Friday, February 15, 2008

The Real Estate Market Today

I am not linking to it, but I just read a rather fat headed post about the 'real estate meltdown'. The writer of the post had no clue as to what has caused the current 'crisis' (Please note the use of 'scare' quotes).

Here is why some houses are now worth less than they were a year ago.

Lenders used brokers to loan people who had not previously been considered credit worthy one hundred percent of equity loans with adjustable interest rates. These rates were made artificially low as an incentive to borrow.

Two simple sentences and that explains it.

Let me break it down.

The lenders generally did not use salaried employees to evaluate the loans that were being made. They used brokers whose compensation depended directly upon making loans. The more loans made, the greater the brokers' compensation. Further the lenders relied upon the brokers to obtain accurate facts from the prospective borrowers and to evaluate their credit worthiness. {sarcasm}There was of course no incentive on the part of the brokers to fudge, shade the facts or lie {/sarcasm}.

The number of mortgage brokers had grown considerably while interest rates were falling. When the rates stopped declining or even rose, the huge pool of borrowers with good credit who had been refinancing dried up. The brokers then looked around for loans they could make so that they could continue to get paid.

Borrowers with poor credit are typically charged a higher rate of interest than borrowers with good credit. That is because they have a higher default rate and the lender wants to offset the risk. In addition, people buying houses have typically been required to put a hefty down payment on their new house. This makes sure that the new homeowner is invested into the house and is therefore committed to it. If the house declines in value due to neglect the first person to feel the pinch will be the homeowner, not the lender.

Recently it has been possible for almost all purchasers to borrow as much as one hundred percent of the sale price. This has been accomplished by using two loans. One at standard terms and one with a line of credit at a higher interest rate. The amount at risk for the purchaser is therefore nothing or pretty near close to. There is therefore no incentive on the part of the purchaser to stick with the home.

The use of teaser rates (artificially low interest rates) and balloon payment loans (loans that require little or no principle payment for a set period, typically six months to a year, and then require either payment in full or a hefty principle payment) has resulted in people buying houses that they could not afford to make payments on once the payments increased to market rates.

Put all of the above factors together and you get the current mess. However, it is not a universal mess. In our local market, most housing prices have not declined. What has been hit hard are new-construction starter homes. That is houses that have been recently built for persons looking to buy their first house. As builders and developers tend to build and develop by subdivision rather than piecemeal, this has caused certain neighborhoods to decline in value. The new owners bought the house, the payments increased, they found they could not refinance to lower the payments, they walked away. When that happens often enough in a neighborhood, prices begin to fall.

And to be blunt, real estate has been over heated in recent years. The housing supply was growing faster than the population at large. When supply exceeds demand, prices fall.

The main thing to remember is that the three most important words in real estate are location, location and location. A house on Park Avenue will always be worth more than a house on Mediterranean.

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