Housing Industry & Mortgage Woes - How Woeful?

Housing Slump, Credit Crunch, Subprime Mess, Record Foreclosures, Housing Bust, Credit Crisis, Mortgage Bust. These are just a few of the headlines and references I have heard over the past month or two referring to the current events taking place in the housing and mortgage industries. A quick search on Google or YouTube turns up mass quantities of information from “experts” making predictions and claiming they have been right all along. Is all of the negative press true? How do we know who to listen to and what experts are correct? I would like to offer some perspective on what is taking place in the U.S. housing market and mortgage industry.

First, please keep in mind, drama sells. In the age of 24-hour news networks with hours of airtime to fill, and the internet that is designed to give everyone a voice, even if that voice is unfettered and unedited, reality can be skewed in favor of the most dramatic scenarios. This is not to downplay the current events, but in today’s news environment, we need to make sure we gain a full perspective before making judgments, and reserve some skepticism for what may be passed off as absolute truths.

The current events are big, but more importantly, they are extremely complicated. The changes taking place in the U.S. housing markets and mortgage industry have effects being felt throughout the entire U.S. economy and to some extent globally. Making absolute predictions is impossible. Factors change daily, if not hourly, and some effects are too indirect to fully understand immediately.

As investors, we need to get educated about the current events, figure out how they are going to impact investment environments, and find the investment niches that make the most sense. Changes in investment environments do not mean the end of investment opportunities; in fact, changes often mean the availability of even more lucrative opportunities.

How Did We Get Here?
This is a very complex subject, and it is difficult, if not impossible, to gain a full understanding from a brief article. The hope here is to get an overview of what is taking place, and gain as much perspective as possible so we can all continue to make educated investment decisions.

Real estate is a consumer product, and as a consumer product it is subject to the well known economic theory of supply and demand. As demand goes up, supply goes down and becomes more costly, and visa versa. For the past 5-10 years (or whatever mark you want to put on our most recent housing boom), the demand for real estate was very high, which drove prices, and as a result profits, very high as well. The high demand, and high potential for profits, drove large quantities of people into the real estate investing arena.

Home sales and rising prices have been at record highs. Some people gained wealth from primary residences or second homes (end users), and many people decided to try their luck as real estate investors. However, not all of these end users and/or investors were well qualified through experience, credit, or income to own the real estate they were purchasing.

This raises the obvious question, why would banks lend to less then qualified buyers? There is no clear and simple answer to this question, but in an attempt to simplify, markets and trends are difficult to predict, and lending institutions, like individual investors, want to gain as much as possible from lucrative trends. The rise in housing was a trend that was lucrative for a lot of people, but in the end, as markets adjust (as they always do), many investors also stand to lose, and lending institutions are no different.

Banks and lenders loosened their qualifications to allow for more subprime loans in an effort to make the most of the rise in housing prices, and to satisfy the demand from institutional investors (hedge funds, mortgage backed securities, bonds, etc. – i.e. Wall Street) that wanted to buy the mortgages that the lenders were writing. The last few years of the housing boom were spurred in large part by these subprime loans. (Subprime refers to mortgages granted to borrowers whose credit history is not sufficient to get a conventional loan at prime rates. Often these borrowers have impaired or even no credit history.) When qualifications were loosened, more home buyers were available to the market, which allowed for prices to continue to increase…i.e. more demand sends prices higher. The issue is that the U.S. economy is now feeling the effects of these less then qualified buyers.

Many factors play a role in the timing and methods in which markets, such as the U.S. housing market, adjust and change over time. One major factor to consider is the high price point of housing compared to the average income of buyers. As housing prices continued to rise year after year, a large gap began to form between the average income of U.S. citizens and the average price of housing. While prices increased and credit was easily accessible, end users and investors were not very concerned about this growing gap because funds, in the form of home loans, equity lines, or lines of credit, were easy to come by; not to mention the ease in which real estate could be bought and sold to create profits. However, as demand began to slow, and in turn rises in price began to slow, this gap became more evident and more of a concern.

As if creating a recipe for poor housing conditions, sprinkle in a few other factors, and a vicious circle is easily created. Housing prices rise and people show little concern about the fact that they may be spread a bit to thin from a financial perspective. Credit is easily accessible, so equity from these rising prices is readily available. As housing prices level off, and in some places decline, it becomes clear that the easily accessible profits from appreciation are also ending. Lending institutions become aware that housing is slowing and they too begin to adjust their practices to the changes in the market. The lenders adjust by tightening their qualifications to qualify for the lending they are offering, which in turn means less people can qualify for loans, i.e. less buyers on the market. Now we have a situation where demand is lowering and supply is rising, and the net effect is a leveling off, if not lowering, of pricing for the available supply of housing.

In addition to these changes to the housing market, another major ingredient needs to be added – Adjustable Rate Mortgages (ARM’s). ARM’s are mortgages that start with a low, “teaser,” interest rate, and adjust to a higher interest rate after a period of time, usually 3-5 years. Towards the end of the housing boom, when lenders were loosening their qualifications to bring more buyers to the market, ARM’s became a regularly used tool by lenders, especially to the subprime market. In retrospect this seems like a risky practice. Give individuals with less then stellar financial pasts loans that are complex, and appear financially manageable at first glance, but will adjust in the near future to much higher payments. During the boom many people tried to point these risks out, but money often speaks louder then words. The risks were considered and lenders chose to continue the practice; mainly because the demand for these types of loans was high from both buyers and Wall Street.

ARM’s that were created towards the end of the boom are now beginning to adjust from their “teaser” interest rates to much higher rates, in turn creating payments that owners can not, or are not willing, to pay. This in turn adds an increase in foreclosures to our poor housing recipe. As markets slow, demand lessens, prices flatten or decline so equity and appreciation are lost, available credit tightens, and then rates adjust up; some owners find themselves in very tight financial positions, and even upside-down on their real estate assets.

Recall the two types of buyers mentioned above, end users and investors. End users are more inclined to fight through difficult financial times with their homes because this is where they lay their head each night. However, many end users, despite their desire to fight, can not make ends meet; especially as rates and their monthly payments drastically increase. Investors on the other hand, are the first ones to turn away from their investments when times are tough. When the housing boom was at its height, real estate investing seemed easy, almost free money, and as a result the number of investors increased dramatically. When times became tight many of these investors lost their desire to work through the difficult times. As a result of end users being incapable of affording higher monthly payments and large numbers of investors losing their will to work through difficult times, foreclosures have increased at record amounts.

The vicious circle now grows as foreclosures are added to the recipe. Markets that are already experiencing slow sales, declining prices, lower demand from buyers, are now faced with even more inventory from foreclosures. Supply increases and demand decreases. In addition, lenders, and ultimately Wall Street, who buys mortgage backed securities, are now seeing large numbers of defaults on their mortgages, which immediately affect their bottom lines – their profits. A short time ago, they could not write enough loans, and their profits were growing at a record pace; now the number of loans they are writing is drying up and the mortgages they were depending on for profits are defaulting.

As Wall Street sees these changes, they too begin to adjust to the market conditions. Funding for subprime loans dries up almost entirely. The force that was helping to spur the boom is now slowed to a halt. Lenders begin to go out of business, and as the lending and investment landscape adjusts, the effects ripple through the U.S. economy and globally. Housing slows, appreciation and equity level off, if not decline, available credit tightens, foreclosures increase, lenders and Wall Street feel the effects, the subprime industry slows incredibly, demand slows and supply increases, corporate and institutional profits are impeded, people have less cash at their disposal and credit is more difficult and more expensive, so people spend less, global investors begin to look elsewhere to invest because the U.S. economy is not growing the way it has for the past few years. This is a very simplified explanation of an amazingly complicated and inter-related process, but the idea is clear – Every aspect of the U.S. economy, and ultimately the world economy, is connected in some way, and as a major economic force such as the housing industry undergoes changes, the effects will ripple through the economy.

The complexity makes economics a very difficult science/art to fully understand, and even more difficult to accurately predict or pin point. The positive aspect of the complexity is that nothing is as clear cut as it may seem from a simplified explanation. Conditions may have seemed ideal during the housing boom – the economy was doing well, and people were creating a lot of wealth through real estate; the reality is that it could not have been ideal because we are now dealing with the backlash of that boom. In the same way, the current housing/mortgage crunch may seem serious, and many would have you believe dire, but conditions are still working themselves out, and positive aspects can and will be found.

What is Really Going On?
Armed with a general understanding of the forces that are coming together to create the current events, let’s focus on some more specifics about these forces. Moody’s Economy.com (a leading independent provider of economic, financial, country, and industry research designed to meet the diverse planning and information needs of businesses, governments, and professional investors worldwide) predicts that 2.5 million first mortgages will default this year, and they expect the delinquencies to peak in the summer of 2008. This is a tremendous amount of defaults, and the peak is still months away. Does this merely reinforce all of the bad news? Not necessarily.

These statistics need to be broken down a bit further. First, the worst-hit loan category will be subprime adjustable-rate mortgages (ARM’s). Nationally, the core of the problem is subprime ARM’s that were originated in 2005 and 2006, when lending standards became very loose. This is clearly a problem, but the problem is contained; it is not throughout the entire mortgage industry.

In fact, the prime fixed-rate mortgage market has seen almost no detioration from defaults. In addition, while the origination of ARM’s has plummeted by almost 50% in the third-quarter of 2007 when compared to 2006, applications for fixed-rate loans have risen by 30% during the same period. The industry is in the process of self-regulating. These trends demonstrate that there is still ample confidence backing the lending industry, but this confidence is only available to support well-qualified loans. There is still plenty of investment capital in the industry, but this capital is being reserved for less risky investments…i.e. well-qualified applicants and fixed-rate loans. This stricter analysis of loans is reducing the availability for home purchases, refinances, and equity access, but this reduction in availability is focused mainly on the outer margins of creditworthiness, where lending has grown extensively the past few years.

In addition to the core of the problem being focused on subprime ARM’s, a large concentration of defaults is focused on a small amount of states. In early September, the Mortgage Bankers Association released its second-quarter report for the three months that ended June 30 and found that most of the loan delinquencies and foreclosures were happening in seven states: Michigan, Ohio, Indiana, California, Florida, Nevada, and Arizona.

The last four states (California, Florida, Nevada, and Arizona) have high rates of ARM’s. These four states are also seeing declining house prices which makes refinancing these ARM’s difficult. In addition, these four states have a disproportinately high share of investor loans, which are more likely to default if the investors see the value of their investments falling because of dropping home prices.

In the first three states (Michigan, Ohio, and Indiana), the high level of deliquency and foreclosure has to do with the underlying economy. For example, Michigan lost nearly 300,000 jobs between 2001 and April 2007. To add another ingredient to the vicious cycle of our housing conditions, local economies have a tremendous effect on the value of housing in that area. In a study done by the FDIC (An independent government agency created by Congress in 1933 to maintain stability and public confidence in the nation's banking system.) looking at housing booms and busts in U.S. cities, it can be shown that the main regional instances of U.S. home price busts since 1978 are connected to fairly acute, localized economic shocks that tend to affect major employers. As a result of this localized economic shock, the most detrimental factor in the bust cities is population outflow. Jobs are lost and people leave the area. Population outflows are extremely damaging to housing markets. The demand for homes is lowered and the number of houses on the market rises – demand down and supply up. The problems of these upper Midwest industrial states clearly follow this trend.

When statistics are further analyzed, it becomes evident that it may not be time for widespread panic. We need focused efforts in the areas where the problems are concentrated.

What Can Be Done to Remedy the Situation?
There are a number of solutions that can be implemented to help the immediate problems and to prevent this type of event from occurring in the future. First, the government recognizes the issues and is taking steps to remedy the problems, while at the same time trying not to over-step their bounds. Since these issues are still so new to the economy, the remedies are still in the process of being created and implemented.

One potential remedy is to allow bankruptcy courts to modify the terms of a homeowner’s mortgage loan. This is not a far stretch from current powers of the courts, which already have the power to modify payments on other secured debts, including mortgages on other properties. Responsible lenders who made loans on reasonable terms would not be effected, but predatory lenders would end up with loans they should have made in the first place.

A second governmental approach is to utilize the FHA (Fair Housing Administration) to help borrowers refinance and avoid foreclosure. The Bush administration is looking to the FHA to offer refinancing options to homeowners, including those who are not yet in default or foreclosure, but who are at risk of falling behind in their payments on mortgages that were structured to offer payments that were very low at first but then escalated. This gives the government the ability to assit those people caught in the subprime mess without advocating a financial bailout.

As recent as October 10th, the Bush administration put forth a new initiative they are billing the Hope Now partnership. The initiative is designed to coordinate the efforts of mortgage counselors, servicers, lenders, investors, and state and local government to reach out to as many homeowners as possible to prevent foreclosures. As of October 10th, eleven loan servicers that handle 60% of U.S. mortgages have agreed to participate in the initiative. It is expected that others will join, and have good reason to join, because minimizing foreclosures benefits lenders and investors as well as homeowners. Hope Now will conduct a national direct-mail compaign to reach at-risk borrowers, encouraging them to either call their lenders or a credit counselor to explore options to refinance or modify their existing loans.

In addition to immediate remedies, actions must be taken to prevent similar scenarios in the future. First, it must be reemphasized that not every borrower was deceived into accepting a hazardous or unsuitable loan. Many investors walked into these loans with full knowledge but chose to dismiss the risks. However, the main group that is being negatively affected by this backlash are the homeowners who chose to accept subprime ARM’s, and this group should be protected from these problems in the future. Mortgages are incredibly complex transactions and borrowers typically want a helping hand to guide them. This helping hand ususally comes from the mortgage lenders that are selling them the product. Furthermore, people who turn to the subprime market for money tend to be the least sophisticated consumers, and the most easily misled.

Here are four suggestions to assist this group:
1. No more “teaser” rates: Loans should not be made unless the lender has taken reasonable steps to ensure the borrower can repay based on the real rate. Lenders should also be required to factor in homeowners insurance premiums, property taxes, and any other debts the borrower may have.

2. Limit Stated Income Loans: These loans were originally designed for self-employed individuals, but mortgage brokers began to abuse them to help people into loans that could not be afforded in the long run. Without proof of self-employment, these loans should not be used.

3. End prepayment penalties for subprime loans: For people with bad credit, prepayment penalties are often used to lock them into a loan with poor rates and terms. Prepayment penalties should not be allowed under a certain credit score. If a borrower is above that credit line, it can be assumed that the borrower understands and can guage the risks of the loan.

4. Mandatory housing counseling for subprime borrowers: Purchasing a home is one of the largest investments anyone can make. It should not be taken lightly. It should be mandatory that vulnerable buyers must be educated about the mortgage process before making such large decisions.

Current Investing Climate
The majority of the U.S. housing markets are doing okay, if not well. The mortgage industry is not in complete disarray. Real estate investments are not dead in the water. With a full perspective of what is taking place, it can be seen that caution is needed, but full stagnation is not required. There are plenty of good investments to be made. The investment climate has changed. Investors can no longer go out and buy any house expecting giant profits, but this change is a good thing. Investors and investments are now becoming more realistic, and the competition for great investments is thinning out as uneducated investors leave the real estate arena all together. Niches need to be found, but the proper investments are out there.

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About The Author
Sarah Barry is the founder of PropertyVestors (www.PropertyVestors.com). PropertyVestors is a successful real estate investment group that creates above-market returns at below-market risk. Access to PropertyVestors' three smart real estate strategies enables investors to achieve double to triple digit returns on their real estate investments.