What a fascinating and tumultuous time is upon us! Both the housing and the
mortgage market are convulsing wildly! There are so many facets to the "big
picture" that I would never presume have all the answers, so the following disclaimer
is in order: I am a mortgage broker and the following is my opinion based on
my experience and my knowledge. You might agree with me, you might not. But
I urge you not to jump to any conclusions based on what I or anyone else has
to say about the current state of affairs. No one can predict accurately how
this is all going to turn out. My point of view is incredibly cynical in some
ways, yet leaves room for optimism with the famous caveat of "it depends." In
other words, my cynical prognostications can all be erased if certain entities
take certain actions. Last thing is that this article is written for the masses,
laypersons included. If you are an industry insider, I apologize, but I will
be stopping to explain some things you definitely already know. Away we go...
In this case, the beginning is not an exact date or marked by an exact event,
but rather the confluence of two important factors: the incredible loosening
of lending standards and the overly-exuberant boom in the housing market. Yes,
there are other important factors, and yes, I will discuss them, but these two
are the big two in my mind.
Let's start with the loosening of lending standards
with large amounts of money (banks, etc...) put systems into place to evaluate
the potential risk associated with a loan. They've been evaluating the risk
on loans since well before I was born. In the mortgage industry, this is called
underwriting. There are underwriters (human beings), and underwriting systems
(computers) that render decisions. Be they human or machine, the underwriting
systems are employed and acting on the instruction of the money source.
"Money source" is a purposely ambiguous term so I can make the following point.
Where does the money for mortgage loans really come from? If Wells Fargo gives
you a mortgage loan, you might guess the money for that mortgage came from Wells
Fargo, and you'd partly be right. Wells did indeed have the money to fund that
transaction, and they may actually hold on to your loan forever, but there is
a deeper layer to the money source than that. Even big banks need LIQUIDITY
in order to continue doing business. When Wells needs liquidity, they obtain
their money at a certain rate based on the appetites of the bond market. Sometimes
this means "selling"
your mortgage. Ultimately, the actual market metric is what's known as the
Mortgage-backed-securities (MBS's) are bought and sold just like stocks
and bonds. By the time someone buys a MBS, its underlying risk and obligation
have passed hands many times. It's gone from the consumer's intention
to finance a house, to a mortgage broker, to a mortgage lender's underwriting
staff, to the corporate structure of that lender, to be packaged in a "pool."
Then it's either sold or held. When it's sold, it can be sold multiple
times. The point is that those that are buying and selling them cannot simply
call up the consumer that got the loan and ask them if they are a good credit
risk. They are many times removed.
So this creates the necessary and crucial task of "judging" how sound of an
investment the MBS is. After all, if a bank was selling a pool of loans with
an average interest rate of 8%, the effective interest rate would only be 8%
if none of the loans defaulted. Just based on historical statistics, a certain
percentage of loans go into default. This risk of default is
factored into the value of an MBS. In determining risk of default, investors
look at several aspects of the mortgages that comprise MBS's: loan amount, credit
score, whether income was documented or not, liquid assets, amount borrower
compared to appraised value, whether cash was taken out, and many more.
Over time, default rates on certain "standard issue" mortgages have become
very predictable. While there are many different types of mortgages, in recent
history, but still before the period of so-called "meltdown,"
a certain type of mortgage was by far the most common. This is a 30 year fixed
mortgage, with documented
income and assets, with a down payment of some sort (or compensating factors
to offset it), and with a reasonably strong credit history. In general, these
are the components of a "Conforming" loan. A conforming
loan is any loan that "conforms" to the guidelines set forth by Fannie Mae
or Freddie Mac, huge Government-Sponsored-Enterprises put in place to help the
American public realize the dream of home-ownership while protecting investors.
So life is good right? Fannie and Freddie have their conforming loan guidelines
in place. Investors can anticipate a predictable default rate and people can
Enter the Problem #1
Unfortunately, not every family's scenario fits the conforming guidelines.
In the not too distant past, there were little or no financing options for these
families. To make a long story very short, investors saw great potential for
this untapped market demographic. Alternative
loans started to emerge with different standards than conforming loans.
Interest rates were raised to account for increased risk of default and investors
"guessed" at what would be the best indicators of likelihood of default. They
knew it would be higher, but unlike the years and years of historical data behind
conforming-type loans, there was no track record for these alternative loans.
What followed was a cataclysmic downward spiral of overly-exuberant underwriting
standards. To keep up with competition, lenders got more and more aggressive,
all the while operating in a market segment with a non-existent track record.
Default rates were being guessed at, and were becoming evident in real time.
Also evident was the fact that "experts" underestimated the actual default rate
of these new alternative loans. Ratings Agencies (wall street
analyst companies), were listing these new MBS's as much better than they were
(because no one really knew how they would turn out). This goes back to the
point of the investor being so far removed from the consumer. Wall Street analysts
were saying that MBS's from these new alternative loans were a hot buy, so investors
bought more. And more demand among investors drove an increase in the aggressiveness
of loan programs and underwriting standards. It was a downward spiral in which
anyone with a pulse could finance a house.
If this existed in a vacuum, it might not be so devastating, but it does not.
This fire happened to be ignited at the same time that a large amount of gasoline,
in the form of a real estate boom was occurring. There can be numerous "chicken
versus the egg" arguments about the housing boom and the loosening of
the mortgage market. The fact is they occurred at relatively the same time and
they fed off each other.
People talk about the real estate boom that began around 2001
and ended about mid 2006. People and "experts" talk about the boom as if it's
something that's happened before. "There have been up times and down times"
they say. "This is just another boom." Those "experts" are wrong. There has
never been a period like this. We have just experienced the largest housing
boom in history. Might there be another one that supersedes it in the future?
Possibly, but I would argue that the current time period will serve as a sobering
lesson for us in the future. I would argue, this is as big as it gets. And it's
not because I have the experience to have lived through previous ups and downs.
It's not because I have decades of experience tracking these issues (because
I don't). It's not because I have the foresight to predict the future of the
markets. It is due to a simple truth: this "boom" is so much more inflated than
any previous booms that it will stand as an obvious outlier in historical home
price data. That is to say, compared to other upturns and downturns, the current
boom is a much much larger digression from the mean than we have ever seen.
Here is an absolutely brilliant
graph by the Yale economist Robert Shiller:
As you can see, there have been ups and downs. All have been within a certain
standard deviation of the mean. The highest highs and the lowest lows have not
deviated more 35% from the mean. Now take a look at the last 5 years. Adjusting
for inflation a house today costs twice as much as the average value of a home
for the last 100 years! We're over 100% away from the mean. I don't remember
a lot from my statistics class in business school, but I do remember the concept
of regression, or a return to the mean. It will happen. But
remember this doesn't mean a house will eventually return to the same price
it was in 1940, it means it will return to the same inflation-adjusted price.
Even so, we are in the middle of a housing price correction right now that will
likely continue. The severity of the correction and the length of the correction
are two things that no one can accurately predict. That is where opinion comes
in. You will hear a lot of opinions on the news, especially the economic focused
news outlets. They vary, but I don't really think the "experts" realize just
how bad things are. This is where my opinion comes in. but first, we need to
talk about the interconnectedness of the mortgage market and the housing market.
There are a couple of caveats to the negativity. First, the mean housing data
does not necessarily take into consideration that houses are much bigger and nicer
(in general) than they were in the past. This may ease some of the regression
to the mean. Furthermore, it's very important to note that different real
estate markets around the country have behaved very differently. Although the
media is national and national home data seems to spell doom for the entire nation,
there are pockets around the country where the real estate market should be staying
more steady. Some have already hit past the bottom, some have leveled out, and
some will actually continue to grow. It just depends where you are and what market
forces at play in your local market.
Mortgages and Home Prices: How They Are Connected
In the late 90's, the demand for housing began to rise steadily. Builders rushed
to meet that demand by building more homes, yet the demand continued. The mortgage
market had to do it's part by making sure more people could qualify to buy homes,
so lending guidelines loosened. This also coincided with a period of decreasing
interest rates. All the ingredients for the meltdown were in place. The lower
interest rates drove an already high demand for homes higher. The easy lending
guidelines made sure everyone could get the loan they wanted. Existing homeowners
tapped their home equity to finance their lifestyles. Home equity
was apparently an infinite well of money. Everyone, including industry professionals,
made future plans on the assumption that values would continue to increase and
money would continue to be easy to obtain.
There is an obvious downward spiral here. It is now culminating with one of
the most dangerous gambles the mortgage market took. Before you read the following
sentence, let me say that there is nothing wrong with adjustable rate
if used for the appropriate purpose in the appropriate
market. That said, ARMS are one of the main contributors to the meltdown. Short
term ARMS were created that allowed someone to have a fixed payment for 1, 2,
or 3 years. The introductory rates on these were low enough to allow first time
homebuyers to buy homes well beyond their means. Brokers and banks assured these
borrowers not to worry because their home would increase in value and they could
refinance in 2 to 3 years to a more favorable loan. It seemed like a workable
plan as long as everything stayed steady.
It Didn't Stay Steady
The new alternative loans (remember the ones with no track record to judge
risk), started to show their track record, and it was worse than expected. When
a loan-type has a worse than expected track record, it leads to investors not
wanting to buy it any more. As a result, the money to fund these alternative
loans began drying up and lenders began to go out of business. This led to a
gut-check among all alternative loans and investors preemptively pulled the
plug on other less-aggressive products as well. So starting in 2007, it has
become much more difficult to obtain any sort of alternative financing. For
instance, in 2005, a homebuyer could finance 100% of their home's value,
without proving their income, with a 620 credit score. Now, lenders don't
even do stated income loans to 100% with ANY credit score! That's a major
change that's happened in just a short 3-4 month period.
At the same time, builders had become so exuberant that they
had (and still have) immensely over-built for current housing
demand. There is far more inventory on the market in terms of new homes than
demand can meet. Even if there was demand for these homes, people can't get
financing any more. Also, let's not forget about the scores of families that
bought homes with short term fixed loans with the hopes of their values increasing,
their credit improving, and refinancing into a better loan. In general their
credit has not improved. In general, their house has not appreciated, and consequently
they cannot refinance into a better loan. BUT they also cannot afford their
Gloom and Doom
Now we have existing homeowners forced into default or short
sale scenarios. This has a direct effect on banks and investors. Guidelines
are further tightened to prevent future woes and this prevents even more people
from getting financed right now. So their foreclosed or short-sold homes are
coming onto the market and bringing prices down. Also, let's not forget about
the huge inventory of new homes on the market. Builders are languishing and
they are forced to drop prices as well. About the only thing that has stayed
positive are interest rates. Historically speaking they are near an all
time low, but it doesn't matter because they are only low on the Conforming
programs. The lending standards are returning to the mean. Home prices are returning
to the mean as well.
All that is to be expected, but here is why it's so bad. The volume of adjustable
rate mortgages that are "coming due," or in other words, hitting their adjustable
period where the payment goes up above what the homeowner can afford, will
be even higher in 2008 than it is in 2007. At the same time, loans are harder
to obtain than ever. Many of these people will be forced into foreclosure or
short sales. These sales hitting the market at incredibly low prices lower the
comparable sales data. The builders with too much inventory on their hands also
lower the comparable sales data average.
And That's Why It's Worse Than Most People Think
We have hundreds of thousands of families across the nation in homes that are
worth less than what they owe. They need to refinance to get out of their ARMS,
but cannot due to both lending guidelines and home values. These families default
or short sell which causes the lenders to take serious damage, which in turn
causes lending guidelines to be further restricted. We are only just on the
way down now. The crash landing has not yet occurred. As I
said, there are more ARMS coming due in 2008 than there were in 2007, coupled
with a tougher financing environment. When these come due and default or short
sell, it further drives down the already decreasing value of real estate. This
in turn harms builders who now have to take much less profit than expected and
in some cases, losses. D.R. Horton's CEO said "2007 is going to suck," and he
I argue that the aspects that make 2007 "suck" are the in greater supply in
2008. "Experts" and analysts incessantly like to state that housing only comprises
a small percent of the entire American economy. This may be true in terms of
jobs, but these "experts," all with much more education than me and much more
air time are failing to see the biggest one of several critical factors in all
of this: HOME EQUITY HAS FINANCED CONSUMER SPENDING. When we
talk about the housing market being a small portion of the economy, that may
be true inasmuch as construction jobs, but what about all of the ancillary effects?
Where do these experts think consumers are getting the money to buy the plasma
TV? Maybe it's on a credit card, but eventually consumers want to consolidate
that credit card with home equity. In the past they have done this, used home
equity to increase their lifestyle, run up the credit cards again, and get bailed
out again by home equity. BUT this will not be available in 2008! The simple
fact that housing is a small part of the economy does not take into effect the
interconnectedness it has with the rest of the economy. Builders losing money
hurts the economy on it's scale, but what about lenders going out of business?
Less people can get financed, so more people default, so more investors lose
money, and less people can pump money into our economy, both on the end consumer
level and the investor level.
It's a bad, bad situation. Intervention can come from many places. There are
several congressional bills that have passed or that are proposed that would
Fannie Mae and Freddie Macs guidelines to allow some aid to the troubled areas
of the mortgage market. It's not a panacea, but it will help. One thing is for
sure: home prices MUST eventually return to their mean on the inflation adjusted
index. Also, lending guidelines MUST return to a sustainable and predictable
level of risk assessment. These two things are in the process of happening now,
but they have definitely not already happened.