A couple of weeks ago, I wrote a two part analysis post on Structured Finance and the CDO market. There was one item of import that needed clarification, so I thought I would take this weekends open thread to do it.
I hope you are all enjoying the free preview of my rough draft for The Great Housing Bubble (or whatever the publisher may want to call it.) Vetting this rough draft in the open forum of this blog has been invaluable to me. The thousands of fact-checkers who read the blog each day have forged its message. I can’t thank you all enough. The daily inundation of analysis posts will end soon as I am getting close to completion of the draft manuscript, so we will be getting back to our daily dosage of schadenfreude soon enough.
Mortgage Default Losses
There is risk of loss in any investment, and losses in collateralized debt obligations arise from the difference in the book value of the underlying mortgage note and the actual resale value of the collateral on the open market, if this collateral is subject to foreclosure. There is an important distinction that must be made between the default rate on a mortgage loan and the resultant loss incurred when a default occurs. High mortgage default rates do not necessarily translate into high mortgage default losses and vice-versa.
Subprime loans have had high default rates since their introduction. When subprime mortgages began to capture broader market share starting in 1994, the rate of home ownership in the United States began to rise. The increasing use of subprime loans and the subsequent increase in home ownership rates put upward pressures on house prices. As house prices began their upward march, the default losses from subprime defaults began to fall because the collateral was obtaining more resale value. This made subprime lending, and its associated high default rates, look less risky to investors because these default rates were not translating into default losses. As time went on and prices continued to rise, subprime lending established a track record of investor safety which drew more capital into the industry; however, since the relative safety of subprime lending was entirely predicated upon rising prices, it was an industry doomed to fail once prices stopped rising.
Take this phenomenon to its extreme and its instability becomes readily apparent. Imagine a time when prices are rising, perhaps even due to the buying of subprime borrowers, and imagine what would happen if 100% of the subprime borrowers defaulted without making a single payment. It would take approximately one year for the foreclosure and relisting process to move forward, and during that year, the prices of resale houses would have increased. When the lender would go to the open market to sell the property, they would obtain enough money to pay back the loan and the lost interest so there would be no default loss. What just happened? Lenders became de facto real estate speculators profiting from the buying and selling of homes in the secondary market rather than lenders profiting from making loans and collecting interest payments. This profiting from speculation is the core mechanism that disguised the riskiness of subprime lending. When these speculative profits evaporated when prices began declining, the subprime industry imploded and its implosion exacerbated the decline of home prices.
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There are no lyrics, but I am a long-time fan of Native American flute Music. Carlos Nakai is awesome.
Hurry on down to Columbus Grove and get a sweet deal on a honey of a property!!! Over 20% off!!! Wow!!! GOURMET kitchen, PERGRANITEEL, this ONE is TURNKEY!!! This one will not last!!! Hurry!!! Buy now or you will miss your chance!!! These prices will not last forever!!! Real estate only goes up!!!
Are you catching the fever of the spring rally yet? Sellers like this one hope you will. I imagine they would rather someone else lose the next $250,000 in depreciation on this property.
Absolutely beautiful single family home in the master planned community of Columbus Grove. Family room with fireplace and media niche. Hardwood floors. Gourmet kitchen with GE Monogram appliances and granite countertops. Preparation island. Breakfast nook. Master bedroom with fireplace and jetted whirlpool tub. Oversized walk-in closet with organizers. Laundry room with storage space and sink. 2-bay expanded garage. Porte cochere. This home has everything!
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Did you notice how close the power lines are to this property? One of our regular readers did, and he sent me this song.
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If this seller gets their asking price, Indymac stands to lose $295,440. I know we profile these daily, and after a while you get used to it, but sometimes you have to wonder, “what in the hell were these lenders thinking?” How do you loan someone over a million dollars when the borrower has put less money into the deal than many of us have put down as a rental deposit? (I suppose in some ways it really was cheaper to buy than to rent.) There has been much discussion here and on other blogs about the willingness of borrowers to walk away from their obligations. The obviousness of it becomes apparent when you imagine yourself in the various circumstances.
Imagine you are today’s homedebtor/bank renter/whatever you want to call him. You have put a modest security deposit ($3,464) into a property, and it has declined in value about $300,000. This property is costing you twice as much as a comparable rental, and it will be many years before resale values would provide you any profit. Wouldn’t you stop renting from the bank at that point and go find a cheaper rental? Of course you would; why wouldn’t you?
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That concludes another week at the Irvine Housing Blog. As you may have surmised, I am making progress toward completing my book on the Great Housing Bubble. You will likely be treated (or you will have to endure) more of the combined analysis and property profile posts in the future. Come back next week as we continue chronicling ‘the seventh circle of real estate hell.’ Have a great weekend.
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.
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.
Unsold in 90+ days
