According to the Richmond Times-Dispatch, September 7, 2008 is deemed the beginning of the American economy's "crash." Most economists point to the real estate markets - both residential and commercial - as a leading cause of the crash. It seems to me the plain English, big picture "cause" is the same for both the residential and commercial real estate markets: the credit markets were WAY TOO LOOSE. Here's how it went in the residential world. I'll talk about the commercial side in more detail in another post.
THE RESIDENTIAL REAL ESTATE CRASH
In the residential world, credit restrictions were relaxed to allow more people to purchase. What that meant was (i) less down payment money was required, meaning the buyer had very little equity in the property; and/or (ii) people with non-traditional employment, such as the self-employed and people with commission-based compensation, were allowed to borrow with extremely relaxed documentation standards. This resulted in what was called the "low doc" or "no doc" loan, short for "low documentation" or "no documentation" loan. After the crash, these loans became known as "liar loans."
Take me as an example. As a realtor with 100% commission-based income, it's difficult to predict what my income ultimately will be from year-to-year. So, if I want to borrow money to purchase a home, I traditionally would have been required to (i) have excellent credit; (ii) have a substantial down payment - 20% of the purchase price or more; and (iii) provide substantial documentation to demonstrate that my income had been at X level over several years, and was going to be at X level, or X+ level, going forward. The underwriting standards - the process by which any financial institution would evaluate my creditworthiness for this loan - would be much more restrictive than those for the plain vanilla conventional buyer with steady employment and income.
In the go-go days of the 1990s and early 2000s, when housing prices were appreciating at astronomical double-digit rates and people began to believe this was a new paradigm, that unchecked appreciation would go on forever, lenders began relaxing the lending standards for people like me. They began to rely on (i) credit scores; and (ii) past and anticipated income, based almost solely on what an individual said they earned. Lending institutions required very little actual documentation - tax returns, 1099 forms, etc. - to establish past and current income. People said they made $X annually, and if the lending institution had an appraisal demonstrating that the home was worth an amount equal to or more than the loan amount, and someone could afford the mortgage payment based on $X annual income + credit score, well, have some money!
The appraisal is another piece of the puzzle besides buyer creditworthiness. The lender had to be confident that the asset backing the loan, the actual house, was worth the loan amount. This was to ensure that the lender could recover its principal, the amount of money lent, if the lender had to foreclose on the property.
So, let's look at an example of a hypothetical purchase. I'll be the hapless buyer. I find a house I want to buy, and the seller and I reach agreement on a purchase price of $100,000. In the traditional conventional lending environment, a lending institution would only lend 80%, or $80,000, of the purchase price and I'd have to come up with that 20%, or $20,000, as my down payment. That 20% is my "equity" in the property. Lending institutions would require the buyer to have contributed at a minimum this amount of value. This is to protect the bank, in case I can't make my payments. That $20,000 in value that I've contributed, my equity, is the "cushion" for the bank to make sure they get back their full $80,000. So, say I can't make my payments and the bank forecloses. They are going to have to pay the attorney that handles the foreclosure, an appraiser to review and evaluate the property, someone to get the property ready for resale, and any buyer's agent's commission upon sale of the property. So there goes that $20,000 in equity. From the bank's perspective, they hope those expenses related to foreclosing and reselling the property don't exceed the original equity contributed by the buyer or gained in appreciation, or they lose money on the deal.
So, what happens if the bank lends me 100% of the purchase price with a no doc loan? Let's say I've said I make $80,000 annually, but I actually make $25,000. What happens if I can no longer make my payments and the bank has to foreclose? And let's also assume that the appraisal is faulty, and the house actually isn't worth $100,000, it's only worth $75,000. If the bank takes back the property, resells it after foreclosure for its actual $75,000 value, and incurs $10,000 in expenses, they are in big trouble. They lent $100,000. They incurred $10,000 in expenses. So they are $110,000 "in." But they only recovered $75,000. So they are out of pocket $35,000, or 35% of what they initially lent. AND that's assuming they recover 100% of the property's actual value. AND that's just ONE deal. Imagine that multiplied by hundreds upon hundreds of loans.
So, why would banks make these 100% - and in some cases, 103% - loans?
There are a couple different reasons, IMHO. They are interrelated, so I'm just going to list them here, and then we'll sort them out later in a subsequent post:
- The federal government wanted to expand home ownership opportunities, so they lowered the lending standards;
- Government-sponsored entities ("GSEs"), Fannie Mae and Freddie Mac, were insuring these riskier loans;
- The front-line lenders were making good money off this expanded pool of buyers. They made the loan, took their payment, then sold that loan into the secondary market, for even more money. After that loan was off the books, they had no exposure;
- There was a market perception that the backing from the GSEs was iron-clad and guaranteed these loans; and
- The financial markets had a greater and greater appetite for securities that generated higher and higher rates of return.
This may be too simplistic an analysis, and there are other major contributing factors. But here's a brief synopsis:
- People who should not have been eligible for loans were borrowing;
- Property values were inflated;
- Lending institutions had few incentives to be more conservative in their underwriting standards, because they immediately sold the loans into the secondary market;
- Investors in the secondary market were buying these real estate-based securities, created by pooling large numbers of mortgages; and
- To satisfy the market demand for these securities, lending institutions created ever-more risky mortgage products and lent to ever-more risky buyers.
Can you say "vicious cycle?"
I'll try to address the commercial market and it's interesting twists and turns in another post. In the meantime, Happy Monday!
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