What Caused the 2007 Mortgage Meltdown?
Act I. The “Perfect Storm”
The following is a brief overview of what has recently taken place in mortgage lending. If you are contemplating buying or selling a home, hopefully, this will give you some insights to help you make more informed decisions.
When a hurricane is being tracked before it hits land, it’s rated from a category one to five based on potential damage from wind velocity. In terms of economic damage, the mortgage meltdown of 2007 is like a category five storm. There is no doubt that what we are experiencing today is unprecedented in real estate and mortgage lending. In fact, in the last few weeks alone over $2 trillion has been lost in global markets because financial institutions in many other countries have also invested in our mortgage-backed securities. As in the movie “The Perfect Storm”, there wasn’t just one thing that brought about this disaster. It was a combination of factors, all perfectly aligned that brought about this crisis.
Act II. What happened?
First of all, in order to stimulate the economy, there were 12 straight rate cuts by the Federal Reserve in 2001 and 2002 totaling 5.25%! This led to a sharp drop in mortgage rates, especially for adjustable rate mortgages (ARMs) and homes became much more affordable. It also led to an over-heated housing market, especially in California, Nevada, Colorado and Florida. Skyrocketing home prices also brought in a wave of real estate speculators, driving up prices even higher. If wages are going up 3 to 4% and the price of homes in some areas is going up 15 to 20%, what to you think will be the ultimate outcome? Let’s find out…Fewer and fewer buyers could qualify for payments with traditional financing, so “alternative” and “sub-prime” loans became a popular solution to close this gap. With values escalating, lenders felt more confident in making loans to customers whose poor credit histories had prevented them from buying homes in the past. More equity meant less risk because a borrower could either tap the equity or sell the home if they ran into trouble. From 2001 to 2006, this “Sub-Prime” loan market grew from less than 9% of the total market to over 20%. At the same time, many of the “creative” financing programs, the so-called “Alt-A” loans (loans based on credit score criteria without the traditional proof of employment income) that had been marketed primarily to high-income borrowers, such as interest only loans, pay option ARMs and stated income loans were opened up to marginal borrowers who could not qualify for traditional mortgage loans. These loan products allowed more Americans to own their own home than ever before and eventually accounted for more than 40% of all the home loans originated! 2004 saw homeownership reach a record 69% of households. These loans were also highly-profitable [GREED] and the large banks saw a way to reach more borrowers without the expense of operating a large number of branches by using mortgage brokers. Mortgage brokers have become the largest segment of the mortgage industry. They make fees for finding the customer and then transferring the loan file to the bank for underwriting and funding. Between 2001 and 2006, mortgage brokers generated about 75% of the sub-prime loans and almost 70% of the Alt-A products. Unfortunately, many borrowers were not adequately counseled about the loan they were getting, or they were sold a loan that was the most profitable for the mortgage broker. During this time, there was very little state or federal oversight of this independent sales force. [Note: Not ALL mortgage brokers are unethical.] Then in 2006, as the “teaser” rates ran out and rates adjusted to more than double the payment, foreclosures began to increase and values began to drop. At the same time, borrowers who had made the minimum payment on their pay option ARMs found that their loan balance was higher than the home’s value. This was the “recipe for disaster” that we are experiencing today.
We are now in what the economists call a “liquidity squeeze”, where money will be more difficult to borrow. It means that most buyers will actually have to have a job, money for a down payment and decent credit to get a loan.
Act III. What’s next?
With credit tightening, a large number of people will now be unable to buy a home. That number is estimated to be about 15% of borrowers who will be impacted. In the last 5 years we have averaged about 6 million homebuyers a year in the U.S. That means that about 900,000 buyers are now out of the market. However, people will still have to sell homes and therefore, inventory may climb to 12 months or more in many areas. Foreclosures are up 47% from a year ago with Nevada, Colorado and California having the most filings per number of households (5 times the nation average). Those numbers will likely increase as ARM adjustments on sub-prime loans peak this year. Although that all sounds like a bleak picture, let’s put the numbers in perspective. There is about $10 trillion in mortgage debt in the U.S. and only a small portion of that amount is at risk, not enough to reach a tipping point that would bring the whole housing market down according to the chief economists at Standard and Poors and Moodys. The reason is job growth and low unemployment. Consumer confidence is at a 6 year high. The Fed and European Central Bank have stepped in to provide liquidity for immediate needs. I believe that the Fed will be cautious in how much money they put into the economy, in order to keep inflation under control. Inflation has a much larger impact on interest rates long-term than the current mortgage crisis.
What should SELLERS do? They should get real about pricing. Even in the strong market that we have (compared to the rest of the country), there are now 15% fewer buyers. Absolutely never accept an offer from a buyer who has not been fully pre-approved by a reputable lender. Ask questions about the type of financing the buyers are using. Stated or no income verified loans are still out there, but could disappear right before closing.
What should BUYERS do? 100% financing will still be available for buyers with good credit for conforming and government loans. It will be harder to find in the jumbo market (loans of more than $417,000) and when it IS available, it will be at a much higher rate. Second liens will be more difficult to get, so PMI will be a more viable option in the future. Most important of all, buyers should be fully approved for a loan BEFORE they begin looking at homes, because the rules have changed.
Buyers and sellers need the advice and guidance of a competent realtor more than ever. This crisis, although serious, has affected only a small segment of the housing market and only lenders who had focused on risky types of loans. While the media has hyped this as a huge local crisis in order to sell newspapers, what we are going through is a “correction” of bad lending practices where loans were made to people who should have been renting until they built up their credit and assets. We are now back to normal underwriting guidelines that we had in the 1990’s.
Epilogue. Losers and Winners
The losers are the “losers” who used predatory lending practices to get borrowers into loans that they had no business doing. They are out of business. There is a huge segment of the mortgage industry that has been virtually unregulated for over 15 years. That is about to change. Unfortunately, it usually takes a disaster to bring about needed reform. Some Realtors are also complicit in this meltdown for not being more involved in their buyer’s choice of a lender and loan program. Many agents knew that they smelled a rat, but chose to look the other way and close the deal. In that case, the customer was the loser.
The winners are all of us who are blessed to live on the North Shore! Although we will not be unaffected by this financial crisis, it will have far less of an impact than other parts of the country. Buyers will be winners because there will be more homes available at more realistic prices as borrowers “bail out” of their escalating loans. Many are just waiting for the pre-payment penalty period to expire. Sellers will be winners because the central Texas job growth will continue to attract home buyers. Honest mortgage advisors will be winners because they will be seen as a valuable resource for making smart financial decisions, rather than just providing a loan. Seriously, the best news is that we will eventually be back to a “normal” real estate climate. It will be painful, but the honest and dedicated professionals who put the CUSTOMER first will survive and prosper more than ever.
Risé Johns has been involved in real estate for over 27 years. Her knowledge, experience and customer service will make your next real estate transaction a smooth one. Call Risé at (512) 267-LAGO for “World Class Service.”
