How Did This Mess Happen?
I. Repeal of the Glass Steagall Act!
Prior to the stock market crash in 1929, both investment and commercial banks took on too much risk, with depositors' money by using those funds for active speculation in the stock market. These banks became greedy, taking on huge risks in the hopes of even bigger rewards. Banking became sloppy and unsound loans were made. Congress deemed that these banks had been the culprit in the crash. In 1933, the Glass Steagall Act was passed to separate investment and commercial banking activities. Now moving to the 1990s . . . after many years of investment bank lobbying, Congress passed the Gramm-Leach-Bliley Act in November of 1999, once again allowing the consolidation of commercial and investment banks into one entity.
II. Now Let the Fun Begin!
From 1999 to 2002, demand for houses and the ensuing price rises could be attributed to economic fundamentals such as low unemployment, expanding household incomes and population growth. Congress told both agencies, in 1999, to ease the credit requirements to low-income buyers. With the events of 9/11 and the Fed's later decision to lower the discount rate to 1%, future home buyers were lured (by lower interest rates) into acquiring property sooner than they had planned. At this time, the biggest players (in home mortgages) were Freddie Mac and Fannie Mae, which actively issued and purchased conventional, conforming mortgage-backed securities.
Loan volume grew to $5 trillion by 2002.
Pay-Option ARMs represented only 3% of loans.
In 2002, federal regulators found (in both companies) irregularities and mismanagement by senior officers, who later resigned. By 2003, regulatory and political factors forced both Freddie and Fannie overstated earnings by $9 billion, which significantly slowed down their future lending volume. With the Gramm-Leach-Bliley Act in place and demand for housing still increasing, the "new" investment banks created private funding in the form of mortgage and asset-backed securities, which replaced the standard conventional lending with looser underwriting standards. In 2004, these investment banks were successful in changing their reserve requirements on securities, which required $1 in reserves for every $12 loaned. The new reserve ratio became $1 to $40! Now new loan programs could be designed to meet the needs of the investment bankers' clients, who were demanding higher returns.
By 2005, loan volume had grown to $9 trillion. 68% of home mortgages were securitized, 33% were non-prime loans, and Pay-Option ARMs grew to 30% of securitized non-prime mortgages. 40% of loans were low or no doc loans These new lending programs allowed less-than-credit-worthy borrowers to obtain loans. With rapidly appreciating home prices, home equity loans were added to the mix and the consumer was living large! Wall Street was now in love with their creation, Structured Investment Vehicles!
(Sources: Glass Stegall Act, Gramm-Leach-Bliley Act, UC Irvine's Paul Merage School of Business, FDIC -1- III. The Structured Investment Vehicle (SIV))
Even by 2005, charge-off rates for mortgages and home equity loans were well below the long term averages (0.05/0.10 versus the long term average of 0.10/0.20). This allowed Wall Street's new credit environment to continue to offer looser lending standards and increased tolerance for riskier, high-yield loan products. The structured investment vehicle was designed to help diversify these risks.
Their Structure: Sub-Prime, 8.3%; Alt-A ,6.7%; Prime, 13.3%; Residential Mortgage-Back Securities, 0.2%. Asset Backed Securities, 12.1%; Collateralized Debt Obligations, 15.4%. Collateralized Loan Obligations, 6.3%; Nonfinancial Corporation Debt, 0.2%. ? Commercial Mortgages, 7.7%; Financial Institution Debt, 28%; Insurance Debt, 1.8%. Ownership Participation: U.S./Foreign Banks, 59%; Hedge Funds/Sovereign Trusts, 28%; Insurance Companies, 6%. Pension Funds, 2%; Corporations, 2%; Mutual Funds, 2%; Others, 1%.
What It Allowed Them To Do:
- Credit was made available to various types of borrowers (sub-prime, businesses, credit card users, leasing contracts, commercial loans, manufacturing, auto loans, etc.) who would otherwise have not been able to obtain such credit.
- Transferred risk to their off-balance sheets (OBSEs), to reduce reserves.
- Permitted exposure to remain mostly undisclosed to regulators and investors.
- Improved loan liquidity; generated fees; obtained relief from regulatory capital requirements.
- From 1997 to 2006, U.S. home prices rose 85% an historical high!
- Their Problems: Default rates exceeded earlier assumptions. The three main credit rating agencies were forced to make precipitous downgrades on a large number of these SIVs.
- Freddie Mac's Alt-A loans are 10% of its portfolio but more than half of its credit losses.
- Option ARMs were 19.5% of loan volume in 2005 and 28.7% in 2006.
- Freddie Mac had a projected model (risk factor) of price declines of 13.4%.
To make matters worse, they made long-term loans with short-term deposits. Investors did not have a clear idea of what portion of an SIV they owned, with whom they owned it with, what portion (if any) was insured, what was their "tranche" position, and were any of the insuring companies covering any of the losses. Due to a lack of this knowledge, many investors withheld funding from these very complex structured products, even those with high-quality underlying assets. By the summer of 2007, the securitization market was dead and the credit crunch hit all aspects of the lending markets. With little money for refinances and rapidly falling housing prices, short sales and foreclosures began to dominate the market. Today, these types of sales contribute to almost 50% of all recorded sales in southern California.
(Sources: Federal Reserve, Standard & Poor's, Federal Deposit Insurance Corporation)
II. The Current State of Orange County Housing As of October 16th:
- 12,722 the lowest number in 18 months and a current housing supply of 4.76 months.
- 49.7% of our entire inventory is priced below $500,000, representing 69% of the demand
- 42.9% of our entire inventory (5,458) is distressed properties, representing 64.2% of demand.
- Short-sales make up 77% of distressed properties with a market time of 6.08 months.
- Bank-owned make up the remaining 23% and have a market time of only 1.22 months.
- In southern California last month, 45.5% of all sales were foreclosed properties.
- 67.5% of distressed properties are priced below $500,000 93.0% of distressed properties are priced below $750,000
- 38.2% of attached homes are vacant
- 25.5% of detached homes are vacant
- 12.0% demand for homes above $750,000
- With 14 months of declining sales in jumbo purchases, the actual median sales price is greatly distorted. Normally, 40% of all sales are jumbo purchases; today they are only 12%!
- Fewer sales reduces the sample size, thus reducing the validity of the conclusions.
- The dominance of foreclosures and short-sales usually concentrated in a smaller area.
- Median sales price is now being distorted by the low-end/smaller property market.
- Larger price declines on distressed sales actually distorts factual metro sales prices.
(Sources: Altera Orange County Market Time Report, John Burns Real Estate Consulting.)
IV. Our Government to the Rescue?
This year, the federal government has tried to "prop-up" both the housing and financial markets through various measures: 1. Economic Stimulus Act of 2008. The IRS mailed out 132 million rebate checks in an effort to help stimulate the economy. Unfortunately, 78% of the rebates went to the payment of bills not to purchase goods and services in the economy! 2. Housing and Economic Recovery Act of 2008 This was to shore up Freddie Mac and Fannie Mae so that they could continue to bring a steady supply of mortgage capital to homebuyers. The Treasury Department was to inject $100 billion into each company. Conforming loan amounts were raised and FHA was authorized $300 billion to help troubled homeowners by refinancing their loans. Increasing the loan amounts was also to help lower interest rates for high-priced areas. A new $7,500 tax credit was given to first-time homebuyers, and $4 billion was allocated go to Community Development Block Grant funds to purchase and fix-up foreclosed homes. 3. The Federal Reserve opened its discount windows and allowed troubled banks to borrow from them through "auction securities." This would allow the banks to strengthen their capital reserves and begin making both residential and commercial loans again. By September, banks had borrowed over $500 billion dollars but banking problems still persisted. At the end of September, the Fed agreed to advance another $228 billion in auction securities, through November. 4. Emergency Economic Stabilization Act of 2008 . . . or "Re-arranging cards in the House of Cards!" A massive plan designed to provide the Treasury with $850 billion to buy or insure troubled securities, with the hope that it frees-up the capital markets and helps stabilize future banks from failing. The plan raises the new FDIC limit to $250,000; limits pay and ends "golden parachutes" for those companies who participate; and directs federal agencies to modify troubled loans whenever possible. FDIC has only $45 billion left after paying out $9 billion for IndyMac Bank. Total insured deposits exceed $4.5 trillion, with $3.5 trillion in money market funds.
More Potential Problems on the Horizon! U.S. Credit Card Debt . . $ 1 Trillion
Corporate Debt . . . . . . . . . . . . . $ 12 Trillion
Mortgage Debt . . . . . . . . . . . . . . . $ 14 Trillion
Credit Default Swaps . . . . . . . . . $54 - $62 Trillion
Derivatives . . . . . . . . . . . . . . . . . .$370 - $583 Trillion
Note: AIG had $1 trillion in assets to back insurance policies. Their problem was the $500 billion of exposure to corporate debt and credit default swaps. On Oct. 10th, Lehman's bankrupt bonds sold for 8.62¢ on the dollar and the credit default swap holders (insurers) paid out 91¢ on each dollar!
(Sources: FDIC, Federal Reserve, Economy.com, Bureau of Economics)
The Challenges Our Economy is Currently Facing Various Headwinds:
1. Wealth Effect - due to declining assets The Federal Reserve reported that real estate "net" equity declined $879.6 billion in 2007. Household equity is at 46.2% vs. 57% ten years ago a record low since post-WWII. CA foreclosures in 2007 totaled 94,969 versus 110,282 for the 1st half of 2008. Through September, Orange County is averaging 1,012 foreclosures monthly. 2. Price Effect - due to higher energy and food prices Commodity prices are on the rise due to a weak U.S. dollar. As prices rise, consumer and business spending decreases. 3. Income Effect - due to higher unemployment Current U.S. unemployment is at 6.1% 760,000 jobs have been lost in the past year. California's current unemployment rate is 7.7%, the highest in 12 years. Orange County's unemployment rate is 5.7%, with job losses exceeding 29,600 in the past year. Less income, less paid taxes, more pressure on federal, state and personal budgets. 4. Funding Conditions - due to the "credit crunch" This is the 20th month since sub-prime, housing woes, and weak financials were reported. Regulators and thus the banks have tightened credit standards for all types of loans. Many loans require larger down payments, actual verification of assets and income. Appraisers are "adjusting" appraisals for the market conditions 5. "Spill-Over" Effect The September delinquency rate on single-family loan balances were 12.5%. If prices continue to decline, another tier of properties with exhausted home equity lines or increasing loan balances could set off another round of very large foreclosures. 75% of Option ARMs borrowers are paying the minimum payment. This is causing the recast date to be reached earlier than had been projected. There is $500 billion worth of Option-ARM mortgages that have yet to recast, with $300 billion worth of mortgages on California properties.
(Sources: Mortgage Bankers Association, U.S. Bureau of Labor, Ca. EDD, Federal Reserve, DataQuick)
VI. How The Financial World Is Changing Real Estate For The Buyer:
There are 71% fewer mortgages available than a year ago. There are no more "Bail & Buy" loans. All assets and income must be verified. Larger down payments are required, with points to be paid on the loan. Fixed rate mortgages account for 69% of funded loans. FHA is the new "big" player. (a) up-front insurance premium is now 1.75%. (b) "Kiddy Condos" for kids in college. (c) down payment goes to 3.5% on Jan. 1st. (d) gift still available for down payment
For The Lender: FHA appraisers must be certified, which will cause a decrease in the number of appraisers. Some lenders may no longer use "in-house" appraisers. Financial institutions will be held liable for any misleading advertising. Adjustable sub-prime loans cannot have a pre-payment penalty for 4 years. Fixed sub-prime loans can not have a pre-payment penalty for 2 years. Truth in Lending statement must be printed in the native language of the borrower. Jumbo loans will be set at $625,500, as of January 1st.
For The Investor: 25% down or more offers the best rates. 20% down will cause rate to rise approximately 3/8% less than 20% down, introduces PMI; higher rates; added approval by insurance companies.
For The Seller: Foreclosures and short-sales will continue to dominate the 2009 real estate market. Listing prices must be competitive with these properties for a successful sale. Regardless of their expectations, their house will be appraised conservatively. Expect the short sale process to take 4 to 6 months. The buyers are still in control of pricing: (a) give careful consideration to a counter offer. (b) expect to pay for all termite work and repairs disclosed by the inspection report. (c) length of escrow will be the buyer's choice, but market conditions can push it longer. (d) making necessary repairs and improvements ahead of time will help the marketing.
(Sources: FHA, Mortgage Bankers Association)
VII. A Final Perspective For 2009: Delinquent December tax bills should give us a peek into potential problem properties. It will be early January before we know the full impact of the latest bailout. The housing market below $250,000 has most likely reached the bottom. Prices now in the $350,000 range are close to the bottom. The rest of the housing market still must suffer a restructuring of price levels. Expect foreclosures and short sales to dominate the market through 2010. Listing inventory should rise due to the large number of foreclosures set to enter the market.
The Light In The Tunnel: The credit conditions should greatly improve, bringing more buyers into the market place. Demand for properties will continue to be higher than the past three years. American households have $7.4 trillion in checking, savings, and money market funds. Americans have $4.1 trillion stashed in Treasury bills and other bonds. This total of $11.5 trillion could pay off every home mortgage in America! Investors have "parked" $3.5 trillion dollars in money market funds and it has to eventually move someplace. Hopefully, a large chunk goes into real estate lending. Most lenders will recover 70% of their outstanding loan balances through repossessing homes and then reselling them. If not, they can sell them off to the Treasury at auction, at the current rate of "X" cents on the dollar (unknown at time of print). Price declines have allowed first-time buyers back into the real estate market. Pent-up demand from buyers, who have been "fence-sitting" for the past couple of years and are now re-entering the housing market, should help reduce our current housing supply. The U.S. income this year will be $14 trillion, while global income will be $53 trillion. The U.S. economy earns $26 billion every day and, even with loan write-downs in the hundreds of billions, it will represent less than ½ of 1% of the combined assets of all U.S. households and non-financial corporations.
Orange County: It has 4 of the top 20 income-earning cities (NB, YL, IR, MV) in America. It has the 5th lowest unemployment rate in the State and job growth is projected to grow next year at a rate of 1% - adding 14,000 new jobs. There are 94,000 small-business employers, of which 62% have fewer than 5 workers and 95% employ fewer than 50 people - leading to stability through diversity. There are 8 billionaires who call this county home. This county ranks 4th in the nation with 315,396 millionaires Rents are up 4.5% (June to June), making OC the 6th highest rental market in the U.S.
(Sources: OC Business Journal, WSJ, Federal Reserve, World Wealth Report, U.S. Census, EDD, REIS Inc. )
On Success "Every man should make up his mind that if he expects to succeed,he must give an honest return for the other man's dollar." Edward Harriman
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