Thursday, June 02, 2005

There's A Train Wreck a-Comin'

The Real Estate bubble is now generally front page news and is starting to be recognized as a national phenomenon. This bubble dwarfs anything seen even in the 1920's. A year ago the Washington Monthly had an article that examined the situation, and it's only gotten worse -- much worse -- since then. The Dot Com wipeout was an obvious foregone conclusion to anyone paying attention in the late 90's. It's hard for me to see how Real Estate is going to be any different.

Excerpt from the article:
Fortunately, the bad actors responsible for this manic inflation are pretty easy to recognize. They look remarkably like the ones who puffed up the tech bubble in the late 90s. In both cases, the unfettered optimism of the buying public was fueled by a brokerage industry almost wholly concerned with making a sale, independent analysts with an incentive to hype prices, and major accounting fraud.

What drives most appreciation in housing prices is the universal human desire to own a slightly larger and more expensive place than one can really afford; a desire restrained in normal times by the universal desire of those who lend money to get paid back.

Getting a home loan used to be a particularly nerve-wracking and unpleasant process. A stern loan officer behind a big mahogany desk would pore over your income and credit, suspiciously probing your portfolio for weaknesses. And sensibly enough: The bank that lent you the money would have to collect on the mortgage for the next 30 years and had to make sure you were really good for it. It hired independent appraisers to make sure the price was in line. This process was a little stingy, and meant some people on the low end of the income scale couldn't buy a home and many others got less home than they might have wanted, but the system usually kept prices in check.

The one exception to this general process was mortgages sold on the secondary market. In the 1930s, Congress created the Federal National Mortgage Corporation (Fannie Mae) to encourage banks to make loans to low-income Americans by agreeing to purchase those mortgages from the banks. In 1970, Congress created a second agency, the Federal Home Loan Mortgage Corporation (Freddie Mac), to do much the same thing. By the late 1980s, these two entities, which belong to the category known as Government Sponsored Entities (GSEs), were buying up and reselling 30 percent of new mortgages and packaging the mortgages to be sold as securities.

Fannie and Freddie's market share was limited by their ability to attract investment capital. But in 1989, Congress instituted some modest-seeming technical changes that made Freddie and Fannie much more attractive to investors, and able to draw much more capital. Under the new rules, for instance, they were allowed to customize securities at different levels of risk and return to meet more precisely the demands of different sectors of the capital market. Then, too, bank regulators let pension funds and mutual funds class Fannie's debt as low-risk. As a consequence, during the 1990s, investors practically threw money at Fannie Mae and Freddie Mac, which became enormously, steadily profitable. The GSEs used the new capital to buy up every mortgage they could, and banks were only too happy to sell off the mortgage paper. The price cap on the mortgages Fannie and Freddie could insure was raised. As a result of all these changes, Fannie and Freddie went from buying mostly mortgages for low-end homes to those of the middle- and upper-middle class. And the share of the nation's conventional mortgage debt which they insure has swelled, to more than 70 percent today, double its share in 1990.

This shift has had two crucial, if under-appreciated, consequences. First, in little more than a decade, Fannie Mae and Freddie Mac have gone from handling one trillion dollars in mortgages to four trillion, with virtually no changes in oversight. Second, their dominance of the mortgage market has profoundly undermined the discipline that once kept housing prices in check.

Once banks knew they could automatically hand off the mortgages they wrote to Fannie and Freddie with basically no risk, the old incentive system dissolved. "Banks and other mortgage lenders are not watching home prices carefully because they rarely hold onto the mortgage paper they create--they just sell it upstream to mortgage investors," John R. Talbott, a housing researcher at UCLA's Anderson School of Business, has argued. "It is a dangerous situation indeed when neither home buyers nor the institutions that finance them are concerned with the ultimate price being paid for the housing asset."

In most markets, buyers and sellers rely on independent experts to bring sanity to prices. In the stock markets during the 1990s, that role had traditionally been played by stock analysts, whose opinions were famously bought off by the investment banks they worked for. Something similar has happened to appraisers, the independent contractors banks hire to determine the worth of a home for the purposes of a mortgage loan. In a recent survey conducted by the October Research Group, more than half of all appraisers said that they personally felt pressured to overstate loans, and "nearly all" said they knew a colleague who had actually done so. The pressure to inflate, October's publisher Joe Casa said, "is much worse now than it's ever been." Industry analysts have estimated that between 15 and 30 percent of houses nationally are over-valued.

It's not just the discipline of banks that keeps people from buying more than they can afford, but also the buyers' own fear and guilt. But in an environment where home prices continue to spiral up, fear and guilt are replaced by a sense that you're a fool not to buy the most house you can possibly get away with.


What makes the current frenzy especially dangerous is that every relevant institution has an incentive to play along. Who, after all, is likely to say stop? Not the realtors. Not the banks, any longer. Not Fannie and Freddie or the private secondary-mortgage operators, who are turning vast profits on the backs of the bubble. Certainly not the Federal Reserve or the Treasury Department, while the economy depends on a sustained housing boom.

Ah yes, Fannie and Freddie. The government just trying to help. Making homes affordable. Great work, guys.

1 comment:

Amber said...

I really wonder what the straw will be that will break this camel's back. Everytime it seems like people's incomes are tapped out, some new crazy mortgage product comes out that allows people to stretch just a bit more and keeps the whole thing rolling along. I recently read about option mortgages (I think that's what they are called) where you pay around 1.5% APR for the first month, then it goes up to 5.75% after that, however your mortgage payment for the first year stays the same as it was in the first month. The extra expense? It just gets tacked onto your mortgage. And to dig the person even deeper into a hole, the mortgage payment can't go up more than 7-10% each year for the first 5 years, so the mortgage holder may not end up even paying for the full monthly interest on the loan for years... all the while, the mortgage amount gets bigger and bigger. Yikes, who thought up such a dumb idea, and why would *anyone* go along with it??

I must admit though, the opportunist in me is hoping to pick up a nice foreclosure a couple years from now once all these interest only ARMs and such start requiring hefty payments...

Anyways, yes this is a subject I follow pretty closely too - thanks for posting that article. I'm always on the lookout for further evidence of the insanity!