June 25, 2009
How did we get into the housing crisis?
By JOHN DAY
John Day Homes
As the owner of a small residential building company, and the 2009 president of the local Master Builders Association, I have the unenviable position of sitting on the front lines of the mortgage and credit crisis. And let me tell you, the view from here isn’t always pretty.
Of particular concern to my fellow association members and myself is the way banks are currently conducting business and treating us. But before I delve into the larger issues surrounding these complaints, I should offer the caveat that most of these banks are members too, and are being faced with their own issues that are beyond our control or sphere of influence locally.
So how exactly did we get into this mess, who caused this problem and what is happening now? First of all, follow the money. Our current crisis actually started back in the 1970s during the Carter administration with the creation of the Community Reinvestment Act. I’m not going to put the blame squarely on the Carter administration, but I will pin the blame on the federal government.
The objective back then was to require commercial banks to lend a certain percentage of their loan portfolios into low income, or otherwise lower cost housing. For many years, the Community Reinvestment Act was, and still provides, a useful source of funding for that purpose.
Over time, however, the initial objectives grew into more lofty goals on the part of first the Clinton and then the Bush administrations.
In 1999, at the insistence of the Clinton administration, Fannie Mae significantly reduced its qualifying standards, which enabled the so called subprime borrower to qualify for a Fannie Mae loan. That broadly increased the number of potential borrowers supposedly qualified to buy homes.
By the time George W. Bush had begun his second term in 2004, the attitude had morphed from, “Let’s get money invested into troubled communities” into “Let’s increase home ownership to 70 percent of the country’s households.” While that sounds like a goal that would be beneficial to the country’s economic health, it turns out to have been the single factor that has lead to the economic disaster we’ve been living in for the past couple of years.
Looking the other way
In order to accomplish that goal of home ownership, the federal government had to look the other way and allow lending institutions to essentially regulate themselves. This would be somewhat akin to allowing home builders to rewrite all of the building codes without public comment or government input.
As long as home prices were going up there was very little risk to the financial institutions participating in the growth of home ownership. Wall Street did what it does best; in the face of a financial opportunity, investment firms figured out how to take advantage of it, and in doing so created enough credit through a variety of new investment vehicles that would keep our hunger for credit fed until it was apparent that prices had grown too fast and required a correction.
With home prices going up, a seemingly endless supply of credit became available to both consumers buying new homes and to the builders who were creating the product for those consumers. And, being the optimists we builders are, we began creating enough supply to meet that demand, fearing that prices would go even higher, possibly creating a problem with housing affordability in the future.
Unfortunately, the math only worked when the supply being created for the demand was sustainable. And in this case, there were two significant problems with the supply.
First, there were a growing and significant number of purchasers who were investors only, and not planning on occupying the inventory once completed. This resulted in a significant oversupply of inventory once the market changed and investors perceived that prices were no longer escalating. All of a sudden, investors started dumping the homes or backing out of their purchase contracts.
The second, and even more significant factor, is that loans were being made to individuals who could not qualify for them. In late 2006, my dog qualified to buy a home with a “no-doc” loan at Washington Mutual (I can disclose this because the bank was seized by the FDIC in the later part of 2008, in case you weren’t paying attention).
By the end of 2006, millions of individuals and families had purchased homes with subprime mortgages. There was little or no documentation required to qualify for these loans. These loans were often structured with very low initial interest rates, to create a false sense of qualification, and often the qualification process was simply fraudulent.
The federal government dramatically increased its goals for home ownership in America, but in the process decimated an industry. From 1987 until January of 2007, home ownership in this country increased from 64 percent to nearly 70 percent of all households that’s something like 6.7 million new households in a 20-year period. If this had been achieved honestly, it would have been the greatest accomplishment in this country’s economic history.
There is little question that the market peaked in the Northwest, including Seattle, in late 2006, but you can only see a peak on a graph in retrospect. After the peak, the industry continued to build at an accelerated pace due to optimistic credit conditions until mid-2007, when unsold inventory began to accumulate. By the end of 2007, we were all wondering if we were going to follow the rest of the country into a deep recession, and by the end of 2008 it was very apparent that we were already there.
Now that I’ve reviewed how we got here, I’d like to consider what is currently happening with credit. The vast majority of our members are associates or subcontractors who provide services to the builder members (the real credit hogs), but we are all impacted by this credit crunch and will be for some time. The current credit climate is just as much a creature of the federal government as the boom market that created the crisis to begin with. Instead of looking the other way, the federal and state financial regulators who have been roundly criticized for under-managing, are now micromanaging all of the banking institutions in this country effectively creating problems that wouldn’t otherwise exist.
Have you ever lined a few hundred dominos up in a row and then tipped the end one over because it’s fun watching the rest of them fall? That’s essentially what’s happening in today’s economy. First you take subprime borrowers who got into their homes on a promise and a whim with little (or possibly no) down payment, then you reduce the value of their investment by 15 percent or more, and you have an entire class of homeowners who owe more than their home is worth (but that’s OK because it’s their first home and they can just move back into an apartment and create a few million units of nearly new inventory).
Let’s not forget about the investors that walked away by the hundreds of thousands. So as inventory goes up, home values go down and inventory goes up again. Now builders are upside down and can’t sell their product for as much as they borrowed against it. Sales rates go to zero and here’s where it gets interesting: The lenders have to re-evaluate the worth of the asset that they’ve loaned against whenever they have sufficient evidence that there is a material decrease in value.
It used to be annually or longer when prices were stable or increasing; now it may be quarterly. When the value of the underlying security no longer provides the loan-to-value cushion it did originally, the banks are compelled to rebalance the loan. That’s a fancy way of saying they need the borrower/builder to pay down a portion of the loan through what they call a curtailment or partial loan payment.
Now the borrower/builder is losing money on the homes they’re building and cash flow is already difficult, so making the curtailment demand is difficult or impossible. If a restructure with additional collateral cannot be negotiated and the builder cannot meet the rebalancing call by the lender, then the builder is in default and the lender, in many instances, is forced to simply stop loaning money to that borrower due to the default caused by the reduction in the value of the collateral.
A real life example
Using a real life example, Builder X purchases 100 finished lots at the peak of the market in 2006 for $160,000 per lot. Builder X is flush with cash and only borrows 70 percent of the lot value or $11.2 million. By the end of 2007, the builder has only sold 10 homes and the value of the homes have gone from $400,000 to some price that we don’t know yet because the builder can’t sell them for $370,000.
The loan is evaluated annually and the lender determines that the lots are now worth only $100,000. The lender is then compelled to request that the borrower make a curtailment payment of 90 lots times $60,000 per lot to keep the loan in balance so that the bank’s lending ratios are in compliance with the agreed upon loan-to-value. In other words, the borrower needs to write the bank a check or provide additional collateral in the amount of $5.4 million to keep the loan balanced and maintain the cushion.
If the builder does not have the resources to balance the loan or chooses to preserve cash, then the loan goes into default and the builder becomes a liability for the lender in the eyes of the regulators.
While the builder is trying to work through all of this with the bank, to add insult to injury, two of the 10 homes are sold to investors and six are sold to subprime borrowers. The investors put their homes on the market below the builder cost and the builder follows suit, further lowering the value. Now, half of the subprime borrowers allow their homes to go into foreclosure after their interest rate shoots up from 3 percent to 7 percent. Their subprime lenders ultimately foreclose and reduce the price at the foreclosure auction by offering a “specified bid” price at 70 percent of what is owed, and now the value is reduced again.
Ultimately, the builder’s lender takes the property back, but is forced to sell it by the regulators for a huge discount $40,000 for each lot to an investor. Those lots cost $65,000 to build, so the raw land is now worth almost nothing.
The way to stop this domino game is to either allow it to take its course, or for this industry, to affect changes in Washington, D.C., if only temporarily, to some of the regulations that are accelerating the spiral of devaluation. The only bad guys in this story are the ones sitting in Washington, D.C., who created this mess to begin with, and the guys on Wall Street who were greedy enough to fraudulently create capital where it really shouldn’t have existed.
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