SubPrime Mortgages
Weathered The Financial Storm … Older & Wiser?
I have a series of 2 words for you …. Consumer Sentiment, Fear and Safety, Confidence and Doubt … and the list goes on. There is a lot of information and discussion regarding the Financial Debarcle-Crisis-Tsunami and so on Bloomberg and related channels. What I want to talk about is the chain of events, the human emotions and actions that led to the situation that is still affecting the world today.
If you follow this theme and look for a pattern in human behavior and thinking, it is the same since the beginning of time. We are driven to safety and in avoidance of the pain of financial loss. Quite a simplistic statement on the surface and yet digging deeper, we could also identify the drastic rise and falls in the share market. Based on the anticipation of gains and people’s “confidence” in the market ahead of other economic indicators the market rises and falls.
Whilst all of us have experienced the recent Financial downturn, I wonder how many people actually understand the mechanics that cause Financial Depression. Curious as a person but also required how to anticipate market shifts in my own career, I wanted to delve deeper into the actual cause of prolongued financial crisis that gripped the world.
It all started when America wanted to offer housing loans to those who potentially could afford it but were either self employed and/or did not have a solid track record of years of success in your business but could afford the repayment. In Australia, we called them Low Doc or No doc loans. Simply loans based on equity deposits of 20% on the home that you intended to purchase. The idea was innovative and also seemed to made sense.
Example: Let’s say you wanted to buy a 500,000 home, had the required deposit of 20% plus state statutory stamp duty, various fees and conveyance costs totaling 5% making it a grand total of 25% of the cost of the home as the required equity to get a bank loan. The Low/No Doc terms would essentially qualify you for a loan of 400,000 – you come up with 100,000 for the deposit and 25,000 for buying costs. Simple enough right?
Well during the Real Estate boom of the early 2000 in Australia, the market was hot and folks were buying/upgrading their homes and investors were going mad looking for margins in the property boom. Some who had no intention of settling their transactions were re-selling their homes before the difference or settle amount was due. So they would buy a property based on a 10% deposit and before the 90% was due in 2 months, they would “flick” the property off.
Lots of folks got hurt as the idea in this case was that as long as you could come up with the deposit, you would be able to buy/flick a property to someone else for more money than what you paid for. In that feeding frenzy environment, lenders were also getting adventurous and happy to offer collaterilized loans for folks who “claimed” using a written statement that they could afford.
Let’s analyse this a bit further … by talking about Joe Blogs a fictitious property punter who is in the market during that time. The equity required on a home that was worth 500,000was going up due to the property bubble and rising market to 600,000. The equity required to purchase the home is 20% of the asking price. Not much negotiation takes place as the Real Estate Agent tells you he has 10 buyers with cash in hand so you have 5 minutes to say Yes, I’ll take it before the price goes up.
So you need 120,000 plus 5% bring purchasing costs making this a total of 150,000 … let’s say of all those able to buy a 600,000 property some can only put up 10% … enterprising second tier lenders who are Not a major banks using private investment funds or Superannuation funds would lower the 20% equity down to 10% to service more buyers. Buyers may not have the cash but could use other assest like shares or their family home.
In this case Joe Blogs would need 10% of 600,000 on a property valued months ago at 500,000 BEFORE the property bubble. He buys it with 60,000 deposit using his family home as collateral. The property settle, he then adds another 30,000 as buying costs and the ends up with a loan of 600,00-60,000 = 540,000 …. on a property as you recall, only valued at 500,000 months ago.
The market collapses and the property bubble bursts and the artificially inflated value of that 600,000 property comes crashing down closer and closer to its original intrinsic value of 500,000. Let’s go to the start of this article and look at consumer sentiment again. Folks are unable to service their mega loans of 540,000 at an interest rate of 8% and have to sell. The bubble has burst and prices are free falling. Out of desperations some lower their asking price to below the 600,000 they paid. In a spiral that has only just started, they lower till a buyer with cash and confidence or desperate to own this property buys it.
For some lower is not low enough so eventually it goes all the way down to 500,000 which was the original intrinsic value that it should have been sold for. However, let’s imagine a speeding locomotive … once moving its hard to stop. The brakes are on but it’s too late. For that poor bugger: Joe Blogs, he needs to consider less than 600,000 … less than 500,000 and settle for 450,000!!!
He owes 540,000, takes 450,000 pays the same Real Estate Agent he bought it from 2% selling fees so he is up for another 100,000 of loss on top of his original 60,000 deposit and 30,000 acquisition fees totaling a grand loss of 190,000 … welcome to property investment 101. Typically in Australia, this would be the case where if Joe Blogs did not honor his debts, he would be made Bankrupt. In the US, I am still trying to find out for sure but as I recall Joe could in effect walk away by handing out the keys … your learned comments are welcome …
In this situation in the US, the bank would still be holding a debt of 540,000 on a property that might be worth less than 500,000 … in fact in our scenario about 450,000. The bank has the task of then selling the property which in this example of being sold for450,000 … a loss of 90,000. Multiply that by a hundred thousand loans and you have a loss of 45 Billion Dollars … TSUNAMI my friends!!!
This is now starting to make sense to me as to what would have happened in the US and not in Australia where folks would have been incentivized to honor their debts and try to hold on to their properties … borrowing from family and friends if need be as the alternative is simply not palatable …
So what do you think?
Dan
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