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 all 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. Typically banks will only lend 80% of the value of a house requiring a 20% down payment. FHA makes it possible, with as little as 3% down for many people to buy a home. In essence, FHA provides most of the equity portion of the loan by guaranteeing that it would be paid. To compete with FHA, private mortgage insurance was established, which made conventional financing competitive with as little as 5% down and provided the same guarantees as FHA.
Soon after FHA came on the scene in 1934, there was a significant increase in demand for housing, which strengthened pricing and contributed to the economy as new homes were built to satisfy the strong demand. Fast forward to the 1990's. 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 marginal credit and people with no money. These segments were addressed with no income verification loans, no asset verification loans, and sub prime loans. The first two required strong credit and money down, and the latter put borrowers with marginal credit into a home, often with virtually no money down. These types of loans do not conform to the 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. Some times 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%?
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 as the market demand for housing was strong. Part of the reason the defaults were relatively low is 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. In the 1990's when the creative financing started to become popular the high inflation, high interest rate environment of the earlier period probably seemed like an anomaly. My guess is that the greed factor prevented the industry from asking, 'what happens when real estate values decline' and plan accordingly.
Historically, residential real estate appreciates at the rate of inflation. When it appreciates at a rate that greatly exceeds 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. A chart that illustrates this point and shows just how speculative the market had gotten can be found below just above the "About the Author" section. It is 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 my guess is that a good part of the excess has been already been eliminated by the decline in real estate prices and the higher than normal growth in inflation. The rest, assuming real estate prices don't continue to fall, can be absorbed by a period of below average price growth. Not the ideal real estate market, but definitely not the end of the world.
By 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, expecting the next few years to be like the last few. Excess inventories move pricing lower. To stem future losses lenders stop originating sub prime loans making a large amount 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.
Someone, many years ago made some really stupid decisions, the consequences of which are showing up today. The Federal government (that means you and I) is now called upon to fix it, or let the US economy fall into the abyss. I believe it will be fixed, it has to be. We will enter an era of saner lending practices, lower demand for real estate, due to a reduction in the pool of eligible buyers and pricing closer to the equilibrium point. Much of the current excess will be picked up by investors seeking to participate in the growing rental market, due to a reduction in the pool of eligible buyers. Eventually, we will again enjoy a stable and healthy real estate climate.
