This article takes a detailed look at the causes behind the severity of the current real estate downturn and the necessary steps on the path towards recovery.
In 1998 America’s central bank, the Federal Reserve (the Fed) started raising short-term interest rates to induce a routine business recession. As planned, the recession took hold in early 2001. However, the effort to cool the economy was short-lived since the economic reaction to September 11, 2001 froze the price of homes at their peak.
Without real estate going through the normal downward market movement to return prices to their historical pricing trend, the stage could not be set for sustainable future real estate prices. Thus, owners of real estate were erroneously led to believe they had come under a new paradigm in economics. This hazardous myth prophesied that the deregulated markets, which had evolved since 1980, would never allow real estate prices to fall below peak levels, but would merely stabilize them for a period until demand would again push prices upward.
After September 11, the Fed and the U.S. Treasury opened the floodgates controlling the flow of money into mortgages. The Fed assisted by lending and buying treasuries in the money markets. In doing so, the Fed added large amounts of fresh cash to the supply of money available through bankers of all sort, be they mortgage or Wall Street bankers.
The cheap, short-term money to provided upwards of $2 trillion dollars for lending on ARMs at teaser rates, all with the express government intent to induce tenants into homeownership. This practice was consistent with the government’s ultimate goal of driving the percentage of homeownership in the U.S. from the stable 64% figure of the prior 20 years to a destabilizing 70% of the population.
The potential disadvantages of homeownership for those seeking new or transferred jobs due to job loss, an improvement in their labor skills, or coping with family dysfunctions such as divorce or disease, were never part of the dialogue. Tenants who turned into first-time homeowners purchased real estate without the requisite understanding that they no longer had the mobility to move freely about the country. They became prisoners in their own homes since they could not quickly sell them.
This flood of money was both in excess of the true needs of people paying for shelter (as either tenants or owners) and cheap for the bankers to borrow (from the Fed and depositors) or receive (by taking profits on bonds driven up in value due to activity of the Fed). The excess continued until July 2004 when the Fed began to slowly cut off bankers’ easy access to the Fed’s unlimited pool of funds by continually increasing the interest rate. This action significantly reduced the flow of funds into mortgages.
Releasing more than just money: mortgage market deregulation
During the same period, the U.S. Treasury and Congress (encouraged by the Fed) continued deregulating and removing the lending parameters restricting mortgage lenders and Wall Street bankers, a process which had begun in the early 1980s. Deregulation allowed mortgage lenders to take on ever riskier lending activity until 2007, the year mortgage borrowers began defaulting and drowning mortgage lenders with foreclosures caused exclusively by imprudent lending practices.
At the time, the tortured reasoning behind the extensive deregulation of mortgage lenders was that Wall Street would look out for its own best interests. Therefore, excessive risk-taking would not be allowed by mortgage lenders as it would destroy its business of making and bundling loans. This flawed behavioral theory of economics overlooked the force behind comparative advantage between competitors of equal footing. Comparative advantage is a force which drives Wall Street mortgage bankers to produce ever greater profits in a race to retain private sector investors who would otherwise go to the competitor producing a greater profit.
Underlying all this action was the Reaganomics doctrine that free enterprise functioned at its best when the risk was high enough to compel companies to set up appropriate parameters for safe lending in the mortgage markets. Government interference was seen as the problem, not the marketplace entrepreneurs.
Wall Street bankers became more actively involved in the mortgage business in 2002. They willingly bought thousands of real estate loans at premium prices from mortgage bankers who originated them as rapidly as the Wall Street gang demanded. Wall Street then bundled these real estate loans into pools of mortgages, each pool being separately managed under pool servicing agreements (PSAs), called servicing. Participation in the pools was then sold to investors in the bond market to recover the funds advanced by Wall Street to buy the loans, the cost of bundling and selling participation in the pools, and profits.
Each pool held the mortgages as the assets which backed up the market value of the bonds issued by the pool and provided monthly income to cover the interest due the bondholders. The bondholders eventually consisted of millions of small and large investors, individuals and institutional, domestic and foreign alike. However, no one bondholder held any one mortgage. Instead, all bondholders in a pool indirectly held a minute interest in all the mortgages held by the pool. This created a chaotic environment, unlike the Dutch system of mortgage backed bonds which allows homeowners to pay off their loans by buying the mortgage backed bond at toxic asset prices in the bond market.
During the rush to buy loans originated by mortgage bankers around the nation, Wall Street began buying up the mortgage banks to get direct control over profits from both the loan origination and bundling/securitization phases. Thus, they could simultaneously originate loans at better rates and on more risky terms than a traditional mortgage lender and resell fractional interests in those loans via their mortgage pooling to investors in bonds — now a world-wide effort — as U.S. dollars accumulating in foreign banks needed a “safe” place to go. Bond rating agencies all collaborated with Wall Street bankers (for a fee) to assure bond investors all over the world that the mortgages backing their bond acquisitions were as good as U.S. Treasuries.
Tranches were created to entitle different classes of investors within a pool to different priority claims on the interest income from the mortgages, similar to third and fourth trust deed holders who have junior priority claims to the value of real estate securing their loans.
This Wall Street modus operandi was perfected by late 2004 when the Fed belatedly started to slow the flow of funds into the economy by raising interest rates on short-term financing. However, it was short-term financing that had supported the initial Wall Street involvement in mortgages. But by the time short-term rates began to rise, Wall Street was almost exclusively relying on investors in mortgage-backed bonds. Wall Street no longer looked to the Fed to replenish the coffers of the involved mortgage bankers and mortgage loan brokers who were producing the flow of loans they needed to bundle and sell into the bond market.
The money supply had been increased by the Fed to keep all type of bankers and bond investors flush with cheap cash to invest. After 9/11, the Fed lent at extremely low rates (until their mid-2004 increase in short-term rates) to provide all the funds needed to finance government deficits (too little tax revenue and egregious amounts of expenditures), the demands of stock market investors for ever greater leverage in stocks and bonds acquisitions, and the real estate market’s need for mortgages and equity financing.
It also supplied foreign central banks with dollars so their citizens could get in on the cycle of profits seeming to flow from investment and consumer demands within the U.S. At one 12-month period during the Fed’s easy-money phase in the first part of the 2000s, the U.S. dollar supply increased nearly 25%.
Mortgage fundamentals vs. the American Dream policy
Considering the real estate investment cycles of boom and bust, the supply of money at cheap rates soon outran the demand buyers of real estate had for cash in the normal course of sales and refinance transactions. The excess mortgage money and equity investment funds were now managed conceptually based on Wall Street stocks-and-bonds analyses. The solid real estate fundamentals which are used to determine the inherent value of each parcel of real estate were not considered.
The uniqueness of each parcel of real estate which supported the mortgage-backed bond pools and made up the assets owned by real estate investment trusts (REITs) has never been understood by Wall Street. For Wall Street mortgage bundlers and first-time investors in real estate, all parcels look the same. Only the yield on the mortgages and profit on a parcel’s resale were used to determine real estate values. These parasitic individuals relied on the borrowers and future buyers to produce their profits, largely ignoring the causes of the risks posed by the failure of these parties to “perform.”
Going into 2000, the “American Dream” of homeownership was being aggressively pushed onto tenants. The government promotion was so successful it drove homeownership rates among the national population from 64% in 2000 to 70% by 2006. This race into homeownership was financed by $2 trillion in additional guarantees and borrowings by Freddie Mac and Fannie Mae, government-sponsored (now government-owned) entities. The funds came primarily from the Fed’s massive expansion of the money supply through their money-market operations. It should be remembered that the Fed has an unlimited supply of money, can never become insolvent, and is always repaid.
When money held by investors starts chasing real estate deals, be they acquisitions of ownership or mortgage lending, mistakes will be made. The more money and investors involved in the chase, the greater the magnitude of the mistakes. Rational analysis is either set aside to get in on the wild ride for profits, or it is overlooked by newcomers due to ignorance of the rules for judging an investment related to real estate.
Wanting to share in the resurgence of cash into mortgages and real estate equities, real estate brokers and appraisers rationalized their way into the extravaganza of buying, lending, and refinancing by limiting their determinations of value to only comparable sales. However, these sales were being driven artificially by the excessive availability of funds.
Real estate brokers and appraisers deliberately rejected the rational tone carried by historic valuation techniques of replacement cost approach (land, labor, and materials) and the income approach (present worth of future benefits of ownership). Even when the income approach was implemented, appraisers used a cap rate they divined from comparable sales prices, deliberately failing to capitalize the net operating income of a project with a rate which included a return of capital, a long-term yield (as though the property were clear of liens), compensation for asset oversight, a reserve for replacement of structural components, and a risk premium for adverse future changes in local demographics.
The call of the wild: scammers, fraudsters and speculators
In addition to the entrance of novice, first-time real estate investors indirectly packaged into real estate via REITS and mortgage-backed bonds, this environment opened the door to scammers, fraudsters, rent skimmers, adverse possessors, and speculators directly owning real estate as hit-and-run types, called flippers. These flippers sensed a quick profit in an artificial fast-moving rise in sales volume and prices.
Flipping ownership for profit was fertile ground for speculators beginning in mid-2003, and ending abruptly in early 2006, roughly a three-year run. Without the ability to resell within six months to one year, speculators who acquired property had to convert to landlording until market prices recover sufficiently to produce a return on their investment. If no profit could be made, they were forced to walk away with whatever price they could get, or worse: merely pass the keys to the lender under their put option in the trust deed.
Real estate scammers engaged in rent skimming by collecting rents from tenants, but deliberately failed to make mortgage payments to the lender. Scammers also appeared under the guise of foreclosure consultants, sometimes cloaked in Department of Real Estate (DRE) advance-fee approvals, or as attorneys (acting as brokers without a brokers’ licenses), and short-sale loan discount facilitators.
Real estate fraudsters posed a hazard for title companies as much as they did for lenders. Fraudsters stole the identities or misrepresented themselves as property owners to encumber properties with loans. Unfortunately, most mortgage fraud discovered by institutional lenders occurred through loans originated by mortgage loan brokers. This discovery resulted in institutional lenders avoiding loans packaged by mortgage loan brokers. Loan fraud also occurred when borrowers flipped property between controlled individuals or entities at artificially inflated prices, and, upon the final transfer in the series, applied for what appeared as purchase-assist loans, the type most sought by lenders.
However, on recording the loan and receiving the net proceeds of the financing, they never made a payment, as their profit had been received through the financing. The fraudsters then simply moved on to the next property to flip vestings at what appeared to be increased prices, finance the phony price on the last change in the vesting, and take another profit from the funds received on the refinancing. Fraudsters had quickly figured out a way to profit other than by selling property on a grant deed to a legitimate buyer. Thus, they left the lender (and the appraiser, and sometimes the notary) holding the bag on an excessive loan amount encumbering a low-valued property.
Others just forged documents to obtain a loan insured by a title company and left the insurer, not the lender, holding the empty bag – and at great cost to the title insurer as they had to pay out the entire amount of the insured trust deed loan without the ability to resort to any property, even for a partial recovery.
The tide of loan originations was turned back by higher mortgage rates, peaking in volume in August 2005. At the same time, the trajectory for the volume of home sales was beginning to peak, and did so six months later in early 2006. Home prices, the second shoe to drop in home sales during a recession, did not peak until late in 2006.
The mortgage scams and frauds that made the mid-2000s unusually risky existed in previous years, but were fewer in number. It was the chase by Wall Street bankers to originate ever more mortgages to be bundled and sold to remote bond market investors, all of whom had no sufficient grasp of real estate mortgage concepts or ownership default risks to protect themselves from the scammers and fraudsters that dealt in deceit.
All service providers affiliated with the settlement of real estate sales and loan originations, such as escrows, title insurers, mortgage default insurers, real estate brokers, etc., joined the hunt by employing great numbers of employees and agents. These tens of thousands of new employees were brought in during 2003 through 2007, and very few were properly trained to spot fraud, much less to prevent it from occurring.
Moving forward with cause and effect
The cause of the carnage in the real estate bust following 2006 was the Fed’s hyper lending through its open-market operations coupled with the utter failure of regulatory agencies to perform. Congress was a willing accomplice, deregulating mortgage lenders and their Wall Street bankers and removing what few restraints remained on lending after 25 years of loosening controls over mortgage lending. Without parameters within which lenders had to structure real estate loans, the forces of comparative advantage pushed Wall Street bankers to drastic leveraging to keep investors in their programs. This drove them to take on the excessive risk of loss built into ever more exotic loan terms, such as option ARMs.
Borrowers taking out ARMs generally had zero ability to pay after the ARM interest rates reset, an effect which gave ARMs the cheerful nicknames back as early as 1982 of ZAP (Zero Ability to Pay) and RIPOFF (Reverse Interest and Principal for Optional Fast Foreclosure) loans. At the time, all that experienced real estate brokers and investors could do was wait out the cycle.
Veterans of the industry knew the result would be a disastrous collapse of both property values and public confidence in real estate ownership and mortgages. They will now have to wait until the bust morphs into a stable (more specifically, flat) volume of sales and prices that remains constant for a period of 12 to 18 months. Then they will be able to acquire real estate below or at replacement cost with a respectable rate of return at a 9-11% capitalization rate more suitable to income property investments – a return to basics once again.
While the Fed mistakenly plowed hugely excessive amounts of funds into mortgage-market situations during the boom and drove prices up, the correct remedy for a recession (or worse) is for the Fed to pump great amounts of cheap money into the banking system for all types of lending in an effort to support prices before they fall too low for lack of funds to finance buyers. The future challenge of a well-administered Fed will be to pull back those excessive funds they fed into the banking system during the recession before prices of consumer goods start to rise more than 2 or 3% annually.
Also, the Fed must change its attitude about asset inflation. In the future, the Fed must act quickly when stock market or real estate prices start to rise. Prices will again rise in both types of investment assets, but at different times — stocks first, followed by real estate two or three years later. The Fed will need to drive short-term rates up and make the dollar scarcer to keep the lid on asset inflation, something they have only done once before — during the late 1920s.
Mortgage rates will continue to follow 10-year treasury rates at a 1.5% spread after settling down from the spread of 2% which developed after the mortgage bust in 2007. Thus, a 3% 10-year treasury rate will support a 4.5% mortgage rate when the confidence level of the American public rises. Confidence will rise throughout 2009 and 2010 as the public learns more and begins to understand the basic operations of central banks and the U.S. Treasury during times of serious economic recession, typically a one year process.
But the Fed, for the same reasons they bought long-term treasuries in an effort to keep mortgage rates down, can just as easily reverse course as asset inflation begins to take place (property prices move up more than 4-5% per annum) and sell long-term bonds at high rates of interest. The Fed can also push regulatory agencies and Congress to again regulate the risks a mortgage lender can take (down payment amounts, terms of the loan, type of appraisal – cost, income, and comparable approaches, repayment schedules, variable teaser rates, etc.).