By Keith Schemm.
In my previous article I discussed some of the reasons why the housing crisis appeared, why borrowers were undeterred by the warning signs of a bubble and how the traditional mortgage broker wasn’t to blame for mistakes made by real estate investors aggressively chasing after profits. Shortly after June of 2003, when
mortgage rates hit historic lows, I think that borrower psychology shifted, which resulted in real estate no longer being viewed as a place of residence but as a risk-free investment vehicle for generating equity gains.
Fixed rates for mortgages had clearly bottomed in the early summer of 2003 and as the rates on 10 year Treasuries jumped in July and August of that year we saw a pullback in the number of prime borrowers who were refinancing adjustable rate mortgages into fixed rate loans. The financially savvy baby boomers at that time were for the most part placing their permanent loans on primary residences, second homes, and investment properties that they intended to keep for the long haul. After all, they had lived through the property cycles of the eighties and early nineties and they knew how the ownership game worked. The cost basis of these properties was still modest and the price spiral had not yet begun.
Under normal circumstances, the rising interest rate cycle would have caused housing affordability to suffer, resulting in a slow down in the buying cycle and putting the brakes on the rapid ascent of home values. In previous cycles, when home values became stagnant, a shift to conservatism would have prevailed that would have automatically served to slow down and stabilize the entire system.
However, because there was an inter-generational transition going on (the youngest boomers were turning 40 and the oldest were pushing 60) and a wave of sophisticated new arrivals and Generation Xer’s were now getting their first shot at home ownership, making things different this time. It is at this point that the normal cycle was pre-empted by these events as a generation of fresh buyers were enabled by the advent of new mortgage financing products which lead them to develop an appetite for housing acquisition as pure investment that then became the game-changer.
A number of factors such as higher education levels, rapid financial achievement, and familial pressures for owning versus renting came together to create the real estate super-speculator which helped create the bubble we are now facing. The fast-forward desire for real estate ownership by the individual that would have normally been aspired to in the course of a decade was compressed into just a few years. This short circuited process had both an upside and downside to it. The early adopters of this strategy benefited handsomely via huge (albeit temporary) ramping up of home prices. But the unrealistic expectations for future appreciation that were raised in each successive wave of buyers that came after ward, destroyed the stability of the system of property ownership as a means of building wealth. Many of the new buyers were not ready for the financial consequences of their actions.
We saw parents helping children accomplish what they themselves took years of hard work and saving to achieve, seemingly happened over-night. For example, there is nothing like the experience of renting and saving for a down payment to focus the attention of a borrower on the responsibilities of home ownership. People seemed to know the price of everything, but the value of nothing. The income and credit qualification process was transformed from a litmus test of financial capacity and true readiness into a game of jump through the hoops and find the cheese at the end of the maze.
Throughout 2004 and 2005 prices continued to climb upward and appreciation of 20% and beyond in a year became common, leading to a destructive attitude towards financial prudence which tended to breakdown people’s reluctance to over-encumber themselves. Deferred gratification was an anachronism. Why bother saving 20% (or even 10%) for a down payment on a home when you could take on a little risk and make that return in a year if you purchased immediately, with nothing down, and accept a minimal mortgage payment on an Option ARM. The financial system was in the process of converting all available income, both present and future, into borrowing power and capitalizing that into the present value of real estate.
Each successive wave of borrowers using creative financing enabled the next by forcing them off the fence and into ownership before they were financially ready. As underwriting ratios were pushed to the maximum; new products were introduced to allow the next wave to come into the market and buy. When the standard 80-20 (LTV-Down Payment) fixed rate or adjustable purchase loan was eclipsed as the standard there was no going back. Soon avoiding Private Mortgage Insurance (PMI) became an accepted practice as borrowers resorted to 80-10-10 financing and then the no-down payment loans followed. Over time what was created was a layering of speculators and borrowers with increasingly riskier loan products which had inherently worse capacities to service loans. All were counting on home prices rising ad infinitum in order to bail them out of a situation that in the long run was unsustainable.
Where we go from Here…
In a late 2006 presentation to investors, Credit Suisse showed how this layering of mortgage risk categories could play out as an ARM Reset Schedule in the coming years. In the graphic below we see that this scenario has in fact played out over the last 24 months is a failure of the sub-prime loans en mass. But what’s coming next?
We are living through an historic time and this period will be looked back upon as a defining moment. What will transpire in the next four years with the un-winding of the mortgage credit bubble as it spreads to Alt-A and Option ARMS will seem unbelievable. Over the next few years as society deals with the aftermath of the mortgage credit contraction, along with the unwinding of derivatives worldwide, including: liquidations, bankruptcies, foreclosures and subsequent homelessness and unemployment that will result, future generations will look back and ask the reasons for the dramatic shift that transpired in the way we lived at the end of the 20th century and the first decade of the new millennium.
These factors are now converging in a self-reinforcing and vicious cycle which will eventually cause the US economy and government finances to implode at virtually every level within the next several years, possibly within month and the rest of the world will follow suit as well. The delicate global infrastructure that is so highly dependent on the smooth functioning of both physical and financial transactions is being thrown into global and domestic chaos.
Moreover, in the past a wrench in the gears of finance could be dealt with over time by additional growth in another area of the economy. But in today’s highly integrated global economy, any loss of income committed to mortgage and other debt service could spell disaster. Our economies have evolved during these relatively quiet decades into a fatally sophisticated system of interdependencies that rely upon stability in critical engines of finance and commerce. That stability is now gone. As the Credit Suisse graphic of mortgage resets implies we are now in the eye of the storm between the effects of the Sub-prime Crisis and those coming in 2009 from the Alt-A and the Option ARM loans. Another cautionary note, the potential fiascos in securitized commercial real estate, student, auto, and credit card debt are also currently looming on the horizon.
