By 'End Times', I'm not referring to the significant global decrease in food production, or the Far East trade war over sand (I'm not kidding--Indonesia has declared a sand embargo against Singapore). Putting those two news items together does have an apocalyptic feel to it. No, what I'm referring to is that mortgage foreclosures and homeowner vacancies have reached record highs (also see here).
Over at Tapped, Dana Goldstein describes a cause of the phenomenon:
The story is always the same: clever marketing campaigns prey on families in blighted neighborhoods, promising them the American dream and then some. Once the potential buyers are reeled in, developers and lenders offer short-term perks like reduced or even free rent and make outsize promises about the property's potential value. And when these working class families agree to buy, they are often overcharged, even as they rely on subprime loans, since low credit scores mean they can't qualify for conventional mortgages.
...When financially insecure families purchase a home through an adjustable-rate mortgage, they become more likely to foreclose, not less, as the value of their property increases. When the housing market booms, interest rates go up, shifting the value of the home from the borrower to the lender as monthly mortgage payments increase. Since incomes aren't growing as quickly as other sectors of the economy, people aren't able to keep up with their bills. The result is a crippling cycle of debt that prevents families from climbing back onto the real estate ladder.
One of the supports of the housing bubble has been the oversupply of credit to those who, frankly, probably should not have it. As this 'shaky' money floods the market, housing prices rise. (an aside: call me old fashioned, but I always thought that home lenders wanted solid loans with a high rate of repayment, not shaky ones. Perhaps that no longer applies in the era of usurious credit card fees?).
If we protect consumers from foreclosure, this would dry up this source of credit, furthering the housing construction stall (and lots of bad things would happen there). On the other hand, artificially high housing prices based partially on a supply of 'shaky' credit is bad too. If you compare the number of divorces and the number of foreclosures, they are roughly equal; both can be traumatic for children. On the economic side, high levels of housing debt for the middle class does not help consumer spending.
I don't see any good way out of this.
Update: to her credit, Sen. Clinton has raised this issue and offered solutions, although I think a better solution would be stricter regulation on the terms of loans that lenders can offer.
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Critics have been saying that it won't matter, because the housing market is insulated from much of the rest of the economy, and then bring in as many differences from the stock market crash as possible. (* This is probably a strawman *)
Honestly though, I can't help but see the "trickle up" effect that this will have on large moneylenders. As more of the middle class defaults on their loans, many banks won't have any actual money. With the decrease in demand for housing that this would bring (not to mention the number of homes being built every month across the country now), there's no way to even get rid of the property, unless they sell it at a cost to them.
IMHO, this could definately be a pending economic boo-boo, but I guess it all depends on whether the government has a big enough band-aid to cover it.
On second thoughts, I don't know how I feel about MHO...
I think we had a few forces combining (no conspiracies though). We had the real estate agents, eager to earn more commissions. Then we have the mortgage agents -you know those guys that call you every evening with yet another loan they wanna sell you, eager for more commissions. Thirdly there seems to be a worldwide glut (not US though) of savings, desperately chasing people to take out loans. So the first two helped the third category ignore the risks.
Honestly though, for the most part the lenders cannot afford to forclose, so they will likely have to renegotiate easier terms for most of the strapped homeowners.
Don't expect to make money in real estate for awhile.
That's no longer true. The way that modern lenders work is that they give out a bunch of loans, and wrap them up into a set of bonds which they then sell. The mortgages become the backings for the bonds; the interest paid by the borrowers is paid to the people who bought the bonds. So the entire risk falls onto the people who buy these mortgage-based bonds.
So the people who issue the loans make their money up front by selling the bonds. If the borrowers later default, the people holding the bonds are the ones that get screwed; the original loan-issuers are completely out of the picture. So the people issuing the loans have no reason to care whether or not the borrowers can actually pay, so long as they can find other suckers to buy the bonds. And since the bonds are set to pay pretty attractive interest rates, there's no shortage of suckers buying up mortgage bonds.
Mark, I don't know the details, but the bond-holders can legally force the brokers to repurchase bad loans -at least in cases where they
can prove fraud on the application. I think the recent chapter eleven cases were for loan originators -so at least some of the risk is where it belongs.
From 1992, but still sadly applicable:
http://www.youtube.com/watch?v=2t8YTvdYXws
big:
Nope, they found a way to weasel out.
When the idea of the bundled-mortages-as-bonds first came out, there were some cases where the bond issuers were held responsible. Since then. they've set up a whole structure of bond categories, where different bonds pay different interest rates based on the riskiness of the loan criteria, and by the order in which the principle of the bonds will be repayed on foreclosure. By setting up that structure, it gives them a legal out - if you buy a high-interest mortgage-backed bond, you've been informed of the risk you're taking, and the person who sold it to you isn't responsible - because they told you, in advance, that they're a high-risk investment.
So the mortgage brokers continue to issue extremely high-risk sub-prime (or effectively sub-prime) mortgages, knowing that it's almost certainly going to be impossible for the mortgagees to make their payments long-term - because there are suckers who'll buy the mortgage-based securities.
Mark, New Century Finiancial, which just went belly up, was a loan originator. The originator is responsible if he participated in fraud,
for example helping the loan applicants to lie on an application, or neglecting to do due diligence. That doesn't mean that the loan packages (mortgage backed securities), are fully off the hook, but it looks like the first wave of casualties are loan originators.
Those "suckers" that Mark speaks of are most of the major market players on Wall Street, such as Goldman Sachs, Citi Group and Morgan Stanley. They're the ones who have been financing the subprime market. Wall Street firms have been profiting enormously from the success of the subprime market for the last 10 years. Now it's time for them to admit to much of the failure. But no one needs to tell them that - I'm quite sure their respective earnings reports are screaming at them. http://money.cnn.com/2007/03/12/news/companies/new_century/
index.htm?postversion=2007031214
Mike, you may be right about the need for regulation. Part of me wants to believe in the free market's ability to correct itself. We're already seeing Wall Street firms and Hedge Funds draw back on their easy credit guidelines, because they're all feeling the pinch. However, Wall Street's inability to remember what easy credit has done in the past (1980s, 1929, etc) makes me believe that the Fed, the Comptroller of the Currency and Congress need to "remind" them on a regular basis.
I've been watching this for a few years, starting as an economics major watching the last run-up of the stock market bubble and now as a young engineer in California waiting for the right time to buy a home. My wife and I are both professionals with solid jobs, good incomes, and cash in the bank, and there's no way we would consider jumping into the bloodbath that is our local housing market.
Sure, we may have the fundamental requirements to compete as home buyers (i.e. money, stability), but there's no way we can out-crazy the people who are willing to risk financial ruin by jumping into these ridiculous loans. Put me in a bidding war up against somebody who has half my income but is more than willing to sign his life away to a predatory lender with the almost religious belief that he'll get rich when his $500K (900 square foot) apartment doubles in value and my response will be, "You can have it, buddy. Maybe I'll come back in a couple of years to pick your bones." A rational person with full knowledge of the rules just can't win that game.
Of course, the end result is entire neighborhoods full of homes populated by the people who are most willing to put their financial futures in jeopardy to become home "owners." At this point, I'm satisfied living in a rental and growing my house fund with a "wait and see" attitude. Maybe I'll be back in a couple of years. The down side to that, even for me, is that no speculative property collapse comes without severe economic consequences. I may have a good chance at buying into a down market, but at what cost to the economy in general? I'm not sure what to expect here in the San Francisco area, but I'm sure it's not going to be good.
Mike -
When it comes to home lenders wanting a solid source of repayment, this is a bit old-fashioned now; in a rising house prive environment, you maximise income from sub primes who first pay more interest, and second get foreclosed on with huge fees and penalties, allowing the lender to get both interest on the loan AND all of the house price appreciation. That's a far higher rate of return than a standard 30 year fixed mortgage.
Of course, if house prices drop too much, this all fails and the lender AND borrower end up broke.
The great problem - one which economists in general and free-market ideologues in partiucular will go to any lengths to deny - is that humans tend to apply a discount rate of around 15-30%. So, just from instinct, people will take $1 now over $1.20 next year, or $1 now over $200 30 year's hence. This was a good attitude when life expectancy was perhaps 35-40, but today it's a really good reason why free markets in personal credit will bankrupt people on a large scale when inflation and/or interest rates are low.
This is why what I would call 'folk wisdom' tends to rail against personal debt, and why the ursurer has such a bad name, historically. It's a kind of learned protection to protect people against their own irrationality. Of course, we are all far to clever to need that nowadays..
How this all ends depends on the government; the choice ends up as being either high inflation, which basically means that the loans are mostly repaid with lower value dollars, or a sustained economic depression where a huge chunk of earned income goes to debt repayment. Consumers and industry based on consumers will generally go for inflation if they have any sense, wheras financial institutions and the rich will go for depression.
Andrew,
You make some very interesting points. I was fortunate enough to have done most of my coursework with an economist who was fascinated by market failures and regarded things like the efficient markets hypothesis as severely broken. When I took The Economics of Stock and Bonds from him, the basic question was, "What the heck went wrong?" It's a question worth asking. We know how to value stocks and bonds. We know how to calculate what they should be worth based on a risk premium, expected yield, discount rate, etc. How on earth could such a smart thing as a market do such an amazingly bad job of evaluating such a simple thing as a price?
It clearly comes down to psychology. We're herd animals who don't think rationally about abstract long-run consequences. We concentrated on the fact that people tend to discount the risk premium whenever there appears to be a large upside. The result is disastrous when it comes to figuring out what the price of a stock should be. I hadn't thought about the debt side of the equation, though.
I don't doubt for a second that people are applying a 15-30% discount rate. We see it in home prices, we see it in the interest rates and debt loads people are willing to swallow, and we see it reflected in the fact that we live in an era where 100% financing on insanely expensive things is not that uncommon. Part of me wants to agree that this may be ingrained in how we're built--it doesn't matter what happens when we're 60 because living to 45 would be a miracle. Another part of me has some pity on people because they've been watching home prices increase at 15-30% year after year in some areas. If I saw that and actually believed that it was a trend that was sustainable indefinitely (that is, if I couldn't do basic math and realize that it's numerically impossible for that to happen), I could be forgiven for applying even a 35-40% discount rate when evaluating a home purchase.
There are a lot of problems, and predatory lenders play a big role, but it runs far deeper than that. Most of the intelligent, educated people I work with (people with degrees in science, math, and engineering) can't really explain the concept of a discount rate. It's not a matter of stupidity or mathematical illiteracy. It just seems that even well-educated people aren't trained to run the numbers in a rational way.