to further bolster its reserves to prudently value the loan portfolio and potential exposure."

They claim not to have anticipated these developments, but all three were predicted by many commentators.

Even in good times the Ponzi business model employed by most of the mortgage banking industry required ever increasing loan volumes to keep default rates down. New loans typically don’t go bad as fast as bad loans, so the rapid growth rate of the sector helped hide the truth about the quality of their holdings. Now that the sector is having trouble growing, reported default rates are on the rise and profits are evaporating.

The market for mortgage backed securities grew far too rapidly, and the supply of easy credit had to end. Now there are far fewer suckers out there who want to buy securitized sub-prime loans because the housing market has turned and foreign investors and portfolio managers are recognizing more of the risks.
-Imaginary profits were boosted by low reserve allowances. Their loss estimates were based on default patterns during the housing boom, not during normal times or a housing bust. As they have to increase reserves to cover real losses, their imaginary profits of the past turn to today’s losses.

Most lenders are trying their hardest to postpone the bad news to keep their stocks afloat and their credit ratings intact. The situation is surely much worse than they are willing to admit. The mere fact that that more of them have started to give warnings is an indication that things are getting really bad in the industry.

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By: Bill Bonner, Addison Wiggin, & The Daily Reckoning Crew


** The whole world is turning its weary, pleading eyes on the American consumer…the marvelous contraption of the modern financial system…

*** There is no way housing has hit a "bottom" yet…living in oblivion…

*** The massive transfer of wealth from West to East continues…glory days are over for hedge funds…an earnest reader takes our words a bit to literally…and more!

———————

Let us step back for a minute.

Stock market investors are giddy because the Dow has hit new highs, even though the broader market has been going down. And even though in real terms, the Dow is 20% below its peak set six years ago.

Speculators, meanwhile, are said to be shifting into Dow stocks and out of gold in order to increase their short-term results, which are the only results they are interested in.

Trillions of dollars are being gambled on spliced and diced derivatives whose real risks are both unknown and probably unknowable.

Meanwhile, house prices in America are going down. House sales are falling sharply; inventories of unsold houses are now twice average levels. And housing costs are now higher than they been for nearly a generation. Which has an obvious and almost immediate effect on the purchasing power of the people who live in them. With no further equity to extract…and a "wealth effect" that has turned either ineffective…or actually negative…the poor householder cannot keep spending. And since 70% of the U.S. economy - the highest percentage in history - depends on consumer spending…and since the world economy still depends on the U.S. economy… the whole world now turns its weary eyes to the poor U.S. householder:

"Please keep spending money you don’t have on things you don’t need," they say to him.

"How about a newer, faster automobile…so you will look rich and powerful as you crawl through rush hour traffic?"

"What you need is a bigger television set…think how your family will applaud when you bring it home!"

"Go ahead, buy a new house…this little setback in the housing market is only temporary…everybody knows houses always go up in the long run. Besides, this new house has granite countertops…end the embarrassment of Formica forever."

What a pity, the poor man is willing to spend. He is ready to spend. He is psychologically, sociologically, and pathologically ready to part with his last dime. But when he reaches for his billfold…what a pity, his pockets are empty!

What a marvelous contraption this modern financial system is!

Investors are paying record prices for companies with record earnings. And whence cometh these record earnings? From the spending by the same consumers who derive their purchasing power from the aforementioned rickety houses!

But not to worry. The National Association of Realtors joins Alan Greenspan in saying "we think housing has now hit bottom." Why do they think it has hit bottom already? What kind of bottom is it that is less than 2% below the all-time high? What kind of world is that allows consumers, homeowners and speculators to go on the biggest, debt-fueled binge of all time…

…pushing up housing so much that the typical house went up more than 50% in the last five years…and permitting Americans to ‘take out’ $1.3 trillion from their houses over a two-year period…

…and then, when the bubble finally pops, punishes them with a decline of less than 2%? The median house in August was worth precisely 1.7% less than it was worth the year before.

Is it not a great world, dear reader? Is it not a wonderful world? Is it not a guilt-free, sinless, all-forgiving, gain-without-pain, two-steps-forward-none-back kind of world?

Is it not a world that doesn’t exist?

More news…

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Mike Shedlock, reporting from Illinois:

"…Pondering the latest birth/death revisions once again, I see construction jobs are being added by the model. 157,000 construction jobs were added between February-September, in the face of the massive housing slowdown…"

For the rest of this story, and for more market insights, see today’s issue of

Whiskey & Gunpowder

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More thoughts…

*** Long term, Asia is almost certainly a better bet for your investments than the United States, says our old friend Mark Faber. Speaking to the magazine Wirtschaftswoche, he noted that while real incomes in North America are stagnant, those in Asia are rising sharply. In China, for example, income per capita has doubled each of last two decades.

What’s more, Asia is becoming less and less dependent on the United States. Instead, of selling things to people who don’t need them and can’t pay for them, Asia will soon be selling to its own rising consumer class. In China, for example, 84% of car buyers are first time buyers. They’ve never had a car before. And think how many people in China still go through their entire lives without the benefit of granite countertops! It takes our breath away.

A "massive transfer of wealth" from West to East is underway, he says. Not only will this make Asia richer…it will also doom people in the West to lower standards of living, simply because, for the first time since the advent of the Industrial Revolution, Westerners must now compete with Easterners for scarce resources. All of Asia now only uses 22 million barrels of oil per day…the same amount as the United States. But Asia has more than 12 times the population.

China consumes only 1.7 barrels of oil per capita…an amount scarcely greater than the United States before the Industrial Revolution began. Asia has a lot of catching up to do, but it’s doing it quickly. And it will mean much higher prices for oil…and other natural resources critical to modern development. Look for oil at $100 to $200 a barrel…and higher gold prices too, says Faber.

[Ed. Note: If - and when - the price of oil soars again, the impact is felt all throughout the economy. The dollar gets destroyed. Energy-dependent industry goes bust. Many stocks go down.

That’s the bad news. The good news is when energy is under the gun, the rising oil price itself opens you up to all kinds of soaring investments. And just on energy shares alone, Outstanding Investments’ have helped their readers do extremely well…you can read all about it here:

There is Still Money to Be Made

*** BBC News tells us that the latest Nobel Prize winner in economics has merely explained a point we have made many times in The Daily Reckoning. Once investors, consumers and businessmen catch onto the Fed’s trick - introducing ‘liquidity’ as though it were additional purchasing power - the jig is up. They anticipate inflation and cease expanding the economy. Instead, prices rise while the economy stagnates. The Fed’s job now is managing inflation expectations so that they continue to inflate without anyone catching on. Otherwise, stagflation results.

The BBC:

"Professor Phelps has been concerned with explaining the relationship between unemployment and inflation, which had been described by some economists as a trade-off.

"He argued that inflation expectations could become embedded in the economy, leading to stagflation despite high unemployment.

"This also meant that if inflation expectations were kept in check, the economy could run at a lower level of unemployment than would otherwise be the case.

"Such views helped influence central banks to try and curb inflationary expectations promptly.

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"Professor Phelps said of his work:

"’I tried to put the people back into our economic model and in particular to take into account their expectations about what other economic actors are doing at the same time and in the future.’"