The financial markets have been going through a difficult time over the past few weeks.  We have watched the Dow Jones Industrial Average post some large swings including days when it moves several hundred points in a single day.  The financial markets are much more volatile today than they have been in the past few years.

The main reason the market is experiencing some much change now is being caused by real estate loans going bad.  Prior to 2000 most home buyers financed their home purchases with a down payment and a traditional 30-year, fixed rate mortgage and we had a history of slow and modest gains in real estate.

In the early 2000’s several things changed causing real estate prices to soar higher.  First, we experienced very low interest rates and allowed homebuyers to get into more expensive homes.  This increased demand which in turn caused prices to move up.  At the same time many people pulled funds from other investments and placed them in real estate feeling it was the next best place to get rich.  Homes were being bought and sold like stocks rather than as a long term investment and place to live.  This phenomenon also increased demand and helped push prices higher.

As pointed out in a recent letter to investors by local company Hanson McClain, “…what probably had the greatest impact on real estate was the change in the mortgage industry.  Historically, most real estate loans were financed by local banks.  Before a bank would loan money, they would do a thorough background check on the borrower, looking at not only their credit history, but also at their current sources of income.   The bank would make sure the borrower had the ability to repay the loan.  Furthermore, the bank would require the home buyer to put their own money down, figuring it was important for the buyer to have some skin in the game.”

After the collapse of the Savings and Loan industry in the 1980’s some mortgage companies developed methods to finance homes without a bank keeping the loan on their books.  Loans were combined in what is called pools and sold to investors.  This was how pension plans and insurance companies got into the home loan business.  The other new player in this arena was what has become known as hedge funds.

Because lenders were selling their loans to investors they had no reason to care about an individual loan once it was sold.  As long as home prices were increasing, the investors were not seeing any losses on the loans they had purchased.  When an individual homeowner/borrower experienced financial problems and couldn’t continue to make their payments, they sold their homes for a profit and the investors were paid.  Whenever loan losses are very low, credit standards are relaxed to help increase loans.  As time went by almost anyone could get a home loan.  Down payments were not mandatory and demonstrating you had income was not even required.  Borrowers could just state their income, or as in many cases the mortgage broker would figure out what income you needed to support the requested loan and fill in the income part for you on your application.   Home prices continued to move higher and higher.

When home prices got to the point where many families could not afford a house, the mortgage companies created new loans that would allow a borrower to buy a house with monthly payments they could afford but didn’t even cover the full cost of interest let alone any principal repayment.  These are known as negative amortizing loans where the loan balance gets higher each month.  Prices for homes went even higher.

It all worked until, the ability to finance and the prices of homes was out of reach and NOT affordable for too large a portion of the population.  Houses that were recently purchased could not be sold for a profit, prices started falling.  Borrowers who had problems making their payments couldn’t sell and faced foreclosure.  As lenders foreclosed prices fell further.

Inventory of available homes has steadily increased as strapped homeowners attempt to sell before changes in their loan products overwhelm their budget; bank owned properties hit the market and seller who hope to persuade their lender to discount what they owe by marketing their homes as “short sales.”  The reverse of what happened at the beginning of the decade is happening; declining demand from fewer buyers is putting significant downward pressure on prices.

Clearly, there is a large number of current homeowners who are not going to own their home when this is done.  Many of them will be forced into foreclosure and some into bankruptcy.  I think it is important to take a long term perspective when viewing the market today.  To do that in the financial markets, my financial advisor, Hanson McClain, advises not to focus on the bad news of the day.   They say, “The news will probably get worse before it gets better.”  They further say, “…if history is any guide, the worst time to be selling is in the midst of a crisis.”  I think some of that advice transfers well to the real estate.  I cringe when I hear friend or client say they have been checking the value of their home on Zillow or some other web based home value site. 

We have to be disciplined not to fall in love with what Hanson McClain calls the high water mark, or the value of your home at the market peak during the summer of 2005.  I talk to prospective buyers who still think they should be able to sell their homes for what it was worth then.

The home mortgage industry is returning to the days of old, where sources of income are verified, debt to income ratios mean something and a down payment is a requirement.  As home owners we should do the same thing and look at our homes as long-term investments to live in and enjoy and leave the speculative investing to other markets.

With this in mind, my reality real estate series, MyForSaleSign, will continue to follow the sale of my rental property in Anchorage, Alaska and we are looking for a new series to begin in the fall.  If you or someone you know is interested in participating please let me know.  I have some great new ideas for our series and need a willing buyer or seller who will be an active participant.