(BETHESDA REAL ESTATE) Dave Stevens, President of Affiliated Businesses, at Long & Foster wrote this excellent article on the current state of the mortgage correction...
The 2007 Mortgage Correction and the Recovery Ahead
With the lowering of the discount rate by ½% the Federal Reserve took the first major step to lead the way in establishing a path towards the next stage of the housing cycle. The following will highlight for you the steps that created the current market climate and the reasons why we are poised for recovery in the mid-Atlantic markets.
The beginning of the big change
Since the peak in mid 2005, the sale of existing and new homes has slowed, reflecting a correction long overdue after an almost decade long un-interrupted period of housing growth and house price appreciation (hpa). This housing slowdown was aided by two key items that helped stall the market beyond any natural timing of the overdue economic cycle. First, we saw a slight increase from the record low interest rates of 2003. As the graph below reflects, interest rates adjusted in 2003 and the corrective period following only foreshadowed the subsequent housing correction in 2005 as the steam from excessive liquidity was impacted by these rising rates.
While the absolute change in the average 30 year fixed rate increased minimally compared to the historical perspective as shown here, this approximate 80bp change from the 2003 low to the post 2003 high fueled the beginning of the correction we are now experiencing.
Adding fuel to the fire:
Compounding the impact of this interest rate correction was the fragile nature of the credit markets that were exposed to a new risk layering that, combined with little interest rate relief, began showing its impact in the sub-prime markets but soon spread to even the prime markets.
The combination of factors, reduced documentation mortgages and low credit scores, layered on top of a variety of adjustable rate products, including interest only and negative amortizing products, resulted in a much higher than expected level of defaults, as the table below shows.
Many of these mortgages were pooled into non-agency, private label, mortgage backed securities with ratings from agencies such as Moodys, Standard and Poors, and Fitch, that did not perform as expected. The securities were sold to investors around the globe at premium prices reflecting their agency ratings. There were two fragile factors, however, that ultimately toppled the market. First most of the mortgages, sold from lenders to Wall Street conduit firms responsible for packaging them in securities for sale, had early payment default (epd) language in them that obligated the lender to repurchase them in the event that one, or some, of the first few payments became delinquent. This became the case and billions of dollars on delinquent loans were returned to lenders across the country for repurchase, per their contract obligations.
Thus began the first crack in the soon to come mortgage meltdown. Companies like Own It, Harbourton, and other less capitalized institutions that focused on sub-prime mortgages exited the industry abruptly, faced with the enormity of the re-purchase obligations from the investors. But, unfortunately, this was just the beginning.
The next crisis to hit the markets would only exacerbate the shock value. With the market already jittery, faced with the sub-prime crisis, the loan performance on other alt-a and prime books were showing the signs of weakness. Unfortunately, since rates had moved slightly upward, ending years of endless improvement, the home price appreciation and home sales had leveled or were slowing in most markets. While this would normally be a case for a normal correction, headed for a "soft landing", the unstable financial markets would fuel this correction. As the table below reflects, delinquency rates tend to naturally rise when home values de-flate.
So now the international markets that had invested for years in this un-ending US mortgage market, fueling it with un-ending capital, were experiencing a different picture. Sub-prime loans were defaulting and forcing the failure of institutions, some with large names like "Ameriquest". Now other non-agency mortgage pools were showing their weakness, filled with no-doc mortgages, interest only ARM's, and a variety of other layered risks. Managers of pension funds, who, for years had felt mortgage securities to be safe investment, saw their values declining rapidly. Foreign investors like the bank of china began to shy away from investing in the US mortgage market. Suddenly, liquidity for anything non-agency (not sold as a Freddie Mac or Fannie Mae security with their guarantee) mortgages dried up.
So what happened next?
American Home mortgage, like many other non-bank mortgage banking firms, had no place to sell their mortgages. American Home suddenly found itself holding a large balance sheet of unsold non-agency mortgages without the capacity to retain them nor any outlet to buy them except at some enormous discount to their original value. For American Home it meant failure. This collapse of one of America's largest mortgage institutions only added to the fear factor. The market went instantly dry. There was no outlet anywhere in the world to sell a jumbo mortgage. This meant the end for dozens of other institutions like First Magnus, Greenpoint, and First Bank of Arizona, all who had to exit the business. The markets became very volatile, and the media only added to the intensity through their evening broadcasts of the "liquidity crisis".
The reality is that this was both liquidity and a credit crisis and while liquidity will return, the impacts to credit will be far more extensive. For the weeks/months following this rapid series of events that caused such an enormous disruption, the only investors left in the non-agency markets were the major banks that had the balance sheet capacity to hold the mortgages and retain the risk on balance sheet while waiting for the markets to normalize. Only the large banks like Bank of America, Wells Fargo, Citi, and JP Morgan/Chase, and several others committed themselves to the industry and had the capital to sustain this correction with least impact to the market.
As the market normalizes, and the Federal Reserve participates by fueling liquidity in the form of cuts in the discount rate, we will see the return of the non-agency market, but it will be far different from before this crisis occurred. 100% loan to value, piggy back mortgages (home equity and 2nd mortgages), reduced and no-documentation, and unique mortgage products such as interest only and "option" arms, will no longer be provided in combinations that result in risk layers that result in defaults at these levels. Lenders will have to show more capital to be extended credit from investors, and underwriting of mortgages will require greater scrutiny from originating lenders in order to help insure that borrowers are getting mortgages they can afford to keep.
A recovery on the horizon?
The market for anyone looking at Housing in the metropolitan Washington DC area is far different than anywhere else. If one is looking to buy, there is a strong argument to be made that buying now may be one of those unique opportunities that happen so rarely in economic cycles. Why do I say this? Four simple reasons:
- The economic strength of this area.
- The inventory on market or relative lack of
- The interest rate perspective
- The rally to come
- Economic Strength: This market area outperforms most national markets. The broad based economy. The employment forecast for the metropolitan Washington DC area calls for a shortage of skilled labor to fill the anticipated job demand from employers. The chart below reflects the fact the metropolitan Washington DC area is at economic full employment and performs better than the national average.
- Inventory: There are two charts below that show key variables. First, new home inventory is not as prevalent as in past corrections. Builders reacted quickly to this market correction and simply backed away from many planned developments. The availability of existing home stock is actually low and, with the coming recovery, this could be inflationary to home values. The second slide shows days on market for listings in our area. As you can see, while days on market have risen, this market performs very well and better than most. This reflects the unique economic strength and the fact that real inventories are not that high relative to the core demographic economic strength of the Washington-Baltimore area. Never the less, the inventory is stronger than is past markets, providing opportunity for buyers to purchase their preferred home with the ability to negotiate.
- Interest rates are close to historical lows. Look at the history of interest rates below. Today, while we sit near the historical lows for mortgage rates, the facts are that, for most of history, interest rates have been higher. The ability to lock into these rates now will save a homebuyer a significant amount of money over time. Failure to act in this current period could end up being a costly error to any prospective buyer sitting on the sidelines.
- The Rally to Come: With federal intervention on rates, a strong core economic market in the Washington-Baltimore area, reduced inventories of new homes, and historically low rates, the market is poised for a housing recovery. The pent up demand building for housing will be fueled quickly by the increased money supply from the fed and the calming of the industry as we come out of the trough, which many believe we hit in the third and early fourth quarter.
The ability for buyers to act during this near bottom of the buyers market is critical. The buyers market we are in now is rare when combined with historically low rates and strong economic fundamentals. When the recovery begins, which may be soon, the loss of inventory will mean less selection and less bargaining power for the prospective buyers and potentially (depending on timing) the loss of this perfect storm we are currently experiencing, where inventory and interest rates both exists put buyers in the best market position possible.
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