Thursday, September 18, 2008

Why too much risk is bad

The housing markets in many parts of the nation are struggling.

Things are considerably better here in Arkansas and I'll explain why in a minute. For now, I think it's important to mention just how we got from one of the most robust housing markets in history just a few years ago to what we have now.

No, I'm not an economist, but I've had a ringside seat to a lot of this in my position as director of media relations for the Arkansas Realtors Association. Part of my job is to compile statewide housing stats and keep my ear to the ground in hopes of picking up on trends before they happen.

So, I'm not an expert. I've visited with plenty of experts over the past few years, however, and there is a commonality in their analysis of housing markets -- everyone took entirely too many risks. Yes, everyone from home buyers to lenders assumed quite a bit of risk and some of them got burned for it.

Let me explain. Not too long ago, they traditional way to purchase a home was to save up enough to put a down payment on a mortgage (20 percent was preferred, but lenders would typically accept less) then get a traditional, fixed mortgage. That traditional method was seen as prohibitive, so lenders started to get creative.

The argument, of course, is that owning a home is part of the American dream so it's in everyone's best interest to make sure as many people realize that dream as possible. In other words, why should someone who has poor credit or no down payment be unduly penalized? Shouldn't those people be allowed to get homes, too?

There is certainly merit in that argument. There were a number of lending practices that were far too restrictive and it was a good move to relax them.

Ah, but some lenders went crazy when it came to relaxing standards and would find some way -- any way -- for anyone with a job and a pulse to get into a home. So, we saw the development of the subprime market and some fairly exotic (and risking) mortgage packages. That market was designed specifically to allow people who were unable to get into a traditional mortgage to finance a home.

That's all well and good, so long as it's done in moderation. It wasn't. The end result of that was that a number of lenders secured mortgages for people that put them into homes that were otherwise unaffordable. The lender was happy because they love closing mortgages and buyers were happy because they managed to get into homes they never believed they could afford.

That all looked wonderful initially, of course, but there's a catch with your more exotic loans -- there are always terms that kick in at some point that push up those monthly mortgage payments. For example, an adjustable rate mortgage (ARM) generally feature a very low initial interest rate but are set up so that rates fluctuate with the market after, say, five years.

The problem when you're dealing with anything other than a standard, fixed interest rate mortgages is that borrowers run the risk of having their monthly payments shoot up on them after the initial period when payments are low ends. In a lot of cases, borrowers got into homes that they really couldn't afford and were doing well to meet the payments during that "safe" period.

Why on earth would banks assume that kind of risk and why would homeowners leap to take advantage of loan packages that should have looked problematic on their face? That's pretty simply, really. Not too long ago, there were a number of economists who claimed that it was actually good for the economy when people carried a lot of debt. Mortgages do generate money in the economy, after all, and the economy does benefit when people pay off their debts.

Furthermore, I used to be a lawyer in the bad ol' days and filed a lot of bankruptcies. In this day and age, people simply aren't conditioned to save up and buy anything -- they want great things now and they're willing to go into debt to get them if their credit allows it. So, there were some unfavorable payments down the road? Big deal! The attitude was, "I deserve this great home and I'll not worry too much about what could happen down the road."

What happened when those mortgage payments went up? A bunch of foreclosures, that's what. A lot of buyers were so wowed by the thought of the homes they were getting that they didn't bother to think about what would happen when those unfavorable terms kicked in and those who thought about the future at all figured they would be able to sell their homes and get out from under their mortgages before they got hurt.

And who could blame them? Back in 2002, my wife and I bought a house in Springdale, Ark. We sold it a mere two years later and made a nice profit on the deal. And that was on a cheap house that cost us about $85,000 and sold for $105,000. Imagine the gains that people who owned expensive homes were realizing.

Gains such as the ones that people were realizing from around 1999 to 2005 were atypical, but people started to assume those increases in value were normal. So, if some unfavorable terms in a mortgage weren't going to kick in for five years, people assumed their homes would have increased in value more than enough to allow them to sell their houses and pocket some cash long before it was time to pay the piper.

As it turned out, that kind of gambling didn't work well at all for a lot of people and they were stuck with mortgage payments they simply couldn't afford. It's worth mentioning that there were a number of economists who were alarmed over the lending practices that came to a head in 2005. They were all told to shut the hell up as there was a lot of money being made around that time and who wants to listen to negativity, anyway?

Here's how all of that has played out in the current market. According to statistics from the National Association of Realtors (NAR), nine percent of all homes in the United States are under subprime mortgages -- the loan vehicles that account for 54 percent of all foreclosures.

In other words, the banks that traded heavily in those things took on far too much risk. A lot of those lenders simply aren't around these days as a rash of foreclosures just killed them.

Is there any good news in all of this? Actually, there is. Buyers are in a better position to purchase homes than they have been for years. If you've got something to put up for a down payment and can swing a conventional loan, you're in great shape -- there are a lot of homes to choose from these days and there are a good number of sellers willing to negotiate.

Another benefit, of course, is that there's downward pressure on prices across the nation. Here in Arkansas, our growth in value is relatively flat, but you'll see sales prices dropping across the nation. That's more good news for buyers.

Also, banks have been forced to reform their lending practices so that higher standards are in place. Hopefully, then, we won't see another housing market crash that takes the U.S. economy with it.

One of the biggest benefits, of course, is that people have been forced to view home values more realistically. Hopefully, at least. Buyers seem to be more interested in purchasing homes they can realistically afford and are no longer looking at real estate as a short term investment like a stock. There were a lot of people who thought they could purchase a house, sit on it for a year and then sell it for a ridiculous profit.

There's some good money to be made in real estate, for sure, but most homeowners won't realize a substantial profit unless they purchase a house and decide to live in it for a few years.

Of course, the housing market will pick up again and will be considerably stronger as both banks and buyers have learned a little something about what comes of taking on too much risk.

So, what's different in Arkansas?

The Natural State may not be immune from slowing sales, but at least average sales prices have remained stable and most sellers are finding buyers if they price their homes in accordance with fair market values. How can that be?

Looking again at NAR stats, we see that more people own their homes outright here and there weren't as many subprime loans issued to Arkies. Here in Arkansas, 42 percent of all homes are owned outright -- quite a bit higher than 32 percent across the nation. Also, only 5 percent of all homes in Arkansas are covered by subprime mortgages -- quite a bit less than the national average of 9 percent.

That low subprime percentage is very important. If we look at all homes in foreclosure across the country, 54 percent of them involve homes covered by subprime mortgages.

That's pretty basic stuff, really. Fewer subprime mortgages mean fewer foreclosures and homes that are free and clear of mortgages tend to not get foreclosed on unless you've got a tax lien or something involved.

The result of the nature of home ownership in Arkansas, then, is that we don't have as many foreclosures here as in other parts of the country so the housing markets have remained relatively stable.

That's actually encouraging. The downside of a bunch of foreclosures and people who need to sell their homes but can't is that we're not talking about numbers -- we're talking about people with families who are suffering. If nothing else, we can be grateful that suffering is at least limited here in Arkansas.


Da Old Man said...

It's interesting. I recently read a book by Galbreath about the collapse of the markets in 1920's, and one of the principle players was Goldman Sachs. You can guess what name is all over the news today, can't you?
They have teams of attorneys and various eggheads just doing their best to "game" the system. And, every time, we lose.

Rich Dansereau said...

This is a great assessment of the situation. Consumers need to realize that all real estate is local. This means what is going on in Detroit will be very different from what is going on in Des Moines. Generalizations that we hear played up in the print and tv media is overgeneralized and cannot be viewed as accurate.

The Natural State Hawg said...

da old man -- Makes you sick, doesn't it?

rich dansereau -- That's a huge mistake the media makes -- to assume there's just one, bit housing market. Hey, we've got some of those national troubles here in Arkansas, but it's nothing like what people have seen in some of the more volatile markets in the country.

麻辣鴨血Maggie said...