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Market Commentary
The Credit Crisis... A Step by Step Explanation
Part I. Understanding the modern mortgage market
The mortgage market is more complicated than many borrowers realize. Most individuals purchase homes using mortgages acquired through lenders, banks, mortgage companies or other financial institutions. Decades ago, the lender would hold a mortgage with the homeowner making interest and principal payments to the institution over the life of the loan. Today, only 20% of mortages are held by the originator while 80% are sold off and pooled into mortgage-backed securities. These securities are sold and resold on a continual basis, and can be packaged into a variety of complex investment instruments. These instruments are purchased and held by large institutional investors including pension funds, finance companies, banks and hedge funds. This “securitization” of mortgages provides liquidity to the mortgage market, and has ultimately lowered homeowners’ borrowing costs.
The “subprime” market is born
In the stagnant homebuying period of the 1970s, mortgage lenders found they could grow their business by easing their credit standards and increasing the pool of potential borrowers. Loans could be issued with little or no down payment or with little or no income and asset verification, thus providing home-buying opportunities to individuals with substandard credit scores. Creative loan terms like low “teaser” rates and interest-only payments also increased the loans’ apparent affordability. Since 2004, the percentage of these “subprime loans” in the mortgage market increased dramatically. Today, about 15% of all outstanding loans are considered “subprime.”
Mortgage originators sold their subprime mortgages to investment banks.
Issuing riskier subprime mortgages made sense for lenders. Lots of liquidity existed in the capital markets, with investors actively seeking high yielding instruments in which to invest cash. Investment banks were eager to purchase subprime mortgages and saw a benefit in the incrementally higher interest rates that these loans paid. The lenders themselves could earn substantial fees from issuing these mortgages but by selling off those mortgages, they could offload the risk. The strategy was good for consumers too, as more people could seemingly afford to buy a home.
Investment banks pooled their subprime mortgages.
Investment banks typically pool large numbers of mortgages into mortgage backed securities. This type of security, known as an investment trust, owns the pooled mortgages, collectively worth millions or billions of dollars. The trust then issues bonds to investors. The mortgage interest paid by homeowners passes into the trust, enabling the bonds to yield interest to the investors holding them. When the subprime mortgage market expanded, so did the presence of these mortgages in the portfolios of investment banks and the trusts they manage.
Investment banks start slicing and dicing.
When risky loans are pooled together in a mortgage-backed security, pieces of the security can be “stripped” out, creating new securities known as Collateralized Debt Obligations (CDOs.) CDOs of varying risk (from very safe to extremely risky) can be created from a single pool of mortgages. Even from pools of risky subprime mortgages, “safe” CDOs can be created (although very risky CDOs also get created in this process.)
Ratings agencies measure risk.
Investment banks work with ratings agencies to quantify the risks of mortgage backed securities, including CDOs. These ratings agencies, including Moody’s and Standard & Poors, rate these instruments according to risk. The rating “AAA” would typically be assigned to the safest securities, while “BB” might be assigned to riskier instruments.
Hedge funds and other investors buy the securities.
Hedge funds are investment funds that utilize sophisticated methods of investing, some of which involves the purchase and sale of complex, specialized securities. In their quest for high-yielding investments, hedge funds and other investors purchase the CDOs created by the investment banks. In doing so, the hedge funds rely on the securities’ ratings to manage risk. The instruments can be very complicated, so the investors themselves often do not have the time, expertise, or resources to confirm or research the riskiness of the security, but rely on the research already done by the ratings agency. To boost their returns, many hedge funds used leverage (debt) to increase their purchasing power.
Part II. The mortgage market unravels.
Housing prices begin to soften.
In 2002 through 2004, the housing market experienced an extraordinary period of price appreciation. During this period, foreclosures were uncommon because troubled borrowers could easily refinance their homes using equity generated through price appreciation. Or, they could quickly sell their homes (often at a profit) before reaching the point of foreclosure. In mid-2005, however, housing prices flattened and eliminated much of the flexibility that troubled homeowners previously relied upon.
Homeowners experience financial trouble.
Many subprime loans offered borrowers low initial rates which reset to higher rates a few years later. Today, many such mortgages that were written in 2004 through 2006 are now resetting, and borrowers are having difficulty making the higher payments. With few options for refinancing or reselling, many borrowers are being forced into foreclosure. Significant job losses in markets such as Detroit also increased the population of troubled homeowners.
Lenders get stuck with underperforming loans.
We mentioned earlier that lenders sell most mortgages to investment banks, which then packaged them into mortgage backed securities. However, many such mortgage sales include provisions requiring the original lender to buy back the mortgage if the borrower misses an early loan payment. This has been occurring with increasing regularity, and lenders are getting stuck holding large quantities of troubled mortgages. Losses incurred on these mortgages have caused some lenders to fail.
Ratings agencies reevaluate risk.
This summer, as the pace of foreclosures accelerated, the ratings agencies began downgrading their ratings on mortgage backed securities. In doing so, they made the admission that they underestimated the risks inherent in many of these instruments. Fixed-income securities are generally priced based on their yield and their rating. So, by significantly downgrading their ratings on these securities, the market values of the securities were immediately and substantially diminished.
Lenders experience margin calls.
After lenders issue mortgages to homeowners, they count on their ability to sell these mortgages to institutions. Many lenders carry large lines of credit enabling them to fund the mortgages in the short term until their receive cash from the sales of the mortgages. But new concerns about inherent risks of mortgages have made those mortgages more difficult for the lenders to sell, while the market value of those mortgages held by the lenders has declined. Because those mortgages serve as collateral for the lenders’ lines of credit, margin calls result, and the lenders are required to find cash to repay their own creditors. Lenders who cannot meet those margin calls have failed. A few weeks ago, American Home Mortgage (one of America’s largest lenders) failed for this reason.
Hedge funds incur big losses.
Certain types of hedge funds have been big purchasers of CDOs and other types of mortgage backed securities, including some of those with the riskiest ratings. As the ratings agencies downgraded their ratings of these instruments, the value of these holdings plummeted. One could argue that the ratings agencies, the investment banks, and the hedge funds themselves all underestimated the risk profile of these instruments. But for the hedge funds, not only did the value of these securities plummet, the leverage used by the hedge funds amplified their losses. Also, the markets for many of these securities simply evaporated. Those hedge funds needing to sell these securities to cut their losses, eliminate risk, or meet investor redemption requests were unable to do so – nobody wanted to buy them. Over the past month, two prominent hedge funds at Bear Stearns were wiped out, and Goldman Sachs spent billions to rescue a group of its high profile funds.
Part III. The contagion spreads.
Investors get scared.
It is common for some investors to overreact to turmoil in the financial markets. When a few notable lenders began to fail as a result of their credit risk exposure, investors in a variety of fixed-income securities (not just those associated with subprime mortgages) shifted their investment strategy away from these securities, effectively shutting down a portion of the credit market. As the credit crisis has evolved, it has affected borrowers’ ability to get certain types of mortgages, even if their credit is excellent.
Private equity deals unravel.
Over the past five years, private equity firms such as The Blackstone Group and Carlyle Group have earned outsized returns by purchasing public companies, taking them private, and levering them up with debt. This debt (in the form of bonds) could be easily sold to eager institutional investors. By smartly increasing leverage, the private equity firms could maximize the returns on the equity they hold in these companies thereby increasing the value of that equity. However, the problem in the mortgage market has had a ripple effect causing a contraction in liquidity in the overall financial markets (meaning there is less money seeking investment.) This summer, several private equity deals have run into problems because the bonds can no longer easily be sold. For example, in Cerberus Capital’s purchase of Chrysler, investment banks failed to sell $10 billion in debt. It is expected that the pace of private equity acquisitions may slow considerably.
Financial markets get pounded.
All these factors have combined to cause significant declines in the equity markets. Stocks of homebuilders, mortgage companies, and investment banks all have exposure to the losses incurred in the mortgage market, and most have seen their stock prices decline substantially. Also, the decline in private equity deal activity is removing speculation about public companies being acquired, causing the stock prices of those companies to no longer trade at a premium. Finally, declines in consumer confidence may result in consumers spending less on other things, negatively affecting the future earnings (and stock price) of companies across a variety of industries.
The housing market slows.
None of this is good for the housing market. Fewer homebuyers are in the market – they can’t get the mortgages they want, or are simply holding off on buying because they are apprehensive. Foreclosure sales increase the amount of inventory in the market and any foreclosures that are sold cheaply may depress housing prices.
Corus Home Realty’s Predictions & Recommendations
Sellers: You need to be patient.
The average sales time for residential properties has increased from a couple of weeks to several months. Most homes will take time to sell, and sellers may experience long periods without any buyer traffic. Even if the house looks great, is priced well, and is marketed well, the right buyer may not come along for a while.
Buyers: Be opportunistic, and get some deals!
In certain parts of the Corus service area, there are some fantastic deals. If you’re willing to focus on those areas having high inventory and foreclosure levels, there’s a lot of room for buyers to negotiate terms, dictate price, and play sellers off against each other. How many home buyers wish they could have done this in 2004 or 2005, when arrogant sellers demanded top dollar? Now you can!! Corus Home Realty is bullish on several highly distressed neighborhoods, and is currently in the process of creating an investment fund to pursue those opportunities.
Buyers won’t get deals everywhere. Parts of the market are healthy.
Across the Corus service area, property sales prices are averaging 96% of their list prices. These are good deals, but they’re not massive discounts. Throughout the Corus service area, there are in-demand neighborhoods where sellers can hold their ground. If you’re buying in this market, we encourage you to consult with your agent to determine prevailing discounts within the neighborhoods you are considering, and to structure your offers accordingly.
Philadelphia and Washington are better off than other cities.
The two Corus markets of Philadelphia and Washington DC do have foreclosures, but the markets are not as hard hit as many other cities. In foreclosure rates, Money Magazine ranked Washington and Philadelphia as #66 and #67 respectively on its list of the top 100 metro areas. On a per-capita basis, the foreclosure rates in our markets are at about one quarter of the level experienced in California, Florida, Michigan, and Ohio.
Click here to read the article.
Locally, employment fundamentals should make this crisis short lived.
We continue to believe that job loss or creation is the #1 factor in the strength of local real estate markets. Philadelphia has a strong, diversified employer base, while the Washington market is expected to add tens of thousands of jobs over the next five years (mostly due to Federal Government activities.) Particularly in the Washington suburbs, the current supply of housing is inadequate to provide for the increasing employment base. Within the next three years, that should strengthen the local housing markets.
The future of the mortgage market is anyone’s guess.
We’re in uncharted territory here, so predictions are tough. A few observers have speculated that the worst of the market is ahead of us. More mortgage companies may go bankrupt, and the wave of foreclosures may not crest until next year. There are also ways that parts of the mortgage market could temporarily “seize up.” Yet, others would acknowledge that the markets are in a bit of panic mode now, there’s a lot of overreaction going on, and that things could improve in a few weeks once the players in the market get a better handle on the situation. The Federal Reserve may reduce rates, and that could also settle things down a bit.
If you’re trying to find a bottom in this market, you’ll miss it.
We’ve been through several market ups and downs. And we’ve had seller clients trying to sell at market peaks, and buyers trying time the bottom of the market. It’s not as easy as it seems. The market turns faster than people think, and you’re only likely to find the bottom about 6 months after it’s occurred. We do know it’s a great time for buyers, and there are deals out there. Are they the best deals? We don’t know. But, we do think that many listed homes are sufficiently compelling, and we’d encourage buyers to consider them.
Do you have questions about the mortgage market? Feel free to contact us at info@corushome.com.
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