Will the Sub-Prime Meltdown Burst the Housing Bubble?
As housing prices continue to make front page news both buyers and sellers worry over the impact on their personal economic future.
At first the housing news focused on the miracle of the market as houses in some hot areas increased in price by 20 to 30 to 50 percent per year-year after year! Then the focus turned to the crash of the market as the Affordability Index, a comparison of average house price to average salary, indicated fewer and fewer households could qualify for mortgages. Wonderment and delight were replaced with gloom and doom. The conversation changed from “How much will prices increase this year?” to “When will the housing bubble burst?” to “How much will prices decline?” to “Will defaults cause a recession?”
In “The Real Estate Market: House of Cards,” the authors discussed the existence of a real estate bubble. One driver of the housing boom was the prevalent use of creative mortgage instruments. These mortgages were often used to allow households that would not qualify for fixed-rate mortgages to enter the housing market. Now that the sub-prime mortgage market has begun to implode, it is time to revisit the topic and see what a difference a year makes.
Creation of an Asset Bubble
The recession in the U.S. that began in early 2001 intensified with the economic, political, and societal uncertainty that followed 9/11. The Federal Reserve (FED) lowered interest rates-monetary easing-to spur the economy. Treasury bill rates hovered around one percent and mortgage rates fell to 40-year lows. More households qualified for mortgages, and the demand for houses increased. Increased demand drove housing prices upward.
Speculators became active participants in the housing market as returns exceeded those on other investments. Stock and bond market returns were low or negative, and very volatile from 2001 to 2004, while the prices of homes in California during the same period rose 71 percent. Some surveys found that real estate investors, many of whom hoped to resell the homes quickly at a profit, bought 23 percent of the homes purchased in the U.S. during 2004. An additional 13 percent of the purchases were second homes. Increased demand from speculators and buyers of second homes put upward pressure on home prices.
House of Cards?
In the “House of Cards,” several factors were mentioned that suggested the housing market could be facing a downturn. The first of these was creative financing. The rapid increase in housing prices caused many borrowers to be priced out of the market. Mortgage lenders reacted by offering a wide variety of mortgage instruments such as low or no documentation of income, adjustable mortgages with low teaser rates, adjustable rate loans with low fixed rates for the first two to five years, no down payment loans, zero percent interest for the first year(s), and interest-only loans with negative amortization. These instruments made borrowers vulnerable not only to rising interest rates (as monthly payments on adjustable rate mortgages increase), but also stagnating or falling prices (as market prices fall below mortgage balances with negative amortization or interest-only mortgages). In June 2004 the Federal Reserve began increasing short-term interest rates, the index for many adjustable rate mortgages. By mid-year 2005, market watchers observed increases in mortgage defaults and delinquencies in the sub-prime category where the delinquency rate, while still low, doubled to 6.23 percent.
The housing market continued to flourish until early 2006 when cracks began to show. Housing prices continued their upward march but at a much slower rate, housing inventory began to build as homes took longer to sell, and buyers stayed on the sidelines in anticipation of price cuts. Speculative and second home purchases slowed in 2006 with second home purchases in California “vacation” areas declining by 37 percent, and sales to Californians in Phoenix, Arizona, declining 50 percent and in Las Vegas, Nevada, by 32 percent.
To exacerbate the problem, mortgages closed two to three years earlier began to reset. Many sub-prime borrowers continually refinanced their homes with loans featuring low teaser rates and postponed large jumps in payments. However, rising delinquencies caused lenders to tighten standards, pushing sub-prime borrowers out of the “refi market,” where borrowers go to refinance their loans. That is, they borrowed again at a lower, “teaser” rate (sometimes increasing the size of the loan and pulling out equity based on the higher appraised value as cash) and used the new borrowed funds to pay off the old loan with the now higher rate.
In February 2007, Freddie Mac, one of the largest players in the mortgage market, announced it was tightening its purchasing standards as of September 1. Freddie Mac does not buy sub-prime loans directly from the institutions that write them. Instead, it purchases bonds backed by pools of sub-prime loans. Under the new guidelines, it will no longer purchase bonds backed by loans with low teaser rates for the first two to three years unless the borrower can qualify at the higher rate.
By January 2007, 14.3 percent of sub-prime loans were at least 60 days late, up from 8.4 percent in January 2006. For Alt-A loans, which fall between sub-prime and prime, the late payment rate rose to 2.6 percent up from 1.3 percent in January 2006. Together sub-prime and Alt-A loans accounted for 40 percent of home mortgages originated in 2006.
The impact of foreclosures is wide-ranging. It is estimated that each foreclosure costs lenders, government, and/or homeowners approximately $80,000. Foreclosures can also cause a ripple effect on the values of nearby properties decreasing them by as much as 1.4 percent. In addition, the real estate boom encouraged mortgage equity withdrawals (MEW) resulting in more than one lender fighting for the leftovers.
To reduce these costs and protect property values, many lenders are trying to reduce foreclosures by providing options such as modifying loan agreements, subsidizing homeowners, or permitting homeowners to sell the houses for less than their outstanding loan (known as underwater or short sale). Lenders forgive the difference to minimize their losses and allow homeowners to preserve their credit rating. Since many lenders are working with borrowers on new repayment terms, the magnitude of the losses on these mortgages is not yet known.
How the Market Works
The sub-prime market works differently than the prime market. Federally insured financial institutions, important lenders in the prime market, originate less than half of sub-prime loans. The sub-prime market has been dominated instead by independent mortgage companies, many specializing in sub-prime loans and having little or no diversification. These companies borrow from investors and lend the money to sub-prime borrowers. They then sell their mortgages often to Wall Street banks-in the past at a nice profit-and pay back their loans. The purchasers of the mortgages then pool them and sell bonds backed by the pool to hedge funds, insurance companies, and other investors. Many of the mortgages are sold to the banks with what the industry calls “repurchase agreements” or the ability of the bank to return non-performing loans to the sub-prime mortgage companies. As delinquencies began to rise, the sub-prime lenders were hit from both sides; funds to lend dried up and investors returned loans, causing a flurry of bankruptcy filings.
As a result of the sub-prime structure and changes in the capital markets, the current real estate slump has affected a different group of lenders. During earlier slowdowns, the majority of the mortgage loans were held by federally insured banks or thrift institutions. However, today 56 percent (versus 12 percent in 1980) of all loans outstanding worth $5.7 trillion have been pooled into mortgage backed securities and sold to private-uninsured-investors such as hedge funds.
This puts at risk individual investors, some of who may not be able to withstand the losses. The extent of the impact is still to be seen. However, some market watchers believe the two hedge funds the investment bank, Bear Stearns, was forced to close down earlier in the summer because of bad bets in the sub-prime market may be just the beginning.
Why Should We Care?
All markets and participants are affected, either directly or indirectly, by events in the housing market. The real estate market has an enormous impact on the health of the economy by affecting consumer spending, the employment rate, and company profits. The housing boom increased consumer spending and the slump may reduce it. This is important to economic health since consumer spending accounts for approximately two-thirds of all spending, and is a major driver of the economy. Increases in property values made people feel rich and this “wealth effect” encouraged them to spend more. In addition, homeowners took advantage of the low interest rates and high real estate prices. They converted their real estate investment into cash by either refinancing and pulling cash out, or borrowing with a home equity loan against the higher value. Consumers are now faced with stagnating or falling house prices, and higher interest rates that discourage borrowing. The question is: Will the slump affect consumer spending and, if so, by how much? Early data while not conclusive is worrisome. Consumer spending adjusted for inflation increased just 1.3 percent in the second quarter of 2007 versus 3.7 percent during the first quarter.
In addition, the stalling of the housing market and implosion of the sub-prime industry has impacted the employment rate. More than 40 lenders have halted operations, gone bankrupt, or sought buyers since the sub-prime market began its slide in the last half of 2006. The largest bankruptcy involved New Century Financial Corporation, a 12-year old, independent sub-prime lender headquartered in Irvine, California. New Century filed for bankruptcy, fired 3,200 workers-half its workforce-and announced it would try to sell its remaining operations. The number of employees fired by New Century was dramatic, but not the only example. Smaller firms have also closed their doors or announced lay-offs as well. Even diversified mortgages companies such as Countrywide have announced employee reductions. In California, mortgage industry job losses soared 367 percent in the first quarter. But, the mortgage industry is not the only one hurt. Employment related to the housing industry-construction workers, architects, mortgage lending services, etc.-will also slow. It is estimated that 70,000 jobs in the construction industry will be lost over the next two years in the U.S.
Firms’ profits are also feeling the pinch. Homebuilders have been hit by events in the housing market. As lending standards tighten, demand for new homes drops. Toll Brothers, a luxury homebuilder, is typical. Their profits fell 67 percent in the first quarter of 2007. Earnings declined from $0.98 per share a year earlier to $0.33 per share. Net contracts signed in the first quarter fell 34 percent and the contract cancellation rate jumped to 29.8 percent, more than four times the historical average of 7 percent.
Profits at the Lowe’s Companies fell 11.5 percent in the fourth quarter of 2006. Same store sales declined 4 percent. Home Depot announced that it expected fiscal 2007 sales growth to be flat and that earnings per share are expected to decline by 4 to 9 percent.
A little noticed consequence of the real estate boom but one with potentially long lasting impact is the allocation of resources. The boom caused a reallocation of resources from the productive sectors to the real estate sector. During the last few years, residential investment has risen to 6 percent of GDP resulting in the diversion of resources from the hi-tech sectors to the low-tech real estate sectors. As a result, more than 50 percent of the private sector jobs created since 2001 was linked to housing-related industries. The impact of this reallocation on the ability of the economy to produce goods and services is still to be seen.
So, what does it all mean? Will the meltdown in the sub-prime market decrease consumer spending, decrease corporate profits, and increase unemployment forcing the economy into a recession? Will the real estate boom be followed by a bust as we saw with the dotcoms? The good news is that unlike stock prices, housing prices do not normally plunge immediately; rather, housing prices drop slowly as they lag a reduction in employment and income. If history is an indication, we will see a return to “normal” or a correction rather than a collapse of the market. However, some areas may be hit harder than others. It is estimated that houses in some areas of California may be overvalued by as much as 40 percent.
The sub-prime debacle may delay the recovery as tighter lending standards and foreclosures increase the housing inventory. Nevertheless, lower housing prices and still favorable interest rates should provide some support. On the positive side, the end of the housing boom may be good news for the overall economy. A return to normalcy in the market should increase affordability while still providing reasonable returns on housing investments. In addition, the meltdown of the sub-prime market may bring more attention and more favorable terms to prime borrowers.
On the negative side, the end of the housing boom may substantially slow economic growth by reducing consumer spending and deflating consumer confidence. Wall Street experienced its sharpest fall in five months on July 26, 2007, after the announcements that new home sales fell 6.6 percent and existing home sales fell 3.8 percent (to a five-year low) in June; mortgage delinquencies increased to 2.9 percent (exceeding expectations); home builders, D. R. Horton and Beazer Homes USA, posted larger-than-expected losses in the spring quarter; and economists reported that the housing weakness could linger through the rest of the year.
Most market observers do not expect the housing slump to cause a recession because employment remains strong. However, events do have implications for the real estate market. As the authors stated in the conclusion of “Is the Real Estate Market a House of Cards?”, real estate basics have not changed. The three most important factors are still location, location, location!
 Bill Sing. “Peak for Housing Said to Be Near,” The Los Angeles Times, September 28, 2005, at C1.
 Michael Corkery and Christine Haughney. “Investors Hold the Key to Housing Boom’s Fate,” The Wall Street Journal, August 17, 2005, at B4.
 Jesse Eisinger. “Consumers May Be Starting to Bend, Judging by Those Subprime Mortgages,” The Wall Street Journal, November, 30 2005, at C1.
 Annette Haddad. “Sales of Vacation Homes Sink 37% in ’06,” The Los Angeles Times, February 23, 2007, at C1.
 Vikas Bajaj. “Freddie Mac Tightens Standards,” The New York Times, February 28, 2007, at C1.
 James Hagerty. “Payment Woes Worsen on Riskiest Mortgages,” The Wall Street Journal, April 4, 2007, at A2.
 Ibid, p. 35.
 Vikas Bajaj. “Defaults Rise in Next Level of Mortgages,” The New York Times, April 10, 2007, at C1.
 Julie Creswell and Vikas Bajal. “Jittery Stock Market Drops as Mortgage Fallout Spreads,” The New York Times, August 1, 2007, at C1.
 Jeremy W. Peters. “Economy Expands 3.4%; Interpretation Is Debated,” The New York Times, July 28, 2007, at B3.
 Scott E. Reckard. “Top Lender Files Bankruptcy, Lays Off 3,200,” The Los Angeles Times, April 3, 2007, at C1.
 “Leslie Earnest, “Pink Slips Litter the Loan Industry,” The Los Angeles Times, April 6, 2007, at C1.
 “A Builder of Luxury Homes Adopts a More Somber Tone,” The New York Times, February 23, 2007, at C2.
 “A Home-Grown Problem,” The Economist, 376, no. 843 (2005/09): 69.
 Walter Hamilton and Annette Haddad. “Investors Fear End of an Era,” The Los Angeles Times, July 27, 2007, at A1.
About the Author(s)
Peggy J. Crawford, PhD, joined the faculty of Pepperdine's Graziadio School in 1997 after serving on the faculties of the University of Houston, Fordham University, and George Mason University. She has published in a variety of journals on topics such as leasing, mortgages, closed-in mutual funds, the depreciation of the dollar, the trade and federal deficits, and the price of oil. She has served as a consultant for such firms as Sprint, AT&T, various state CPA societies, and the Washington Redskins (her favorite client!).
Terry Young, PhD, has over 15 years of business experience in Asia and the United States. Thoroughly versed in international economics, Dr. Young has extensive knowledge of the global marketplace, with primary emphasis on Asia. Her consulting expertise includes global sourcing, business start-ups and management in such industries as food distribution, the textile and garment industries, agriculture, electronics, and real estate development. Dr. Young's 20-year university teaching experience includes assignments at the University of Southern California, at two California State University campuses, and a full-time professorship at Pepperdine University's Graziadio School of Business and Management where she received the Luckman Distinguished Teaching Award in 1994.