The real estate market is the world’s largest margin account. Unlike a margin account in the securities markets when one’s broker might call with an occasional reality check and choice of forced sales, borrowers and lenders in real estate can avoid those pesky reality checks – at least for a while.
Inflation Fueled Folly
Times were somewhat difficult for banks a scant few years ago; too much money, plenty of much reserves, not enough borrowers, low interest rates and spreads over the Treasury yield curve were so narrow that the bond market along with corporate debt was not an answer either. Banks had plenty of money and even more important, the reserves to create more. There was a saving grace however; the booming real estate market.
How do you sell someone a house that doesn’t qualify to buy one in a conventional sense with a conventional loan? Relax credit standards, create loans with "teaser-rates" and other gimmicks such as no money down so people qualify for loans that they would not otherwise qualify for. If the borrower couldn’t cover the cost when reality took over, they could always sell the property and make a killing on rising real estate prices. It worked for a while.
Over the past eighteen months, those teaser rates and interest only loans have started to re-price at market rates. Real estate isn’t selling and if the property is in an area where prices soared, borrowers and the banks are finding out the hard way that prices on real estate, like any market, can and do go down.
Slow Motion Train Wreck
The one category on any bank’s balance sheet that is an absolute bane is the "Real Estate Owned" category. Foreclosures are bad news all around. Homes that have been foreclosed on, aside from being traumatic for the home owner are non-earning assets for the bank. The price is almost certainly south of the value the loan was made on and the market is so soft the property has a difficult time being sold at all, often times at a loss to the borrowers and lending institution.
Confluence of Events
No lender is apt to hang on to this debt when they can sell it and keep the whole operation going full tilt, and that is exactly what they did. The fixed-income dealer community accommodated the lenders and helped them securitize this debt into collateralized debt obligations - one trillion dollars worth.
All things come to an end and eventually adjustable-rate mortgages started to re-price just as interest rates started to climb, economic activity slowed, unemployment started to increase, real estate prices reached a plateau and all of a sudden, delinquencies and foreclosures started to rise.
The dealer community has responded by increasing risk premiums on bids they make on weak credits in general and sub-prime mortgage debt in particular. The institutional "buy-side" is demanding greater credit spreads over Treasuries and spreads on credit default swaps on sub-prime mortgage debt have widened sharply since last year.
Can the Fed Fix It?
The short answer is – maybe. In the United States there are five different regulatory bodies that oversee financial institutions. No single one is in charge, although obviously the Federal Reserve is the most visible and has the most clout.
The Troubled Asset Relief Program (T.A.R.P.) is a subject of much debate on whether it should even exist or not. So far, no one has addressed the rules or abolition of them that helped precipitate this crisis in the first place.
For example, letting banks carry loans at book value rather than market value is ignoring reality, the abolition of the Glass-Steagall Act that separated commercial and investment banks for years is also a subject of debate, eliminating the uptick rule on short sales exacerbates market volatility and not regulating the over-the-counter derivatives market for decades could be a contributing factor.
Dean Lundell - A capital markets professional with over thirty years of experience and a licensed Commodity Trading Adviser.
Join the Conversation