Originally Posted By: rbracklow
This post was automatically imported from our archived forum.
Here is an eye opener that has been brewing for quite some time!!
Fannie Mae, Freddie Mac's Role In The Perfect Real Estate Storm
Lenders, Realtors, appraisers and investors are already beginning to feel the winds pick up for the perfect real estate storm. Some believe that much of the fallout will be fueled by easy credit encouraged by Fannie Mae and Freddie Mac to support their valuations.
It all began with automated underwriting conceived during the Clinton boom, which took its scoring models from credit cards, and then a number was derived by FICO to apply to mortgages.
Explains David Reed, director of Internet lending for Southtrust Mortgage, "They are approving loans that would never have been approved by a human being. We are going through good times, and we are approving loans, but what happens when good times end? For these people who don't have good credit, or low appreciation, we don't know if these scoring models work because they haven't been tested in bad times."
What's scaring Reed, he says, is that time and time again, he is seeing loans approved that have him raising his eyebrows. "One just came back across my desk - this got approved? The borrower had good credit, but his ratios are 69."
That means the borrower's payment is 69 percent of his gross income. That's a far cry from the days when lenders started to sweat when borrowers got near 36 percent including credit card debt.
"Fannie Mae and Freddie Mac have a stock price to keep up," suggests Reed, "so they have to expand their homeownership rate, and you wrap that around homebuyer assistance programs and all these state and federal bond agencies that help people get in homes, which is a great thing. But that means providing a mortgage that we can eventually make money loaning, and if you can't qualify, now you have to buy mortgage insurance.
"Do we really need this high level of homeownership?" he asks, "if you squeeze somebody into that home, and hold your breath, it is possible that when something bad happens they'll get foreclosed on and have that on their credit the rest of their life. I'd much rather tell somebody to just chill for 180 days and save five more percent or find a gift. That's the prudent approach, and that is coming from somebody who is making money off of loans."
Adjustable rate loans have made huge gains in the marketplace, even as fixed rates have dropped to 40-year-lows, as borrowers try to leverage themselves into bigger, better homes. ARMs got an unexpected boost recently from FED chief Alan Greenspan, who suggested in remarks made in June that "to the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home."
Florida appraiser Jack Conner says he believes Greenspan promoted ARMs to the public in order to support the banks' margins. "As the rates creep up, there will be a real squeeze on these folks," he worries. "As debt grows an the public goes back to the piggy bank to get some more of that equity fix, the rates will be up, so it follows that refis will be at higher rates and higher monthly payments until the tide turns and we appraisers start to show 'declining' as a check box under 'values.'
"As the bottom falls out, and the folks who have not tapped their equity see this fall, they will rush to the home equity market to save their paper equity. The banks will begin to question the value issue. Once that snowball starts rolling, it will be up to the appraisal industry to stop it. AVMs. in widespread use right now can be made to say almost anything."
Conner predicts a real meltdown. "Values will begin a real decline," forecasts Conner, "and it will be sell, sell, sell. Folks who have used their heads and not tapped their equity see values plummeting and banks will have record numbers of foreclosed properties on the market in all sectors. Noone does anything, waiting for the bottom. Banks begin to fail, Freddie Mac goes under, FNMA totters. It could make the Savings and Loan debacle of the 1980s seem tame, and this one everyone will feel. Standby for the regulators to get heavily involved in the lending process again. The party is just about over and we are in for one hell of a hangover."
Conner provides this equation as illustration: Rental rates decline + home values increase + interest rates down + equity borrowing up + lending practice loose + no new job formation + real income below inflation rate as percent + home appreciation up 17 percent = Perfect real estate storm.
Houston Realtor Tom Johnson says he is already seeing the storm clouds. "I am a survivor of the 80's in Houston, so that may color my opinion," says Johnson. "Since Texas did not have home equity lending until recently, I have not seen upside-down homeowners until recently. I just took a promissory note from a seller for a portion of my commission because he did not have equity sufficient to cover closing costs. He had been in the house four years. The lack of appreciation is a warning. The buyer's appraisal came in 15 percent higher than the sales price. This is starting to look a lot like 25 years ago."
Johnson says, "We do not have the loose and easy S & L money, but with the Fed-induced low rates, we have free (almost free) and easy money that is greasing all this leverage."
An economist and real estate investor, who prefers to remain anonymous, offers his take on the perfect real estate storm.
"First, as short rates rise and ARMs adjust, the vast majority of recent buyers who took out ARMs and counted on continued low rates and price appreciation to guarantee a refi will default," he predicts. "Millions of these people are in over their heads and know it, but they couldn't pass up what they saw as a one-way bet. They will lose their bet. All of a sudden lending standards will tighten and appraisals will become more realistic. They will then compare their carrying costs to the real market value for their property and turn in the keys.
"The second squeeze will take place as the market overall stagnates, affordability drops, buyer expectations decline, and would-be sellers get stuck with an asset they can't or won't sell," suggests the investor. "All of a sudden transactions costs become meaningful, and the cycle goes into reverse. Property tax rates rise to cover the declining assessments, utilities become a real cost of ownership rather than a cost to carry until the profitable refi or sale, and so on. The people who stretched to 40-percent or more of gross income on PITI have no idea how this is going to bite them.
"The popular notion that an interest rate increase of several percentage points will only slow appreciation is typical market hype," he scoffs. "It's no different from the New Era Internet stock boosters in 2000. At best, rising rates will freeze the market so that the net for a sale in a flat market will be 7 to 10 percent after transaction costs. More likely, it will lead to quick 5 to 10 percent price declines (which most people will regard as the worst being over) followed by years of flat to declining prices as all the macro economic ratios (debt to income, ownership cost to rental cost, etc.) return to historic levels. This will wipe out most of the recent equity gains. Unfortunately, homeowners have cashed out a large part of these equity gains so they will be underwater on their mortgages.
He instructs, "It's a fundamental principle of markets that when everyone knows something is going up, the next move is down - hard. A second fundamental principle of markets is that the retail crowd is always wrong at the tops and bottoms. Combine this with the biggest asset most people will ever own, more leverage than they can handle (or understand), transactions costs and carrying costs that they don't understand, and wrap it all up in a get-rich mentality and you've got the makings of a disaster.
"As for how bad it will get, my bet is on 30-percent declines in all the hot markets, i.e., both coasts and miscellaneous high-tech centers in the middle. This assumes that the Fannie and Freddie hedge funds don't bring down the entire system when the cycle goes into reverse. (As an economist, I cannot possibly see how Fannie and Freddie can be fully hedged when 1) they directly or indirectly guarantee more debt than the U.S. Treasury, 2) they are leveraged many times more than the commercial banks, and 3) the only conceivable counterparties for Fannie's and Freddie's derivatives (JP Morgan, Merrill, Citi, etc.) would logically be on the same side of the book as Fannie and Freddie.) If the systemic risk that Fannie and Freddie have created comes true, then I have no idea how bad housing will get.
"It would be catastrophic."
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