Posted on 12/08/2006 10:07:04 AM PST by RobRoy
“It’s different this time,” are four of the most alarming words an investor can hear. Very rarely do things turn out differently; history shows that normally they go wrong in almost exactly the same way they did last time round the cycle.
But when it comes to the US housing market, there are reasons to expect that things will be different this time. But not in the way that optimists expect – instead the difference is that the damage could be more far-reaching than ever before.
Plenty gets written about the vast scale of this real estate bubble, the world of pain that housebuilders, realtors and overstretched buyers are finding themselves in and the likely impact that falling prices will have on the American consumer’s willingness to run up debt at the mall.
What’s sometimes overlooked is the other end of the equation: the huge amount of risky loans that have been issued to fuel this bubble and the question of who will be left holding the baby when it all blows up... In the modern mortgage market, loans often don’t remain with the bank that issued them. Instead they're parcelled up into bond-type structures called mortgage-backed securities (MBSs) and sold on to investors. The buyers range from hedge funds and pension funds to the Chinese government diversifying its dollar assets away from Treasuries.
This process - called securitization - looks like a winner for all involved. The mortgage lenders get rid of the risk of more borrowers than expected defaulting on their payments. The buyers get a higher interest payment from the MBSs than they would from a corporate bond with a comparable credit rating (this is because individually the mortgages are riskier, which means they pay a higher interest rate; but if you collect enough together, you reduce the risk of too many defaulting, which makes for an improved credit rating). And the investment banks collect a fat fee for arranging the deal.
MBSs aren’t a new development. The first ones appeared during the 1980s and played an important part in the Savings and Loans crisis. The banks persuaded S&Ls to turn their mortgage portfolios into MBSs and sell them, then use the proceeds to buy MBSs issued by other S&Ls. That may not sound like great business acumen, but it should be borne in mind that the S&Ls were run by near-amateurs working on the time-honoured 9-6-3 business model: lend money at 9%, take deposits at 6% and be on the golf course by 3pm.
Since then, the scale of the MBS market has expanded enormously. And one segment that has grown particularly strongly in recent years is subprime mortgages - loans granted to borrowers who are a higher credit risk.
Banks charge higher interest rates for subprime loans, making them a very profitable segment during boom times. So as the housing bubble inflated, subprime originations soared from around $100bn six years ago to over $800bn last year. In the process, lenders lowered their standards, throwing money at people who wouldn’t have even qualified as subprime in previous years.
The problem is that when the housing market or the broader economy turns down, delinquencies (late payments) and default rates on subprime mortgages shoot up. And that seems to be what’s happening now. Investment bank UBS reports that nearly 4% of subprime mortgages issued and bundled into MBSs this year are 60 days or more behind on their payments. While that may not sound too alarming, it’s the highest rate in over a decade - almost one percentage point higher than in the 2001 recession - and the economy as a whole isn’t even officially in trouble yet.
These delinquencies don’t bode well for the performance of this crop of MBSs in years to come. Typically, delinquencies and defaults pick up from year three of an MBS’s life; high delinquencies in year one are generally a sign that higher-than-usual defaults can be expected later on (because people who struggle to meet payments from the off are likely to struggle even more in subsequent years). That means that many investors who have bought subprime MBSs may soon find high default rates eating into their returns.
In theory, this will mostly affect investors who have bought bonds with lower credit ratings, but in practice even investors who bought higher-rated bonds may take a hit. Nobody really knows how subprime MBSs will perform during a falling housing market, because there’s so little historical evidence to assess them. One Merrill Lynch report reckons that a 5% fall in house prices could see defaults rise to double digit rates, which would be enough to hurt some investors who’ve bought seemingly-safe A-rated paper, the analysts reckon.
And of course, not many MBSs would actually have to cut payments; just the increased threat of it could send their prices tumbling. As happened with the S&Ls, plenty of investors will then find that they didn’t understand the risks they were taking on. But this time, the scale will be much greater.
Still, at least the lenders can take comfort in the fact that they’ve got all the risk off their books, can’t they? Not quite. MBS buyers may have been very reckless recently, but they’re not completely stupid. Usually the lender must buy back mortgages that go bad within the first few months. That could prove a trap for reckless lenders. This week, Ownit Mortgage, a formerly fast-growing subprime lender in California, shut its doors after apparently running out of cash to meet its repurchase obligations. It’s unlikely to be the last firm to meet that fate.
Hey, all that stuff is no problem when prices are on a quick track rise. You can even make up the difference with new home equity loans against your "newfound equity".
'Course, if prices flatten or even go down...
Why is that?
Not in New York City...it's heating up again this fall.
Because ex-Texan said so.
I think it depends on the situation. It also may expose that inflation is higher than some "official" figures may suggest. That is, prices may go up faster than your wages.
It is also a more accute problem when interest rates rise and refinancing is not an option.
I have also seen people get in so deep with the initial loan that they create a problem from which they may never recover. Y'know, like the people who pay several hundred dollars (or more) a month just on credit card interest. Living like paupers on $10,000 a month just trying to pay the bill for past extravigances. I've seen it and, to a lesser degree, experienced it.
Well, one reason is that sometimes, when you are in over your head, you sell your house. My friend did that. His company was six months behind on payroll. He HAD TO sell and made out like a bandit (the market was going up!
But if enough people find themself in that position at a time when they are "backwards" on their loan (they owe more than the house is worth - for those in Rio Linda), they can't sell. They default.
A 5% drop in prices wouldn't affect someone who owes less than 90% or so of their homes current market value, yet has to sell. They'll pretty much break even after RE fees, etc. But if enough people who have 100% loans and flat or reverse ammortization loans, there will be serious impact to them. And considering the buying/refinance frenzy in the last few years, I think this may just be the elephant in the room.
I should check current RV sales and prices.
I got myself into a sizable amount of debt when I was a young adult. Fortunately, my income increased while I managed to keep my spending from continuously increasing as well.
Now my debt consists of just my mortgage, though I may borrow money when buying a new vehicle in a year or two.
Awesome! They say with age comes wisdom. I had to learn the same lesson. What killed me though was a divorce. And if you have kids, it is the gift that keeps giving - I mean taking.
I'm getting seriously tired of the lead suspect in Natalie Wood's unfortunate death trying to convince me to sell my house one piece at a time (reverse mortgage) and then trying to read the reams of fine print at the bottom of my analog screen every morning at 5:00 AM on AMC.
All lenders are predators when it comes right down to it.
My brother is a securities broker. He has no equity in his downtown condo and refinances every chance he gets - but he invests the money. All of it.
His philosophy is that if prices go up, it's good for him. If they go down and he can't make the payments, he walks away.
Which would you rather have, good credit or a couple million in the bank. Yeah, me too.
An interesting side light on the new Bankruptcy Law is that home loans are not included in Bankruptcy now. If you buy a 500,000.00 house and take out Bankruptcy, after the Bankruptcy you still owe the remainder of the 500,000.00. You cannot walk away from that home loan as people have in the past.
Yes, but you cannot go to "debtors prison". But I agree with your concern. I think the way our current predatory consumer credit system and real estate lending system are set up, coupled with our new bankruptcy laws, it looks like we are setting up generation "y", and some of "x" and the boomers to be indentured slaves.
Coming soon no doubt !
Really? What is says is "apparently". The article is 100% speculation. A better reason why they problem went bankrupt is they grew very quickly, did not know what they were doing and were hit hard by the slowdown in mortgages. The article is all smoke and mirrors, no substance.
It seems to me that the bottom line is to be smart and those who won't be can't be protected against themselves, really.
If I had 2 million in the bank and I couldn't make the payments on a condo, I'd figure I was a really poor rich man.
Excellent find. Thanks for the ping!
LOL!
>>If I had 2 million in the bank and I couldn't make the payments on a condo, I'd figure I was a really poor rich man.<<
Yeah, There were some details I intentionally left out. One would get that impression from what I wrote though.
My brother does not consider a personal residence to be an investment. Most of the people in the business that I know tend to take that tack. I actually have a friend that owns several rental properties and rents his home as well.
Toss in $80K of student loans and they could be in serious debt until the day they die.
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.