In The News...
There are no economic reports today.
Today is the 1 year anniversary of the bear market lows for Stocks hit back on March 9, 2009 at the height of one of the worst recessions since WWII. The Dow closed at 6,547.05 and yesterday it closed at...
|
|
You can’t turn on the television without hearing all the doom and gloom. With all the stories in the news ranging from credit tightening and lending guidelines changing to the financial sky falling, it’s hard not to wonder how this affects us locally. So, what’s it all about? And more importantly, what does it mean for each of us?
There is a great amount of confusion over what is happening, so let’s get our arms around it. Over the past several years, lenders have opened their purse strings to homeowners with somewhat non-traditional (“non-conforming”) situations. These could be poor credit history, inability to document income and assets, high loan to value, or any number of factors that do not fit with the traditional box. These loans are often called “Subprime” and “Alt A”. Typically subprime loans are loans to borrowers with less than good credit, although other factors may mandate the necessity for this type of loan. ALT A loans are predominantly borrowers with good credit, however they are unable or unwilling to document income and/or assets...perhaps they are self employed. Another type of non-conforming home loan is one where the credit and income may be fine, but the loan amount is higher than $417K maximum loan amount that can be done using the pools of money from Fannie Mae and Freddie Mac. Instead, these “Jumbo” loans come from private institutions.
So why did investors loosen the purse strings to these non-traditional loans?
Like with any investment, the investors for Suprime and Alt-A are willing to take on more risk the greater the reward. The appetite increased for these type of loans because the return was so nice and the real estate market was appreciating. Loans were performing thus risk was minimal in this “risky pool.”
Very few mortgages are held by the bank or investor that funds them. Instead, they are “pooled” and sold on the open market. To keep it simple, a lender may sell your $100K interest bearing mortgage for $101K. So the lender has made a profit and has replaced the funds they loaned you and can loan the money again to someone else.
But lately, default and foreclosure has been on the rise. This is partly due to the fact that with the credit tightening earlier this year combined with a soft real estate market, many troubled homeowners found themselves unable to refinance or sell in order to get out of trouble. This growing concern has resulted in these institutions demanding a higher “risk premium” for purchasing these pools of loans. So now, they are only willing to pay $95K for that same $100K interest bearing mortgage. All we have to do is multiply that times thousands upon thousands of loans, and you have millions upon millions of dollars in loss for the company that is selling the pool at a much lower price than they were expecting. This is called “liquidity crisis”. The lenders that are closing their doors are having to do so because they were holding too many of these loans, forced to sell at substantial losses which led to the decision to shut down.
As lenders watched this unfold around them, they increased their rates dramatically to be better prepared for increased risk premiums down the road. The next step taken by many lenders was either a tightening or complete withdrawal of these loan product offerings. This shift occurred almost overnight.
A growing concern in this mess is the mark-to-market accounting in an illiquid market. Mark-to-market accounting (also known as "fair value" accounting) means that companies must value the assets on their balance sheets based on the lastest market indicators of the price that those assets could be sold for immediately. "Immediately" is the tipping point. Declining housing prices doesn't just reduce the value of the mortgages defaulting, they reduce the value of ALL mortgages and mortgage-related securities.
Think of it this way. You live in a neighborhood were the average home value is $350,000. Your neighbor has a life changing event such as a job loss or death in the family. In order to survive financially, they must sell their home and sell it quickly. It's a firesale. They list the home and sale for $300,000 just to dump it fast. Now this home becomes a "comp" for the neighborhood and all the values drop. Your other neighbor accepts a job opportunity and is being transferred to another state. The value of the neighborhood has now declined due to the firesale, and he can only get $275,000 for his home. Now you are ready to sell because your family is growing...what price might you get? See the trend?
Now apply this scenario to the accounting rule. The balance sheet must be based on the latest market indicators. Indicators! Immediate firesale prices. So they reduce the value on the balance sheet because the collateral protecting them is supposedly worth less.
The credit agencies see declining capital margins, so they downgrade the company's credit ratings. That makes borrowing more difficult. Their stock price begins to decline. Now they are subject to "margin calls". This means that as their losses and risk premiums increase, the value of their portfolio (assets) decreases. The credit lines that are securing those portfolios begin to issue margin calls since the value of the asset that secures it is now diminished. When the margin call comes in, the lender is required to pay down their balances. In turn, this means they have less availability to fund their new loans, which exacerbates the problem.
Now the companies in financial distress begins fire sales of its assets (the securities) to raise capital to meet margin calls, the prices bottom again and now set the new standard.
This has begun the downward death sprial for financial companies large and small. Panic sets in which drives their value under the mark-to-market accounting down to zero. Suddenly, the balance sheets start to show insolvency.
Not everyone is caught up in the mess. It’s really getting back to common sense basics. To get a home loan, you must have a job, savings, be able to provide documentation and the proven ability to repay. With the scarcity of 2nd liens, many people will paying PMI again. However, it’s tax deductible this year.
Now it’s absolutely imperative, even if you aren’t in the market for a new home or refinance, to make sure that your credit standing is as solid as possible. Review your credit report for any possible errors. With no immediate need for a home loan, time is on your side.
For sellers, it’s important to get real about price. Tightening credit and diminishing mortgage products will continue to reduce the pool of qualified borrowers. It’s also important to get pre-approved for your next purchase. You don’t want to sell your home only to discover you can’t get approved to buy another.
As for buyers, don’t get too busy shopping for a home before doing your homework. Review your credit report. In many cases, improvements to credit scores can be achieved with some minor changes. Get pre-approved and begin collecting your paperwork.
If you are in the market for a home loan, understand that now is the time to be working with a qualified professional that can keep you informed of the constant changes in the market as well as move and adapt with them. Your home and your financing are just too important, and times have changed.
Perception is real, and reality must be managed. Remember, this dramatic shift we are experiencing is simply a matter of getting back to basics. Once the dust settles, there will be a renewed appetite for real estate and the market will improve.
|
