Times have changed for Mike Teer. A real estate broker in Riverside, California, Teer’s business has fallen off _dramatically over the last 18 months. And it’s no wonder. In the first half of this year, Riverside posted the highest number of foreclosure filings of any metro area in the country—a total of 41,351, or one for every 33 households, according to data provider RealtyTrac Inc.
Not too long ago, Teer says he could place a “For Sale” sign in a yard and offers would start rolling in, often that same day or, at the most, within just a few days. Now he says properties stay on the market an average of 90 to 120 days. As a result, three of eight agents left Teer One Properties, his 18-year-old firm. “Those agents whose only source of income was real estate commission checks and who have gone several months without a closed transaction have been forced to get another job,” says Teer.
The housing slowdown has also led to changes in his day-to-day activities. Though Teer has more time to work with clients, he has also taken up blogging and opened an account with Zillow.com, the popular Website that allows users to obtain an estimate of a home’s value. “Frankly, these are things that I didn’t have to do two years ago,” he says. But perhaps the most significant change is that it’s been increasingly difficult to get buyers to pay the true value of a house, forcing sellers to become more flexible. Says Teer: “For more of my clients who are selling and can’t afford to leave the house empty, I’m helping them find tenants to lease the property, for at least a year, to give them more time for the market to recover.”
Even though he says no more than a handful of his deals involve subprime loans—which are higher interest rate loans offered to borrowers with low credit scores or a heavy debt load—it may have been unavoidable for Teer, as a broker in a hard-hit market, not to feel the sting. But it’s the more widespread fear of just how far the subprime mess may impact other areas of the economy that has led to increased stock market volatility and caused lenders to tighten their purse strings.
In September the Federal Reserve took action to suppress rising economic anxiety by cutting the fed funds rate—the rate banks charge each other for overnight loans—for the first time in four years, lowering it from 5.25% to 4.75%. How Chairman Ben Bernanke would address the subprime situation was regarded as his first major policy challenge since taking office. The fed funds rate had been 5.25% since June 2006, which marked the end of a string of 17 rate hikes. Whether lowering interest rates will calm investors’ nerves and stabilize the market will take time to play out.
To get a handle on how the housing slowdown may continue to ripple through the economy, it’s first necessary to look at how the subprime stone was cast. Barring the economy slipping into a recession, it appears that the subprime situation may present a classic half empty/half full scenario for investors.
The Subprime Stone
It’s abundantly clear to many market watchers that maintaining low interest rates for such an extended period naturally fuels speculation and risk-taking. So why did it seem that most of Wall Street was taken off guard when cracks appeared in the subprime foundation?
One key factor is that many of the mortgages offered to subprime borrowers were relatively new creations. “The option adjustable rate mortgages and the interest-only mortgages, etc., had never really been rolled out in such volumes,” says professor Raphael Bostic, director of the Master of Real Estate Development program at the University of Southern California in Los Angeles. “In particular, we had never seen how they performed in periods of [economic] stress.”
These new products were introduced as lower interest rates fueled the housing boom and lenders looked for ways to maximize their participation. As they sought a larger piece of the housing action, many lowered their credit standards. At times, adjustable rate mortgages were made without regard to the borrower’s ability to repay once the low introductory teaser rate was reset to a higher level. The reset often resulted in a substantial increase in the monthly mortgage payment, making for an unaffordable burden.
Because their low introductory rates made homeownership more affordable, adjustable rate mortgages increased in market share. Now, many are pointing their fingers at mortgage brokers for pushing these products to subprime borrowers. They claim a number of brokers made assurances that it wouldn’t be a problem to refinance before the interest rate reset—typically within two to five years. However, as the market softened, it has become difficult to refinance. The end result: Many face foreclosure.
The rising foreclosure rate will have a significant impact on African American homeownership, which has declined slightly in recent years and remains below 50%. Studies by the Durham, North Carolina-based Center for Responsible Lending and the Washington, D.C.-based National Community Reinvestment Coalition have analyzed mortgage origination data revealing that African American borrowers are more likely to receive high-cost subprime loans. And it’s not just a low-income phenomenon. In fact, the NCRC study, Income is No Shield Against Racial Differences in Lending, found that in 159 metro areas across the country, more than 40% of the loans to middle- and upper-income African Americans were high cost. Because “subprime” refers only to the interest rate attached to the loan, it’s important to remember that they can be fixed-rate or adjustable-rate mortgages. Similarly, it’s important to note that while such disparities must be addressed, it’s unwise to speculate as to how much of the difference can be attributed to predatory lending.
All the while, as housing values climbed, investors sought to participate in any way they could. Wall Street satisfied that demand by churning out mortgage-backed securities. “Increasingly in recent years, mortgage lenders have shifted from lending money and holding the mortgage to lending money and then pooling the mortgage with others to issue securities against it,” says Dr. Andrew Brimmer of Brimmer & Co. in Washington, D.C., and a member of the black enterprise Board of Economists. “Many of those securitized mortgages were rated AAA and AA by the rating agencies.” These newly created bonds, called collateralized mortgage obligations (CMOs), are backed by the income stream from the bundled mortgages. Generally, bonds that are backed by debt instruments, including _mortgages, are referred to as collateralized debt obligations (CDOs). It was the meltdown of subprime mortgages and the CDOs that they backed that _rendered two Bear Stearns _billion-dollar hedge funds nearly worthless in July.
As institutional investors sought to maximize their returns through these mortgage-backed securities, somehow the riskiness of lending to borrowers with less-than-stellar credit was downplayed. “Once some organizations started to have problems, all of Wall Street has said, ‘Whoa, wait a minute. What
have we been doing for the last couple of years?'” says Bostic, a former senior economist for the Federal Reserve Board of Governors. He says the liquidity crunch came about as a result of institutions “taking a step back” and assessing the risks they’re taking on. Still, for some it was too late. According to Bloomberg’s Subprime Scorecard, more than 100 mortgage companies have ceased operations or sought buyers since the start of last year.Indeed, it was the rising liquidity crunch that led the Fed to inject billions of dollars into the financial markets through a series of repurchase agreements in August. In a repurchase, the Fed buys securities from dealers, who then deposit the proceeds into commercial banks. This rais
es the amount of money in the banking system. Ultimately, when the securities mature, they are returned to the dealers, who in turn repay the Fed.
“The Fed took action because the commercial paper market seized,” says Cyril Theccanat, managing director of investment management at Smith Graham & Co. Investment Advisors L.P. in Houston (No. 8 on the be asset managers list with $2.3 billion in assets under management). “They were very concerned that there would be a spillover effect in the real economy.” Commercial paper—including CMOs—is short-term debt, with a maturity of 270 days or less, that is primarily used by corporations to finance inventory or manage working capital. “If _corporations are unable to fund themselves in the short-term market, then that is going to have negative implications from the standpoint of capital spending and job growth,” he says.
The Ripple Effect
Subprime loans account for 23% of the mortgage market. Of those loans, the Center for Responsible Lending forecasts that one out of five originated in 2005 and 2006 will end in foreclosure. So far, the delinquencies are concentrated. The Mortgage Bankers Association reported that in the second quarter, the increase in foreclosure filings in four states—Arizona, California, Florida, and Nevada—was largely responsible for an overall rise in the national delinquency rate, which grew to 5.12% of all loans outstanding. In a release, the association’s chief economist said that were it not for the increases in foreclosure starts in those states, there would have been a nationwide drop in the rate of foreclosure filings.
But with billions of adjustable-rate subprime debt expected to reset in the next few years, the circle of subprime ripples may continue to grow wider.
The Housing Market
“Surprisingly, the high end of the real estate market has ground to a halt,” says Maceo Sloan, chairman and CEO of NCM Capital in Durham, North Carolina (No. 7 on the be asset managers list with $2.5 billion in assets under management). “The ramifications on this type of slowdown in the upper end of the housing markets will have a spillover effect into purchases of appliances, furniture, and other goods. This was certainly not an area that was expected to have problems.”
Jackie Williams, a real estate broker with 31 years of experience and the owner of Sterling Realtors in Middletown, Connecticut, puts it in perspective. “It really is not doomsday,” she says. “If we can survive 1988 through 1991—with banks closing, interest rates escalating to 10% and 11%, and a shutdown of lending to people with less worthy credit—we can survive anything.” Her agency, which has a roster of 27 agents, sells an average of 300 homes a year. Williams says that roughly 20% of her company’s transactions involve subprime mortgages.
For those who are currently looking to buy a home, she encourages people to try to identify all possible sources of funding and to exercise caution to fully understand the terms of the loan. Borrowers should be sure not to overlook smaller lending institutions such as local banks that often set aside funds for community lending programs. And as a buyer: “Now is the time to negotiate,” she says. “Everything in the world is negotiable.” Along those lines, Teer says he tells buyers not to get too caught up in cosmetic issues that they might be able to correct themselves, but to instead prioritize “health and safety” issues such as plumbing, heating, and the condition of the roof.
In Middletown, Williams says that housing inventory is up 30% to 40% over last year, making it much more competitive for sellers to get the attention of buyers. Like Teer in Riverside, she says sellers in her market have to “price to sell” and be willing to negotiate, or risk having the house sit on the market for an extended period. What’s more, because of channels like HGTV and the plethora of interior design programs on television, she says buyers often have high expectations. Sellers also should work with their realtors and tap in to their expertise in terms of setting a price and determining what steps may need to be taken before putting a house on the market.
The Stock Market
The recent market volatility hammered a wide range of investments, as risk was increasingly being thought of as a four-letter word. As a result, some instruments may have been unduly sold off as investors traded based on fear rather than a fundamental analysis of the security.
“The subprime collapse had a contagion effect,” explains Bruce Goode, president of Cleveland-based Goode Investment Management, noting that its impact was felt across the entire fixed-income market. He maintains, however, that there are solid investment opportunities. Goode advises investors to stick with quality—buy high-quality AAA or AA rated bonds that have been beaten up. (To understand how your portfolio may have been impacted, see “Mortgage Mess,” Moneywise, this issue).
For Jason Tyler, a senior vice president with Ariel Capital Management L.L.C. in Chicago (No. 2 on the be asset managers list with $16.1 billion in assets under management), it’s precisely the companies that issue credit ratings that he believes present an opportunity for contrarian investors. “People are starting to point fingers at the bond rating agencies, saying they should have predicted the subprime meltdown,” he says.
While threats of litigation circle around Moody’s Corp. and Standard & Poor’s, a unit of The McGraw-Hill Cos., Tyler points out that they’ve faced litigation risk before and that long-term investors may want to take a look. Noting Moody’s particularly strong franchise and market share, he believes its shares present a “great opportunity” for investors who can remain patient over the next several months during which the stock may take a few more knocks. In mid-September, shares of Moody’s Corp. were trading at $44.38, down 39% from $72.44 at the end of May.
Tyler’s colleague, Matt Sauer, senior vice president and co-portfolio manager of the Ariel Appreciation fund (CAAPX), says that in the current environment, shares of Illinois Tool Works (ITW) look attractive. Based in Glenview, Illinois, the company makes metal and plastic fasteners, food service and welding equipment, and other products. Because the company is very diverse with respect to its products and customers, as well as geographically, Sauer feels it has the ability to weather different economic cycles. In mid-September shares were trading at $56.83, up 24% for the year.
Still Water
As investors look for market stability and scrutinize whether the recent interest rate cut will quell the likelihood of a recession, experts caution that it would be detrimental for regulators to swing from one extreme to the other. While the growth of the subprime mortgage market initially benefited many black homeowners, increased regulation may limit the African American community’s entrée into homeownership and the wealth building opportunity that it provides.
As a prime example, Brimmer notes the risk in assuming many subprime borrowers were somehow tricked into their loans. While it’s true that many mortgage lenders vigorously promoted their loans, he says there was a demand for housing among low-income borrowers that was simply met by the marketplace. It’s a sentiment that underscores the challenge the NAACP faces in its pending lawsuit against a dozen subprime lenders alleging “institutionalized systematic racism.” Brimmer cautions that increased regulation to control predatory lending may have the side effect of pricing many African Americans out of the housing market.
Back in California, as Teer looks ahead, he says above all else, there’s no need for homeowners to panic. Those who don’t have to sell in this market should ask: “‘Am I in a safe
neighborhood with good schools and in a community that I like?’ If the answer’s yes, then their investment is no more of a risk today than the day they bought the house.”
Make the Most of It
How to navigate the subprime fallout
If you’re buying a home …
- Investigate all sources of funding. Work with a reputable lender and investigate community-based programs that may offer down payment or closing assistance. _Ultimately, make sure you fully understand the terms of the loan.
- Negotiate for what’s important. Get a home inspection report from a licensed contractor or home inspection company. Ask the seller to focus on critical repairs, but consider fixing cosmetic concerns yourself.
- Assemble a team. Get references for any professionals—real estate agent, mortgage broker, attorney, etc.—who will provide information that’s vital to your decision _making.
If you’re selling a home …
- Stage the home. Paint, replace carpeting, etc., to ensure the house appeals to the widest range of potential buyers.
- Price to sell. Work with your realtor, visit the local _property assessor’s office, and use online resources to research what comparable homes in your area are _selling for.
- Be willing to negotiate. Understand where you may need to be flexible to avoid killing the deal.
- Consider leasing. Weigh the possibility of leasing the home to minimize potential losses and buy some time for the housing market to improve.
If you’re managing your portfolio …
- Buy solid companies on the dip. Market volatility and investor fear can cause a stock to drop, regardless of the company’s future viability.
- Think defensively. As the economy slows, look for opportunities in sectors that are more likely to hold up in a downturn, such as healthcare and utilities.
- Check your asset allocation. Make sure that you’re holdings are diverse and make any necessary adjustments.
- Hold on to cash. Don’t be afraid to increase your cash position as you wait for increased stability in the _market.
Where’s the value of your home headed?
| Metropolitan Area | Median Home Price (2Q 2007) | Percent change from year prior | Percent change forecast,year ahead |
| Atlanta | $174,400 | 0.6% | 3.1% |
| Boston | 416,880 | -1.7 | -7.8 |
| Charlotte, NC | 202,750 | 4.5 | 0.9 |
| Chicago | 287,240 | 2.9 | 0.7 |
| Columbus, OH | 147,990 | -1.5 | 2.3 |
| Dallas-Fort Worth | 153,020 | -1.2 | 3.0 |
| Detroit | 100,320 | -2.1 | -3.4 |
| Houston | 151,860 | 1.7 | 2.3 |
| Indianapolis | 122,100 | 0.8 | 3.3 |
| Jacksonville, FL | 196,490 | 0.0 | -6.7 |
| Los Angeles | 553,560 | 5.9 | -8.3 |
| Memphis, TN | 141,510 | -0.9 | 2.0 |
| Miami-Fort Lauderdale | 380,220 | 2.7 | -7.6 |
| Nashville, TN | 183,370 | -1.4 | 2.1 |
| New York | 534,620 | 3.3 | -7.3 |
| Philadelphia | 235,800 | 2.9 | -4.7 |
| Phoenix, AZ | 260,620 | -1.5 | -10.9 |
| Raleigh, NC | 223,450 | 5.5 | 1.6 |
| width=”30%” valign=”top”>San Francisco | 825,100 | 2.6 | -7.0 |
| Washington, DC | 427,810 | 3.6 | -9.2 |
*Existing single-family houses
source: nar, moody’s economy.com