To determine what's ahead, brokers can benefit from a realistic look at the nonprime crisis
Paul L. "Buddy" Warner, partner, Jeffer, Mangels, Butler & Marmaro LLP
As published in Scotsman Guide's Residential Edition, February 2008.
It has been many years since the United States has seen a major downturn in the housing market such as the one taking place today. The U.S. Office of Thrift Supervision predicts that between $300 billion and $680 billion of adjustable-rate mortgages with teaser rates from the boom era of 2000 to 2005 will reset to higher rates this year -- and nonprime borrowers hold about 73 percent of them. Clearly, the market still has issues ahead.
The optimistic prediction is that the market will be stable -- if not disappointing -- this year, but it won't get worse. If this does become a recession year, housing will be the principal culprit. This has less to do with losses on mortgages themselves than with the dramatic increase in foreclosures and depressed housing prices. Consumers likely will borrow less -- especially against their homes -- to finance spending. They also will be less likely to make the purchases that fuel the economy.
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Who's to blame for this? Who will suffer from the fallout, and will anyone benefit? Overall, how will the different players react to 2008's market?
To find these answers, brokers can benefit from looking back.
Cause and effect
At the beginning of 2000, the Dow Jones industrial average stood at more than 11,000 points. It dropped to the low 7,000s toward the end of 2002, and it did not rise to 12,000 until the end of 2006.
In the first half of this decade, the equity markets also were fairly stagnant. Federal Reserve-regulated interest rates were the lowest they had been in about 40 years.
At this time, investors in the top tier, who could afford to take risks, bought hedge funds in hopes of achieving higher returns than they could obtain in equities or traditional income-producing instruments. Large underwriters created special funds to invest in higher-yield mortgages, creating credit availability to the nonprime sector that did not exist previously.
With this new credit, the homeownership rate increased by approximately 5 percent between 1990 and 2005. Many of these new homeowners used teaser-rate loans, out of which they could refinance if they made the initial payments during the one- or two-year teaser period.
To top this off, between 2000 and 2005, real property values increased rapidly, while inflation rates stayed low. In this climate, a nonprime candidate could borrow $100,000 toward a no-downpayment purchase and refinance after two years into a $120,000 property, transforming the terms to an 80-percent loan to value.
In July 2004, interest rates began to creep up. The market reached a saturation point -- the cash flow from nonprime mortgages stopped materializing, and many hedge funds saw a dramatic loss in value. The appetite for these loans disappeared.
This left mortgage brokers in a bind. Few investors wanted to purchase the loans they could originate. Borrowers in need of refinances soon faced a world without the type of nonprime loans for which they originally could qualify. Meanwhile, foreclosures reached record highs.
Hence, the current crisis.
Winners and losers
The only immediate winners from this crisis will be those few investors who somehow anticipated a decline in the market and the derivative securities that supported the securitization of mortgages. Other winners, of course, are those who sold their homes at an inflated price and got out of the real estate market altogether. Shrewd investors who purchase cheap foreclosed homes now and can hold them until the crisis passes and the market rebounds also stand to profit.
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