It’s the Economy, Stupid (part 2)
-
Part 2:
Residential real estate values were out of touch with wage rates *By 2007, it became obvious residential real estate values were not sustainable given current wages and interest rates. For example, according to city-data.com, the 2007 median household income for a family in San Diego, California was $62k, while the average house or condo value was $558k. Thus, the average house value was approaching 10 times median household income. A typical prime mortgage costs the homeowner about $600/month per $100,000 borrowed, so financing $500k for a $558k home (58k down payment) results in a monthly mortgage payment of about $3k. Dividing $62k median income by 12 months, we arrive at a median monthly income of about $5200. Doing the math, on average, a staggering 57% of the median gross monthly household income would be required to pay the mortgage on a house purchased in San Diego, which is about twice the recommended mortgage obligation of 25-35%.
Remember, these numbers are for prime mortgages. Subprime mortgage interest rates would increase monthly payments even further. Regardless, there was no way for many housing markets to sustain the alarming appreciation that was often seen in the 1990’s. Something had to give.
How did we get there? Residential sales and construction began to level off in 2002-2003, and left to its own devices, the housing market quite possibly could have followed a normal cycle of recovery. On the contrary, with limited exposure, financial incentive, and often well-meaning but questionable judgement, lending agencies and mortgage brokers began to relax qualifying standards which refueled demand with a flood of new mortgages, many of which were subprime. The real estate market had been so strong for so long that many individuals and investors had never experienced a down market. Why wouldn’t valuations continue to rise?
Consisting of mortgages purchased from the U.S. Federal Housing Administration and Veterans Administration by Fannie Mae and Freddie Mac, the issuance of mortgage-backed securities, which are securities backed by the principal and interest of a group of mortgage loans, peaked in 2003 with a staggering value of over $2 trillion usd which represented about 1/3 of all outstanding mortgages. Just when the residential housing market was poised to take a breather, Fannie, Freddie, brokers and investors hit it with a stimulus of unprecedented proportion. The market on steroids, real estate valuations continued to rise until mid-2007. What began as a typical housing market cycle had turned into a tsunami.
Many investors and fund managers had become enamored with Fannie and Freddie’s success story, and proceeded to purchase large amounts of mortgage-backed securities, often on margin. In the summer of 2008, as reality set in, the current value of these securities dropped precipitously. As a typical scenario, an investor calls his/her broker and requests the purchase of $1 billion worth of mortgage-backed securities on margin. Buying on a margin of 40:1, the investor is out $25 million, with 10% or $100 million, backed by the security, going to the broker. If real estate values contained in the mortgage-backed security drop only 10%, the current value drops to $900 million. Subtracting the broker fee of $100 million, the initial investment of $25 million has turned into a loss of 225 million. Multiply this scenario times a thousand, and it’s easy to see how quickly things can go from manageable to catastrophic.
Is America alone to blame for the housing and financial crises? By no means. Fact is, housing had become grossly overvalued throughout Europe as well, especially in Ireland, the U.K. and France. Could the United States have done a better job regulating these securities? Absolutely. Unfortunately, regulators , rating agencies and auditors tend to become sympathetic to those they regulate, which makes catching major problems in a timely fashion extremely difficult. What started out as a typical housing cycle has become a worst-case scenario, and it will take a tricky bit of balancing by the Government and Federal Reserve to pad the fall.
