During the Great Housing Bubble, many speculators tried to make money through trading houses. The vast majority of these traders were not professionals but amateurs who thought they could be professionals. Most amateurs ended up losing money because they did not understand what it takes to be successful in a speculative market. The first and most obvious difference in the investment strategy between professional traders and the amateurs in the general public is their holding time. Traders buy with intention to sell for a profit at a later date. Traders know why they are entering a trade, and they have a well thought out plan for their exit. The general public adopts a “buy and hold” mentality where assets are accumulated with a supposed eye to the long term. Everyone wants to be the next Warren Buffet. In reality this buy-and-hold strategy is often a “buy and hope” strategy — a greed-induced, emotional purchase without proper analysis or any exit strategy. Since they have no exit strategy, and since they are ruled by their emotions, they will end up selling only when the pain of loss compels them. In short, it is an investment method guaranteed to be a disaster.
There is plenty of evidence houses were used as a speculative commodity during the Great Housing Bubble. Since the cost of ownership greatly exceeded the cashflow from the property if used as a rental, the property was not purchased for positive cashflow, and by definition, it was a speculative purchase. Confirming evidence for speculative activity comes from the unusual and significant increase in vacant houses in the residential real estate market.
National Homeowner Vacancy Rate, 1986-2007
If markets had not been gripped by speculative fervor, vacancy rates would not have risen so far above historic norms. If houses had been purchased for investment purposes to make money from rental income, the houses would have been occupied after purchase and vacancy rates would not have gone up. A rise in vacancy rates would have resulted in downward pressure on rents, and the investment opportunity – if it had existed initially (which it did not) – would have disappeared with the declining rent. There is only one reasonable explanation for increasing house prices and increasing rents during a period when house vacancy rates increased 64%: people were purchasing houses for speculative gains and leaving them unoccupied while the owners waited for prices to rise.
When house prices stopped their dizzying ascent, many speculators found themselves with large monthly debt service costs and no income to offset expenses. Many chose to quit paying their mortgage obligations and allowed the property to be auctioned at foreclosure. Many chose to rent the properties to reduce their monthly cashflow drain, and they became accidental landlords. In the vernacular of the time, they became floplords – flippers turned landlords.
Becoming a floplord was fraught with problems. First, they were not covering their monthly expenses, so the losses on the ”investment” continued to mount. This was a convenient form of denial for losing speculators because they believed they were buying themselves time until prices rose again allowing them to sell later either at breakeven or for a profit. Since they bought in a speculative mania, prices were not going to recover quickly and the denial soon evolved into fear, anger and finally acceptance of their fate.
Another problem floplords faced was their own inexperience at managing rental properties. Most had never owned or managed a rental property, and none of them purchased the property with this contingency in mind. They often found poor tenants who did not reliably pay the rent or properly care for the property. This created even more financial distress and greater loss of property value as the property deteriorate through misuse.
The problems of renting were not confined to the floplords. Sometimes the renters were the ones who suffered. Many floplords collected large security deposits and monthly rent checks from tenants and failed to pay their mortgage obligations. This situation is called “rent skimming,” and it is illegal in most jurisdictions, but this crime is seldom prosecuted. Most of the time, the first indication a renter had that their rent was being skimmed was finding a foreclosure notice on their front door. By the time of notification, several months of rental payments were gone and the renters were evicted soon after the foreclosure. Renters seldom recovered their security deposits.
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Valuations in Northwood for homes 2,000+ SF are still bubbly. Recently we featured a floplord looking to cover about 2/3 of his ownership cost (or ask 50% more than the property is worth depending on your point of view.) Today’s post features another floplord in the neighborhood with Secret Gold. The property is going to be a big loser for the owner, and since you can rent an identical property for $3,900, it doesn’t make much sense to spend around $5,500 a month to buy it, unless of course, you like the $7,400 a month equity burn on top of your oversized payment.
WOW!! Take a look at this Beautiful home in Desirable gated commmunity of Northwood II. OUTSTANDING SCHOOLS, PARKS, POOL AND CLUB HOUSE. ! Beautiful quality upgrades. Gorgeous gourment kitchen with cherry cabinerty, stainless appliances includes, wine refrigerator. Island breakfast bar, beautiful granite counters. Prestine wood floors, upgraded carpet, window coverings. French doors lead to relaxing patio with soothing waterfall. Short distance to shopping, library and the NEW GREAT PARK IN PROGRESS. Move-in condition. Low homeowner association fee.
WOW!! This realtor can’t spell commmunity, gourment, cabinerty, or Prestine. I am not a stickler about spelling, and in fact, I am not a great speller, but when the computer puts a big red line underneath it, I have to go out of my way to ignore it. Please, someone at the MLS needs to get spell check software.
What does the Great Park have to do with anything?
Interesting that $120 a month for an HOA fee is considered low.
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This property was purchased at the peak, and now if they get their asking price, the sellers stand to lose $245,280 after a 6% commission. This is their best-case scenario. If they become a floplord and hold the property all the way to the bottom, they will lose close to $500,000. Of course, they could always hold it until prices come back… in 2030.
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.
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.
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.
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.
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.
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