Yesterday the housing numbers came out, showing that existing home sales had fallen and that the current supply of existing homes on the market is enought to last 11 and 1/2 months. One good piece of news is that home sales in the West were up, largely due to a drop of more the 17% in home prices. Ouch!
Foreclosures are up meaning that the supply of homes is only getting bigger. It's a wonder how new home builders can even stay profitable. D.R. Horton, the country's largest homebuilder is set to release their quarterly earning the first week of August.
BACKGROUND
It’s now 2008, and the Credit Crisis is in full swing. Money is hard to get no matter if you’re just an individual looking to buy a home or if you’re a massive corporation looking to restructure your debt. This tightening of credit has caused the U.S. Economy to practically stop growing. As a consequence more and more people are being laid off each week, homes are languishing on the market, foreclosures are rising, there are runs on banks, and no one is quite sure when it will end.
To understand what is happening we have to go back to the beginning, to the start of the great bull market in real estate, which coincided with the beginning of the millennium.
REAL ESTATE
From the end of the 90s to the middle of the first decade of the new millennium, the real estate market in the U.S. was booming. Financial innovations had occurred that brought in new participants to the market. Everyone was buying, and everyone was making money.
Investors on Wall Street were flooding the credit markets, eager to get their hands on high returns. Banks were loose in their lending practices, giving loans that required little or no money down. It wasn’t a problem, since by the time the homeowner would have moved in the house would have gained tens of thousands in value.
On top of all this, interest rates were at historical lows following the events of 9-11. By June 2003, Alan Greenspan, the then Chairman of the Federal Reserve Board of Governors, had lowered the Federal Funds rate to 1%.
Everyone wanted to be a homeowner and get a piece of the action as home prices kept skyrocketing. Like every speculative bubble, this one had people thinking it would never end. Land is finite, they reasoned, and the population can only grow.
MORTGAGES AND MONEY
There was a lot of money to be made in Real Estate. If a bank required you to put nothing down, the only cash out of your pocket would be closing costs. Suppose, during this time you bought a 4 bedroom 2200 sq. ft. home in Pennsylvania with no money down for $250,000. Let’s say the closing costs were in the neighborhood of $9,000, and after 1 year you resold the home for $300,000. Even after paying the realtors $18,000 for their cut, you still had $32,000. That’s a 255% return in one year! You put in $9000, you get back $32,000, which means a profit of $23,000.
Flipping became a pastime. It was common for investors to sell the contract of sale before they even got to closing. The Florida and California markets were particularly good at this.
The banks were more than eager to keep lending because the investors on Wall Street were hungry for anything giving above average returns. So long as Wall Street was willing to buy those loans from the banks, the banks kept issuing more.
Ultimately, the flow of money attracted the brightest minds on the Street and innovation in the forms of exotic derivatives based on mortgages followed.
COLLATERALIZED DEBT OBLIGATIONS
Enter the Collateralized Debt Obligation, the infamous CDO. You can think of a CDO as an income stream. By investing in a piece of a CDO you’re essentially getting a stream of income at some predetermined rate. The higher the rate, the riskier the stream is.
To understand what a CDO is you have to start with the homeowner. All mortgages originate at the retail level, when a buyer takes out a loan to buy a home. Let’s use Wells Fargo as an example, since they are the commercial bank that originated my loan. Wells Fargo lends out money to thousands of homebuyers, but Wells Fargo doesn’t have an infinite amount of money, so at some point they have to sell those loans.
Say we have 1,000 loans of varying profiles, some went to people with good credit (prime loans), some went to people with bad credit (subprime loans). Wells would then resell all 1,000 loans on the secondary market, usually to one of the government backed agencies, like Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac would pay Wells Fargo for the loans, so that Wells now had more money to loan and create new mortgages. Fannie Mae and Freddie Mac would bundle these loans by type, and resell these bundles as asset backed securities to investors on Wall Street.
Now Wall Street doesn’t make money by buying and holding. They make money by reselling and charging a fee. The clever investment banks, for example Bear Stearns, bought mortgages from the government backed agencies and repackaged them into CDOs. So you can see what a CDO is, it’s just a bunch of bundled mortgages. But the structure of the CDO is where the real financial engineering occurred.
You can think of a bundle of mortgages as a stream of income. What the investment banks did was to divide the income stream into different segments or tranches. As money would come in each month, the top tranche would be paid first. This top tranche would have the lowest return, but was the safest. The bottom tranches would be paid last and therefore were exposed to the most risk (so when a subprime borrower defaulted, the bottom tranches would be out of luck). But those bottom tranches also had the highest returns.
Unfortunately no one really wanted those bottom tranches, because they were essentially made up of the worst loans out there. Remember this was a time when people with no jobs, assets, or income could get a loan. So the banks created hedge funds that used borrowed money to buy these risky tranches. You can see where this is going.
By leveraging, (borrowing money), to fund these hedge funds, the banks amplified the potential losses. Moreover, these funds had wonderful names like the High Yield Credit Fund, so that investors would buy into them.
Things started coming to a end in terms of easy money towards the beginning of 2007, by the middle of that summer, Bear Stearns became the first to report losses as two of their funds went bankrupt.
Those funds were just the tip of the iceberg. What would follow would be a drying up of credit which would affect every American.
STAY ON TOP OF THE NEWS
So this is the environment that we find ourselves. Tight credit and risk averse investors and prevail. Now that we now how we got here we can figure a way to get out. Stay tuned…
It’s now 2008, and the Credit Crisis is in full swing. Money is hard to get no matter if you’re just an individual looking to buy a home or if you’re a massive corporation looking to restructure your debt. This tightening of credit has caused the U.S. Economy to practically stop growing. As a consequence more and more people are being laid off each week, homes are languishing on the market, foreclosures are rising, there are runs on banks, and no one is quite sure when it will end.
To understand what is happening we have to go back to the beginning, to the start of the great bull market in real estate, which coincided with the beginning of the millennium.
REAL ESTATE
From the end of the 90s to the middle of the first decade of the new millennium, the real estate market in the U.S. was booming. Financial innovations had occurred that brought in new participants to the market. Everyone was buying, and everyone was making money.
Investors on Wall Street were flooding the credit markets, eager to get their hands on high returns. Banks were loose in their lending practices, giving loans that required little or no money down. It wasn’t a problem, since by the time the homeowner would have moved in the house would have gained tens of thousands in value.
On top of all this, interest rates were at historical lows following the events of 9-11. By June 2003, Alan Greenspan, the then Chairman of the Federal Reserve Board of Governors, had lowered the Federal Funds rate to 1%.
Everyone wanted to be a homeowner and get a piece of the action as home prices kept skyrocketing. Like every speculative bubble, this one had people thinking it would never end. Land is finite, they reasoned, and the population can only grow.
MORTGAGES AND MONEY
There was a lot of money to be made in Real Estate. If a bank required you to put nothing down, the only cash out of your pocket would be closing costs. Suppose, during this time you bought a 4 bedroom 2200 sq. ft. home in Pennsylvania with no money down for $250,000. Let’s say the closing costs were in the neighborhood of $9,000, and after 1 year you resold the home for $300,000. Even after paying the realtors $18,000 for their cut, you still had $32,000. That’s a 255% return in one year! You put in $9000, you get back $32,000, which means a profit of $23,000.
Flipping became a pastime. It was common for investors to sell the contract of sale before they even got to closing. The Florida and California markets were particularly good at this.
The banks were more than eager to keep lending because the investors on Wall Street were hungry for anything giving above average returns. So long as Wall Street was willing to buy those loans from the banks, the banks kept issuing more.
Ultimately, the flow of money attracted the brightest minds on the Street and innovation in the forms of exotic derivatives based on mortgages followed.
COLLATERALIZED DEBT OBLIGATIONS
Enter the Collateralized Debt Obligation, the infamous CDO. You can think of a CDO as an income stream. By investing in a piece of a CDO you’re essentially getting a stream of income at some predetermined rate. The higher the rate, the riskier the stream is.
To understand what a CDO is you have to start with the homeowner. All mortgages originate at the retail level, when a buyer takes out a loan to buy a home. Let’s use Wells Fargo as an example, since they are the commercial bank that originated my loan. Wells Fargo lends out money to thousands of homebuyers, but Wells Fargo doesn’t have an infinite amount of money, so at some point they have to sell those loans.
Say we have 1,000 loans of varying profiles, some went to people with good credit (prime loans), some went to people with bad credit (subprime loans). Wells would then resell all 1,000 loans on the secondary market, usually to one of the government backed agencies, like Fannie Mae and Freddie Mac.
Fannie Mae and Freddie Mac would pay Wells Fargo for the loans, so that Wells now had more money to loan and create new mortgages. Fannie Mae and Freddie Mac would bundle these loans by type, and resell these bundles as asset backed securities to investors on Wall Street.
Now Wall Street doesn’t make money by buying and holding. They make money by reselling and charging a fee. The clever investment banks, for example Bear Stearns, bought mortgages from the government backed agencies and repackaged them into CDOs. So you can see what a CDO is, it’s just a bunch of bundled mortgages. But the structure of the CDO is where the real financial engineering occurred.
You can think of a bundle of mortgages as a stream of income. What the investment banks did was to divide the income stream into different segments or tranches. As money would come in each month, the top tranche would be paid first. This top tranche would have the lowest return, but was the safest. The bottom tranches would be paid last and therefore were exposed to the most risk (so when a subprime borrower defaulted, the bottom tranches would be out of luck). But those bottom tranches also had the highest returns.
Unfortunately no one really wanted those bottom tranches, because they were essentially made up of the worst loans out there. Remember this was a time when people with no jobs, assets, or income could get a loan. So the banks created hedge funds that used borrowed money to buy these risky tranches. You can see where this is going.
By leveraging, (borrowing money), to fund these hedge funds, the banks amplified the potential losses. Moreover, these funds had wonderful names like the High Yield Credit Fund, so that investors would buy into them.
Things started coming to a end in terms of easy money towards the beginning of 2007, by the middle of that summer, Bear Stearns became the first to report losses as two of their funds went bankrupt.
Those funds were just the tip of the iceberg. What would follow would be a drying up of credit which would affect every American.
STAY ON TOP OF THE NEWS
So this is the environment that we find ourselves. Tight credit and risk averse investors and prevail. Now that we now how we got here we can figure a way to get out. Stay tuned…
Friday, July 25, 2008
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