Thursday, April 2, 2009

The Housing and Mortgage Crisis Explained

In the US, a person's home is their castle. Home ownership is high up on the list of goals for almost every American. We have the highest per capita home ownership in the world. As a result, in most cases, a family which owns their home, has the largest portion of their net worth tied up in that home.

The US government, and the political class that runs the government, understand the voter's interest in home ownership, and recognize that home ownership creates wealth and stability. Therefore there have been, since the founding of our nation, many and varied incentives to own a home such as: a clear inclusion of property rights in our earliest laws: homestead provisions: land rushes: tax benefits: special mortgage opportunities for veterans: and more recently, direct intervention to stimulate home ownership.

Supply Demand Curve

All commodity bubbles and busts have a few things in common. And at the base of these common factors are two algebraic curves. The first of these is the Supply Demand Curve. Hopefully you will not mind a simplistic example.

On a really hot day in July, we open a lemonade stand in a neighborhood which is 6 blocks from the closest retail store or any other place where cold drinks are available. We sell our lemonade for $1 a cup and sell out the first day. We are now faced with a choice. Buy more lemonade and potentially hire friends to help with the crowds, or buy the same amount and raise the price. We choose to do a bit of both. We increase supply and raise the price to $1.25. We sell out again, whereupon we repeat our strategy. We also note that our patrons are coming from further and further away, so we assume that our quality story is being passed along by our customers.

Week two, we have raised our price to $2 and have a couple of friends manning the stand while we keep the stand supplied with batches of fresh cold lemonade. However, halfway through week two, we note a slight fall off in sales. Asking around, we determine that a competitor has opened up 4 blocks away and is selling the same size glass as we are for only $1.75. Later that day when we go to the store to buy more lemons, we find that the bin is almost empty and the price has doubled. We go to another store 2 miles away (increased cost), and buy all they have at this new higher cost. We are now invested in a commodity that has a shelf life (might go bad before we can use it), and our costs and overhead have gone up, while our sales are dropping.

We can lower our sales price to draw our customers back from the competition, raise our prices to take into consideration higher costs, and hope to hold our loyal customers, and/or look for better prices on our raw materials. Then the mercury does some work for us. The temperatures sore over 100 with 95% humidity, and there seems no limit to how much we can sell. We raise the price to $3.00 and have no problem getting it. A third stand opens 4 block away, but it doesn't slow us down. We are having to drive all over town to find lemons, and the price is soaring, but our profits are still ok. A fourth stand opens 2 blocks away. Then Mama Nature throws a curve, and a cold front moves in.

You guessed it. Nobody wants any lemonade. The lemons are rotting. We are laying off our friends. The grocery stores have ordered lots of extra lemons, and they are now discounting. We lower our price to 50¢ hoping to at least break even on our remaining lemons, but there are no takers.

The Fear/Greed Curve

You may also have noticed another curve at work in the above example. As the demand was strong, we became greedy and raised the price as high as the market would allow. As raw materials became scarce we became fearful, and we bought up all the supply, even at the much higher price. As the market plunged, we became fearful again, dropping our price to avoid massive losses, and laying of people to lower our overhead.

These two curves operate in EVERY market. Oil, steel, t-shirts, cars, advertising space, and yes, housing units. And one more - mortgages.

Put It All Together

In the late '90's and early new millennium a few things all came together.

Dot com bust. Those who got burned in the market, saw real estate as undervalued, so shifted some of their portfolios here.
Government. Both the Clinton and Bush administrations pursued policies of making home ownership easier. This came in large measure from reducing interest rates and making mortgages easier to get.
Massive Capital Influx. Money managers saw a bonanza and huge amounts of risk capital flooded into mortgages. Banks and other lending institutions leveraged these loans at much higher levels than in the past.
  1. Dot com bust. Those who got burned in the stock market, saw real estate as undervalued, so shifted some of their portfolios here.
  2. Government. Both the Clinton and Bush administrations pursued policies of making home ownership easier. This came in large measure from reducing interest rates and making mortgages easier to get.
  3. Massive Capital Influx. Money managers saw a bonanza, and huge amounts of risk capital flooded into mortgages. Banks and other lending institutions leveraged these loans at much higher levels than in the past.
  4. Demand. Initially demand was increased from three sectors. Family formation by late blooming baby boomers, huge increases in legal and illegal immigration, and prosperity from low unemployment.
  5. Demand part 2. Speculators hit the market from two directions. Existing homes were purchased by flippers, who fixed them up (or not) for flipping. Home builders built homes as fast as they could.
The Concept of Marginal Demand

An illustration: I am an illegal immigrant. I have just arrived in the country and have enough money for one month's rent if I can share a room in the worst part of town. I find just such a room, but it is because I can afford $10 more than the guy whom I replace. He is out and homeless for a week, but comes back into the market offering $20 more. In the meantime I have found permanent work with a good steady income, so I want a place of my own.

I find a place and end up paying $20 a month more than I wanted to in order to beat the competition of 5 other dudes who are trying for the same space. They all look for ways to add to their income or pair up in order to get housing. Finally, 3 of them get together and buy a 2 bedroom.

When you are checking out the West Side of Los Angeles, looking to stay under $1,000,000 for a 3 bedroom tear down, you may not be thinking about the effect that this illegal immigrant had on the price you are paying. But each incremental family unit puts pressure on the entire system, causing folks to make decisions based on their own demand, the available supply, their fear, and the greed of buyers and sellers.

Now then, business slows down and the local ICE agents get more aggressive. I decide not to help get my brother into the country, because there isn't enough work to take the risk. The other two guys who were fighting me over that apartment, are now totally broke, so they head back to Mexico. I start seeing empty apartments in my building months before there are any vacancies in Santa Monica. The demand is decreasing at the margin. As the economy slows down, the out of work bookkeeper moves back in with his mom, and the divorcing couple decide to keep living together.

The Speculators

Another Illustration: My cousin owns 5 houses. He has used all of his savings, his credit cards, borrowed money from our grandpa, and he can't make the mortgage payments. He needs to sell one of these houses. But there are no takers. He lowers the price, still nobody comes. He finally has an offer below what he paid. The buyer can't get financing. FIVE houses sit vacant. He tries to rent them, but the rent he can get is not enough to pay the mortgage, property tax, insurance, and other costs.

One more illustration: The builder used to see 100 folks every weekend coming through his models. Now no one comes. 70 homes sit vacant. He lowers the price and gets two offers. The customers can't get financing.

The Bankers

Under the old rules, bankers could lend out 10 to 15 times the amount of their net assets. Not so different than the homeowner. During the craziness of the recent bubble, many mortgage institutions were only putting up 3%.

Under the old rules, homeowners put up at least 10% cash (more commonly 20%) to buy a home, and the bank wanted to be darn sure that this money wasn't borrowed. The homeowner had a stake, and a hedge against the value of the home going down. During the craziness of the recent bubble, the homeowner could potentially put nothing down, and the money lenders didn't care where the client got the down payment, or if they could pay the money back.

Do the math. The leverage used to be 10 X for the home owner and around 10 X for the bank. Together, they were leveraged 100 X. This historic amount of leverage served the customer and banker very well for a long time. But in 2005, it was not uncommon for the home owner to be leveraged at 20 X or more and the lender to be leveraged at 30 X. Combined leverage of 600X.

You may be reminded of the 1929 stock market crash where folks could leverage stock purchases 10X. Today that limit is 2X, and that limit has done well for the market for 60+ years. With leverage of 600X on homes, a very small crack in the value of those homes created chaos.

The Securitizers

To make matters much worse, these highly leveraged assets were now bundled and sold to 3rd parties. In other words, your broker might suggest that you buy 10% of a bundle of 100 mortgages. These 100 mortgages would be made up of old mortgages, new mortgages, at various interest rates, that were made to customers offering various amounts of truth about their ability to repay, etc.

How in the world would your broker know if this was a good deal for you. He wouldn't. But both of you might assume that it was a really good deal when the underlying assets were going up and up and up, and therefore creating ever more security for you. And you would be right.

Unfortunately, when the value of the homes (assets) in these bundles started going down at a steep rate, it became almost impossible for anyone, even the smart guys who were paid huge amounts to do so, to place a realistic value on these assets. When your broker called you now and wanted you to buy 10% of one of these bundles, he wasn't quite so sure about the value today, or in the future. Since you had no assurance and no optimism, you said no. And on the margins, everyone said no. And the value of these products sunk to almost -0-.

Nobody Left

The homeowner who bought a home between 2006 and 2007 was quickly underwater. This was especially true if the down payment was -0- or 5% or if the income wasn't really there to support the payments.

The speculator was in even bigger trouble. The banker who was lending at 30 X assets was forced to revalue those assets. If home prices were down 20%, the banks assets dropped 20%, and now the leverage on those was getting close to 40X. First of all the bank regulators were not ok with that. Second of all the investors in those lenders were not happy with that. In fact, while the banks and other mortgage institutions were having to add assets to bring that number back to 30X (adding assets in this case meant raising outside investment in the banks), the investors in these companies demanded a return to safer leverage levels of about half those levels or 15X. Lending stopped. These institutions could not lend more until they raised more capital.

The banks would like to sell these mortgages to the securitizers, but since it was impossible to value the underlying assets, and no real hope of the assets increasing in value, there were no buyers. The banks and other mortgage backers had no where to turn for money to rebuild their asset base. They needed either more deposits (if they were banks), or they needed to raise capital in the form of stocks, bonds, or sell of parts of themselves.

Depositors were not too keen on putting their money in institutions that were looking shaky. Investors not only weren't going to buy more stock, but were bailing out of the stocks they did own. Selling off other parts of the business at a good value takes months or years. Fire sales reduce value dramatically.

Full Circle

Now the entire problem comes about full circle. Housing demand is down due to all the reasons stated above PLUS incomes are dropping and unemployment is high. Housing supply is huge because speculator homes are vacant, and foreclosed homes are coming onto the market in record numbers. The prospective home buyers who would like to buy a home are less likely to find a mortgage due to more stringent requirements for down payments and income verification, further reducing the available demand. This then causes additional downward pressure on home pricing, which exacerbates the problem for recent home purchasers or refinancers, lenders, and securitizers.

To be honest, I've left out a few layers here and there to keep the subject under control. But the description is somewhere between simplistic and grad school. Understanding the nature of this bubble and the unexpected consequences is good for the soul and all that. It might even help in making a future judgment about say, the price of gold right now.

Now What?

We will assume for the moment that if you have read this far, you are primarily interested in getting a mortgage for your first or next home, or you want to take advantage of these odd ball times to refinance. Your goal might be lower payments, shorter payback, reduced principle, cash out, or even how your mortgage plays out in a bankruptcy.

You are very likely interested in what the new administration in Washington is doing that could effect your decision making process on all of these matters. Future articles will be answering those very questions. If you would like to subscribe to this blog, you may do so here.

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