Christ, this is going to get ugly.
Before I even get started with this, I want to make one thing perfectly clear: I am not an expert on mortgage finance by any means, nor am I a participant in the real estate sector in any direct professional capacity. I’m a writer with a small knack for research. I do happen to have a client or two in the real estate business, but that’s it - otherwise, I’m just a guy trying to make some sense of this mess. Probably, much like you. So please bear with me here, guys.
As the subprime meltdown story develops, it just looks worse and worse. Let’s start with the death, dismemberment and barbecue of a sacred economic cow - the idea that real estate never drops in value:
The National Association of Realtors said Wednesday it expects its measure of home prices to fall this year for the first time since the group began keeping track nearly 40 years ago.
In its latest monthly forecast, the real estate group said it expects a 0.7 percent decline in the median price of an existing home sold in 2007. A month ago it had been projecting a 1.2 percent increase. Half of all homes sell for more than the median and half for less.
The subprime mortgage mess led the group to cut its sales forecast as well, by 100,000 to 6.34 million homes, a pace that would be about 2 percent below the 6.48 million existing homes sold in 2006. The group cited problems some buyers may have getting financing.
Coming from the NAR - the paid cheerleaders of the real estate industry - this is HUGE. These guys have every reason imaginable to downplay bad news and to talk up happy thoughts, and they’re now predicting the first drop in home prices in at least 40 years. Even the paid optimists are now building arks.
But what’s driving this? How did all this happen, and where is it going? A major player is the ongoing collapse of the subprime lending market - the financial industry dedicated to making big loans to people who can’t afford them. Such as Alberto and Rosa Ramirez, $15,000-year Californian day laborers who qualified for a $720,000 mortgage.
On a home appraised at $560,000.
But for Rosa and Alberto Ramirez and many others like them, a foreclosure moratorium won’t help. It’s not that a better loan would have remedied their situation — it’s that they can’t afford the home they bought. “Many of my clients can’t afford their homes in any circumstance,” says Simmons. “I have a dishwasher who bought a house and never even moved in. The moment he saw the first payment, he knew he couldn’t afford it.”
Indeed, the Ramirez family exemplifies a type of new buyer that didn’t exist a decade ago. Neither Rosa nor Alberto speaks English, so they were completely dependent on their real estate agent and their mortgage broker for advice and to translate and educate them about the process. “In other business transactions in California, if you negotiate in Spanish, you are required to provide translations of all documents. But real estate contracts are exempt from this,” explains Simmons, who currently has 30 active cases and sees her potential caseload growing by the day. “There’s a large increase in the amount of borrowers reaching out to lawyers with subprime loans. I’ve gotten to the point that I have to say to a lot of people, ‘I can’t represent you, I have too many clients.’ It’s astounding to me. I neither expected nor have I seen anything like this in all the years I’ve practiced law. It’s as if in real estate it’s gone back to the Wild, Wild West of San Francisco in the 1800s.”
Makes sense. Who would be most commonly affected by a subprime collapse? Lower income borrowers, disproportionately minorities. But this just got insane - what drugs were the lenders on, to loan gobs of cash to people who can barely afford to rent? We’ll come back to that in a second.
But first, what are “they” going to do about it? Surely, people in charge are stepping in to fix things. It’s not like we’re going to collapse the economy or anything. Right? Right? Like, bailout programs?
The new programs are a response to the nation’s rapidly growing mortgage problems. The delinquency rate among borrowers with poor credit has risen to 13.3 percent, according to First American LoanPerformance. That’s the highest level since the company started tracking delinquencies in that group a decade ago.
For all borrowers, delinquency rates have risen nearly 50 percent in the past two years to a recent 2.87 percent, according to Equifax Inc. and Moody’s Economy.com. Historically, more than half of all borrowers who become delinquent on their mortgage eventually enter foreclosure with their bank.
“There are hundreds of billions of dollars worth of problem loans out there,” says Zach Schiller, research director at Policy Matters Ohio. “We have much larger problems than can be dealt with by these programs.”
But at least we’re only talking a billion or three. What’s a few billion between friends? Let’s just bail this thing out and move on.
But economists and industry experts say the cost of a bailout would be significantly more than that.
Christopher Cagan, director of research at First American CoreLogic, says rising mortgage payments on adjustable rate loans will force 1.1 million homeowners into foreclosure over the next 6 years. He estimates the cost of paying off the debt for those borrowers would be $120 billion.
Oh crap. But we’ve done the bailout thing before, back in the 1980’s. The S&L crisis. We could do it again, right? Isn’t that still the best move?
Rise notes that even a $120 billion bailout would not be without precedent. Economists estimate the federal government spent upwards of $150 billion to resolve the Savings and Loan Crisis of the late 1980s and 1990s.
Still economists say bailout could have the effect of causing more defaults. “If the plan is to pay off loans when people quit, then I plan to quit paying my loan,” says Michael Englund, chief economist at Action Economics.
What’s more, some economists say a bailout could encourage more risky lending in the future. “A bailout would validate what some of these lenders and borrowers did, which we now understand was reckless,” says Carl Tannenbaum, president of the National Association of for Business Economics.
“I don’t think that’s what we want to do.”
Okay, okay, fine. I get it. We’re screwed. This is going to be ungodly expensive. Over a million foreclosures. Empty houses dragging down neighborhood property values all over the country, raising crime rates and generally destroying communities. All over the place.
But at least it’s just real estate. It’s not like this situation with New Century and other subprime lenders calls into the question the underlying stability of the American financial system. It’s just real estate, right? If you don’t own a home, or you have a mortgage that you can afford, it’s not going to affect you, right?
Fasten your seat belts, friends, and let’s go back to that question of why lenders across the country loaned so much money to so many people who obviously could never pay it back.
In 1983, some Wall Street investment banks had the nifty idea to create a special kind of securitized asset based around mortgages. The general idea was for a bank to bundle a large number of mortgages together into a financial pool, to then be busted up into bonds. Investors - banks, individuals, anyone - would then buy the bonds, and as those assets matured with the underlying mortgages, their value would appreciate. They’re called collateralized mortgage obligations.
From a risk management perspective, the practice makes a huge amount of theoretical sense. Securitizing mortgages this way allows a bank to widely distribute the risk of default among many parties, while at the same time entirely eliminating the risk they themselves hold. Effectively, the banks pass the dangers along to investors and wash their hands of the whole thing. Some of these bonds are even FDIC insured. As long as we’re only talking about the occasional default, and things don’t get too out of hand, the loss of any single default should be easily outweighed by the appreciating value of the other working mortgages.
The problem is that this practice has a side effect: by reducing lending risk for banks, it makes a very lucrative business of cutting high risk mortgages. It encourages lenders to gamble. That’s what happened here - lenders across the nation spent years issuing securitized high-risk mortgages, passing the risk along to investors in the form of CMO bonds, and lived large at the craps table.
Sheila Bair, FDIC Chairman, testified to the Committee on House Financial Services Subcommittee on Financial Institutions and Consumer Credit on the subject, back on March 27. Her testimony was long and complicated, but valuable reading:
Some financial institutions seek to manage the risks associated with nontraditional and subprime mortgage products by securitizing their mortgage originations and spreading the risks of these products to investors. In fact, the share of U.S. mortgage debt held by private mortgage-backed securitizations doubled between 2003 and 2005, helping to fuel the growth of subprime and nontraditional mortgages. The ability to securitize pools of such mortgages certainly helped to make these loans available to borrowers through both FDIC-insured institutions and through mortgage brokers. Although securitization can spread the credit risks associated with these mortgages to investors, such a strategy may not mitigate the risks caused by poor controls over underwriting or the lack of adherence to representations and warranties made to the investors.
Bonds, meanwhile, aren’t usually considered high risk purchases. You put money into bonds when you want a nice, stable accrual - if you’re looking for risk, you buy stocks. Unfortunately for the owners of CMO bonds, instead of the occasional mortgage default here and there, we’re now going to have millions. Hundreds of billions of dollars lost, a great deal of that washing over into the bond market.. and into the pocketbooks of investors such as banks, governmental agencies, pension funds and insurance companies. They’re going to take heavy losses and pass the pain along.
This isn’t going to be limited to lenders at all. This is going to be a tsunami, crashing its way through the entire American financial system. And we’re all going to feel it. Welcome to the New Economy, friends and neighbors.
