The US Mortgage Market: A look back at the past (Part 1)

shutterstock_211430341This is the first installment in a 3 part series where we are going to delve into some of the causes and effects which led to the great mortgage meltdown and the resulting real estate recession.  We have broken down the 3 parts in this series into yesterday, today and tomorrow.  Basically where we’ve been, where we are and where we might be going.

In this first installment we are going to look into what caused the Mortgage Market Meltdown.

In the years from 1997 to 2006 the price of the average American house increased by over 124%.  This rise in the value of people’s homes led to the highest increase in net worth of American households over an equivalent time period in American history.  The equity in people’s homes quickly became their major net worth component.  During this time many homeowners made the decision to refinance their homes and pull cash out by increasing the balance of their mortgages.  They used the money obtained from their homes for just about any purpose.  Lifestyle spending was the predominant use of the money from their homes.

Easy credit and the belief that home prices would continue to go up was driving real estate prices higher each month.  The California real estate market was acting very much like the Wild West.  No one thought about consequences and the potential risks they were taking. The thought by many homeowners that home prices would never go down was the word on the street.   During this period the motto was “just about anything goes” and just about everyone got a loan.  If you had a pulse and fogged a mirror then you could get a loan.  If you had bad credit, no problem, there was a loan program for you.  No income, no worry there was a loan for your situation too.  No questions about credit, income or where the borrowers got the down payment.

In 2006 at the height of the real estate market the estimated value of residential real estate in the United States according to the Federal Reserve Board was over 24 trillion dollars.  Written out it looks like this: $24,000,000,000,000.

Loans such as Stated Income and No Doc programs ran rampant.  The acronyms such as SISA, (stated income, stated assets) or NINA (no income, no assets) were available up until 2007.  A new segment of the real estate market was born during this time which became known as the Sub-Prime Market.  These were loans programs that had additional reductions in both credit and income requirements allowing for borrowers to get approved when even FNMA & FHLMC were not willing to lend.

shutterstock_196104473The following loan programs were being advertised and offered by banks and mortgage lenders all across the country:

  • Bad credit loans
  • Poor credit Loans
  • No credit loans

 

Borrowers who where currently in bankruptcy at the time their loan applications were submitted were also able to get approved.  The only requirements were that they had to dismiss their bankruptcies prior to signing their loan documents.  People in bankruptcy are prevented from signing contracts as any agreements they sign would be void.  So you can say that the banks did have standards, they didn’t want any void loan documents.

Borrowers were granted loans by the big banks and other institutional lenders due to pressure to lend to everyone with the goal of home ownership for everyone.  FNMA (Federal national Mortgage Association) and FHLMC (Federal Home Loan Mortgage Corporation) which combined purchase the majority of loans funded in this county greatly relaxed their loan purchase standards.

The affects of people that never qualified or should not have been granted financing caused a supply/demand imbalance resulting in pent up demand that led to increase in real estate prices.  When the monthly mortgage payments became too difficult for those granted financing many of their homes fell onto foreclosure.  This situation in the real estate market started the downward slide and led to the worst recession since The Great Depression of 1929.

By 2004 the Federal Bureau of Investigation (FBI) had warned that an “epidemic” in mortgage fraud was taking placed in the mortgage industry at a level never seen before.  This situation was able to be perpetrated due to the relaxed lending underwriting standards.

The amount of homeowners falling behind in their mortgage payments increased dramatically and was at its highest in 2010 as can be observed in the following chart.

California Mortgage Payments 90 plus Days Delinquent

During 2007 mortgage lenders were forced to initiate foreclosure proceedings on 1.3 million properties.  This was a 79% increase over the foreclosures that were initiated in 2006.  By 2008 over 9% of all mortgages in the country were in some stage of foreclosure.

Just about every bank, mortgage company, credit union and any other real estate lender lost vast sums of money from borrowers defaulting and from the losses from foreclosing on numerous properties.

By 2008 banks and just about every other lender including private lenders suffered substantial losses never before seen in our country.  Many lenders pulled out of the lending business and the ones that were left became very conservative in their lending practices where just about no one could get a loan.

The two major players in the secondary mortgage market are FNMA (Federal National Mortgage Association) and FHLMC (Federal Home Loan Mortgage Corporation) revised their lending standards.  The two mortgage buyers comprise over ¾ of all residential mortgages annually.  These 2 entitles do not make loans directly to borrowers wishing to purchase or refinance their homes.  What FNMA & FHLMC does is buy loans that are made by banks and financial institutions thus providing them additional capital to allow them to lend to the next borrower who walks in the door.

The way that FNMA & FHLMC controls the mortgage market is through Seller Servicer Agreements that are entered into between each institution that is approved to sell loans to the respective agencies.  The 2 agencies have underwriting guidelines and requirements as to what loan products they will purchase.  So as such the originating banks and institutions adjusted their lending policies to coincide with the loan quality they are able to sell to FNMA & FHLMC.

So when FNMA & FHLMC lowered their underwriting standards and requirement in and around 2003 the banks and financial institutions went along with the reduced, underwriting standards and purchase requirements.  In addition pressure was put on the lending community through the Community Reinvestment Act (CRA).  Another government law that has unlimited power over those regulated.

Part way into the mortgage loan melt down FNMA & FHLMC tightened up their lending standards.  The pendulum swung the other way and the underwriting lending standards were brought to a level where if anyone did want to get a real estate loan were not able to get approved.

The news on the street was property values were dropping, no one wanted to purchase and for the few that did couldn’t get financing.  So what little demand existed went to near zero causing the real estate market into free fall.

Owners Equity in Household Real Estate

 

An additional negative impact on the mortgage market was from the effect caused by those who either could not afford to purchase or those who could barely afford to purchase but who had the intention to hold onto the properties just long enough to sell for a nice profit.  Well many of these people were left holding the bag when values started to drop at rate where they were just not able to sell prior to their mortgage balances exceeding their property value.  The result was that selling became impossible.

Many of these people also became victims to the mortgage melt down defaulting on their mortgages, going into foreclosure and ultimately losing their homes and having to relocate.  The negative effect on their credit was to be felt for many years.

Properties foreclosed upon by banks and other lending institutions increased dramatically as shown in this graph.

Foreclosure Inventory Count

 

The Federal government the party who is so often looked at to come and save the day held hearings and set up investigative boards in an attempt to determine what and who caused the mortgage meltdown.  Many programs designed to bail out the banks were put into operation and billions of taxpayers’ dollars were transferred to banks and institutions to shore up their financial situation in an attempt to prevent a run on the banks and further financial calamity.  The government involvement and participation can be argued made the overall situation worse or at least allowed the real estate recession to continue on longer than if things had worked themselves out without government involvement.

In addition to the billions in losses suffered by homeowners and the additional monies lost or squandered by the government led to the largest private and public sector losses in the history of our country.

As an additional insult to injury the state and national economic recession led to a substantial increase in the unemployment rate which let to additional job losses and resulted in additional foreclosures.

In an attempt to find blame citizens and elected politicians rallied around the idea that it was the lending community that was to blame due to their reckless lending policies.  Just about never was the cause of the mortgage melt down thought to be from the irresponsible behavior of the borrowers or from political pressure imposed upon banks and lending institutions.

New regulatory agencies and government bodies were enacted by congress along with billions in expense of operating the new government agencies to oversee the mortgage market.  The changes in the regulatory policies has led to substantial additional costs and reporting requirements for banks and real lending institutions.

In part 2 we will look further into the regulatory changes and the point where the market turned around.

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