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Dear iTulip,
First, some background before my questions.
Wife and I owned a Coldwell Banker franchise for a number of years in northern California. Sold it in May, 1989, before the market turned. Lucky timing. The housing market then experienced what I called a 'mini-depression' in our area. We experienced this from 1989 to the fourth quarter of 1995 when the market started to emerge. Housing prices in tract homes in our community dropped in value from twenty to twenty-eight percent depending upon location, age, and so on. The largest decline in upper income property that we saw in our area was a 48% decline in appraised value by a lender for a property that was then sold all cash to an investor.
We survived this downturn by representing lenders who had foreclosed on properties. We represented companies as large as Great Western and many smaller ones. We also were Fannie Mae reps for a short time. Early in the cycle, we saw an attempt by the lenders to compete with everyone else in the downward trending market. They expended considerable capital repairing and servicing their listings. However, as time went on and their own inventory increased substantially along with everyone else’s, and I suspect that they were beginning to experience the cash flow and property management cost of owning so many properties, their strategy changed. First they put properties up for auction, later packaged billion dollar plus sales of inventory to other financial institutions at discounted prices, and finally they adopted a system of “forgiveness.”
The “forgiveness” formula went like this. Rather than absorb the defaulting loan property by foreclosure and subsequent expenses, if a defaulting homeowner had the means (employment or otherwise) to make some monthly payment, the lender would tack the previously defaulted monthly payments plus penalties on to the end of the loan, extending the years of payment, and a new loan was structured so that monthly payments were reduced to allow the homeowner to keep the property. This eliminating the lender's capital expense problem of marketing a property in a spiraling down market. It seemed to work.
My first question is, I recognize that the northern California market was not then is not now a national market, and its engine of employment is still local. Nor did we have a confluence of economic and social factors then that are seemingly coming to a point of resolution today, one way or another–such as high consumer debt levels, lower levels of home equity due to cash-out re-financings and zero-month-down mortgages. These factors are new this time. That said, do you see the developing recessionary real estate market mitigated in the future when lenders employ the techniques mentioned above, or is the problem too large to be solved by these methods?
Second, during the 1989 to 1995 period, I don't recall a great deal of discussion about the impact of securitization and credit default derivatives as they related to real estate. I'm getting the impression that has change considerably. Is that true? If so, what potential benefits and liabilities does this development present in the current downturn.
Finally, the 48% decline I mentioned on one property was an upper income property. The high end of the market seemed to take it in the shorts more so than the median stock. Why might that be?
Signed,
Northern California Residential Realtor Agency Owner
Dear NCRRAO,
The process you describe is much as we experienced in many areas of the country at the time. In the early stages of a housing downturn, lenders behave like they expect prices to soon stabilize or even begin to rise again, as if they are actually going to make money next to real estate sales agents and individuals in the market who are taking losses. But they soon realize that being a seller in a declining housing market is not a good time to be a property owner who needs to sell, and they soon give up on this approach and move on to the business of cutting their losses as much as possible. The unique factors of this period that you mention will certainly make the process more difficult for everyone involved this time around.
The most challenging aspect of this period is that many mortgages that are most likely to go bad are already about as creative as you can imagine–zero money down, principle only, etc. The problem is not the affordability of the mortgage, the problem is that in the Frankenstein Economy they lent money to borrowers who do not have the income to pay and, with little or no equity in their homes, have little motivation to try. If lenders attempt to get even more creative to make these "affordable" mortgages even more affordable, such as by tacking defaulted payments and penalties on to the end of a mortgage, the banks do not solve their problem. Their problem is not only how best to unload properties in a declining market but how to avoid technical insolvency, as has already driven a few canary-in-the-coal-mine sub-prime lenders, such as Ownit Mortgage Solutions, out of business over the past few weeks. It is unusual for lenders to reach this point so early in the cycle, and recent defaults may portend many more larger mortgage lenders closing in the future as bad loans pile up.
In our explanation from January 2005 Housing Bubble Correction, unemployment is the most important factor determining the extent of the challenge lenders ultimately face as the housing market declines. The chart by the FDIC, below, was included that shows the strong correlation between unemployment and home price growth. If unemployment rises, real estate prices will decline further, putting even greater pressure on both borrowers who will owe more on their mortgage than their home is worth and on lenders who will wind up with thousands of properties returned by to them by borrowers.
On credit default derivatives, these are derivatives that act as lender's loan insurance. The banks use derivatives to insure loans against losses from default. Assuming the insurance “works,” that is, that the counterparties can and will pay up if borrowers default–in fact, if thousands do so over the next couple of years–the best case result is that the next time the lender goes to buy this insurance to extend new loans these derivatives will be far more expensive, and that cost will have to be passed on to new borrowers as higher interest rates and fees. The analogy is what happens to the cost of flood insurance after a hurricane.
On the high end declining first, the reason is that building a $1 million home does not cost $500,000 more than building a $500,000 house, maybe 20% to 50% more but not 100% more. The difference is a fat profit. Incidentally, this is why builders invented MacMansions in 1980s, as a way to increase floor space without increasing building costs much, allowing builders to charge more per house and earn more profits. The MacMansion premium and the profits these inflated homes generate go away first in a downturn as buyers become more careful about protecting the investment value of their purchases.