Everyday we hear something new on the news about what is happening to the housing market across the entire United States.
We see our neighborhoods flooded with “For Sale” signs and vacancies due to foreclosures and yet do we really understand why this is happening and when it will end?
I am convinced that many of you have heard of the term “recession” and many of you believe we are in one, but did you know that we are actually in a housing depression, not recession, and that everything will get worst before it gets better? I am sure by now you are telling yourself, here is another great article that will point the finger and tell me nothing more than what I already hear on TV and this is where I tell you that my job is not to change your mind about who is to blame or persuade you think a certain way. My job is to provide you with the knowledge and tools to be able to think correctly and question what you see on TV because you know the facts and what they mean.
Lets begin by describing some key terms that are often put out there and their impact on the housing market.
–SubPrime Loans: In simple terms, sub prime loans were mortgages that were given to consumers that should not have had them. Consumers wanted to purchase homes but did not have down payments, good credit, good income, reserve funds or any of the other qualifying factors that a normal mortgage has. Due to the limitations that the customers had, these loans usually carried low interest rates and payments for the first 12-24 months and then readjusted to very high variables there after, making it impossible for the borrower to pay.
–Predatory Lending: Predatory lending is when a big bank/lender (predator) chooses to go seeking and attacking borrowers by offering them loans knowing they could not afford them. In other words, they know you shouldn’t have it, but they want to make their money so they will sell it to you, even if they know it will hurt you on the long run. They even go as far as to target a certain demographic to ensure the level of education is low and/or they don’t have the ability to read all the fine print and clearly understand what they are getting into.
–Short Sale: Think of a short sale as a Pre-Foreclosure. The bank and you agree that you cant afford to pay your loan, and so you both agree that the house needs to go but you dont want foreclosure on your credit report and the bank doesn’t want that large of a loss, and so you split the loss in two and attempt to sell the house at a much reduced cost. A short sale can be processed in many different ways and usually no money will leave your pocket up front, but taxes are a different story.
–Foreclosure: Bank owns your house.
So here is the equation so far…
Subprime loans+Predatory lending+Target borrower=Short sales+foreclosures
Stated Income deals: Mortgages that did not require income verification, your word was as good as gold. If you claimed to drive a taxi and that you made $130,000 per year, the lender would approve the deal even though they knew it was unlikely. (Side note: Not all stated income deals are bad.)
–The Government’s Role: To create as many initiatives as possible that would allow lenders to put more people in homes. Bush had several initiatives going back to 2001 that focused on untying the hands of the lenders and allowing them to get creative with their loans. By doing so, more people were able to afford homes. Wrong, more people were able to afford home payments, not homes.
–Mortgage securities: Banks always look for more ways to make money and minimize their risks of loosing any. When banks were allowed to sell mortgage securities, it only took a minute for them to realize that there was money to be made. Mortgage securities are simply a mortgage loan that a bank owns cut into three pieces and sold on the open market. In other words, even though you make you payments to a certain bank, they no longer own the rights to your properties but three other people do. Those three other people also happened to be banks, investors and foreign investors. Think of this, banks now no longer needed to assume a risk for selling you a mortgage, instead, someone else would assume it and both parties got rich. So why would banks care as much of you can’t afford your home? Some banks cared, some didn’t…
Here is another equation to think about:
Greedy Banks+Greedy investors+Government+Securities=lots and lots of foreclosures
So now that we know what the terms are and their implication in this matter, lets understand what really happened.
In my previous article: What is Credit? I speak of an example where your house increases in value over 10 years as a means to making money. So how come so many people and banks are losing money?
Well lets look at how it all began…
Back in 1999, the Greater Washington Area was growing at a very quick rate, many IT companies were booming and coming to the east coast due to cheap real estate and major acreage availability. In other words, they were building lots of big buildings for very little money. Government offices followed from DC and then followed the small businesses and the whole food chain.
With all these new businesses came new workers, and these workers all needed homes and so began the start of the real estate bubble. Too many people were here, not enough homes were available and compared to other states that they came from, it was cheap. What we know about basic supply economics is that the lower the supply, the more the demand, the higher the cost.
Then came unrealistic inflation from builders. Since prices needed to go up and supply kept going down, homes were selling to the highest bidders with major lot premiums. These premiums made existing houses rise as well since neighborhood homes were selling for $50,000-$100,000 more than valued because of demand. The good news then was that only qualified people were playing in this game and they were only buying one house to live in but were getting less for their money.
Then came the government in 2001 and their challenge to banks to make it affordable and get creative with the loan processes and allow more Americans to own homes. As an incentive the government decides to open the securities market to mortgage bonds and allows banks to package mortgages and sell them to the public as an investment. Think of it this way, as a bank, you have the right to give people loans, make money off of them and then not even have to fund them, since you are selling them off to someone else immediately and get your money back; no risk. This is money 365 days a year for banks and so they decide to do what everyone else that is in business does, make more loans and make more money, even if it doesn’t make sense to put people in homes, its income and growth. What’s the worst that could happen? You foreclose and they get your property worth a $100,000 more than you bought it and so not only you are out but they make money. No risk involved.
Two years of prosperity and growth occurred, the world was perfect. You owned a house, you had equity and used it to do what you never thought possible and you though to yourself, I never knew I could afford all these items, luxuries and lifestyle. The banking system grew by close to 160% year after year, more people moved here, more people bought homes, more jobs were created and more money was spent on useless things that no one could afford before.
Then came a different breed of investors and lenders. Predatory lending started getting worst, and becoming apparent and mass marketed and investors that weren’t really savvy but rather amateurs that wanted a piece of the pie decided to get into the market and buy properties that they wished to flip and rent. Bad idea! The worst part of it all was that anyone in the mortgage business was making $150,000 a year and didn’t know what to do with it but waste it in poor investments and lavish lifestyles. Another bad idea!
I always say that a good indicator that a bubble is coming is when your friends start coming up with unrealistic plans in how they can make money from a market trend. This to me indicates that there are plenty of people that are already playing that shouldn’t be playing. At this point, the savvy investors are out of the game and all thats left are the investors that can’t afford what they bought and rely on others to make their payments through rent and would be lost without it.
2004 came and the market stabilized itself, there was no longer an over demand for homes, and supply was adequate to no longer ask for lot premiums. No lot premiums means that the inflated $50,000 – $100,000 you were making from your home in less than 1 month is now gone and if you were the last horse to cross the finish line, then you just lost $100,000. Losing money on paper is irrelevant unless you need to sell or refinance, and unfortunately you happened to have purchased from a predatory lender that sold you a subprime loan that adjusted itself and doubled your payment after 12 months of ownership. That is really unfair, but yet no one forced you to sign knowing you couldn’t afford it, and no one forced you to sign without reading.
The domino effect started and the housing market started getting infected, as new home prices leveled, used homes were not worth as much. As foreclosure of all those second and rental properties increased, used and new home values decreased across the board. Then came the next problem; the big spenders no longer had the ability to refinance as their values dropped and so they couldn’t minimize their payments and keep those great luxuries that they believed they could afford.
2005: Short sales and foreclosures were now on the rise and starting to hurt values, the same economics rule applies again; more supply, less demand drives prices down. More mortgages started adjusting, more people couldn’t afford their homes and more people left their homes. Big spenders were left with luxuries that meant nothing and 2nd mortgages they couldn’t afford.
This was starting to become a huge issue for homeowners. Everyday everyone waited for the comeback of the market and it never happened.
2006: The banking problems start to show themselves. Major losses on books and records for banks and major losses from investors that bought into the mortgage securities that banks were selling. Major losses mean major layoffs and the first people to get laid off are those same people that were spending their easy earned money on bogus and useless luxuries and now were losing their homes, as they no longer had comparable incomes or any real skill set that earned them their job. They earned and lost their jobs due to demand.
Then came immigration. Immigration? It seemed that the government’s plans to deport illegal immigrants couldn’t come at a worst time. It was bad because most Hispanic families that had been victim of predatory lending were counting on 2-3 incomes within the same household to make ends meet and afford their home, incomes which were not always legally earned and taxed. With these incomes now gone and the mortgages adjusting themselves, the foreclosure rates started soaring causing values to come down further.
2006 was a bad year for many people but then came 2007 and unfortunately, the situation got worst.
2007: More of the same intensified. Major losses for banks, major losses for investors, major lay-offs, inflation, energy prices soaring, home value diminishing over 20% over the previous year. The world was coming to an end for many people but the reality was that at this point if you had purchased a home before 2002 and didn’t get robbed by paying a premium you were still not upside down. That’s right, for the most part. The market had only corrected the lot premiums and the increased prices due to supply and demand, land values had not fallen as hard and dollar per square footage had also not taken a drastic loss. So the reality that most didn’t see was that the market equilibrium took place earlier than expected and removed the fluff (fake income and wealth) from the market, and all that was left was real money.
With all the craziness, more subprime loans started adjusting and caused more people to continue down the path of foreclosure, many of which could have been prevented by a simple call to your lender that you chose not to make just as you chose to not read the paperwork in front of you when buying your house.
Then came the blaming: Government blamed banks, banks blamed lenders, lenders blamed customers and customers blamed banks and the blame game began but no real solution found.
Let me tell you what is the cause of all of this meltdown:
We all believe in the American dream, the opportunities that exist here, and want to believe that the american dream is about making as much money as possible and therefore get greedy when we see opportunity.
Banks got greedy, homeowners and investors got greedy and so did the government. We can blame banks because they made money on your misery and people made money on someone else’s misery by working for those particular banks and not caring for the consequences of their actions, but Main Street also got greedy by trying to make a quick buck without reading the fine print or how about buying 2-3 homes and reselling them for a profit in less than 2 months. Banks did not do that, people did that to other people, and believe me when I say that it wasn’t the rich ones that turned on the poor but the educated ones that saw opportunity and seized it. The morale of this story is that the common goal in this country is to make money, and people from Main Street to Wall Street made money, and lost money and there is nothing abnormal about that. Those that made money and got out on time were those that possessed a fair competitive advantage over the others, they educated themselves on what they were doing before doing it and seized the moment.
So remember: To make money, you must understand money.