For well over a decade, I worked in the mortgage and banking industries helping to finance the “American Dream.” However, in late 2004, I walked away from my job and the public company I helped create. I left not only my company, but also the industry all together. Why? I felt like I was a buffalo in a mass herd of greed that was about to run off a cliff. The real estate market was becoming vastly overvalued. The big Wall Street firms were creating mortgage products allowing virtually anyone to qualify for a $500,000 plus mortgage. Real estate agents and mortgage bankers were encouraging the stampede. People earning $150,000 a year were taking on million dollar interest only mortgages with adjustable rates and little or no money down. The greed was fueled by ever increasing real estate prices and the ability to use leverage in a rising market. As it turns out, I was about a year and a half too early from a well timed exit.
How Did We Get Here? We Are All To Blame
Congress and the press have hammered the mortgage industry and the big Wall Street firms for the subprime loan debacle, the ensuing credit crunch, and the collapse of the residential real estate market. Ultimately, we are all responsible. The blame must be cast broadly. Let’s take a look at a few examples of some of the culpable parties.
Wall Street: For years, the mortgage industry was dominated by banks and mono-line mortgage companies. Then, the big Wall Street firms like Merrill Lynch, Lehman Brothers, and Bear Sterns entered the picture. The new players created “exotic” mortgage products that could be bundled and sold as mortgage backed securities to investors on Wall Street. With these loans, mortgage brokers and bankers were able to provide loans to people with no money, no income, and bad credit! These loans were then packaged and sold on the secondary market as AAA rated bonds. These new products were like releasing tigers into an already stampeding buffalo herd. I believe this group should take the largest portion of the blame. In their quest for outsized profits, this group not only has damaged the real estate market as a whole, but practically destroyed the credit markets as we know them today.
Loan officers and Real Estate Agents, eager to earn bigger and bigger commissions, encouraged their customers to buy larger houses. Not enough money for a down payment? No problem, there are plenty of 100% financing alternatives available. Can’t afford the payment? Go with a negative amortization loan or an interest only loan. What if the customer can’t make a payment later? Neither the loan officer nor the real estate agent has a stake in what happens to the customer after the home closes. The real estate agent gets their commission and the mortgage broker sells the loan within ten days of closing. This group, myself included, should take second place in the blame game.
Financial Planners/Investment Advisors: On radio talk shows, books, blogs, and newsletters, financial planners and investment advisors encouraged their clients to buy the big houses and leverage them to the hilt. Others encouraged their clients to take cash out of their homes and invest the difference in the latest investment du jour. By utilizing cheap credit, Americans could leverage a small down payment into a fortune.
The Government, the Federal Reserve, and the “Quasi Governmental Agencies”: Congress and the president continue to push for greater home ownership in America. Presidents and senators alike routinely tout homeownership rates as a measure of success. The Federal Reserve helped fuel the fire by pushing short-term rates to record lows of 1%. Mortgages, especially Adjustable Rate Mortgages, became temporarily cheaper and cheaper. Meanwhile, Fannie Mae and Freddie Mac expanded their product line from conforming loans to “Alt A” and subprime. Everyone got into the game.
(click to enlarge image)
The Press: As usual, it is the press that adds significant fuel to the fire. Here are some head lines from some of the top US Magazines. Too late on both occasions, note the timing of the headlines and the timing of the articles:
The Herd, i.e. all of the rest of us:
Fueled by greed and the desire for bigger and bigger houses, Americans super-sized their home purchases and bought homes they could not afford. The buy now, pay later mentality enhanced the demand for interest only loans and negative amortizing loans. The speculators, flippers, and “investors” with little knowledge of boom and bust cycles pushed the herd into a full stampede and then vaporized at the bottom of the cliff.
Where Are We Now?
As of December 31st 2007, the S&P Case/Schiller Home Price 20 City Composite Index has dropped 9.1% from a year ago. This is the largest decrease in the 20 year history of this index. For comparison purposes, the 90-91 housing recession bottomed at -2.8%. The table below shows each of the 20 markets represented in the Index. Miami, Phoenix, and Las Vegas top the list with drops in excess of 15%. For more information on how this index is calculated, go to http://www.homeprice.standardandpoors.com/
(click to enlarge image)
According to the index, nationwide housing values peaked in May of 2006 at an index value of 205 or roughly two times the value of a home in 2000. Thus, home prices more than doubled since the beginning of this century. In the Washington DC market, which includes Northern Virginia and Maryland, average home values peaked at nearly 250% of value in 2000. The December 2007 figure is down 10% from its peak nationally and the Washington DC market is down 13%.
Using the same index, we find that today’s home values have now fallen back to their levels of April of 2005. If you purchased your home prior to the spring of 2005, you may not have experienced a drop, yet. These statistics are national in nature and reflect averages. Homes in places like Portland, Seattle, and Dallas have not experienced much of a drop. This is because they did not participate in the run-up that other areas experienced.
Another well known housing index is published by the OFHEO (Office of Federal Housing Enterprise Oversight), the group that authorizes the annual “conforming loan limits” for Fannie Mae and Freddie Mac. This index shows a much milder drop including an annual price decline of just 0.29% and an annualized fourth quarter 2007 drop of 5.16%. The major difference here is that this index represents loans closed by Fannie Mae and Freddie Mac, which for 2007, were all below $417,000. As you would expect, lower priced houses have not decreased nearly as much as higher priced homes.
Below is a table summarizing the two indices over the past five years:
Where Are We Headed?
In the last major residential real estate cycle, the peak of the market was reached in October of 1989 and it was not until January 1998 before the market came back to its 1989 peak. Will the current cycle be similar? Not likely. The run up in prices and the disparity from personal income is far greater during this cycle than in the late 80’s. It now seems likely that we will have a 20% market correction from the peak to trough that was reached in May of 2006. This is in line with the prediction I made in 2005 when I stated we were due for a 10% correction. This would put values at the summer 2004 level using the Case/Schiller Index. The good news is that we are more than half way there.
As with many boom and bust periods, a market that is artificially pushed to extreme heights takes many years to come back. For example, gold prices peaked in 1980 and did not come back for over 25 years. The same goes for most of the internet companies that were vaporized in the dot bomb era and in nearly every other boom bust cycle. The NASDAQ market index is less than half of its peak in 2000. However, during each of these cycles, there are incredible opportunities to pick up the survivors at very cheap prices. While I do not believe there will be a material rebound for a few years, the opportunity to pick up some choice real estate at depressed values has not been this good since the early 1990s.
The next time you see a herd of buffalo stampeding your way, such as the current commodities markets, head in the other direction!
