Real Estate Market Crisis - Term Paper Example

Introduction Lenders who issued sub-prime loans, appraisers who inflated home values, and sellers who decreased the price of their homes through short sales in order to avoid foreclosures, caused today’s real estate market crisis. Getting consumer credit through various financial institutions especially banks requires consumers to maintain a certain degree of credit rating in order to qualify for those loans. Unlike large corporate companies, consumers or rather individuals pose a different challenge and dynamics to financial institutions to cater their needs for credit and formal funding requirements of these individuals. It is because of this reason that various banks and financial institutions have developed their internal rating methodologies which they assign to various consumers asking for credit. Banks than through their internal as well external credit scores or ratings decide to whom they should provide the credit. These criteria of credit rating often are designed to be tough since Banks in order to avoid defaults, tighten their criteria to extend the credit to these customers. However, due to increasing needs of those customers, whose credit history or their credit ratings do not fall under the criteria laid down by the banks, banks try to accommodate them also. Sub-prime lending is the part of that phenomenon. 1. Sub-Prime Lending A subprime lender provides loans at higher interest with inappropriate incentives to high risk borrower. Ideally a subprime lender is one who lends to the borrowers who do not qualify for the loans from mainstream lenders. This is because of the fact that those borrowers who have a bad credit history. A subprime lender is mainly an independent entity or the sub-entity of the main players in the markets. However the only way to identify the lenders who lend to the subprime borrowers is to judge from their prices as they are normally higher than the prices charged by the normal lenders with standardized terms and conditions in the market. A subprime lender generally lend following types of loans: i) Interest Only Loans are the loans which give borrower an option to pay interest on their loans only; thereby Principal remain unchanged and at the end of loan term payments increase substantially. Traditionally these loans are cheaper in nature as the normal mortgage loans require some portion of principal and mark-up to be paid in the monthly installment of the mortgage. These loans became popular mainly due to the fact that they required lower loan payments therefore buyers can afford the larger homes as their monthly mortgage bills become lower as compared to other standardized mortgage loans. These loans however can be dangerous especially when markets are lower and down. Since the interest rates are fixed for very short period of time i.e. 1 to 5 years therefore as the re-pricing of these loans approach, any increase in the interest rates will suddenly increase the interest repayments. This will result in loans being converted into conventional mortgage loans which eventually force the borrowers to face new and tougher requirements to meet besides paying the principal repayments. (Amadeo). ii) Negative Amortization arises when an investor pays the amount less than the accrued interest and the interest is added back to the loan balance. Normally amortization means the reduction of the loan balance as under the conventional mortgages, a buyer’s payment to the financial institution comprises of two parts i.e. principal as well as mark-up. The negative amortization is usually availed by the buyers in order to reduce the payments at the start of the mortgage. Within the perspective of subprime loans, negative amortization works fine for the buyers with low income or bad credit history thus enabling them to pay less and still enjoy the home mortgage. The negative amortization therefore has been used both for fixed rate loans and adjustable rate loans. With reference to the adjustable rate loans, negative amortization also works to safeguard the buyer from the large interest rate shocks as the increase in the interest rates may force them to pay higher than their normal interest payments. The downside of negative amortization is that the payment must be increased later in the life of the mortgage. The larger the amount of negative amortization and the longer the period over which it occurs, the larger the increase in the payment that will be needed later on to fully amortize the loan. The biggest risk in this kind of loan arises when the buyer is going to sell his home. “If theyve lived in it for several years while paying on a negative amortization loan, its possible that the loan amount has become larger than the amount that they can actually sell the house for. In other words, when they go to sell the house, not only will they not gain any profit, but theyll actually owe money to the bank. So if a homeowner doesnt fully understand the long-term consequences of a negative amortization mortgage, it can lead to severe and unexpected financial difficulty with negative effects on your credit-even foreclosure or bankruptcy.” (Mortgage News Daily) When we talk about the negative amortization on the fixed rate loans, the risk of increase in the mortgage payments in the future increases and the instrument under which this is guaranteed is called Guaranteed Payment Mortgages or GPM. B. Gain in Equity to refinance Subprime lending become more complicated when buyers in anticipation that the home prices will increase therefore they pay low rates in order to gain advantage of the price increase in equity to refinance. However this has not been the phenomenon mainly due to following two reasons: 1 Minimum payment options increased principal balance. In anticipation of the increase in equity, buyers paid low interest payments which subsequently contributed towards the increase in their principal payments when loans were about to mature or when the refinance option was to be availed. This significantly reduced the spread between the equity gain and the principal outstanding in the loan thus effectively reduced the perceived benefits for the buyers to refinance at the later stages of the finance. 2 Home values have potentially depreciated against the perception of the market and the consumers. What was perceived that the home prices will increase in the future does not prove right therefore further reducing the equity of the buyers. Further the refinance standards were tightened by the lenders therefore with diminishing equity values and tightening refinance standards, the buyers found themselves trapped to pay the higher interest payments with virtually nothing to gain. This has therefore complicated the market and the buyers started to default on their repayments thus creating a crisis in the real estate market. 1. 2. Overinflated Home Appraisals A. A. Appraisers inflating home values to benefit brokers, lenders, and agents Probably the second most important reason behind the crisis in the real estate market is the fact that the appraisers tend to increase the value of the homes. Since the loosened monetary policy allowed the reduction in the interest rates and there were excess liquidity present in the market therefore lenders in order to grow their business started to lend with loose credit term to accommodate as many customers as they want. Since the economy was facing a boom therefore the home prices were inflated too. Over inflated home appraisals were made mainly due to following reasons: 1 Appraisal Fraud; lenders offered overpriced loans since the appraisals made were on the higher side therefore in order to take benefit of the higher real estate values, the lenders ignore the risks involved in the process and offered overpriced loans. Since appraisals were overpriced therefore lenders disbursed more than the required amount for the mortgage loans thus effectively draining the resources in potentially threatening and risky business options. Besides inflated priced collaterals were sold as securitized securities by linking the cash flows from the mortgages with the securitized securities therefore technically recouping the lost liquidity made through mortgage loans. 2 Mortgage Fraud; brokers and agents made larger commissions as the higher values entitled them to get higher commissions and better incentives. This has worked in two ways. Through appreciating the values of the homes, lenders not only get the psychological benefit that in the event of foreclosures, the bank can recoup their investment by selling them. Thus the inflated market prices on one hand not only provided the necessary psychological comforts to the lenders but also provided the large commissions to the brokers and agents for booking the new loans. 2. B. B. Inflated appraisals stuck homeowners with loans exceeding their home’s value The inflated prices of the homes caused the homeowners to avail higher financing which were higher than the actual value of their homes therefore when they went to sell their homes, the prices they fetched were significantly lower than the their loan amount. Inflated prices have been resulted into following: 1 No equity, no refinancing: Since the values of the homes were significantly lower than the loan amounts of the buyers therefore there were no significant increase in the equity of the buyers hence there were not being eligible to refinance their home mortgages when their payments finally increased due to the start of the principal repayments of the loans. 2 The up side down on the mortgage occurs when the buyers owe more than the value of the mortgaged home. Since in the beginning of the mortgages, the buyers prefer to interest only loans therefore when the time to repay arrive, given the inflated appraisals and prices, the homeowners find themselves trapped. Since one one hand cannot sell the homes to get inflated equity and secondly they owe more than the worth of the homes this combined with the financial hardships force buyers to short sell their homes. 3. 4. 3. Short Sales and Depreciating Home Values In order to avoid the foreclosures and in the wake of depreciating home values, buyers finally decide to do following with the help of their lenders: 1) They short sale their homes as they owe more than the value of their homes and lenders in order to decrease their losses, allow the short sales of these homes thus a vicious circle tend to complete where homes bought with great expectations are sold out in desperate conditions. 2) Since buyers short sell their homes with the help of the lenders therefore from the lenders perspective, short selling of the homes create a lesser impact on the credit history of the buyer than the outright foreclosure. It is because of this fact that lenders somehow manage to recoup some of their investments in the end therefore short sale remains a very viable option to both lenders and the buyers. However these short sales under the distressed conditions are sold at less than their values therefore they place a negative impact on the prices in the existing market because they are one of the strongest signals to determine the value in the market. Besides short selling of the homes create other non-financial costs for the area as the new and potential buyers view the area with more suspicion and take time to decide on making their purchase of the home to be acquired through short selling and under financial distressed condition. Conclusion The current state of the real estate market is a result of inappropriate lending practices and fraud which has and continues to force many homeowners to simply walk away from the “American Dream”. There are many players involved in this whole process and the current crisis in the economy due to subprime mortgage market is the result of the combined greed of lenders and appraisers to take advantage out of the potentially unaware customer. References Amadeo, Kimberly. "Interest Only Loan." 2008. US Economy. 23 March 2008 . Blanton, By Kimberly. "Dark side of subprime loans Mortgages for those with bad credit leap in popularity despite high foreclosure rate." 3 August 2005. boston.com. 19 Jan 2008 . Mortgage News Daily. "Negative Amortization Mortgage: What It Is and Why to Avoid It." 2006. Mortgage News Daily. 23 March 2008 . Read More