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Had someone told me a couple of years ago that a poorly thought through loan program aimed at putting marginal buyers into a home would bring the banking and investment brokerage industry to its knees and threaten to sink the economy I would have thought that person was crazy. Even today, when that is exactly what has happened, it still seems inconceivable.

A capitalistic economy is based on innovation, finding new and better ways to do things and exploiting opportunities in the market place in the pursuit of profit. Home ownership is one of the main fundamental supports to our economy, it empowers people and gives them a stake in their community. The traditional loan requires a 20% down payment from the buyer, which makes it difficult for many people to buy a house. That is where mortgage insurance comes in. For a premium they guarantee that the portion of the loan above 80% of the value of the property will be paid. The most popular "low down payment" financing is through government programs such as
FHA and VA. FHA, with as little as 3.5% down, and VA with 0% down, make it possible for many people to buy a house. In essence, they provide most of the equity portion of the traditional loan by insuring or guaranteeing, with VA, that it will be paid. To compete with FHA, conventional mortgages use private mortgage insurance to take the place of the government backing and make conventional financing a competitive option with as little as 5% down.

FHA came on the scene in 1934 as a way to make widespread home ownership possible for the middle class. As the great depression ended and lending requirements eased, thanks to FHA, demand increased for housing. This strengthened pricing and contributed to growth in the economy as new homes were built to satisfy growing demand. During the latter years of World War II the 30 year slump in housing prices that began during World War I was coming to an end. Fast forward to the 1990's. Home ownership had become a reality for middle class families. However, there was still several segments of the population that were not being served, the self employed that had trouble substantiating their true income, buyers with
with no money for a downpayment, and people with marginal credit. These segments were addressed with no income verification loans, 100% loans, and sub prime loans. The first two types of loans required strong credit, while the latter put borrowers with marginal credit into a home, often with virtually no money down. These types of loans do not conform to standard guidelines, hence the name "non conforming".

Many sub prime mortgages were the adjustable kind, the interest rate during the first two years was a little above the standard rate with a prepayment penalty during that time. After two years it became adjustable and the rate soared. The borrower was encouraged at the time the loan was originated to get their credit issues corrected and refinance at the two year anniversary to avoid the new, much higher rate. Reality check... most people with bad credit are either not able or not willing to do what is required to fix their credit problems. Sometimes the credit problems are caused by events out of their control, but most of the time they are caused by unwise spending habits which are hard to change. If making the mortgage payment at 8% is tough, can you imagine what it would be like at 14%? No wonder, people stopped making payments.

The new loan products did what FHA backed loans did when they came on the scene, cause a housing boom. With housing in great demand, prices rose. Sub prime loans and the other exotic loans provided a great way for borrowers that otherwise could not qualify for home ownership to get into a home and build equity. They also provided solid profits for the lenders. They were high yielding loans with a default rate only slightly higher than traditional conforming loan products. When defaults did occur, the collateral had appreciated nicely, so the cost of the foreclosure and original loan were usually recovered. The market demand for housing was strong and foreclosures were a popular way for buyers to "get a deal". Part of the reason the defaults were relatively low was that borrowers who needed to move or were having trouble paying the loan could sell the house, pay off the mortgage and put a few bucks in their pockets.

What happens if the real estate market stops appreciating? I don't think that was ever factored into the equation. Every investment category has its ups and downs, so in theory real estate should be no different. For instance, real estate had a rough time at the end of the 70's and early 80's, mostly because of skyrocketing interest rates, which made it hard to afford. Foreclosures rose and houses were hard to sell. However, pricing was not badly impacted due to high inflation during that time. The savings and loan crisis in the early 1990s, which ironically was caused in part by bad commercial real estate loans, briefly put a damper on housing. Again, pricing was not materially affected. In the late 1990's when the creative financing started to become popular it probably seemed that the resiliency of the real estate market was assured. My guess is that the greed factor prevented the industry from asking two important questions, 'what will these types of loans do to the supply & demand equation' and 'what happens if real estate values decline'.

Historically, residential real estate appreciates at the rate of inflation. When it appreciates at a rate that greatly exceeds or lags the inflation rate for long periods of time it is almost a sure bet that it will seek to return to the inflation rate or its equilibrium point.
All investment categories share that behavior, seeking a return to the equilibrium point, whatever that may be. Residential real estate's equilibrium point has remained fairly stable from the late 1940's to the late 1990's. The equilibrium point changes only when there is a major change in supply and demand. The period in the 40's when FHA loans were spurring demand as the country was emerging out of the Great Depression is an example. It is also an example of a return to the equilibrium point, which probably required a friendlier lending environment to compensate for the demand damage caused by the Great Depression. Below is a chart from a very interesting study by Yale economist Robert Schiller. The very right of the chart shows a chilling development, a parabolic rise in pricing fueled in part by the increased demand generated by sub prime and other non conforming mortgage loans. What isn't shown, and can only be left to imagination, is the future return to the old equilibrium point as the demand created by those loans evaporates.

Normally these excesses take time to correct. The chart ends at the peak in the market and a good part of the excess, it is now at about the 155 level, has already been eliminated by the decline in real estate prices and the higher than normal growth in inflation, except for 2009 which was deflationary. The rest, assuming real estate prices don't continue to fall, can be absorbed by a period of below average price growth. However, until the economy hits a growth phase prices will probably continue to decline modestly. Not the ideal real estate market, but definitely not the end of the world.
Graph of housing appreciation relative to inflation.

The increased demand caused real estate prices to soar, but by late 2005, the demand for real estate peaked. Everyone that wanted a house had one. As demand wanes, so does pricing. When pricing falls to a point that homeowners that need to sell can't, because they won't net enough to pay off the loan, defaults rise. Making things worse is that many of the homeowners with sub prime loans have nothing in the transaction, so they have nothing to lose by walking away.

As defaults rise and houses are foreclosed, more supply hits the market, moving pricing lower. To exacerbate the problem, builders were holding very high levels of inventory at the peak, expecting the next few years to be like the last few. Excess inventories move pricing lower. To stem future losses, lenders stopped originating sub prime loans and tightened lending requirements on conforming loans, making a large number of buyers ineligible to buy houses, thus reducing demand and driving pricing lower. The problem feeds upon itself with the media fanning the flames. You can't help but read or hear about the "housing crisis", which further reduces demand by scaring us into avoiding real estate altogether. The end result is that banks and investment houses holding mortgages, especially the risky types, have suffered debilitating loses. Much of the collateral supporting those loans is not worth what is owed against it and what value it has can't be realized because of its reduced liquidity, no one wants to buy it.
Unfortunately, the current high unemployment rate will probably lead to another wave of foreclosures. This round may be particularly damaging due to the real estate incentives offered over the last couple of years. The incentives accelerated buying activity turning tomorrow's buyers into today's buyers. We may have returned to one of 2005's problems "Everyone that wants a house has one", though not to the same scale.

  July 1, 2010

Written by Mike Salkin, Berkshire Real Estate market analyst.


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