| The "Sub-Prime Crisis" | ||
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April, 2008 The current iteration, the "Sub-prime crisis", of course, refers to loans made to buyers of marginal qualification. While the interest rates are nominally higher, these buyers are, more often than not, qualified for the loan based upon an artificially low "teaser" rate, which only lasts for a short time, after which the thing becomes "fully indexed". Talk about self-delusion! Many were also 2nd TD's made with variable interest rates and, when subordinated to the existing 1st, resulting in a total encumbrance often exceeding 90% of the property value. Any decline in the market reduced the incentive for the homeowner to continue to make payments -- after all, he's already cashed out whatever equity he had. As the market began to cool in 2005-06, there was an apparently irresistible temptation to make these loans in an attempt to keep things going. The other aspect of this that, in this era of hyper-sensitivity, is rarely discussed is something else that laid the groundwork. In the early 2000's when the market was heating up, activist and special interest groups lobbied Congress to loosen the credit reins so that "the disadvantaged" and "minority" buyers could participate. This is a little like lowering the standards for firefighters so more women can qualify. I'm sorry, but the standards should be based upon doing the job, be it fire and rescue or re-paying the loan, not monetary affirmative action. So Fannie Mae and Freddie Mac, the government surrogates who buy loans in the secondary market, obligingly lowered the standards for loans they would purchase, and Shazzam! Many of these loans made to borrowers whose main qualification was that they were some sort of "oppressed minority", went into default. So let's examine how this could happen twice within such a short time. The scenario from roughly 1999 thru 2005 was eerily similar, except that cause this time was internal: this time, with so many marginal loans out there, the trigger was that an unacceptably high percentage of them became "non-performing" -- in other words, the borrowers ceased making payments. These loans were now owned by secondary and tertiary investors who, seeing this, suddenly stopped buying any more of those loans in the secondary market. This meant that new buyers could no longer get these loans and that lenders who had made loans with the expectation of selling them suddenly had a bunch of unsaleable loans on the books, tying up their cash. Countrywide was a large and highly publicized recent example of this. This, in turn, caused new buyers to be unable to get a loan (or at least a loan at anything like the interest rate they had been counting on), which caused sellers to have to reduce their prices in order to sell, property owners with now unaffordable loans unable to refinance, and down went prices. Couldn't anyone see this coming? Sure, but those closest to it were also benefitting from it, and no one has a crystal ball. The vast majority of the self-styled pundits invariably predict that whatever is going on a the moment will continue for the foreseeable future -- same thing is happening now. Of course, as with all seminal events, those who predicted it come out of the woodwork after the fact (Pearl Harbor, 9/11, etc), but these people lacked the track record and were generally unknown and un-listened-to beforehand. If one studies enough history, one figures out that there was always someone somewhere who, often by chance, accurately predicted every event, even if it was the only time they were ever right. Basically the causes can be put in 3 categories: greed, conflict of interest, and incompetence. Naturally many people wanted a piece of the hot market -- in the late '80's Home Savings and American Savings were probably the most extreme examples of lenders who made loans to people who really weren't qualified -- I used to call them the "lenders of last resort". But everybody was getting paid -- the loan rep, the underwriter, the other bank employees, the stockholders, the realtors, the inspectors, the escrow officers, title officers, appraisers -- and it was in the interest of all to keep the gravy train going. Sellers receiving record high prices and buyers who thought they would never qualify to buy a house weren't complaining either. From here, there didn't appear to be anyone in actual overall charge. There was an implicit assumption that someone was passing judgment on these loans -- of course the appraisers wouldn't let the sale proceed if the property wasn't sufficiently worthy, and of course someone at the lender was carefully scrutinizing each loan package to make sure the buyers met the necessary criteria, right? Wrong. There have been occasions over the years that I have found it necessary to get into the bowels of various lenders. Picture each loan file with a check-off sheet stapled to the front and, basically, when all the boxes were checked off (by a clerk), the lender made the loan. There didn't seem to be anyone who actually analyzed the merits of the thing as a business proposition. One aspect of this that has gotten relatively little attention is the appraisal process. The assumption is that appraisers are akin to Moses coming down with the Stone Tablets. Nothing could be further from the truth. If one dissects the way appraisers actually operate, the problem becomes clear: appraisers, whether actual bank employees or independent "fee" appraisers, don't look at property. When they are called upon to make an appraisal, the only property they actually see is the one they are appraising -- even tho they are almost always using recent sales as the sole support for the value they come up with. Of course, it's tough to actually see recent sales once the new owner has moved in, so the appraiser is reduced to driving by, looking at the description in the MLS listing, calculating "dollars per square foot" (notoriously inaccurate and the last refuge of those who haven't seen any property), etc. Unknown to the appraiser is that half the 40K sf lot of one comp was a 75% slope, that the "panoramic view" was only obtainable by standing on the toilet in the powder room, the quality and actual extent of the "total remodel", etc, etc. There is also considerable pressure on the appraiser (who knows what the sale price is) to bring the appraisal in at that price -- not higher and certainly not lower. Being the Don Quixote of the real estate business, I have been trying to get lenders to change their basic approach to the appraisal process. The inertia of the eons (whether with lenders or JBL) is tough to overcome. So why would a lender operate this way? Because the loan (with the exception of what are known as Portfolio Loans, which we can discuss later if you want) was going to be immediately sold off in the Secondary Market, passing the liability on to a 3rd, 4th, or possibly 5th party, who assume that the lender had done a workmanlike job in approving it. Lender gets his money and uses it to go thru the same process with the next applicant. In the case of the recent "crisis", these loans were packaged by secondary purchasers and re-sold as "mortgage-backed securities" to investors who also trusted the legitimacy of the process. Again, all this is of less concern as long as real estate values are climbing. History teaches that that isn't the case. The Press has been a de facto participant in all this. Obviously news has become more show business than the profession it used to be, with desire for ratings and the resulting revenue driving the most attention-getting headlines and stories. This wouldn't be so bad except that most people get their information from the press, and the way news is reported can have a self-fulfilling effect. Additionally, on-air TV talent (from which most people get their news) are clearly hired more for the way they look and sound than for any knowledge they might, by chance, have. The combination of unfamiliarity with the subject and desire for ratings motivates them to concoct the most sensational headlines and stories they possibly can. "Real Estate Sales Down 20%" can be interpreted in a number of ways, and may have a grain of truth buried somewhere, but it has the desired effect of grabbing the attention of readers/viewers. I'm sure you've all had the same feeling, but in my case, of the two subjects I know a fair amount about -- real estate and military history -- extrapolating the ignorance and misinformation regularly displayed by the press in those areas to all the subjects they report on is distressing. So just as the press helped drive the market up, they are giving the impression now that all is a wasteland of foreclosures, distressed sales, and declining values. That is indeed the case in certain markets (Las Vegas, Temecula, Lake Elsinore, Moreno Valley, Antelope Valley, etc), but those tend to be the very markets that experienced insane rates of appreciation 2000-2005, and are now coming back to earth. So, what has been done to address this? The pronouncements out of Washington, at least so far, appear to exceed the reality. When the "Stimulus Package" was passed, it provided for the "Conforming Loan Limit" to be raised from $417K to $729,750 (in LA and Orange Counties) until 12/31/08, the theory being that this would allow people in distress to get out of their unmanageable loans by refinancing. Problem was that, by then the financial markets were so spooked that no one would buy that paper. After many iterations in implementation sub-committees, with no buyers stepping forward to buy these new "jumbo" loans, it was finally arranged that Fannie Mae and Freddie Mac would buy the loans. So, basically, the risk is being passed on to the taxpayers. This does appear to have had a salutory effect on the under $1.5 million price range, which had really been whacked by lack of jumbo loan availability. I'll take any bets that the 12/31/08 expiration of the Stimulus Package will not be extended. The ironic part is that if the new limits have their intended effect of stabilizing the market above the bottom of the precipitous cliff they were predicted to fall from, that is all the more reason to make the limits permanent, as a reversion to $417,500 would be too far under the average sale price to be of much use, promoting a resumption of the very drop it was designed to prevent.
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