Housing: The party's over, now the bills come due
By Doug McInnis
But the real estate bust has focused attention on some very real problems, particularly in the subprime lending arena, which provides loans to high-risk borrowers. While a pronounced loosening of home lending standards has helped a lot of buyers get into homes they otherwise could not afford, it has also, predictably, led to disaster. Negative amortization mortgages, which don't require borrowers to pay any principal or even the full interest on their home loans each month, have been particularly troublesome.
"They're not paying down the principal. The unpaid interest is being added to the balance. And then the mortgage grows larger every month," says Tina Jennings MBA '99, a loan officer at Wells Fargo (which doesn't offer negative amortization loans) in Mill Valley, Calif. "The loan amount could grow to where it's higher than the value of the property, and that's what has happened."
Nor is that the only problem. The widespread use of adjustable rate mortgages in recent years is expected to lead to increasing numbers of defaults as rates reset upwards. Some $326 billion worth of adjustable rate mortgages issued between 2004 and 2006 will go into foreclosure over the next six to seven years, estimates First American CoreLogic, a mortgage industry research firm. This amount covers 1.1 million foreclosures, according to CoreLogic.
In addition, many investors have gained a pronounced appetite for higher risk in hopes of netting higher returns – one reason why the risky subprime home loan market has thrived. Former Federal Reserve Chairman Alan Greenspan bemoaned the trend towards higher risk in remarks delivered February 26, right before China's Shanghai Composite Index dropped nearly nine percent in a single day, helping to trigger a 416-point drop in the Dow Jones Average. "We have extraordinarily low-risk premiums now," he said in a Wall Street Journal article. "Risk is no longer perceived as major risk, at least as it was in years past, and that, I must say, I find disturbing."
The housing downturn has also focused attention on the dangers inherent in an increasingly global economy, in which events half a world away can rattle markets in America. This has happened before; witness the fallout from the Thai currency collapse and the Russian debt default in the late 1990s. But this marked the first time that a rumble in China's overheated equity markets spurred a worldwide reaction – one that sent U.S. stocks plunging and further damaged the high-risk segments of home lending in America.
In the earlier financial crunch, the Thai and Russian problems generated global uncertainty that spurred a "massive flight to quality investment instruments," says Dan Quan, former chief mortgage economist for the Federal Reserve Board, who now teaches real estate and finance in Cornell's School of Hotel Administration. "They sold everything that was risky and bought Treasuries."
The partial puncture of China's overheated stock market in late February did the same.One immediate impact was falling prices for certain securitized mortgage instruments for risky loans generated in the United States. That caused those loans to become more expensive and harder to get. "When they sneezed in China, it affected the ability of homeowners in America to get a home-equity loan," says Quan, whose courses in securitization are popular among Johnson School students.
The pain hit two markets that were already in trouble – subprime and Alt-A home loans, the two highest risk categories for real residential real estate. "Home buyers in these groups already had little or negative equity," says Quan. "And there were two things going on that had already impacted them. Property values were falling, and you had this upward adjustment in interest rates, which made in harder for [subprime and Alt-A] borrowers to make their payments.
"What happened in late February (when China's market fell) made it worse. People sold Alt-A and subprime bonds. That caused the price of the bonds to fall and the yield to rise. As a result, when they issue new subprime or Alt-A loans, the rates will be higher – and that tends to dry up the market."
History repeats itself
One of the basic lessons of history is that it tends to repeat itself, and that's certainly true with real estate. Alan Mark, MBA '80, has seen variations on the current themes before in a career that has spanned more than two decades. "We're definitely affected by global events," says Mark, president and founder of the Mark Company, San Francisco, a 75-staffer firm that offers market research, marketing, and sales expertise for residential condominium developers. "I first realized that when the Asian financial crisis began in Thailand and then spread. It was as if someone tripped over the extension cord, and the lights went out. Sales just stopped. We were about to open a residential condominium project when it hit (in August 1997). We were lucky we had a lot of buyers in the pipeline. They moved forward, but it was difficult to get new buyers until January 1998."
A decade earlier, Mark had quit his New York job to start a business which bought, renovated, and resold homes in the East. Soon after, the real estate market nosedived. Home prices dropped 25 percent along the eastern seaboard. "Nobody was buying," he recalled. The end result was that he couldn't resell the fixer-uppers he had bought. In months when he couldn't make the payments on them, the bank tacked the unpaid amount onto his steadily growing debt. In this business, he says, "You get the scars and the bruises. I wound up bankrupt, and much more conservative (in my future investment strategies). I also learned that I would rather go through that at age 35, as I did, than at 55."
What's at risk
As the current bust shakes out, the economic debris could be considerable. The nonprofit Center for Responsible Lending recently estimated that 2.2 million homeowners will lose their homes and as much as $164 billion through foreclosures on subprime loans. But there will be losses throughout the financial sector as well. The first dominos, the subprime lenders, have begun to topple.
In theory, the damage from the financial sector should be limited by the growing use of bundled mortgage securities, which minimizes risks for both lenders and investors. In the old days, homeowners got a home loan from their local savings bank, which held on to the mortgage. If something went wrong, the lender got the home back and absorbed any related losses. One side benefit of this practice was that it encouraged conservative lending policies, which would have prevented much of the pain seen today.
These days, home lenders quickly sell their loans – including most subprime loans – to commercial banks and Wall Street firms, which repackage the loans into securities. These securities are sold around the world, thus diluting the risk. If a home loan goes sour, it will be only one of many in a bundled security. But the risk hasn't disappeared completely. In some cases, subprime lenders are subject to buy-back provisions, and as the subprime market soured, these lenders were forced to buy back a lot of bad loans. As a result, subprime lenders have begun to fail
But the pain can and apparently has moved up the economic food chain. For instance, if a subprime lender fails, the commercial banks and Wall Street firms can't enforce the buy-back provisions. In that case they're stuck with any bad loans they can't give back and can't bundle into securities for resale.