Home $weet Home (III)

Now we know how the real estate market has become a bubble and the demand side of the equation. In this episode, we will look into the supply side: the lending financial institutions. Traditionally, the subprime lending is the practice of extending credit to borrowers with high credit risk — e.g. a FICO score of less than 620, unable to access prime rate loans (hence the term “subprime”). Subprime lending became popular in the US in the mid-1990s, with outstanding debt increasing from $33 billion in 1993 to an estimated $1,300 billion in 2007. This substantial increase is mainly attributable to lending institutions which quickly realized that they could make huge profits from origination fees and from selling the asset-based securities (ABS) to investors.
These lenders believed that the risks of subprime loans could be easily managed. That belief held as long as home prices did appreciate. When home values declined, many borrowers realized that the value of their home was exceeded by the amount they owed on their mortgage. Those borrowers began to default on their loans, which drove home prices further down. On one side, Quick Loan Funding used to target people who could not afford a down payment and had poor credit. On the other side, Ownit Mortgage Solutions offered 100% home loan for people with good credit who could not afford a down payment. These mortgage lenders became an overnight success by doing the nasty loans to a lot of people that were not supposed to get a loan. Bottom line, lenders were giving a mortgage to anyone who had a pulse.
Most of the people that took ARMs planned to refinance their mortgage before the payments went up. Homes had turned into ATM machines and the economy flourished. In 2004 homeowners withdrew an estimated $900 billion dollars by refinancing and spent the money on whatever they could buy: from new cars to exotic vacations. Lenders were more than happy to accept more and more mortgage loans in order to issue MBS and sell them to hungry investors around the world. The banks were so eager to get a piece of the action such that they dropped many requirements for the underlying mortgages. For instance, the banks removed the litmus test: no income, no job & no assets. Wall Street provided capital to mortgage lenders to supply them with mortgages they could sell afterwards. With MBS market reaching record levels, Wall Street investment banks launched into the CDOs – Collateralized Debt Obligations. The ABS securities were bundled and re-sold but often buyers did not really know exactly what they were purchasing.
Part of the blame should be assigned to the rating agencies – Moody’s and S&P, which rated billions of MBS and CDO securities. During the boom, when home prices surged and virtually no borrowers defaulted, the riskier BBB-rated securities made from mortgages looked as good as the safe AAA’s. The credit rating agencies had an incentive to award a security the best possible ratings. That was the case because the agencies were paid for their appraisals by the very banks that issued the securities.
These days, economists claim that house prices will keep falling in most places because those prices are still dangerously high compared to incomes and rents. Banks’ analysts say a safe mortgage is a maximum of three times the buyer’s yearly income with 20% down-payment. Landlords say a safe price is a maximum of 15 times the house’s yearly rent. Buyers are still borrowing 6 times their income and putting only 3% down, and sellers are still asking 30 times annual rent, even after recent price declines. Renting is a cash business that reflects what people can really pay based on their salary, not how much they can borrow. Salaries and rents prove that prices will keep falling for a long time. So, watch-out my friends!