Did the Great Recession make you weary of real estate investments? Or, were you among those who benefited from short sales and foreclosures? Nearly all of us were hit by the economic fallout. While this might make us shy away from investing, it’s important to remember every economic problem creates the potential for economic gain.
Making smart decisions as we move forward requires a firm grasp on where we’ve been. Many historical factors can help intelligently influence our understanding of current and future markets. Here are a few things to understand about the housing market:
Collateralized Mortgage Obligations
In 1983, Gordon Taylor and Dexter Senft from Saloman Brothers developed the idea of bundling mortgage payments into $1000 increments which they sold to investors. These bundles became known as Collateralized Mortgage Obligations.
How did this create a profit? For example, if a mortgage had a seven percent interest rate, they paid investors six percent. This was good for banks because they could get money from investors to make loans on which the banks would make a margin. They were also able to spin the risk off to the investors. If borrowers defaulted on their loan, it was the investors who mostly lost.
This development was also good for homeowners because it created a pool of money from which they could borrow to buy a home. And, it was good for Wall Street because they profited from the fees this process created.
Collateralized Debt Obligation
Spring forward roughly 20 years. The principle of Collateralized Mortgage Obligation was expanded to more than just home mortgages. This became known as the Collateralized Debt Obligations.
Loans (for anything from homes to cars, planes, vacations, and boats) were bundled into bonds called Tranches. Think of Tranches as building blocks, stacked one on top of another. The first money to come in paid off the top block and so on and so forth. Meaning, the bottom Tranches had the most risk. Lenders were able to get Tranches rated by rating agencies which used the historical default rate on mortgages to determine the bond’s worth. To cover the potential default from borrowers, a few additional mortgages were added to the bond beyond the bond’s determined worth. Thus, the bond appeared to be a foolproof investment. Unfortunately, if too many borrowers defaulted, bond holders took a cut.
In the 1930s, Congress and the President signed into law the Federal Deposit Insurance Corporation (FDIC). This insured individual accounts up to $100,000 should a bank fail.
However, in the 1970s depositors began carrying much higher balances, in the $10 to $100 million range. These large depositors wanted insurance.
To insure depositor’s money, banks created REPO (short for repossess). REPO normally consisted of Collateralized Mortgage Obligations and Collateralized Debt Obligations.
Adjustable Mortgage Rates
Adjustable Mortgage Rates were created out of the big push to sell more and more homes. Teaser rates offered low mortgage rates, such as 0.5, 1.0, and 1.5 percent, for a given period of time. This low rate was then adjusted to a much higher percentage, requiring homeowners to pay significantly increased sums.
During this same time, No Income No Job No Asset Loans (NINJA Loans) were introduced. Borrowers needed no qualifications to buy a home. Lenders saw NINJA Loans as a win-win. If the borrower defaulted with an annual property value increase of 14 or 15 percent, they could sell the home and still turn a profit.
Part of the initial dip in the housing market was artificial. For example:
Four homes are sold in one year, two for $500,000 and two for $100,000. The average home price would be $300,000. One year later, the people who bought their home $100,000 sold for $200,000 and the people who bought for $500,000 sold for $1 million. The profit would be a factor of two.
But, suppose the new buyers for the $500,000 home (now priced at the inflated $1 million) didn’t get financed and the sale didn’t go through. It would appear home prices fell by 50 percent. In reality, they’d increased by 100 percent.
This example is grossly exaggerated, but done so to illustrate what was happening – high-end homes were not selling. Lower priced homes were.
Additionally, understanding what helped some companies succeed can help you identify those same characteristics in potential future investments. Each week on About Money, I interview a successful business owner whose company survived the Great Recession.
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