Education

Sub-prime Explained

NOTE: While this is a fairly apt explanation regarding the hows and whys of the sub-prime mortgage crisis, it was also written almost a year ago and is therefore somewhat outdated. Consider this not so much commentary and more of a guide to the roots of the housing crash and the recession in general.

Traditional Lending Transformed

Real estate has provided the foundation of social wealth for centuries. It has been asserted that approximately 7 in 10 millionaires made their money in real estate. The dependable income streams and asset appreciation associated with most types of real estate offer steady, predictable returns based on a physical "brick and mortar" asset. These returns can be amplified through easily accessible credit. In the simplest mortgage transaction, the bank looks at the borrower's financial status, reviews the asset in question for quality, and assesses the market conditions to determine the level of risk in lending for the mortgage. The quality of this underwriting has a direct correlation with the quality of the mortgage income stream and the stability of the related cash flows. Mortgage lending, due to the general high quality of traditional underwriting, has been viewed as a high quality stream of income. Entities called Conduits and Brokers came into existence to extract more value from the system by making mortgages more accessible on more borrower-friendly terms. This shift away from direct bank lending resulted in a reduction of underwriting quality. Large pools of mortgage debt were sold to consumers and then resold in bulk to Wall Street in the process of securitization. These mixed pools of mortgage income were then taken and mixed together into increasingly complicated financial derivatives, certified as investment grade, and offered for sale to banks, governments, and investors. This process was seen as an effective means of spreading the default risk and overall risk across the entire financial industry.

A Bubble Is Born

As these Conduits and other institutions began to chase borrowers with increasingly competitive and attractive leverage terms, a liquidity bubble was created in the real estate market. By selling off the risk of their mortgage pools to Wall Street, the lending institutions no longer felt the "fear" associated with poor underwriting standards as the risk was now owned by others. The underwriting standards fell across the industry as competitive pressures favored the borrowers. In order to continue building momentum by selling new mortgages to fuel the booming mortgage-backed securities market, the industry crafted creative mortgages designed to entice people into borrowing, people who otherwise would not qualify. Some of the creative mortgage loans offered to borrowers include:

• Interest only mortgages - where the principle is never repaid
• Negative amortization mortgage - where borrowers pay LESS than the interest payment and the debt actually grows
• Balloon payment mortgage - where initial low rates reset in successive years to much higher levels

Over the last several years, it became common practice to refinance existing assets and thereby extract stored equity. Real estate became the U.S. economy's liquidity engine as people tapped into the equity built up in their assets to fuel consumption of non-equity goods and services. This trend led to a speculative frenzy of both buying and building. The explosive growth in the supply of cheap and accessible debt drove new buyers into the market like never before. Asset prices soared as scores of people leveraged themselves dangerously based upon inflated asset prices which were being driven upwards by the boom. This process effectively drained the equity out of the system as assets began depreciating.

The Bubble Bursts

Speculation was rampant as many gambled that the boom would continue long enough for them to get out. Borrowers, intending to refinance their assets and secure the capital gains reaped as market prices skyrocketed, were caught unaware as liquidity dried up overnight. Once the market slipped into decline, many homeowners found themselves unable to service their debt commitments, and as a result, are now forced to liquidate assets to stay solvent. As the crisis unfolds, we are faced with a rapidly growing body of renters for whom ownership is no longer an option.

Collateral Damage & Opportunities

The mortgage-backed securities made widely available by Wall Street contain many sub-prime loans in their mix. They were sold to banks, governments, businesses and the like on a global scale. The supposed value of these securities can be traced back to the very simple cash flow coming from sub-prime mortgage payments. These securities contained investment grade mortgages alongside "junk" mortgages, making it impossible to tell how much of the content is "junk". This makes valuing them challenging. The entities and governments who funded the real estate boom in the U.S. by buying these securities are now left holding paper whose value, and therefore liquidity has all but disappeared. The damage created by this situation extends beyond the real estate industry. Banks and other financial institutions are grappling with their exposure to this crisis and many homeowners face the prospect of losing all of their equity, while still being required to service large debt payments. Many will try to refinance and stem the bleeding but a large portion of the population will be forced to liquidate their holdings at rock bottom prices. Out of this turmoil, a tremendous opportunity is materializing. Bad times for some represent an opportunity for those with money to invest, and multifamily real estate is an excellent place to profit from the current situation.