The Perfect Storm

An insider’s look at the modern real estate crisis

 In 2007, real estate began a downward spiral that would change history forever because most homeowners and real estate investors didn’t understand how to strategically borrow money or invest in real estate. Combine this with banks flooding the market with cheap money and extremely liberal loan terms and the writing was on the wall. You could see this catastrophe coming from a mile away.

Bank lending guidelines + financially uninformed America = Modern Real Estate Crisis

Zero down

In the years leading up to the real estate catastrophe, banks created huge demand for real estate with gimmicks to entice people to get in to the real estate market. The banks knew exactly what they were doing when these gimmicks were created. In the 90’s, a healthy economy allowed for real estate prices to go up at a normal level – about 5% per year. Unemployment was low everywhere, wages were great and the auto industry was as healthy as ever; so banks decided to cash in on it. They started offering home loans with no down payment required. It used to be that you had to put 20% down on a home to get a loan. If a person who puts 20% of their own money into a home and stops paying for whatever reason, the bank forecloses and takes back a sellable asset with 20% equity in it. Additionally, when a person puts up a 20% down payment, which often times is that homeowner’s life savings, they will do anything to keep their home. This makes the chances of a foreclosure very small.

But when zero down loans came out, many more people became qualified home buyers. No longer did they need to save money while renting – they could just go buy. With more people buying, there was more room for error – in this case, high principal balances if a loan went into default. If a person stops paying soon after buying a home with no down payment, the bank forecloses on an asset with no equity at all – they have to usually sell it for a loss. And this is exactly what started to happen.

Enticing loan products – ARM’s

In the early 2000’s, the Fed lowered interest rates to never before seen lows. At the same time, banks were creating very liberal loan products to create more business. These loans were not understood by the general public and they were misused badly. It used to be that a homeowner had to put up a 20% down payment to get a standard loan with a 30 year amortization and a fixed interest rate. Times were changing fast as banks began selling adjustable rate mortgages (ARM’s) to tempt would be homebuyers into borrowing money. This was going to be perhaps the biggest factor that contributed to the crisis we’re in now. Unlike a 30-year fixed rate mortgage, an ARM features a much lower initial “teaser rate” to entice the homeowner to select that loan. This low interest rate is fixed for a set period – usually 2-7 years. At the end of that period, the interest rate jumps significantly, forcing the homeowner to refinance. Banks want homeowners to keep coming back to refinance – they make a lot more money this way by charging junk fees on the consumer’s new loan and creating an entirely new mortgage – which wipes away the 2-7 years of ARM payments that are made on the initial loan previous to the refinance. The new loan adds several more years of interest a client pays because they’re being issued a brand new loan with 30 more years to pay. Everyone who chose an ARM and had to refinance out of it basically threw 2-7 years of mortgage payments out the window.

If a homeowner plans on living in their home for a just few just years before selling, an ARM makes sense. It keeps payments low and the loan is going to get paid off anyway when the person decides to sell the house. But those who chose an ARM and didn’t sell their house, had to go back and refinance – just what mortgage lenders wanted. With all the lender fees associated with refinancing, homeowners were losing several thousand dollars every time they refinanced. The lender fees associated with this refinance activity were tacked on to the principal balance of the new loan. For the first time ever, people were having their equity eaten up by mortgage costs due to ARM’s expiring.

Bad personnel/Unqualified people – No license necessary

Who benefited from all of this? The banks and the loan officers who were originating these loans for the banks. Also during this time, independent mortgage brokers were sprouting up everywhere to compensate for the demand banks and lenders were creating. Most loan brokers were individuals who simply originated loans and sent them to various banks and lenders they were signed up with. Many brokers did this right from their own home. Most brokers lacked professionalism and few truly understood what they were actually doing. On the other hand, many mortgage companies hired dozens of loan officers that were 20 years of age or under. The public was literally putting their most important asset – their home, in the hands of youngsters who had never even bought their own homes!

Still yet, other loan “specialists” jumped right into the hot market and committed blatant fraud. One way was by obtaining loans on dilapidated houses by submitting falsified appraisals. These real estate con men would supply lenders with appraisals that pictured completely different and very nice looking homes than the actual home being sold. Unsuspectingly, banks would lend these crooks money on the homes that were falling down. The banks were under the assumption that they were lending the money on the house they saw in the appraisal – and to a legitimate client. Another technique many of these white collar criminals would employ was brokering loans to false identities that of course, never made a payment on the house. How could they make payments? They didn’t exist. This false identity scheme siphoned tens of thousands of dollars from lenders every time crooks did this. These underground techniques significantly helped in causing the mess the lending market is in right now.

Just about every real estate related service requires a license. For instance, a real estate broker has a broker’s license. This allows the broker to hire licensed real estate agents. Home inspectors are licensed. Appraisers are licensed. Builders are licensed. Insurance agents are licensed. Real estate attorneys are licensed. But mortgage brokers and loan originators did not need a license to sell mortgage money during the mortgage boom. I find it ironic that the very people controlling trillions of dollars that were lent during this period were not licensed. The average American’s largest financial decision was being controlled by mainly untrained, under educated kids and non licensed individuals.

I remember going to different mortgage companies in the beginning of my real estate investment career. One time, I saw ten 18–22 year olds sitting at desks where they were telemarketing to sell mortgages. Many homeowners listened to what these telemarketer mortgage “pros” had to say. They would give all of their personal information away to the telemarketer – right over the phone. Most of these homeowners had a lot of equity in their home at that time, so they carelessly allowed anyone – even anonymous telemarketers to refinance them, charging thousands in junk fees to an uninformed and naïve America.

Not every broker or loan officer was bad though – many were honest and simply prospered from the “boom” in home loans. I knew some loan officers and brokers who were making over one million dollars per yearduring this time. Remember, all the money they were making had to come from somewhere. It was coming from the equity in people’s homes – equity that truly wasn’t there because the bank’s availability of mortgage funds had caused a perceived higher demand for housing – and thus a wave of upward price deflection. In other words, the banks had created an artificial demand resulting in artificial home values by lending so much money during this period.

Greed

All loan officers make money two different ways on each loan they originate: by charging origination feesdirectly to the borrower rolled into their closing costs and by collecting yield spread premium (YSP) payouts from banks. It is very important that all current and potential homeowners understand these two fees and how they work. YSP is money a loan officer can make by adding a higher percentage on a given interest rate. For example, the box of Cheerios you bought for five dollars was bought by the grocery store you purchased it from for three dollars. The grocery store makes the difference – that’s called profit. Interest rates are issued by the government and they too are marked up by the banks and lenders – just like groceries. If a homeowner qualifies for a 6.75% loan, the loan officer has a right to mark up the rate significantly – and receives hefty monetary compensation for doing so. In this scenario, the loan officer may sell an 8.75% interest rate to the consumer on the loan. The loan officer then makes the 2% difference he sold. The bank pays him as a reward for the mark up. On a $200,000 house, that’s $4,000 for the loan officer. What’s in it for the bank? A higher interest rate compounded over several years – that’s why they encourage the mark up. Everyone makes more money – and you, the homeowner loses money.

On the other hand, the origination fees that were abused during this period also cost homeowners thousands. Origination fees appear right on the HUD, which is a homeowner’s abbreviated real estate closing receipt breaking down the entire buy, refinance or sales transaction from a monetary standpoint. Mortgage brokers would psychologically “read” their clients level of financial education and charge whatever origination fees they wanted, up to roughly 5% of total loan size. I once saw paperwork from a mortgage broker showing the origination fees charged on one client’s refinance. This poor man owned a $250,000 house and the mortgage “professional” had charged him $10,000 in the form of unnecessary origination fees – all because this man couldn’t understand what he was signing on the loan application. Also remember that the costly origination fees charged to millions of Americans during this period were on top of the interest rate YSP markups! Nearly every mortgage company encouraged these perfectly legal, yet unnecessarily high markups during this period – which were being charged by unlicensed and inexperienced loan officers.

In normal circumstances, the closing costs of a refinance loan are added to the payoff of the old loan. In essence, the closing costs generated by refinancing gobbles up thousands of dollars of a homeowner’s equity. So everyone that had to refinance their ARM’s to a new mortgage when the ARM’s adjusted lost several thousand dollars of equity in the form of closing costs. Additionally, much of the money comprising closing costs on refinances were generated from pre-payment penalties (PPP’s) on homeowner’s original ARM’s. PPP’s usually cost homeowners 1% of their total loan size. This 1% PPP was also added to the payoff of their old home loan when they refinanced – thus eating away even more equity and costing homeowners thousands more.

But how much the homeowner lost in total closing costs with each refinance depended on how slick the loan officer was in selling them the origination fee after reading his client’s level of financial education. Paying closing costs is all fine and dandy when a homeowner has some equity to play with. Excess equity absorbs closing costs when a homeowner refinances. But banks had sold a lot of zero down loans in the preceding years. When homeowners tried to refinance out of their original zero down ARM’s, they couldn’t because the closing costs couldn’t be rolled into the equity of the home – there wasn’t any equity there, nor was there any to begin with when the home was originally purchased. What’s more is that people who buy homes zero down usually don’t have or can’t manage to save any money. Therefore, many homeowners couldn’t come up with the $4,500+ in closing fees and PPP’s to close a refinance if their home indeed had no equity in it. These homeowners were now stuck with a high interest rate loan with payments they couldn’t afford.

With ARM interest rates beginning to adjust to levels in excess of 11%, combined with banks selling loans to people that couldn’t really afford their original ARM notes, homeowners started to walk away form their houses. These homeowners were the first batch of foreclosure victims that initiated the crisis we find ourselves in now. The banks had allowed them to bite off more than they could chew. So don’t wonder why the real estate market crashed. Americans asked for it – and banks delivered.

Unqualified borrowers – SISA and No Doc Loans

With unsuspecting and misinformed homeowners buying into all of the liberal ARM programs banks were selling, combined with greedy loan officers ripping equity out of homes with their excessive fees, the “perfect storm” real estate catastrophe had developed. The final ingredient that pushed everything over the top was during 2000 – 2006, when banks were lending to people who shouldn’t qualify at all for mortgages. I remember one lender that allowed people with a 550+ credit score to buy a house with nothing down. In case you are unaware, people with credit scores in the 500’s have all sorts of blemishes on their credit report. From bankruptcies and foreclosures to unpaid medical bills and maxed out credit cards; people with bad credit were getting 100% financing to buy a home. That’s like lending money to a thief. People with credit scores this low do not pay their bills – that’s why their scores are so low! Banks also were allowing loan officers to “state” a borrower’s income and cash reserves. This is called a stated income, stated asset (SISA) loan. Finance experts have nicknamed SISA loans “liar loans” because all the client’s income and cash reserves on the loan application are never verified by the bank lending them the money. This opens the door for all sorts of exaggerations on the loan application in an attempt to get someone to qualify for a loan. In creating SISA loans, banks were acknowledging that they knew when a borrower didn’t have enough income or cash reserves to get a home loan. But banks were still lending the money anyway. All that was needed for a SISA loan was marginal credit. Also during this period, no documentation (No Doc) loans were also available. This meant that a borrower or loan officer could state (lie about) the client’s income, state (lie about) their cash reserves in the bank and not be required to prove any form of employment. No joke: broke, jobless people with good credit scores could get a zero down home loan during this period! With banks throwing money out there like that, a crash was inevitable.

Right now, all banks in America have tightened up their loan programs significantly. With these programs being drastically modified, the availability of money for home loans is all but gone. The demand for real estate hasn’t slipped at all, nor will it; consumer demand is not what caused this crash. The crash was caused in large part by real estate prices being driven down by scared banks and unavailability of funds; right after a historic period of banks giving more money away than they ever have in history. Right now, many buyers cannot qualify to borrow money and sellers cannot sell to these would-be borrowers because of huge price drops caused by the lack of available mortgage funds. People still want to buy and sell just as much as ever before, but the same banks that drove prices up with their availability of funds and liberal loan programs have caused a massive price downturn by yanking these generous loan programs away. Very few people can make a move in real estate right now and real estate prices won’t recover until the banks permit them to move by releasing funds.

Another problem this lack of available capital has created is a homeowner’s inability to refinance out of their existing ARM’s. Many people that were financed into ARM’s over the last five years are now going into foreclosure. So many homeowners had zero down loans and because banks are not lending so liberally now, there is nothing they can do but let their house go into foreclosure. Their payments have adjusted to levels they cannot afford. There isn’t any equity left in the home to absorb the cost of refinancing and paying off the original loan. Many people owe more than their home is worth. Because so many homes are going into foreclosure, and with no end in sight for most of the US, values will continue to drop. This makes it nearly impossible for those that withstood the last few years to refinance their houses if they need to.

For example, say a homeowner owns a house that appraised at $200,000 five years ago. Assume that home has a loan balance of $180,000. In this situation, the homeowner could refinance with ease if they needed to – especially with all the former loan programs that were available. But home values are based on the prices of similar houses that have sold within 3-6 months and within ½ mile from the subject home. We in the business call these homes “comps”. In a healthy real estate market, everything sells with ease at full price because banks freely lend in these times. This keeps home values up. In the last two years we have obviously seen values drop due to the foreclosure crisis. This means the only available comps most appraisers are left with are foreclosed, vacant homes tainted with the poison of the price slip the banks caused by “turtling up”. If the homeowner in this example needs to sell or refinance, they may have a house that is now worth only $150,000 because the only homes selling near there are low priced foreclosures. A homeowner with a loan balance of $180,000 and a house now worth $150,000 with an adjusted ARM interest rate of 11% …what can the people in this example do but walk away?

Wages don’t keep pace with appreciation

When home prices go up, does your employer bump your wages up to compensate and help you afford your home? No way. But over the last ten years banks were making loan terms so lenient that people were buying homes in price ranges that were way too high for the wages they were making. Remember – many loan programs didn’t require any income documentation – they were SISA or No Documentation “liar loans”. Things got worse for banks and homeowners because wages were stagnant during this period and Americans continued losing their jobs due to ongoing industrial competition overseas. They also began losing their homes; homes they couldn’t afford in the first place.

Because banks were lending money so generously over the last 10 years, people came out of the woodwork to become homeowners. Why would anyone rent when they could own a home with no money down? This mentality drove both good credit borrowers and bad credit borrowers to all of the banks and brokers so they could get pre-approved to buy their home. And buy they did. So many people being induced by the banks to buy homes on extremely lenient loan terms drove housing prices through the roof. Any seventh grade kid who took economics knows that when demand goes up, supply goes down – driving prices up due to scarcity. Lenders were literally pushing people into homes they couldn’t afford. One loan product offered by a myriad of banks and lenders called the Pay Option ARM, was a loan that offered the homeowner four payment options every month. One option – the “minimum payment” option, had an interest rate below 4%. What many people were unaware of is that by making that minimum payment every month, the lender was adding the difference between the <4% minimum payment interest rate and whatever the prime rate was at that particular time – say 6.75%. This monetary shortage in payment was added to the loan balance every time the homeowner did this. It was deferred interest. This is called negative amortization. Exercising this payment option added hundreds of dollars more to the principal balance of the house every month. So instead of a homeowner paying their house down, they were actually burying themselves in more debt under the conditions and terms of the loan they took out. The low payment options on these loans tricked consumers into thinking they could afford twice the home they could. Many borrowers didn’t know these loans were negative amortization loans and they too were just another way for banks to induce refinances and home purchases during this period. What’s more is that banks were paying a hefty 4% in YSP versus the standard 2% to loan officers that sold these loans during this period. These Pay Option loans would become another reason why real estate is in such a crisis right now.

The Evolution of the new Global Economy

The Far East has become a powerhouse in the last decade. They are now in the midst of what America was in 100 years ago – an industrial revolution. Cars, electronics, clothing; you name it and they’re making it. They produce these goods often times to a higher quality standard and at prices much lower than their American counterparts. This has cost America jobs and wages – at a time when Americans could least afford it: when all those ARM’s began to expire and adjust to astronomical interest rates.

Over the last 100 years, a large part of our nation was built on the products and innovation of the Big Three automakers (GM, Ford and Chrysler). With the emergence of foreign competition in the auto industry, The Big Three now have to share the marketplace with foreign competitors. The Big Three started announcing cut backs and lay offs in 2005 due to the bite that foreign automakers were taking into the American made marketplace. Hundreds of thousands of jobs were lost all over the US. Ford downsized 44% in 2007. General Motors filed for bankruptcy in the second quarter of 2009. If you consider the trickle down effect these job losses had on other industries like suppliers, the job loss total is somewhere in the millions – and growing.

Speculators and Ill-informed Investors

Lastly, the past decade saw ill informed real estate investors jump into the market and force prices up. Remember that real estate prices were already artificially inflated due to the demand the banks created over the past decade. Everyone was buying homes with cheap, easy money and when investors saw this, they jumped in. This forced prices up even more. Some investors would exercise cash out refinances on their homes, then take the money and run. They did this because banks were giving real estate investors 100% financing on investment homes for the first time in history. It was all too easy for investors to get money. Criminal investors knew that nothing would happen to them if they refinanced cash out of their investment properties and ran away without making even one monthly payment to the bank that lent them the money. They were taking advantage of the window of opportunity before this historic period ended.

This artificial demand for real estate and the money that came with it didn’t last long. Legitimate investors that got in on the tail end of the big boom have been put in a difficult position because their homes have depreciated tens of thousands of dollars. They either have to let these homes go back to the bank in foreclosure or they must keep their investment homes – thus owing more on these homes than they are currently worth. That’s what over-availability of loan products, loan fraud, greed and a sudden dry up in available mortgage funds does to a housing market. Sure the liberal loan products and fly by night lenders that flooded the mortgage market over the past ten years played a major role in causing the market we’re in now. Don’t get me wrong though; it wasn’t all bad. From 2000 to 2006, many ethical investors that timed it just right rode the real estate wave to millionaire status. It was hard not to – the money was there for the taking.

Banks today have completely overcompensated. Getting a loan is like climbing The Great Wall of China. This is not good because it’s had a massive trickle down effect thus halting our overall economy. Banks have already started to realize that they’re losing money by not lending money. Banks have also started to realize that they’re taking back too many foreclosed homes. They’re now hastily working with their customers as they know this will be a long recovery process made even longer if they don’t step in to help the average homeowner in modifying their original loan.

Turn that finger around and point it at yourself!

But there’s an even larger problem that we must probe: Accountability. There is no accountability when an investor buys up a bunch of property with borrowed money, then refinances all the remaining equity out, and hopes for the best with no care in the world. Sure, investors who did this over the past ten years lost their homes and got their credit scores demolished for several years, but the bigger issue is that banks and lenders encouraged this by creating ultra liberal loan products. Nobody is being held accountable for the current accumulation of defaulted loans despite everyone knowing who the culprits were on both sides. And those same investors and mortgage lenders will be back doing this investment activity again when the banks start loosening the noose again. Homeowners and investors who receive hundreds of thousands of dollars should be held accountable if they walk away from property they owe money on so long as they are in a situation where they can take corrective action. Owner occupant homeowners, investors – it doesn’t matter. If banks had more proactive borrower accountability standards in place for borrowed funds, the real estate market crash wouldn’t have been as severe.

Needless to say, the golden parachute deployment in 2008 for mega-banks and the hundreds of satellite lenders that were spawned by large scale investment banks during the mortgage boom in the mid 2000’s needs to have a large hole punctured in it. In the banking world, taxpayer funded bailouts must come to an end so that the built in economic boom and bust cycles that exist because of such a constitutionally breaching system come to an abrupt end. There is no such a thing as a financial bailout for the American citizen if he or she makes poor financial decisions. But yet, the Federal Reserve can keep the printing presses rolling for colossal banks with the “promise to pay” being made every day by future taxpayers. If the average taxpayer cannot counterfeit money, then why should the banks who caused such a colossal breakdown be so fortunate?