The Writing was on the Wall

Addendum to Part 1 of a 2 part series–"Which End is Up" or Understanding Our Housing Market"

Historically low interest rates, low cost housing availability across the country, investors hungry to reap a return after the dot com crash all set the stage for an overactive interest in housing as an investment.

There are really three distinct factors which played into the current market conditions across the county. The first is the sub-prime market. Essentially, these are loans which are made to folks who otherwise could not qualify for an "A" paper loan-usually that means low credit scores. Anyone with even the foggiest crystal ball could foresee that giving loans to people with bad credit is risky. The second major players were investors. Aggressively seeking any new vehicle to safely invest thousands turned to real estate. The availability of innovative interest only and negatively amortizing loans fueled the investment fire. Investors were able to put little or no money down on a new housing development in Las Vegas and before the project was completed for occupancy could re-sell at a huge profit.

As with any scheme is better to get in early rather than later. Not only did the country as a whole have more sub-prime loans it had more investors with less emotional ties to their homes. Both of these relied on one thing-low interest rates. As the "fixed for five year adjustable loans" came due, for many investors it no longer made sense to hold onto their investment as rents could no longer cover the payments. This created a flood of inventory as investors-all with the same issues (rising interest rates) flooded the market. Since these were investment vehicles which had for the most part already established considerable equity-selling and selling fast was the exit strategy. Of course this meant selling lower than your competition. The third factor was Wall Street’s hunger for new high yield investment securities which neglected to understand the risk these investment vehicles carried.

On the homeowner side, many of the sub-prime loans also began to adjust with the difference being many of these folks could not afford the new higher payment. The few that had neg-am loans had no equity to fall back on since housing prices were falling due to the sell-off of investment properties. This forced those who could to try and sell, further increasing inventories and lowering values; while others simply had no choice but to fall into default–eventually losing their home to the banks.

Now the banks are on no place to hold onto all of those loans they made so they sold them as securities on Wall Street-another set of hungry investors who jumped on the bandwagon and bought up all the sub-prime loans they could get their hand on. With thousand of loans in default, mortgage companies and Wall Street was stung by portfolios which were now worth nothing and did what Wall Street always does-overreact. With the sub-prime rate of default was reaching 15%, the default on Jumbo loans was only leas than 1/2/ of one percent. Throwing the proverbial baby out with bath water, they hastily decided that all mortgage backed securities were bad and no longer bought any Jumbo loans either (those over $417,000 not backed by Fanny Mae or Freddie Mac). With no one to buy these loans this raised the cost of Jumbo rates since mortgage companies were now forced to carry the loans "in-house", or add it to their portfolio–substantially increasing their exposure and risk therefore charging more. In July the overnight rate for Jumbo loans increase over 1% in one day.

Since most of the loans in the Bay Area are Jumbo loans this effectively made the cost of homeownership increase substantially overnight-hence with homes less affordable and at already historically high prices, a pull back began.

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