An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise their contract rights by a given date, they lose their contractual right to do so. An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. The writer of an options contract is typically paid a fee or a premium for taking on the risk that prices may move against their position and the contract holder may exercise their right. The holder of an options contract willingly pays this premium to limit their losses to the premium paid if the investment does not go as planned. Most options expire worthless.
Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage. Another method speculators and homeowners alike used was the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well. The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. If fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks. Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly.
Today's featured property exercised her "put" option she obtained from her lender in December 2006 with a "strike price" of $645,000. This was a far better deal than selling the property. If she had sold it, she would not have probably obtained this price, and she would have had to give 6% of that money to a realtor. By getting a lender to give her 100% of this money, she comes out at least $38,700 ahead, and probably more than that when you consider the discount to move the property. It is a wonder more people did not do this.
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It appears as if she made two payments before stopping. I guess the intent to defraud is not quite so obvious if you make a token effort at payment? The notice of default was served in July for back payments of $19,943, and the property was purchased by the lender at auction on 1/11/2008 for $691.227. The additional $46,227 being lost payments and expenses.
Townhouse style condo, 2 attached garage with direct access to the unit. Fireplace in living room with sliding glass door to patio. Light & bright, vaulted ceilings & skylights. 2 balconies upstairs, with view of greenbelt. Spa tub in master bath.
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This property is one of the few stressed properties I have seen in Turtle Rock. A healthy market would absorb a few of these without much damage, but in a stressed market like ours practically devoid of buyers, a few of these properties set the comps, and values take a serious dive. Our market is as fragile as an egg, and these foreclosures are as violent as a sledge hammer.
This property is the tale of two parties. The lady who "put" this property to the lender made $116,000 on the deal. She will have to deal with bad credit, and if she has any of this money in liquid assets, the lender may go after it, but in all likelihood, she will get to keep her "profits" from the foreclosure. The lender will not do quite so well on the deal. Their basis is $691.227 plus whatever expenses they incur managing the property through disposition. If they manage to get this selling price and pay a 6% commission, the lender stands to lose $150,821. Let that one sink in for a moment. This lender made a loan, received two payments, and then proceeded to lose $150,000.
The "put" and "call" option features of mortgages during the bubble are the direct result of 100% financing. Speculators and homeowners have too little to lose to behave responsibly when 100% financing is available. Without increasing the cost to speculators through downpayments or a loan-to-value limit on refinances, speculators are going to utilize these mortgage products in ways they were not intended. There were many expensive lessons learned by lenders concerning 100% financing during the Great Housing Bubble.
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Wanna be's throwin' ones tryin' to show that they makin cash
Lookin' stupid than a mother all though it'll raise ya tabs
Cause the vehicles and jewelry we got is way mo' advanced
There's more colors in a watch than a set of jamaican flags
Pick it all up in bags the promoters like make it fast
Cause here comes another monsoon and these boys is goin' make it last
Y'all hit the club tryin' to act like ya poppin' tags
Hit the club and ya new clothes and you know you goin' take it back
I'm a fly rides owner ain't no need to take a cab
Cause the key ain't nothin' to me I got cars so just take the slab
Say you doin' it bigger it trip us so they can laugh
Cause I done ran threw way mo' numbers than student's can do in math
40 large in my pocket's is causin' my pants to sag
Still in love with my money like I use to say in the past
Commodities are items of value and uniform quality produced in large quantities and sold in an open market. Although every residential real estate property is unique, these properties became uniformly desired by investors because all real estate prices rose during the Great Housing Bubble. The commoditization of real estate and the active, open-market trading it inspires caused houses to lose their identity as places to live and call home. Houses became tradable stucco boxes similar to baseball playing cards where buying and selling had nothing to do with possession and use and everything to do with making money in the transaction.
In a commodities or securities market, rallies unsupported by valuation measures will fall back to fundamental values. It is very clear the rally in house prices was not caused by a rally in the fundamental valuation measures of rent or income. Many people forgot the primary purpose of a house is to provide shelter — something which can be obtained without ownership by renting. Ownership ceased to be about providing shelter and instead became a way to access one of the world’s largest and most highly leveraged commodity markets: residential real estate.
Commodities markets are notoriously volatile. In fact, this volatility is the primary draw of commodities trading. If market prices did not move significantly, traders would not be interested in the market, and liquidity would not be present. Without this liquidity, hedgers could not sell futures contracts and transfer their risk to other parties, and the whole market would cease to function. Commodities markets exist to transfer risk from a party that does not want it to a party who is willing to assume this risk for the potential to profit from it. The commodities exchange controls the volatility of the market through the regulation of leverage. It is the exchange that sets the amount of a particular commodity that is controlled by a futures contract. They can raise or lower the amount of leverage to create a degree of volatility attractive to traders. If they create too much leverage, trader’s accounts can be wiped out by small market price movements. If they create too little leverage, traders lose interest.
The same principles of leverage that govern commodities markets also work to influence the behavior of speculators in residential real estate markets. If leverage is very low (large downpayments or low CLTV limits,) then speculators have to use large amounts of their own money to capture what become relatively small price movements. If leverage is very high (small downpayments or high CLTV limits,) then speculators do not have to put up much money to capture what become relatively large price movements. The more leverage (debt) that can be applied to residential real estate, the greater the degree of speculative activity that market will see. Also, the smaller the amount of money required to speculate in a given market, the more people will be able to do so because more people will have the funds necessary to participate. When lenders began to offer 100% financing, it was an open invitation to rampant speculation. This makes the return on investment infinite because no investment is required by the speculator, and it eliminates all barriers to entry to the speculative market. In a regulated commodities market, the trader is responsible for all losses in their account. In a mortgage market dominated by non-recourse purchase money mortgages, lenders end up assuming liability for losses in the speculative residential real estate market. This is a fantastic deal for speculators; for the lenders... not so much.
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Today's featured property is a classic example of speculation in the residential real estate market. When this seller was a buyer, they utilized 100% financing right at the peak of the bubble. Now that resale values have gone south, the speculator is letting the property go into foreclosure, and the lender is going to be left holding the bag.
Terrific Location in Irvine--conveniently close to parks, schools, shopping, dining and entertainment. Beautiful landscape/hardscape done by professionals in the backyard. Hardwood floors throughout first floor.
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If the lender gets the asking price on this one, they stand to lose $192,500 after a 6% commission. This also assumes the borower is current on the mortgage and there is not a large amount of deferred payments adding to the balance due. All part of the price these lenders paid for enabling people to trade houses as commodities and assuming the risk of loss.
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God money Ill do anything for you.
God money just tell me what you want me to.
God money nail me up against the wall.
God money dont want everything he wants it all.
Head like a hole.
Black as your soul.
Id rather die than give you control.
Head like a hole.
Black as your soul.
Id rather die than give you control.
Bow down before the one you serve.
Youre going to get what you deserve.
Bow down before the one you serve.
Youre going to get what you deserve.
God moneys not looking for the cure.
God moneys not concerned with the sick among the pure.
God money lets go dancing on the backs of the bruised.
God moneys not one to choose
No you cant take it
No you cant take it
No you cant take that away from me
Mortgage Equity Withdrawal or MEW is the process of obtaining cash through refinancing residential real estate using the accumulated equity as collateral for the loan. Before MEW, a homeowner would have to wait until the property was sold to get their equity converted to cash. Apparently, this was deemed an inefficient use of capital, so lenders found ways to “liberate” this equity with home equity lines of credit or cash-out mortgage refinancing. The impact of MEW on equity is obvious; it reduces it by increasing the loan balance. It has been noted that equity is a fantasy and debt is real, and MEW is the process of living the fantasy with the addition of very real debt. MEW has been utilized by homeowners for home improvement for decades, but the widespread use of this money for consumer spending was an innovation of The Great Housing Bubble. Since consumer spending is almost 70% of the US economy, mortgage equity withdrawal was the primary mechanism of economic growth after the recession of 2001 – a recession caused by the deflation of another asset bubble, the NASDAQ technology stock bubble.
Many people who extracted their home equity lost their homes for lack of ability to refinance or make their new payments. After so many people lost their homes due to their own reckless borrowing, it is natural to wonder why these people did it. Why did they risk their home for a little spending money? First, it was not just a little money. Many markets saw home values increase at a rate equal to the median income. It was as if their home was another breadwinner. The lure of this easy money was too much for many to resist. Also, during the bubble rally people really believed their house values would go up forever, and they would always have the ability to refinance enormous debts at low interest rates and maintain very low debt service costs. Most people did not think it possible they would end up in circumstances where they would lose their homes; however, they did lose their homes; they were wrong, very wrong. Given these beliefs, the equity accumulating in their house was “free money” they just needed to access in order to live and to spend like rich people. Even though they were consuming their net worth, and making themselves poor, they believed they were rich, and they needed to spend accordingly.
Mortgage Equity Withdrawal 1991-2007
Most homeowners do not save money for major improvements and required maintenance, and these homeowners often take out home equity lines of credit as a method of mortgage equity withdrawal to fund home improvement projects. The logic here is that renovations improve the property so an increase in property value offsets the additional debt. In reality, home improvement project rarely adds value on a dollar-for-dollar basis, particularly with exterior enhancements which often only return 50 cents on the dollar in value. The home-improvement craze was so common that the term pergraniteel was coined to describe the Pergo fake wood floors, granite countertops, and steel appliances that were popular at the time.
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Much of the money homeowners borrowed fueled consumer spending and reinforced poor financial management techniques. It was common during the bubble rally for people to run up enormous credit card bills then refinance every year and pay them off. It is foolish enough to finance consumer spending, but it is even more foolish to pay for this spending over the 30-year term of a typical mortgage. The consumptive value fades quickly, but the debt endures for a very long time. Many people responded to the “free money” their house was earning by liberating their equity as soon as they could so they could buy cars, take vacations, and generally live the good life. This borrow and spend mentality was actually encouraged by lenders who were eager to make these loans and even the government who was benefiting by economic expansion and higher tax receipts.
Gross Domestic Product with and without the effect of Mortgage Equity Withdrawal
The recession of 2001 was caused by the collapse of stock prices and the resulting diminishment of corporate investment. The recession was shallow, but the economy had difficulty recovering mostly due to continued erosion of manufacturing jobs. The Federal Reserve under Alan Greenspan was desperate reignite economic growth, so the FED funds rate was lowered to 1% and kept there for more than a year. It was hoped this increased liquidity would go into business investment to restart the troubled economy; instead, it went into mortgage loans and consumer’s pockets through mortgage equity withdrawal. Basically, the entire recovery from 2001 through 2005 was an illusion creating by excessive borrowing and rampant spending by homeowners. The economy did not grow through production, it grew through consumption.
There are many theories as to the decline and fall of the Roman Empire. One of the more intriguing is the idea that Rome fell because it was weakened by the parasitic nature of Rome itself. Rome existed to consume the resources of the empire. Boats would come to the city loaded with goods and leave the city empty. Consumption kept the masses happy and thereby quelled civil unrest. The Roman Empire was the world’s only superpower with an unsurpassed military might. Equally unsurpassed was its ability to consume resources. Does any of this sound like the United States? The United States has clearly become a consumer nation, and the government does not have a problem with borrowing huge sums of money to keep the economic engine of consumption going. In early 2008, the Congress passed a “stimulus” package where many people would receive direct gifts of money to go spend and keep the economy going. Since the Federal Government was already running a deficit, this money was borrowed from future tax receipts and given to the populace to spend. With house prices crashing, direct handouts of borrowed government money were necessary to make up for the loss of borrowed private sector money that used to be available through mortgage equity withdrawal.
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The best things in life are free
But you can keep 'em for the birds and bees
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
Your lovin' gives me a thrill
But your lovin' don't pay my bills
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
Money don't get everything, it's true
What it don't get, I can't use
Now give me money (that's what I want)
That's what I want (that's what I want)
That's what I want (that's what I want), yeah
That's what I want
How common was this phenomenon of mortgage equity withdrawal? We have profiled many examples of it, and today's property is yet another. Now give me money, that's what I want...
Back on the market!!! REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! What an opportunity!!! Wonderful single level home with breakfast nook. Recently remodeled kitchen & bathrooms, newer carpeting and wide baseboards create a nice theme as you are warmed by the custom tuscan colors throughout in this wonderful single level. Extra LARGE living room/dining room with fireplace for those large family gatherings. Lush atrium brings the outside in. Down the street from parks and nearby schools. Turnkey!!! Preforeclosure
REDUCED TO THE RIDICULOUS AND WHAT A DEAL!!!!!!!!! It is writing with ALL CAPS and numerous exclamation points that reduces this listing to the ridiculous.
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Notice this property was purchased in 1996 for just over $200,000, and now it is a preforeclosure selling for over $600,000? How is that possible? Mortgage equity withdrawal.
In 1996, this property was originally purchased with a first mortgage of only $142,000, and the buyer put $62,000 down.
In early 2001, they opened a HELOC for $60,000 -- their first step toward the Dark Side.
In 2002, they refinanced for $227,000 pulling out all their equity at the time.
In 2003 they opened another $100,000 HELOC.
In 2004 the HELOC was $189,800.
In 2005 the HELOC was increased again to $250,000.
In 2007 the HELOC was increased to $318,000.
The sum of their debts appears to be $545,000, so unless their is more debt not recorded in the public record, there may still be some equity in this property. So why is it in foreclosure? The owners probably cannot make their payments. The credit crunch is a problem of borrower insolvency, and this borrower is likely insolvent. Maybe they will get lucky and sell this property to pay off their debts?
You can see the steady pattern of mortgage equity withdrawal that almost exactly mirrors the mortgage equity withdrawal chart.
Of course, these people are selling their home now, and the HELOC income stream is coming to an end. So what does this mean for our borrow-and-spend economy? It is likely we are going to experience a severe consumer spending recession. Borrowers like today's featured seller are being cut off from credit, and their wild spending is going to stop. Today's property owner is one of many who are facing the same circumstances. The cumulative impact of the loss of this massive spending stimulus from all these homeowners is going to be catastrophic to our economy. If the whole nation is going into a spending recession due to this phenomenon, imagine how bad it is going to be here in the conspicuous consumption capital of the world -- Orange County, California.
At this price, the property is worth $608,000 with a 160 GRM. Anybody want to go pay them $968,000 for it?
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Up a lazy river by the old mill stream That lazy, hazy river where we both can dream Linger in the shade of an old oak tree Throw away your troubles, dream a dream with me
Are sellers still dreaming of a market that no longer exists? There haven't been many $500/SF transactions in Northpark lately, but who knows, this guy might get lucky.
Beds: 3 Baths: 2.5 Sq. Ft.: 2,000 $/Sq. Ft.: $484 Lot Size: - Type: Single Family Residence Style: Contemporary, Spanish Year Built: 2003 Stories: One Level Area: Northpark County: Orange MLS#: S510268 Status: Active On Redfin: 1 day New Listing (24 hours)
From Redfin, "STUNNING SINGLE STORY! CHECK OUT AWESOME PHOTOS! FIRST CLASS Feel Good Home with TWO Master Bedrooms! BIG BACKYARD w/ MAGNIFICENT Garden, Hardscape and Fountains! Gorgeous GRANITE Kitchen with ENORMOUS Center Island! Exclusive, GATED Community with RESORT-LIKE Pool, Spa, Cabanas, and State-of-the-Art GYM. Italian Porcelain Tile Floors, Plantation Shutters and Custom Silk Drapery, TALL Baseboards, DESIGNER Paint, Built-in Closet Organizers, Epoxy Garage Floor, Security System. TURNKEY. .. HURRY!"
INTERMITTENT caps LOCK problem.
I guess this realtor wanted everyone to know they actually paid for photos. They are pretty good.
FIRST CLASS Feel Good Home? Is that before or after it declines another $400K in value?
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This seller put down a significant downpayment, so the bank will not be sharing in his loss. If he gets his asking price (unlikely), and assuming a 6% commission, the seller stands to lose $115,080. Considering he owned it just less than 2 years, that isn't very good. Realistically, this price will need to come down before it sells, so look for a much larger loss.
BTW, this sold for $560,000 on 2/28/2003. Don't be surprised if we see that price again in a few years.
The Great Housing Bubble was an asset bubble of unprecedented proportions. Between 2000 and 2006 Home prices increased 45% nationally, and in California home prices increased 135%. Had this amazing price increase coincided with a period of high inflation, it may not have been indicative of a price bubble, merely the general increase in prices of all goods and services; however, inflation was low during this period. The inflation adjusted price increases nationwide were 23% and in California it was 100%.
Figure 2 - Inflation Adjusted Median Home Prices 1986-2006
There are many variables that impact house prices, and some of the variability in prices over time can be attributed to changes in these variables; however, since most houses are purchased with lender financing, and since lender financing is linked to income, the price-to-income ratio is the best metric for evaluating long-term housing price trends. The price-to-income ratio does not need to be adjusted for inflation as both prices and income will rise with the general level of inflation. Most of the fluctuations in the ratio are based on changes in financing terms, in particular interest rates, and of course, irrational exuberance.
Figure 3 - National Ratio of House Price to Income 1975-2006
When measured against historic norms of house price to income, the degree of price inflation was staggering. Nationally, the ratio of house price to income increased 30% from 4.0 to 5.2. The only way this can occur is if 30% more debt is serviced by the same income. Some of this increased ability to service debt is explained by lower interest rates, but most of increase came from people choosing to take on larger loads due to the irrational expectation of ever increasing house prices coupled with loose lending standards which enabled the populace to take on these debts. The national trends were small compared to the frenzied activities of bubble markets in California where most markets saw their house price to income ratio double.
Figure 4 - Ratio of House Price to Income in California, Orange County and Irvine 1986-2006
Buyers were never forced to buy, it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. None of them were forced to buy. The exotic financing was not a result of high prices; it was the cause of high prices. Those who were financially conservative and did not take on debt under terms which put them into bankruptcy were competing with those afflicted with a spending pathology. In retrospect, it was a competition they were better off losing. By late 2007, the market balance shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers, their dreams of riches from perpetual appreciation was in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homedebtors with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.
Oh We're Not Gonna Take It
no, We Ain't Gonna Take It
oh We're Not Gonna Take It Anymore
we've Got The Right To Choose And
there Ain't No Way We'll Lose It
this Is Our Life, This Is Our Song
we'll Fight The Powers That Be Just
don't Pick Our Destiny 'cause
you Don't Know Us, You Don't Belong
oh We're Not Gonna Take It
no, We Ain't Gonna Take It
oh We're Not Gonna Take It Anymore
oh You're So Condescending
your Gall Is Never Ending
we Don't Want Nothin', Not A Thing From You
your Life Is Trite And Jaded
boring And Confiscated
if That's Your Best, Your Best Won't Do
I think these clueless WTF sellers have finally pushed me over the edge. I want to shame them; shame them all. I'm mad as hell, and I am not going to take it anymore. How much longer are we going to watch these people put ridiculous prices on properties before we all decide "We're Not Gonna Take It Anymore?" When do sellers start worrying about insulting the intelligence of buyers? How can you list a property for $240,000 more than an arguably superior property 4 doors down, particularly when the comparable property isn't selling?
Please, somebody help me understand the thought process here.
OK, my neighbor, who has a similar house, has been trying to sell it for almost six months. My neighbor paid almost $400,000 more for their house, so it is probably a nicer property, but mine is better because it is mine. It isn't a short sale, so there is nothing stopping my neighbor from selling (other than there are no buyers.) My neighbor has reduced his asking price $400,000 over the last 6 months trying to get out. I know this because I am a neighbor, and my realtor must know about this property and has also told me. I have been hearing stories about price declines, but my neighborhood is different, and my property is special, so I am going to ask...
$240,000 more than my neighbor and $235,000 more than I paid in March of 2006 (almost the peak.)
Yes, that makes sense. The market has bottomed, and the spring rush is coming. I am sure some buyer will see the unique qualities of my property and pay me the profit to which I am entitled.
Is there some other way to see this listing price? Please help me. I can see no other line of reasoning or pattern of thought that can produce this asking price. How out-of-touch with reality are sellers today?
You know, perhaps we should stop calling them sellers because there is no way the property is going to sell for this price. Perhaps we should call them "listers" or "askers" or "clueless-WTF-nutcases?" What do you think?
Just move in. Highly desirable Juliet's Balcony model with larger lot. Porte cochere and French doors leading to nice courtyard on side of home. Walk in and see living rm and library. Large gourmet kitchen with all the extras like Viking 6 burner with griddle, stained maple cabinets, stainless steel appliances, granite counters, pendant lights. Craftsroom downstairs with built-in cabniets and computer niche. Wine cellar. Built-ins for TV area in family room and master. 20' diagonal tile flooring with granite inserts downstairs. 4 bedrooms upstairs each with own bathrooms. Master and one other bedroom have retreat areas. Master bath has spacious tub and glass enclosed shower. Balcony upstairs. Backyard has been professionally hardscaped with built-in BBQ, and plants will be completed. Enjoy all the amenities of a contemporary home. Location is great near 2 parks. Association offers a 9 acre recreation center and 3 pool areas.
pergraniteel -- "stained maple cabinets, stainless steel appliances, granite counters,"
Update 4 — The saga continues… This house was relisted again for $1,359,000. The total loss stands at $473,540. After putting $525,400 down, I imagine this seller did not think they would be risking a short sale. Their equity is all but gone…
Beds: 4
Baths: 4.5
Sq. Ft.: 3,750
$/Sq. Ft.: $453
Lot Size: 6,348 sq. ft.
Year Built: 2005
Stories: 2
Type: Single Family Residence
View: Park or Green Belt
County: Orange
Neighborhood: Woodbury
MLS#: S472319
Status: Active
On Redfin: 215 days
Unsold in 90+ days
From Redfin, “The Jewel of Woodbury! Ready to deal. Rich woods on floor, ceilings, p aneling etc. Gorgeous paint schemes, tile designs. All Viking Kitchen, open bright floor plan typical of Juliet’s Balcony homes. Surround sound, huge master bath, all bedrooms are suites. Designer window treatments. Across from a private park. Walk to parks and 6 pools, elementary school, shopping center. Woodbury’s amenities are incredible and the lifestyle resort like.”
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IMO, the property being offered for $240,000 less is a superior property. I think the front landscaping is certainly more attractive. Anyway, as a public service, let's help this hapless lister pick a better asking price.
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That concludes another week at the Irvine Housing Blog. Come back next week as we continue chronicling ‘the seventh circle of real estate hell.’ Have a great weekend.
I feel sad for this child. This was some child's private world lovingly painted with beautiful clouds, dancing characters and the sun peaking through the window. The room looks joyous and happy. When these parents wished upon a star, I wonder if it was for mortgage relief so they could keep their house and their child could keep their special place. Alas, it was not to be...
Beautiful family home located in Irvine, home features 4 bedrooms, 2.5 bathrooms, the master suite has a walk-in closets, kitchen features center island and eating area, the family room has a cozy fireplace, a spacious living room and eating area, inside laundry and a two car direct access garage, property shows like 'NEW'
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I would comment that the lender is not doing well on this one, but since New Century is already out of business, it is a moot point. The trustees managing the portfolio of bad loans written by New Century are going to lose a total of $231,694 after a 6% commission. Another day, another quarter million dollar loss in Irvine...
In this dirty old part of the city
Where the sun refuse to shine
People tell me there ain't no use in trying
Now girl you're so young and pretty
And one thing I know is true
you'll gonna die before your time is due
watch my daddy in bed and tired
watch his hair been turning gray
He's been working and slaving his life away
oh yes I know
He's been working so hard
I've been working too
Every night and day
Yeah Yeah Yeah
We gotta get out of this place
If it's the last thing we ever do
We gotta get out of this place
'Cause girl, there's a better life
For me and you
We Gotta Get Out of This Place -- The Animals
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One of the remnants of kool aid intoxication is the overwhelming desire to own a house. There is an undeniable human need for people to have a place to call their own: there is an instinct to nest; however, when this natural desire for permanence in an ever changing world is coupled with the greed-induced delusion of a financial mania, the desire to possess real estate moves beyond basic human instincts into the realm of gluttony, greed, envy, and pride. As the price crash grinds on, people will become less desirous of real estate. Some will lose interest simply because prices are not going up; some will come to revile real estate because they are trapped in one of America’s Debtor Prisons; some will be sickened by the lingering memory of financial distress, foreclosure and bankruptcy. The slow grind of declining real estate prices will have these effects on people, and over time, the mass psychology of the market will shift from the bubble rally mentality of "all real estate is good real estate" to the bubble crash mentality of "all real estate is a ball-and-chain." Think about what it must be like to spend 5-10 years paying 50% of your gross income on a property worth less than your mortgage. If prices ever did come back to get you out at breakeven, you would sell in an instant, but until prices came back, you would spend your time thinking, "We gotta get out of this place."
Excellent location on the greenbelt w/ mountain view, all living space on one level, three full bedrooms w/ retreat-perfect for home office, elegant hardwood floor rotundra opens to great room with wall of windows, custom built-in entertainment center, fireplace, crown moulding, surround system throughout, ceiling fan, open kitchen w/ walk-in pantry, hardwood floor, step-up breakfast counter, corian countertops, maple cabinets, G. E. profile appliance package, recessed lighting, lovely master suite w/ French door access to private/large eat-in covered view balcony, finely designed drapery, ceiling fan, corian countertops, separate glass enclosed shower, deep oval soaking tub, dual vanity, large walk-in mirrored wardrobe closet w/ organizer, convenient interior laundry room, garage w/ vertical & overhead storage/work bench, resort life-style amenities: pools, parks, spas, meandering greenbelts, gazebos w/ fountains, clubhouse, tennis/sports courts
rotundra?
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Would anyone be surprised if I said this was a 100% financing deal? It also appears that the asking price is $4,000 below the original amount of their first mortgage. The second mortgage is going to be a total loss. If this sells for its asking price, the total loss on the property is going to be $178,228, assuming a 6% commission. I have to wonder why people are bothering with these short sales? The vast majority end up as foreclosures, and either circumstance hurts their credit tremendously. I suppose it gives them the feeling they are doing something, albeit wasted effort.
I'm sitting looking out the window like damn
Tryna fix this situation that's at hand
You still running through my mind
when I'm knowing that you shouldn't be,
Me all on yo mind
and I'm knowing that it couldn't be
Cause you ain't call
and I ain't even appalled
I still got allot of pain
I ain't dealt wit it all
To get you outta my system.
You know what you do to me (do to me)
You don't even understand (damn)
You know what you do to me (do to me)
It's so hard to get you outta my system.
Today's post is part II in an analysis series. Part I was yesterday's post: Structured Finance 101. If you do not fully understand structured finance, this post may be difficult to follow. I will answer any questions you might have in the comments section.
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Systemic Risk in the Housing Market
Credit rating and analysis of collateralized debt obligations and all structured finance products are part of the smooth function of the secondary market for mortgage loans. A credit rating agency is a company that analyzes issuers of debt and debt-like securities and gives them an overall credit rating which measures the issuer’s ability to satisfy its debt obligations. There are more than 100 major rating agencies around the world, and three of the largest and most-important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.
Credit ratings are widely used by investors because they provide a convenient tool for comparing the credit risk among various investment alternatives. The analysis of risk is crucial in determining the interest rate a syndicator will need to offer to attract sufficient investment capital, or from the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this critical, third-party analysis both sides of the transaction can rely upon for unbiased, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.
Unfortunately for many investors in collateralized debt obligations during The Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were subsequently downgraded. In defense of the agencies, they were providing an analysis of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any analysis and widely ignored by investors who are counting on the rating to be a market forecasting tool rather than the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.
Risk Synergy
One of the major failings of the credit markets in The Great Housing Bubble was the failure to take a holistic view and evaluate the systemic risks involved. A typical credit analysis reviews various risk parameters and attempts to rate the impact of each. The implicit assumption is that the total risk is equal to the sum of the parts; however this is not necessarily the case. Synergy is when the whole is greater than the sum of its parts, and there is a strong synergy in default risk in collateralized debt obligations that became apparent during The Great Housing Bubble. The credit rating agencies failed to identify this risk synergy until after the fact.
The risk of default in a tranche of a collateralized debt obligation is directly related to the default risk in the underlying mortgage notes. There are six general areas of credit default risk that may be evaluated independently, but their interactions are often synergistic in nature: creditworthiness risk, high combined-loan-to-value default risk, high debt-to-income ratio risk, fraud and misrepresentation risk, investment perception risk, and market valuation risk. Of these general areas of risk market valuation is most responsible for creating synergistic effects and amplifying default rates. Since many of the more “innovative” loan programs entered the market during a time of rising prices, there was no history of performance of these securities in other market conditions making it very difficult to assess the impact a down market would have on default rates. As it turns out, exotic loan programs do not perform very well in any conditions other than a raging bull market.
Creditworthiness Risk
Every mortgage loan that is originated contains an evaluation of the creditworthiness of the borrower who is responsible for making timely mortgage note payments. The most common evaluation tool is the FICO score. Prime borrowers have the highest FICO scores, they are considered the lowest default risk, and they receive the lowest interest rates as a result. Subprime borrowers have the lowest FICO scores, they are considered the highest default risk, and they receive the highest interest rates. This is the best documented and most carefully evaluated risk parameter. Before many of the loan programs were introduced during the Great Housing Bubble, FICO scores strongly correlated with default rates. This correspondence broke down in the price decline when the bubble popped because the other risk factors proved to have a greater influence.
High CLTV Defaults
The combined-loan-to-value (CLTV) is the total debt of all mortgage obligations as a percentage of the appraised value of a particular property. A high CLTV generally corresponds to a low downpayment, but as resale values fell in the market crash, the CLTV rose for many borrowers as a consequence of falling prices. Although all borrowers with high CLTV loan balances show high default rates, it is important to distinguish between those borrowers who had a high CLTV because of a low downpayment and those who had a high CLTV because of falling values. Even though downpayments are a sunk cost and irrelevant to the market value of a house, it does have a strong psychological impact on the behavior of homeowners. People who put little or no money of their own money into the purchase of real estate exhibit greater default rates because they are not losing much of their money. Most people really do not care if the lender loses money, particularly if they will not have to repay the lender for the loss. When a borrower has less of their money in a transaction they are less likely to sacrifice to stay current on their mortgage note obligations, and they are more likely to default if resale values decline, particularly if their payments are greater than the cost of a comparable rental.
Fraud and Misrepresentation Risk
Most purchasers of collateralized debt obligations did not realize there was a huge amount of fraud and misrepresentation in the underlying loans they were purchasing. High CLTV financing, particularly the widely offered 100% financing, became the ideal tool for fraud. A fraudulent transaction required a “straw buyer” willing to sacrifice their credit for a fee, an appraiser willing to inflate the houses value, and a realtor and a mortgage broker either willing to go along with the transaction for cash or too ignorant to see the truth. In the transaction, the straw buyer purchased a house for greater than its true market value, and the excess payment was used to pay off the corrupted parties. Fraud was much easier to commit with 100% financing because the bank loaned the full amount of an inflated appraisal. It is much harder to commit fraud when the bank only loans 80% of a property’s value. Most often the seller was in on the scam and was using the transaction to get out of a bad deal, but sometimes sellers were also innocent victims. The straw buyer had no intention of repaying the loan from the start, and the property quickly went into foreclosure.
A more common problem was misrepresentation of income. Stated-income loans, also known as “liar loans,” were very common during the bubble rally. People would simply make up a number that qualified them for a loan and state it on their mortgage application. One of the assumptions purchasers of CDOs made was that the originators of the underlying loans made sure the borrowers really made enough money to pay back the loan. Often times the extent of the loan originators due diligence was examining the borrower’s signature on the loan application and hoping they were telling the truth. This was a very serious problem for valuing an interest in a CDO because there was no way to accurately determine the viability of the income stream when the income of those responsible for paying the underlying mortgage notes was in doubt.
High DTI Defaults
The debt-to-income ratio is the total amount of payments compared to gross income expressed as a percentage. A lender evaluates the DTI of the mortgage loan as well as the total DTI of all borrower indebtedness when making a determination of creditworthiness. Historically, a borrower could not have a mortgage DTI in excess of 28% and a total DTI greater than 36% to qualify for a loan because debt burdens in excess of these figures proved to have high default rates. Despite the proven history of default of high DTIs, lenders widely ignored these guidelines in The Great Housing Bubble in the quest for more customers. During the rally, few of these people defaulted because they were offered even more debt through home equity lines of credit from which they could make mortgage payments, and the few who did get into financial problems simply sold their house to pay off the mortgage. During the rally, people were keen to take on mortgage debt because interest rates were low, and it was a necessary tool for obtaining real estate and its commensurate appreciation benefits. It did not matter if 50% of more of a borrower’s gross income was going toward debt service if the property itself was providing the additional income necessary to sustain the borrower’s lifestyle. Of course, this only works when prices are increasing rapidly. Once prices stopped rising, the property could no longer provide additional income, and the borrower had to make the crushing payments out of their work income. Without the benefits of appreciation, borrowers quickly found the burden of a high debt-to-income ratio overwhelming, and many borrowers defaulted because they payments were too much to handle – just as past history said they would be.
Investment Perception Risk
One of the biggest fallacies pushed on the general public was the notion that residential real estate was a great investment. This idea caused people to view houses as an investment and treat them accordingly. When the participants in a housing market perceive houses as an investment, they will more easily default on the loan than if they viewed the house solely as a family home. People develop emotional attachments to their family homes, and they will sacrifice much in order to keep it. People behave in a more businesslike manner when they view a house as an investment, and they are willing to give up the house if the investment does not perform as planned. Many people when faced with the reality that house prices were not going to go up and payments were going to continue to cause losses decided to stop making payments and let their investment go into foreclosure. Financially, it was the correct decision given the alternative of continuing to make payments on a losing investment. When the “Great American Dream” of home ownership was tainted by investment motives, it became a nightmare for all concerned.
Market Valuation Risk
The biggest risk faced by buyers of collateralized debt obligations is the default risk of the underlying mortgage when the collateral for the mortgage (the house) is overvalued in markets characterized by low affordability. The greatest risk of default is based on changes in the resale value of homes. All other default risk factors are masked when prices are increasing, and they are amplified when prices decline. Valuation risk is the ultimate synergistic factor.
There are three methods of appraising the resale value of residential real estate: the sales comparison approach, the cost approach, and the income approach. The sales comparison approach uses recent sales of similar properties in the market because comparable sales reflect the behavior of typical buyers in the marketplace. The cost approach determines market value by calculating the replacement cost of an identical structure plus the cost of the land or lot upon which the house would sit. The income approach determines market value by analyzing market rents of comparable properties and applies the gross rent multiplier of expected rents. Most lenders give the greatest weight to the comparable sales approach when establishing market value before applying any loan-to-value limitations to the loan amount. The income approach is generally only considered for non-owner occupied homes. The three-test approach to appraising market value as used during the Great Real Estate Bubble is fraught with risk and seriously flawed.
The comparative sales approach reinforces delusive behavior and irrational exuberance of a financial mania. If everyone is overpaying for real estate, the comparative sales approach simply enables greater fools to continue overpaying for real estate. Since market prices for houses which serve as loan collateral fall to fundamental valuations based on income after the financial mania runs its course, mortgages originated based on the comparative sales approach have a great deal of market risk not reflected in the pricing of collateralized debt obligations based on the underlying mortgage loans.
The cost approach has an even greater level of market risk. The cost of a structure may represent a relatively small percentage of the market value of real estate in high-value markets. In some of the most overvalued markets during the bubble, the replacement cost of the structure may have been $250,000 while the value of the underling land was $450,000; however, since the market value of land is a residual calculation based on the market value of the property, the value of the land cannot be determined independently of the house situated on it. Either the comparative sales approach or the income approach must first be applied to establish the market value of the property before any calculation of the market value of the land can be determined. In short, since the cost approach is dependent upon another valuation method, it is not useful as an independent method of property valuation. Also, since the valuation of land is extremely sensitive to small changes in the valuation of the property, the cost approach is misleading with respect to the valuation of residential real estate.
The only reliable method for the valuation of residential real estate is the income approach, and it is the only approach that is widely ignored by the lending community. It has been demonstrated in previous residential market bubbles in California and in major metropolitan areas in other states that once a price decline begins, prices fall to fundamental valuations based on income and rent. The reason for this is once the speculative investment incentive is removed from the market, buyers do not support prices until there is a new reason for them to buy: they save money versus renting. Comparative rents are the fundamental valuation of residential real estate. Mortgage default risk is low only when market prices are in line with comparative rents or when market prices are increasing. Default risk is low when prices are in line with rents because a property can be converted from owner-occupied to a rental unit and the payment can still be covered. Default risk is low when prices are rising because a borrower experiencing financial difficulty can always sell the property to repay the loan. Unfortunately, once market prices increase beyond the level of comparative rents, they will go through a period of decline back to comparative rent levels; therefore, if lenders continue to use the comparative sales approach, they will enjoy a temporary period of low market risk while prices increase and another painful period of losses when prices decrease. As was demonstrated in the aftermath of The Great Housing Bubble, these periods of lender losses can imperil the entire banking and financial system. The only way to prevent the pain of loss is to recognize the end-game risks when prices are increasing and choose not to participate in that lending environment. Many lenders did not participate in the crazy lending of The Great Housing Bubble, and they were not damaged in the aftermath; however, the hunger for mortgage loans from the CDO market compelled many lenders to join in or get buried by their competitors. The only real market-based solution to the problem of originating bad loans must come from the CDO market.
The CDO Market Solution
The solution to preventing future bubbles in the residential real estate market lies in the market for collateralized debt obligations. The government sponsored entities created the secondary mortgage market in the 1970s, and the CDO market is the extension of this market bringing large amounts of investment capital to residential real estate. During the Great Housing Bubble the CDO market did not properly evaluate the risk of default on the underlying mortgage notes they pooled. If the CDO market evaluates mortgage default risk based on the income approach rather than the comparative sales approach, the performance of CDOs will be greatly improved, and investor confidence will return to the market. It is only after the risks are properly evaluated that capital will return to this market. If the CDO market evaluates risk based on the income approach, the lenders that originate loans hoping to sell them to CDOs will be forced to do the same. If lenders originate loans based on the income approach, the irrational exuberance that creates financial bubbles will not be enabled. People would still be free to overpay for houses with their own money, but the scope and scale of financial bubbles will be limited to the funds of buyers, and the banking system will not be imperiled by the foolishness of the market masses when prices fall to fundamental valuations based on rent and income.
Today's post is the first of a two part analysis series describing the mixture of magic and alchemy that is structured finance. Part II, Systemic Risk in the Housing Market will be posted tomorrow. I will answer any questions you might have in the comments section.
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Structured Finance
Structured finance is an innovation of the finance industry on Wall Street. It is a method of redistributing risk based on complex legal and corporate entities such as corporations, limited liability companies or some other kind of legal entity capable of entering into contracts. The shares or other interests in structured financial entities are derivatives that obtain their value from an underlying asset. Any asset that has a regular cashflow can be pooled through structured finance to create an asset-backed security. This cashflow can be split among various parties and valued based on the risk of repayment.For instance, the most common form of structured finance utilized to inflate the Great Housing Bubble was the collateralized debt obligation or CDO. A CDO derives its value from the underlying, asset-backed securities which in the Great Housing Bubble were generally bundles of mortgage loans. Mortgage loans have a steady cashflow stream as each homeowner pays their mortgage obligation, and these loans are collateralized by residential real estate. In the event of default on the mortgage held by a CDO, a house can be put through foreclosure to satisfy the mortgage debt and thereby return capital to the CDO.
In any asset-backed security, assets are bundled together to reduce risk and make the asset more attractive to investors. In contrast, if an individual buys a mortgage loan from a lender in order to receive the interest payments, this investor assumes all the risk of default. The default risk might be low, but if one party must bear this risk, the investor significantly discounts the security to compensate. However, if this individual investor buys a small share of a large pool of mortgage loans, the investor reduces their risk exposure significantly and thereby their discount for purchasing it. The value of the security is increased by pooling and thereby lowering the risk. Also, for an individual investor to purchase a mortgage loan requires a significant equity investment as mortgage loans are often in the hundreds of thousands of dollars. If a number of mortgage loans are pooled and sold off to many investors as shares or interests in a financial intermediary like a CDO, the equity requirement can be lowered considerably thus opening this type of investment to a broader investment community. It is the spreading of risk and the lowering of equity thresholds that makes structured finance such an appealing investment tool.
Collateralized debt obligations, like other asset-backed securities, are divided in segments known as tranches (rhymes with launches.) These tranches are typically titled: senior, mezzanine and equity based on their risk exposure. There is no single structure or formula for a CDO, and many contain numerous subdivisions resulting in more segments than the three described. Similar to the lien order of mortgage obligations, these tranches are paid in order of priority. The senior tranche is paid first, the mezzanine tranche is paid next, and finally the equity tranche is paid any remainder. Since these obligations are paid in order, the senior tranche has the least risk exposure and lowest returns, and the equity tranche has the highest risk and greatest potential for return. To further lessen risk (and make the transaction even more complicated) insurance policies are often issued to insure the buyer of a senior tranche against loss. These policies known as credit default swaps were a very lucrative business during the Great Housing Bubble. It was such good business that many insurers took excessive risks and lost a great deal of money when house prices declined.
The real magic of structured finance is its ability to take assets of low investment quality and turn it into something viable. George Soros aptly titled his book, “The Alchemy of Finance.” Like the alchemists of medieval Europe, modern investment bankers try to turn lead into gold. The syndicators who create and manage collateralized debt obligations assess the risk of loss on the underlying asset and break it down into three categories corresponding to the three tranches. The equity tranche in a CDO assumes the expected risk of loss. For example, if subprime loans expect an 8% loss from defaults, then the equity tranche will be 8% of the CDO. The syndicator typically keeps this equity tranche as part of their incentive fee, but practically speaking, the discount would be so steep it is hardly worth selling. If defaults losses are less than 8%, they see tremendous profits, and if it is over 8%, they see nothing. The Mezzanine tranche assumes the risk beyond the expected risk. If the average default loss is around 8%, and the highest default loss ever recorded is 24%, the mezzanine tranche exists to take on this risk. There is a very good chance they will see most or all of their money because the average default loss is being absorbed by the equity tranche. The senior tranche is supposed to have no risk from default loss. The line between mezzanine and senior is at or beyond the highest default loss rate ever recorded. This is not to say there is no risk, but it would take an unprecedented event to see any losses in this tranche – something like the collapse of The Great Housing Bubble.
Syndicators of collateralized debt obligations go to the open market to raise sufficient capital to buy the necessary securities and cover their fees. Since there is very little risk to the senior tranche holders, they require a lesser return on their investment. Although they own 76% of the CDO and receive 76% of the cashflow, they will pay more than 76% of the capital costs of the syndication (close to 85%) and still receive their required rate of return because the underlying subprime loan pool is paying in excess of the return required by senior tranche holders. The mezzanine tranche has more risk, and they will require a higher rate of return more closely approximating the interest rate on the underlying subprime mortgage. The remaining cost of the syndication is raised by the mezzanine tranche. The equity tranche raises no additional capital, and it is generally kept on the books of the syndicator as a bonus.
One can argue that structured finance creates greater efficiency in our financial system because capital is freed to pursue other objectives. Although, it can also be argued, as Warren Buffet has, that derivatives, the product of structured finance, are “financial weapons of mass destruction.” Both arguments stem from the same characteristic of these securities: excessive debt. When the loan that became part of the collateralized debt obligation was originated, this money was created out of nothing by the originating lender. This is how all money is created in a fractional reserve banking system. As long as there is sufficient cashflow, debt creation is normal; however, when excessive debt is created and available cashflow cannot service this debt, the system experiences the very serious problem of insolvency which can lead to monetary deflation – the disappearance of lender-created money into the ethers from which it was created.
If an individual investor wanted to buy a mortgage loan, it would be purchased with equity rather than lender-created money. However, once packaged into a CDO, the senior tranche is often purchased by an investment banker or another lender which also created this money from nothing. Since the equity tranche raises no capital, the mezzanine tranche may be the only money in the structure not created by a lender out of the ethers. With so little “real” money in the deal, there is very little buffer between what would be a loss of invested capital and a banking loss of created capital. There is a tipping point where the debt service exceeds the cashflow, and when this tipping point is reached, the entire debt structure may collapses in a deflationary spiral. The structured finance products such as collateralized debt obligations and their derivatives are highly leveraged instruments with a very sensitive tipping point. Monetary deflation was a major concern to the Federal Reserve as the Great Housing Bubble began to deflate.
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