It’s been 25 years since the fed funds target changed as much and as quickly as it has in the past nine days. Today, the Federal Open Market Committee (FOMC), the Fed’s policy arm, reduced the overnight bank loan rate by 50 basis points to 3.00%. The action follows fast on the heels of a 75-basis point cut on January 22. The FOMC gave prominence to financial markets, “which remain under considerable stress,” and tight credit conditions for “some businesses and households” in explaining its action.
This morning’s weak reading of fourth quarter 2007 Gross Domestic Product (GDP) certainly justifies the Fed’s concern. GDP, the total value of the nation’s output from domestic operations, rose a bare 0.6% (annualized). Residential investment dropped a shattering 24%, the eight straight decline, as housing suffers through its worst crisis in 25 years. Consumer spending grew just 2% and inventories fell, indicating a lack of confidence in future sales growth. For the full year, GDP increased 2.2%, the weakest rate of growth since 2002.
The FOMC’s statement concludes by cautioning that “downside risks to growth remain,” and that it “will act in a timely manner as needed to address those risks.” This is what used to be called an “easing bias,” meaning that the Fed is more likely to continue reducing the fed funds target than to stand pat or raise it. For now, the fireworks are over, but don’t leave yet.
Mortgages & Markets
But if we weren’t worried in 2005, we are now. We have come to understand that the current housing predicament is not a mortgage problem but a market problem. Nothing exemplifies the problem as clearly as the implosion of the basic premise that created and sustained the subprime lending boom. Some of these borrowers, of whom a large percentage were first-time homeowners, were enticed by unscrupulous mortgage brokers, others succumbed to the dream of home ownership no matter what the risk, while others simply failed to understand what they were signing. But all believed that the value of their homes could only go up. They believed it would be easy to refinance their mortgage or sell their home at a higher price whenever they chose. And why not? From January 1989, when the National Association of Realtors began compiling data, through June 2005, the average sale price of existing homes in America rose in a steady upward trajectory from $113,000 to $275,000. Because prices had always risen in the (observable) past, people believed that prices would always rise in the future. This belief, rather than some intrinsic quality or scarcity value in the homes themselves, created an expanding pool of buyers willing to pay rapidly rising prices.
Market value is classically defined as the amount a willing buyer will pay a willing seller, with neither being under pressure to buy or sell. But houses are usually bought on credit, so the definition must be amended: The market value of a house is the amount a willing buyer will pay a willing seller and a willing lender will loan. Value is legitimized by what is commonly called an MAI appraisal. Unfortunately, the term “MAI appraisal” is often misunderstood as something more official than it really is. MAI stands for Member of the Appraisal Institute. The Institute is simply a trade organization that has established criteria for those it certifies; it is in no sense a regulatory body. A good appraiser can estimate the general condition of a property and compare it to the value of similar properties in similar communities. Thus, appraisals trail the market; they do not set it. During the housing boom, reputable appraisers found recent sales of comparable homes at ever higher prices, which justified—indeed forced—them to raise the values on homes they were currently appraising.
Reputable lenders, like ShoreBank, working with reputable appraisers and creditworthy borrowers made mortgages on homes whose values were established by recognized market mechanisms. We knew what the market was telling us, which was information about sales and prices. But the market did not provide specific information on how many mortgages in a neighborhood or on a block were exploding ARMs or had been made with no equity required of the borrower. It did not provide information on whether the mortgage payments consumed 25% or 50% of the buyer’s gross income. It did not provide information on whether a first-time homebuyer had ever had to buy a refrigerator or pay to fix a leak in the roof or even seen a water bill. As long as home prices continued to appreciate, the damage was masked, the rot was invisible.
Home price appreciation had kept previous episodes of high delinquency and foreclosure contained. Prices dipped slightly in the second half of 2001, but quickly recovered. Rapidity was an important part of the equation. Because homes continued to sell, the comparables on which their market prices were based could be discovered from willing sales. But when, as now, foreclosure sales start to predominate over willing sales, the determination of appraised value becomes vicious. When an appraiser’s comparables are three foreclosure sales, instead of three market sales, the value of all houses in a neighborhood falls precipitously.
Another difference between the present situation and previous downturns is that in the past, problems in the larger economy filtered down into housing. As a result, the impact was more localized. Home values fell in Tulsa and Houston when the bottom fell out of oil prices. Housing depreciated in Silicon Valley when the dotcom bubble burst. Today, problems in housing are bubbling up into the larger economy. Local differences, while still significant, are more smoothed out. Lo-doc, no-doc, no-money-down, and all sorts of irresponsible mortgages were available everywhere to anyone through electronic delivery channels. The process, begun in the 1930s, of standardizing mortgage markets is complete, but it has had the unintended consequence of standardizing housing markets as well. This time, when delinquency and foreclosure rates spiked up, there were few markets with large groups of renters left to come in and pick up the least expensive tier of houses.
Without this push, markets have stalled. Homeowners who can afford their mortgages and have no need or desire to move are fine. Homeowners who would like to move, often can’t. But homeowners who, in the past, could solve financial difficulties by refinancing, taking out a home equity line or selling their homes, are in real trouble. The market has turned on them. The lead story in the January 13 “Chicago Tribune” describes how home sales in south suburban Will County have fallen by a quarter and new construction has come to a halt. Will County, according to the article, is one of the fastest growing areas in the country. It added 21,350 households in 2006 alone and continues to benefit from a steady inflow of new businesses and jobs. Yet, its housing market is collapsing.
The erosion of the Chicago market, especially on the South and West Sides where ShoreBank primarily operates, is considerably worse. We can now clearly see how the damage was done. The following chart shows how lending worked in the South Shore neighborhood of Chicago in 2005, the latest year for which this data is available:
Lender Total Loans Percentage Higher Cost Loans
Long Beach Mtg. 144 96.5%
Countrywide 137 48.1%
Argent Mtg. 126 86.4%
Fremont 124 91.1%
ShoreBank 100 0.0%
These five lenders accounted for 30% of the loans made against single-family properties. Three of them—Long Beach, Argent, and Fremont—are (or were) subprime specialists. Nine out of ten of their loans are high-cost; that is, subprime. Countrywide’s loans were split about half and half between high-cost and conventionally priced loans, while all of ShoreBank’s were conventionally priced. Nevertheless, there was evidence in 2005 that the advent of subprime was a positive for the neighborhood. Loan originations in South Shore more than doubled between 2000, when the top three lenders were Bank One, Bank of America and ShoreBank, and 2005. Foreclosures actually declined 9%, from 223 to 203.
But, the high cost of subprime mortgages was only part of the story. It’s probably fair to apply national statistics to the loans made in the South Shore neighborhood, which, in turn, is representative of all ShoreBank’s Chicago neighborhoods. A very large percentage of subprime mortgages made between 2004 and 2006, up to 93% by one estimate , were exploding ARMs. Three-quarters of these loans did not escrow for insurance and taxes. Moreover, African-Americans were far more likely to get subprime loans: 52% in 2006 compared to 41% for Hispanics and 22% for white non-Hispanic borrowers.
The chickens are now coming home to roost. In 2006, 331 foreclosures were started in South Shore. In the first half of 2007, there were 215, which annualizes to twice the 2005 rate. For Chicago as a whole, 6,339 foreclosures were started between January and June 2007, a jump of 42% from the same period in 2006. Recently, 723 properties were offered at the weekly Cook County Sheriff’s sale earlier this month. Half were on the South and West Sides. There were no bids.
It’s hard, impossible really, to say exactly how far local market prices have dropped. The chart below shows estimates from four different sources of the one-year change in home values in Chicago, Detroit, and Cleveland. Each source uses a different methodology, a slightly different time-frame and even different geographic definitions.
Loan Performance Case Shiller Radar Logic OFHEO
Chicago N/A -3.24% -7.60% 2.16%
Detroit -3.16% -11.20% -6.80% -6.12%
Cleveland -8.10% -4.53% -2.20% -1.78%
About the only conclusion that can be reasonably drawn, is that prices are falling, but by how much is far from clear. We estimate that locally, prices have fallen at least 10-15% so far and may well have much more to fall before bottoming. While our neighborhoods did not boom as outrageously as Las Vegas or Miami, prices did reach unsustainable levels. The Bank tried to stand out against the trend in the early years, but the more time that passed, the more it became apparent that ShoreBank had only two choices: Make loans based on current valuations or quit the business. ShoreBank never seriously considered the second option. Instead we continued to make mortgages that borrowers could afford. We continued to make credit available to local investors for properties that cash flowed as rentals if they could not be sold once rehab was complete.
In the boom times, to abandon lending in the neighborhoods would have meant that many fewer responsible mortgages were made. Now, in the bust times, we still keep lending, because, as Michele Collins, head of Single-Family Lending says, “There is still a need for housing and for people who want to make a living in real estate. Just like us. We do mortgages. We’re not going to say, ‘We don’t do loans anymore.’ We are fighting for the life of our communities. If everyone runs away, you can just take a shovel and bury the neighborhoods.”
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