Thursday, May 19, 2005

New Speculative Tool: Letters Of Credit

A new twist has shown up in the lending business. "Investors are getting a chance to purchase luxury condominiums along the Gulf of Mexico with minimal cash out of pocket, as lenders increasingly allow them to use letters of credit in lieu of cash downpayments."

"Letters of credit demonstrate the investor's commitment to make future payments,with the bank assuming the financial burden for those that do not own up to this promise..but critics believe they fuel speculative buying."

"'If these letters of credits are being given in markets that have a high share of investor purchasing, then it seems speculative, and it's something I'd pay attention to,' says Doug Duncan, chief economist for the Mortgage Bankers Association."


At 3:08 PM, Anonymous Anonymous said...


Don't you have a job? Or is this blog it. (sarcasm)

I just saw the print WSJ with the letter of credit purchasing (speculation) article and wanted to get the link posted but you beat me to it.

I appreciate the even handed moderation. I don't see the value of an echo chamber like so many of the other housing bubble discussions.

On your blog even the blatantly inflammatory and ad hominem attack posts get taken apart with facts and generally quality analysis.

That is a key data point from my perspective that we are experiencing a housing bubble is the bull arguments tend to be vague platitudes or rear-view mirror analysis.

In my experience on the corporate side the only companies that consider using a letter of credit are desperate and sliding into insolvency or use them very sparingly for bet the company types of business.

At 3:37 PM, Anonymous JJL said...

I want to second the thoughts in the 3:08pm post. Coming here is both informative and fun. As to the letters of credit, does anyone have the kind of knowledge to answer this question: When is there just too much credit out there? At what point will Banks, lenders, derivitives brokers etc back off and say no? I am not sure what would constitute a no mas policy, but surely we must be getting close.
Thanks to Ben again for this site.

At 3:50 PM, Blogger Ben Jones said...

Thanks guys.
Yeah, I have to work. I write and manage some websites. I am starting a few new sites as well.

If you have the WSJ story, please post some details. I would like to know specifically where these condos are. If it is in Texas, I am gonna have a laugh.

With letters of credit, the bank is creating money outside of the Fed system; unbelievable!

At 3:52 PM, Anonymous Anonymous said...

By their very nature, banks are moronic. They will NOT materially change their lending behavior and utter disregard for risk until they are stuck with a swollen (like a festering Herpes sore)non-performing asset portfolio. At which point, the government (the entity AKA you and I) will bail them out.


At 4:07 PM, Anonymous Anonymous said...'s the article:
The Letter of Credit Returns
Along Gulf of Mexico Banks Push Envelope in Effort to Finance Second Homes for Baby Boomers

May 19, 2005; Page C1

Buy beachfront property! Almost no money down!

More investors prowling some of the hottest real-estate in the country have discovered an old-fashioned financing tool -- the letter of credit -- and are using it in a way that may be adding fuel to an already overheated housing market.

Regional banks active along the Gulf of Mexico, where thousands of luxury condominiums are planned, are offering letters of credit to high-end home buyers, who use them instead of a cash down payment to reserve condos before they are built.

A person who obtains a letter of credit is promising to make a future payment, or else the bank that wrote the letter of credit is on the hook. Some letters of credit are secured by the person's assets; some aren't. They have long been used by companies, often when there is a lag between striking and closing a transaction, such as in securities transactions or the import/export business.

Using a letter of credit to buy a home has been rare -- until now -- in beach communities in Florida, Alabama and Texas, where baby boomers are buying second homes. Estimates call for 20,000 condo units to be built in Florida and Alabama alone in the next two years, many at prices of $500,000 to $1 million. Some commercial lenders won't advance construction financing for condo developments until the builder "presells" at least 60% of the units, even though they may not be built for a couple of years.
[Moguls MO]

For customers who don't want to tie up cash that long, the letter of credit is attractive. "You're not using any of your cash, and protecting your cash is one of the most important things to an investor," says Kathy Martinez, who has been investing in real estate for 25 years and currently owns eight condos and seven preconstruction units along the Gulf Coast.

In Alabama, buyers are allowed to use a letter of credit for as much as 20% of the down payment. In Florida, a buyer can get a letter of credit for half of a 20% down payment; the rest must be in cash.

How letters of credit get used to buy condos is fairly simple. Typically, a developer "presells" by letting a buyer reserve one or more units with a small cash payment. The buyer then has 30 to 60 days to get a letter of credit covering up to 20% of the purchase price. Once the developer gets the letter, the deal is binding, and the reservation becomes a sale. The buyer may then get back that initial cash payment.

Ms. Martinez recently received a letter of credit from Vision Bank in Gulf Shores, Ala., for 20% of the value of a $460,000 condo there. Like other investors, she hopes the property will appreciate by the time construction is complete, allowing her to sell for a profit -- without spending anything but the letter-of-credit fee charged by the bank. Such fees are in the 1%-to-3% range of the letter-of-credit value per year.

Helga James, a Gulf Shores mortgage broker, says "everyone makes out" with letters of credit: Banks get fees and customers, buyers get to invest their money elsewhere while waiting for construction, and developers are assured their money.

Some say letters of credit make it too easy for speculators. Economists estimate about 20% of residential property sales involve investors, not families or individuals who plan to live in the home. Such purchasing could be artificially lifting prices and demand and could destabilize a market should speculators start dumping homes, these economists fear.

"If these letters of credits are being given in markets that have a high share of investor purchasing, then it seems speculative, and it's something I'd pay attention to," says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington.

The banks believe waterfront property is unlikely to lose value, and they see letters of credit as a way to attract high-end clients amid competition from the nation's biggest residential mortgage lenders, including Countrywide Financial Corp. and Wells Fargo & Co.

Offering the letter of credit "has been very profitable for us and has allowed us to build relationships" with wealthy clients, says Danny Sizemore, chairman and chief executive of Vision Bank. Mr. Sizemore says the bank manages its risk, requiring that customers have equity in an existing property, cash in a certificate of deposit or other assets.

SunSouth Community Bank in Destin, Fla., a division of the Bank of Bonifay, Bonifay, Fla., is issuing an increasing number of letters of credit. The most popular type, an unsecured letter, requires no collateral, but the customer has to have a good credit score, a stable job and income and between one half and two times the letter-of-credit amount in stocks, a CD or in a checking or savings account. Most applicants qualify, but because of strong demand, "we have reached our cap for unsecured credit," says Jayce Holley, a vice president at the bank.

J. Collier Merrill, a developer in Pensacola, Fla., says banks do a good job with letters of credit, and the market does the rest. "We do have a lot of investors on our rolls right now, but there are enough baby boomers out there who are going to want condos here for at least another 10 to 15 years, and they're going to buy from these investors," he says.
---sorry to post the whole thing, but a link won't help unless you subscribe to the online WSJ..

maybe this thing isn't over yet....

At 4:09 PM, Blogger Ben Jones said...

Check this message board post out.

"I bought a house from Pulte at Sun City in Indio, CA and three days later they slashed prices and I lost all my equity-- $72,000. They sold to so many speculators they drove up prices and the boom exploded. Pulte did the same thing in Las Vegas last September. They are bad people."

Anybody know if this is true?

At 4:13 PM, Blogger Ben Jones said...

4:07 anon,
Thank you for posting the story!

At 4:15 PM, Anonymous Anonymous said...

I don't have a WSJ subscription. I found a copy in the men's room at the office.

here is the link to the cover page.,,markets,00.html

It is the 3rd bullet point down.

At 4:20 PM, Anonymous Anonymous said...

After reading that WSJ article about letters of credit I can only say that credit creation is TOTALLY OUT OF CONTROL in this country.

Seems like new ways of borrowing, and new uses for old ways, are cropping up continuously. It's like Monopoly Money!

I think we have to at least be open to the fact there could be one more big explosion upward in prices.

John Murphy, the dean of stock market technicians, studies the different stages of stock market cycles by looking at which sectors are performing best.

Well, in today's comments, he says the market is getting ready for a sustained rise; and the breakout in technology stocks this week is the clue. Job market seems to be strengthening and long term rates are hitting new lows...

God, could this thing be getting ready to take off again?? Nothing would totally surprise me anymore.


At 4:30 PM, Anonymous JJL said...

No money in, tons of money out, no risk. Ladies and Gentlemen, who in the world keeps buying in this market? It cannot all be speculators. Everyone I know is buying and when i ask why they say: 1. The market always goes up 2. Low interest rates makes buying a home a steal 3. I have to, everyone else is doing it.
As far as answer 1, well anybody with a Domania account can see that isnt true. As for answer 2, I say car purchase interest rates are at an all time low, but if the car cost 3 times as much, is it still a deal? They of course not, thats stupid, then stare off into space. Answer 3 is the real reason this wont end anytime soon. With the explosion of TV shows about homes, refurnishing homes, home makeovers, etc it is engrained in the mind. I am very discourged as of late, and see no end to this madness.

At 4:36 PM, Anonymous Anonymous said...

It won't last much longer.

In Southern CA, year-over-year gains are dropping fast.

All of SoCal is 15.5% yoy.

San Diego, Orange Co and Ventura are all about 10%.

LA county is still 15% (most of the gains are now being driven in poor zip codes, with better zip codes flat for the last six months.

15.5% is still way too high, but it is dropping a few percent per month now.

I believe it will be below 10% sometime this summer, and then panic will set in.

At 4:42 PM, Anonymous Anonymous said...


I hear you. My wife wants to move out of our fully paid condo and she looks at me like I am a madman when i get into my housing bubble diatribes. We will buy a house within the next 6 months -- not because I think it is a prudent financial thing to do, but more because I value my marriage for than a $200,000 loss at this point. She has been patient but we are just out of room and she has dealt with my madness for 5 years now. This keeps me awake at night and it is very, very stressful but we are going to bite the bullete because we need a bigger place to live and putting our life on hold is just not going to cut it. I have no misconceptions about continued appreciation. In fact I expect a 20% decline over the next couple of years in Fairfield County, CT. We need to move on with our lives -- it is hust a damn shame that the FED and the lenders have let the home buying process be hijacked by speculators at the expense of people who just want to buy a decent place to live to raise a family and be members of a decent community. I am pissed but what can I do.

At 4:57 PM, Anonymous Anonymous said...

While letters of credit seems like a pretty nifty idea if your a buyer, I doubt they will prop up the market. Fannie Mae and Freddie Mac are the real mechanisims behind the credit bubble. Banks make thier money on the fees now and sell the mortgages to Fannie and Freddie. The banks and mortgage brokers have no incentive to make safe loans they just pass them on! But cracks have been appearing for over a year now at Fannie and Freddie. With the latest coming from Mr. Greenspan himself. It's very propoable by this time next year things will be very different!
Oh and yes. I did hear of the Las Vegas story last year. It generated a law suit by a fellow who had just bought at full price, then found out the company slashed house prices. This fellow was an investor and brought more than one house.

At 5:08 PM, Anonymous Anonymous said...

A little humor I thought of as I read this article.
You can either laugh or cry, your choice.

Hey why should I, Joe Six Pack miss out and not make money!
Here is my proposition:

I, Joe Six Pack start a new funding venture.
Joe Six Pack starts the Bank of Anonymous (All you need is a computer and a printer).
For a small fee 1-2% Joe Six Pack will give a Letter of Credit (LC) from the Bank of Anonymous.
Speculator takes this LC from the Bank of Anonymous and pretends to buy a condo/house.
The builder will pretend to sell you the condo/house.
The condo/house project will pretend to sell out.
The developer-funder will pretend to approve this project and other project in the works.
The condo/housing unit pretends to be worth more that the original price.
The city and state pretend to collect taxes from this future development.
Everyone pretends to be worth more and spends more.

Everyone make out!

Hey, the Government prints money, the banks make money, the realtors make money, the mortgage brokers make money. Why shouldn’t I, Joe Six Pack make money?

Can anyone see any flaws in my thinking?

Joe Six Pack.

At 6:13 PM, Anonymous Anonymous said...

4:42 Anony:

Rent is the other sensible answer.

With renting in San Diego a mere 40% of the purchase price - it's the smart financial move even if the market moves up from here.

That way you get more space you wife needs and you give it a year to see the trend developing - possibly preventing a 200k loss.

In San Diego with 80% of mortgages aparently I/O ARM's - prices simply can't rise much further - the worm is turning - giving in now could ruin you financially for a long time to come.

At 6:21 PM, Anonymous Anonymous said...

Anon 4:36

i saw that same article in the Los Angeles Times on Wednesday. I also agree if we have slowed to 15% during the busy months, just wait until we get the results once the slower months get here. Last year the market ran up until about July then slowed. If same thing happens again this year, we should be seeing 10% YOY by the end of summer.

At 6:31 PM, Anonymous Anonymous said...

Just talked to my Re broker in North San Diego County, (one of past hottest areas). He says it's slowing down fast. He has to have double the listings to get the same turn over.

Tick tick tick tick.............

At 6:39 PM, Anonymous nostradamus said...

(That is a key data point from my perspective that we are experiencing a housing bubble is the bull arguments tend to be vague platitudes or rear-view mirror analysis.)

Bull arguments, whether about housing or the stock market, almost always sound like vague platitudes and cheerleading. Yet prices of things (art, RE, stocks, dog food) always go up over time. That's because the U.S. economic system is based upon inflation and currency debasement.

Since the Federal Reserve was created in the early 20th C., the dollar has lost 97% of its value. If you $1 million dollars under your mattress in 1913 and woke up in 2005, you'd have the equivalent of $30,000 today in 1913 buying power. So given our system, like it or not, you've got to put your money somewhere---be it stocks, bonds, RE or beanie babies.

The bears always sound more intelligent than the bulls. Witness the late '90s. There were actually people who were trying to make a fundamental case for non-rev dotcom stocks to be valued at $300 a share. Of course, it was nonsense. But Americans are programmed to believe that everything goes up.

The only time bears are right is when the bulls take it too far, like in the late '90s and likely now with real estate.

But it's tough to be bearish because our whole system is predicated on inflation. And since the dollar is the world's default currency and we spend more military dollars than the rest of the world combined, we can pretty much print whatever we want and dare anyone to do anything about it.

At some point, our system will no longer work as other nations (or groups of nations) become strong enough either economically or militarily to stand up to us. But we aren't there yet. And when we get there, the least of our troubles will be worrying about the housing bubble.

At 7:22 PM, Blogger Ben Jones said...

(I think we have to at least be open to the fact there could be one more big explosion upward in prices)

I agree. But many markets are overripe. There is already panic in parts of Australia and the UK sounds more nervous everyday. I expect the US metro markets will break down one by one, or by region, unless there is an economic shock. In that case it could all change value overnight.

At 8:01 PM, Anonymous Anonymous said...

===A letter from the FED===

Asking FOMC board about their view on the RE bubble I got a reply
that confirms that they know all about it, but do not make it official (I'm guessing not to spook those volnurable, leveraged to the max, new home "owners" and speculators alike); Here are few things from the FED reply:

House prices have risen sharply nationwide (especially in the large
metropolitan areas) in the past five years, even as the economy has


Despite the major declines in equity markets, a sharp
retrenchment in investment spending, the economy’s downturn has been
mild. Many economists have attributed this to the rising house values and
have noted that such rising has offset the falling value of people’s

Those who study the housing market argue that the increase in
house prices has been driven by market fundamentals, i.e. the economic
conditions are strong enough to justify higher prices. It is also
important to take into account that mortgage rates are currently very
low. Despite the run-up in prices, lower interest rates combined with
higher incomes have resulted in more affordable housing. In its last
annual survey of consumer spending, the Bureau of labor Statistics of the
Department of Labor notes that, in 2000, American households spent 29.6
percent of their after-tax income on housing, compared with 30.9 percent
in 1995.


Many people think that the Federal Reserve should “detect” bubbles in the
prices of some classes of assets, such as equities and real estate. In
advancing this view, many also suggest that, monetary policy should be
more proactive in trying to correct developing imbalances in asset
markets. If the Federal Open Market Committee (FOMC) could rid asset
markets of bubbles accurately and painlessly, the Committee would do so.


Also pointed me at this link from 2002 (when it was all still, well cheap comparing to today):

At 8:31 PM, Anonymous Anonymous said...

4:42 Anon, you can move to a bigger place and still rent. Maybe you could frame the idea as a compromise...
Best of luck to you.

At 9:56 PM, Anonymous Anonymous said...

>Anon: I have to buy now or my wife will leave me!

Can't you rent a bigger place?

I see it lots. People HAVE to buy a house for the livestyle. It's a trap in my opinion. You can rent a house and have the lifestyle.

Well, if we rent, "a landlord has control over us."

In these new gated communities, you still have to follow the community rules. Houses can't be painted certain colors, etc...

Kind of like renting, except you own and your neighbour says you can't install a satellite dish, put in a deck, have cars on blocks, or whatever...

If you divorce, will you split the 200k loss!?

At 11:33 PM, Anonymous Anonymous said...

(John Murphy, the dean of stock market technicians, studies the different stages of stock market cycles by looking at which sectors are performing best. In today's comments, he says the market is getting ready for a sustained rise)

I read Murphy's work and he's pretty good, although everything is based on chartwork (he runs, the best charting site). Charts, by definition, are backward-looking. A few weeks ago he told readers to get out of the market and to buy inverse index funds---funds that do the opposite of the indexes (i.e., they go up with the Nasdaq goes down, etc.)

So his market calls are subject to severe whipsaws.

That said, it sure does look like the market wants to go higher---bad economic data, rising Fed rates and all. I've been expecting a rally in here. It's not unusual for the stock market to rally for no particular reason, even when the data (GM/Ford cut to junk credit, some of Europe in recession, Fed rate hikes) doesn't look favorable.

Many say that the stock market "discounts" the future, i.e., it goes up sometimes six months before the news starts turning good again and vice versa. But a quick look at stock market history shows that this really isn't the case. The market does what it wants to do. And if enough big money folks want higher prices, they get them. As one analyst often says, "Markets don't move, they ARE moved."

If we are starting another "leg up" in the bull market that started in 2002, it wouldn't be surprising. Nor does it mean the market won't fall hard afterwards.

Remember 2000? The market broke down hard in March/April and looked set to fall much further. Then out of nowhere, a summer rally commenced on June 1 and lasted until August 31. The S&P500 rallied 16%. But once the rally was over, the market fell apart.

Remember 1987? The market again started to break down in the spring but a miraculous rally occurred and the S&P500 rallied 21% from late May to Aug 27. Then the market crashed in the fall.

Remember 1929? The market yet again looked poised to break down in the spring. And again on June 1, it started a 30% rally that lasted until Aug 31. Then it crashed in the fall.

So a mega summer rally would be no surprise. But don't assume that a stock market rally presages good times ahead. It could be just the opposite if 1929, 1987 and 2000 are any indication.

At 6:59 AM, Anonymous Anonymous said...

To the guy in Connecticut who's wife wants more space:

For goodness' sake, sell the condo and RENT a bigger house. Perhaps your wife will see it as an acceptable compromise?

I'm going through the same thing with GF in Washington, DC. I sat her down and explained the madness - she gets it, thank God!

We'll be renting a nice house at a steep discount from the cost of buying. And I promised her she could pick her dream house a few years out and we would steal it - probably bank REO. God I hope I'm right.....

Good luck!


Post a Comment

<< Home