Notes from Jim Haughey
Reed Construction Data Chief Economist Jim Haughey discusses how current developments in construction markets and the ecomony will bring opportunities and challenges for designers, contractors, and materials and services providers. His reports will cover near-term building demand, cost and financing changes, and will provide early notice on changes in the detailed two-year construction forecasts elsewhere on this site. Feedback and questions from readers are encouraged.
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Thursday, August 23, 2007
How Did the Mortgage Mess Happen and Can it Happen Again?
First, the subprime mortgage crisis appears not to have caused an extended credit crunch thanks to quick, aggressive action by the Federal Reserve Board. So, very little of the problems in the housing market will spill over into the rest of construction or the broader economy. Nonetheless, there will be a further delay in the recovery of the housing market, a marginal drop in demand for nonresidential space and facilities but no direct negative impact on public construction.
Into the 1970s, residential mortgages were largely made only by Savings and Loan Associations or other savings banks and were not sold but kept within the S&Ls, financed by consumer deposits. To get a mortgage, you first opened a savings account at an S&L and then applied to a lending officer who lived in the same community. You had to demonstrate that you had 10% or more collateral, sufficient income and a good credit record. All of the information you provided was verified.
This system prevented fraud and kept default rates very low. If there were layoffs in the local economy, the S&L knew which homeowners would be affected and could deal them individually. But the system had other problems. A strong housing market which boosted mortgage demand, a weak economy or higher investment returns elsewhere which cut S&L deposits occasionally dried up available mortgage funds and sent mortgage rates soaring.
The access to credit problem was fixed by permitting commercial banks to enter the mortgage business and Fannie Mae and Freddie Mac were expanded to provide mortgage applicants with access to funds from any source which Fannie and Freddie tapped by issuing bonds. There was little if any worsening of credit quality because you still had to meet with an office at a commercial bank. Freddie and Fannie knew that the commercial banks could be relied on to buy back mortgages that went bad; mortgages were only a small part of any bank’s assets. The experience through multiple recessions, some quite severe, convinced investors that supplied funds to Freddie and Fannie that their risk was very small.
Then in the mid 90s a parallel mortgage system appeared and began to grow for loans too risky for Fannie and Freddie. It began to expand rapidly about four years ago, spurred by two developments in the housing market. First, home prices soared in California and the Northeast, largely due to restrictions on homebuilding. This gave rise to the “jumbo” mortgage market. Today, that is mortgages over $417,000, too big for Fannie and Freddie to buy. Congress, after all, can not be seen to be subsiding rich families. Another source of mortgage funds was needed to serve this market.
Second, mortgage brokers became more significant, enabled by new technology that permitted them to operate nationwide using the telephone or the Internet. This class of mortgage originators has no other banking relationships with mortgage applicants and relies only on commissions. The advent of telephone salespeople and direct mail copywriters was a recipe for fraud. Legally, mortgage brokers had the same obligation as commercial banks and S&Ls to share in the default losses from mortgages but this turned out to be impossible to enforce since sales organizations simply folded up when they ran out of good leads.
More mortgage volume means more commissions which lead to the explosive growth of a variety of non prime mortgages which, like jumbos, needed a new source of funds. Wall Street created the CDO, collaterized debt obligation to package mortgages and sell them to hedge funds and other investors looking for high return and willing to take high risks. This worked fine for several years as double digit rises in home prices permitted overextended homeowners to either grow into their mortgage or exchange it for a prime rate loan.
The financial theory was that slicing mortgages into pieces, creating packages with various statistical levels of risk and selling the packages worldwide would keep the risk for each investors that held mortgages or mortgages backed paper manageable in the event of a rise in defaults in a weak housing market. There is nothing wrong with the theory but two assumptions were wrong.
First, some holders got greedy and took too big a position in high risk/high return mortgage paper. They could not absorb the inevitable losses.
Second, the losses were larger than expected because too many of the original mortgages were fraudulent. There was both applicant and originator fraud. The homeowners could retreat to bankruptcy to avoid their debts and were less reluctant to do this than holders of prime mortgages. The mortgage brokers knew they could simply disappear as a corporate entity if they were called on to buy back bad mortgages. The consequence was that the mortgages were worth less than the investors paid for them when the initial teaser rates began to reset higher and defaults soared.
You knew what happened next. The first failures of mortgage brokers and mortgage investors set off a domino chain of company defaults and caused a brief credit crunch.
Can it happen again? Yes, and it will unless changes are made in the non prime mortgage market. The key flaw is the original mortgage. It has to be policed for fraud and affordability at the market interest rate. Either one or both of the parties to the original contract has to accept an enforceable assumption of default risk or public regulation is the alternative.
A secondary flaw is the portfolio mix of the unregulated investment entities. Too much leverage and too many high risk assets is a formula for disaster. These are private losses but cause problems for everyone else.
at 8/29/2007 1:49:13 PM, Carson Horton said:
This all sounds good and well as far as explanations go, however I would suggest that this analysis along with that of most mainstream observers. It seems to me that at the heart of the whole "sub-prime" loan mess is the fat that housing prices have escalated to the point that the overwhelming majority of buyers cannot afford to purchase a home if it weren't for sub-prime lenders. It's all well and fine that the Fed jumped in just in the nick of time and saved the day for the credit markets and all of the Wall St. pirates. However, if they end result is going to be that sub-prime lending as we have come to know it is going away then I really don't see how the housing market (both new and resale markets) are going to avoiod be crushed. The simple fact is that the vast majority of woring adults do not earn enough money to afford a median priced or even an average priced home n the community where they live. In most cases even a two income household is strapped to afford a hoome. If the outcome of the sub-prime fraud is that borrowers will be held to old school lending standards and qualifying guidleines then I see no end in sight for the misery that is likely to befall the housing business and the vast majority of the real estate markets around the country.
at 10/3/2007 9:07:44 AM, Joe Pullen said:
Until our society learns not to live on borrowed funds, the credit crisis will be around forever. Most families today have a huge amount of credit card debt. They are only able to make their minimum monthly payment which means they will never retire their debt. The mortgage industry has made millions of home equity loans. The families that have paid off their debt with a home equity loan cannot afford to sell their home because there is no equity. We will have to embark on an aggressive educational plan to change our younger generation notion of satisfaction now instead of saving for our future. We also have to turn around the current savings rate of our nation.
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