DFW OVERVIEW
Part 1: Mortgage Market Meltdown – What Happened?
Ted Wilson
Housing Consultant
Residential Strategies, Inc.
‘Credit crunch. ‘Bubble burst. CDOs. SIVs. These are all terms that have appeared in news stories discussing the mortgage market meltdown. But what do they mean? What really happened, and what does this mean for the DFW new homebuyer? The following is an explanation of the events that triggered changes in the new home market over the past two years.
Interest Rate Declines of 2001-2003
The story begins in 2001. If you recall, that year saw a slowdown in the economy in the wake of the dot.com collapse. Then came 9/11. An already fragile economy weakened. Normally, a slowdown in the economy means weakness in the housing industry, but not in this instance. The Federal Reserve cut interest rates in order to stimulate the economy. Lower interest rates meant cheaper mortgages — much lower than they had been in some time. The consumer responded by purchasing new homes. For many, this was the opportunity to buy a bigger, more expensive home. With the low mortgage rates, monthly payments didnt change much on a larger house. For others — especially renters — this was the opportunity to purchase a home for the first time. The lower interest rates meant that they could now qualify for a new home.
Markets Respond Differently
The real estate markets around the United States behaved differently during this period. In places like California, the inventory of new homes was already tight. If youre familiar with the politics of the area, you probably know that getting approvals to develop land for a new neighborhood can be very difficult — and takes a long time to accomplish. In these markets with a tight supply of housing and an increased demand due to low mortgage rates, prices soared. (Remember Economics 101 — price is determined by the intersection of supply and demand.)
Dallas-Fort Worth and, for that matter much of Texas, responded differently than California and many of the other coastal markets that had a tight inventory of houses. Texans pride themselves on their pro-growth attitudes and, for the building industry, the response to the lower mortgage rates was to rev up construction. So as demand increased in DFW, so did the supply of housing. Prices edged higher here due to increased land, labor and construction costs, but the area trailed the nation in year-over-year house price appreciation.
The big run up in housing values in the coastal markets was referred to as the ‘housing bubble. Several economists were alarmed by the rapid run-up in values and labeled the phenomenon a ‘housing bubble — something that would eventually burst. In hindsight, consumers in the coastal markets would have been well-served to heed these warnings. The skeptics were right on. At the time, many of our DFW clients complained that they were not participating in one of the biggest surges in real estate prices that the country had seen. While, in the short run there was some truth to that concern, our explanation was that DFW was much less at risk to a price collapse. Slow and steady — that is the course you want housing appreciation to take. In hindsight, thank goodness we didnt see a meteoric rise in values. Look whats happening now in the coastal markets!
Builders, Mortgage Companies, Wall Street Firms Keep the Party Going
By 2004, it appeared that the surge in real estate would begin to slow. The lower mortgage rates brought a wave of buyers into the market, but it didnt look like rates would drop much further. By this time, the economy was recovering nicely and job growth — an important market driver for housing — was up around the country.
As housing analysts began to forecast a plateau in housing activity, the large builders, mortgage companies and Wall Street firms came up with a novel method to expand the market. The idea was to extend credit to buyers who previously would not have qualified for a mortgage and thereby expand the market. Moreover, they would do it using sophisticated, untested and unregulated business models.
The two predominant loan types that were made were subprime and Alt-A loans. A subprime loan is a loan to a borrower with weak or bruised credit. An Alt-A loan is a ‘stated income or no document loan. In many cases, these were called ‘liars loans because there was typically little- to- no verification that what the borrower said was true. Subprime loans were used to expand the number of borrowers at the entry level part of the housing market. The subprime loan was the predominant non-conforming loan type in DFW. Alt-A loans were used largely in the coastal markets where housing prices had soared. Borrowers overstated their income to qualify for a house that normally would be beyond what they could afford.
While subprime and Alt-A lending was not new to the market, typically in the past it had occurred through large, regulated banking institutions that required ample reserves set alongside those loans. Instead, Wall Street lent money to mortgage originators who aggressively sold subprime and Alt-A mortgages in the format of a 2/28 Adjustable Rate Mortgage with a low introductory teaser rate. What this means is that the first two years of the mortgage, the household would have a low, below market house payment. After two years, the mortgage adjusted or reset to a higher interest rate, which meant a larger monthly payment.
In theory, if housing values continued to climb in the market, this worked well. The household would load up on a house they couldnt afford, but the inflating property values would mean that the house was worth a lot more when the mortgage reset occurred. Many of the households that obtained these mortgages early on saw the equity in their house grow considerably. Many households withdrew this equity, thus prompting the comment that many treated their house like a piggy bank to supplement a lifestyle they couldnt afford.
So why would lenders make these aggressive loans? Well, the concept worked like this. Wall Street made loans to the mortgage originators who then made the subprime and Alt-A loans to the consumer. The mortgage originators then resold these loans back to the Wall Street firms who repackaged them as a debt instrument called a Collateralized Debt Obligation (CDO). The CDOs were broken up into different traunches (slices) that were graded in a range from the very risky to the least risky by rating agencies such as Standard & Poor and Moodys. Moreover, if a borrower in any of the loans couldnt make his payment (defaulted), then it would affect the riskiest traunch first. As a result, the rating agencies gave the least risky traunches the same grade as Treasury Bills!
The Music Stops
The CDO concept worked well at first. After all, house prices kept going up in the coastal markets. Wall Street firms were making lots of fees and the builders and mortgage companies were making record profits.
But in the spring of 2006, problems emerged. First, because the economy was recovering nicely by this time, the Federal Reserve raised interest rates to counter the potential affects of inflation. Second, even though the consumer had non-conforming mortgages such as the Alt-A loan available, the price of real estate was becoming largely unaffordable for many households. The result was that builders saw their housing inventory begin to accumulate. Consequently, they began discounting houses in order to offer greater incentives to the consumer.
For much of 2006, builders thought they would sell their way out of the slowdown. It was true they werent making as much money on their houses as they originally thought, but they were still making money.
A year later, in early 2007, disaster struck the mortgage companies. In the coastal markets, a wave of mortgage resets occurred and the consumer suddenly found that his house had not appreciated in value. Not able to make the higher monthly payment, many defaulted on their mortgages. In light of this wave of mortgage delinquencies and defaults, the mortgage companies were first in line to fail. Headlines suddenly appeared in several newspapers announcing the failure of these mortgage companies.
Not surprising in light of these challenges, surviving mortgage companies backed off the aggressive Alt-A and subprime loans. A new era of mortgage qualification standards was ushered in as the easy credit where almost anyone could qualify for a new home was withdrawn from the market.
What was lost with these changes in the non-conforming mortgage market was that conventional loans — namely FHA/VA loans, Fannie Mae and Freddie Mac — were still available and affordable. A buyer with reasonable credit could still qualify for a house. That condition still holds true today. What was eliminated was the aggressive mortgage lending to households that shouldnt have bought a house in the first place.
The Non-Conforming Mortgage Market Unravels
By July 2007, the secondary mortgage market had gone from bad to worse. Many of the purchasers of the CDOs (which were sold to financial institutions all over the world) had no way to know the value of their securities. The underwriting had been so poor to begin with — and with default rates soaring — many owners of CDOs decided to get out of the market. As they rushed to sell their CDOs, prices collapsed. There were not enough purchasers.
With few-to-no purchasers, the issuance of new non-conforming mortgages basically died or was priced very high. One type of non-conforming loan — the Jumbo Mortgage — was also affected. A Jumbo Mortgage is a loan over $417,000. Fannie Mae and Freddie Mac were only able to make loans up to this amount, so a loan in excess of this amount was considered non-conforming. Typically the loan rates on Jumbo Mortgages had been only 1/8 to 1/4 point higher than conventional loans, but during this period their pricing soared, ultimately settling in at about 1% higher than conventional rates.
As the CDO market floundered, it suddenly became clear that many banks were in trouble. They had purchased these CDOs thinking that would make a nice profit. They would get a high interest yield on the CDOs and then issue their own bank debt at a lower rate, thereby profiting on the ‘spread between the two rates. With the values of the CDOs plummeting, the financial stability of these banks came into question. As a result, many lenders became very wary about who would receive loans. This wariness is referred to as the ‘credit crunch. Basically, the financial world changed because there was tremendous uncertainty as to how much exposure each bank had to these risky loans. Because many financial statements were less than clear on the issue, the financial world set about reassessing risk.
One of the revelations was that many U.S. money center banks were trying to benefit from the ‘spread between CDO interest rates and their bank debt rate. These banks had set up an entity called a Structured Investment Vehicle (SIV). The SIV was an off-balance sheet company (meaning it didnt show up in the banks financial statements) that had loaded up on CDOs and was now suddenly in trouble.
Government To The Rescue
In the midst of this turmoil, the Federal Reserve realized that they must act, and act quickly. Their first move was to provide liquidity to the banks. The concern was that with the market wariness, the financial system would seize up. The second concern was that the disruption in the financial systems might throw the economy into a recession. By now, the national housing problems were becoming pronounced, so the concern was that the consumer would stop spending if their houses were dropping in value. About 2/3 of the Gross Domestic Product is dependent on consumer spending. So the Federal Reserve began dropping short-term interest rates to stimulate the economy.
Since last fall, several other governmental programs have been initiated to help consumers stave off foreclosure, increase the loan limits for conventional loans in the most expensive housing markets and put cash back in the consumers pocket to keep spending up.
So where is this headed? Please refer to the second article, Housing Market Outlook.
Overview Videos:
Affordibility
Good Time to Buy
Housing Values
