lending Advice
The Mortgage Crisis: Looking Back and Looking Forward
By Mark Levine
“If you owe the bank a hundred pounds, you have a problem. But if you owe a million, it has.” Those wise words were once spoken by the late British economist John Maynard Keynes. Banks have problems these days, and indeed those problems stem from the fact that many people cumulatively owed billions of dollars and were unable or unwilling to pay it back. Of course, the details of the 2007 “credit crunch” are much more complex than that, but the big story is that banks and other financial institutions significantly overextended themselves.
There is no need to retell the origins of the crisis here, since you have already heard much more than you ever wanted to hear about subprime loans. However, as always, it is still very important to learn from the past. To do that, let’s step back for a moment in order to recognize the magnitude of the situation we faced throughout the second half of 2007.
First of all, there’s the nontechnical side of the story, which I believe is the most fascinating. Before last year, most of us were accustomed to reading our real-estate news in specific industry magazines, newsletters and research reports. There were, of course, occasions on which a real-estate story made front-page news in more mainstream sources. However, that was usually an extreme case, like Rockefeller Center being sold or Donald Trump building another million condominium units somewhere.
Suddenly, at the beginning of 2007, things changed. At that time, newspaper headlines started referring to a looming housing slump and the possibility that we had reached the end of the meteoric rise in home prices. However, there was still only very little mention of how these events might lead to credit problems. But the mortgage news was right around the corner. In fact, in this same column exactly one year ago, I made the statement that, “One troubling sign, which is just beginning to rear its ugly head, is the sudden rise of residential mortgage delinquencies.”
In hindsight, that seems fairly prescient since residential defaults rapidly increased throughout the year. However, I also noted that the mortgage side of the business “has not yet become a general interest story for mass media and, frankly, it probably will not.” In hindsight, I could not have been more wrong!
Somewhere around the middle of last year, it seems that the cover story about housing prices turned into the cover story about mortgage issues. The cover story about mortgage issues then turned into the almost daily story about massive bank losses and talk about various bailout options. Eventually that story even blossomed into discussions about our fragile economy heading for a recession. In just a matter of a few months, the story about falling home prices could be connected to many different stories about current and future economic woes on a macro level. For those of us who like our year-end lists, the mortgage crisis was second only to the Virginia Tech killings in the Associated Press’s list of the top news stories of 2007.
Some of the numbers are perhaps even more surprising than the headlines indicate. For starters, the estimated defaults by subprime mortgage borrowers is somewhere in the $200 billion to $300 billion range. Considering that we’re talking about relatively small residential homes—not huge office buildings or apartment complexes—that is a very large amount of defaults. Some experts say that even those numbers are grossly underestimated.
But even those large numbers are not enough to make any dent in our overall economic machine. The problems really occur when you look at where these mortgages are held and how they affect other investments. Essentially the widespread news about the mortgage crisis created a mild panic among investors. Thus any lender, fund or investment vehicle that had exposure to mortgages suddenly experienced fairly significant withdrawals. With this rapid selling spree, prices of mortgage-related securities declined quickly.
Because banks and other financial institutions are required to report the values of their holdings at fairly regular intervals, they were rapidly disclosing significant drops in the values of their mortgage-related holdings. This had two significant results. First, it fed the panic surrounding declining values because it helped exacerbate the news of the looming crisis. There was essentially a snowball effect where the original selling created bad news, which created more selling. Secondly, it triggered financial institutions to quickly increase their required cash reserves in order to protect their liabilities and secure their balance sheets.
This is where some of the numbers and names involved are staggering. For instance, Morgan Stanley took a $9.4 billion “mortgage-related” write-down in December. This led to an overall quarterly loss of $3.59 billion for the major financial institution. If you do the math, you see that the mortgage issues by themselves made the difference between a major quarterly loss and what would have otherwise been a hugely profitable period.
Morgan Stanley wasn’t alone. Nearly every other financial institution in the United States reported similar issues. Bank of America reported a $3 billion write-down due to a drop in the value of mortgage-related securities. Merrill Lynch took a whopping $7.9 billion write-down attributed to subprime mortgages and collateralized debt obligations (which are generally comprised of mortgage-related securities). Closer to home, banks such as Washington Mutual and Wells Fargo joined the club by reporting original mortgage losses in excess of $2 billion. These reports are just estimates and certainly change as the issues evolve, but thus far the numbers just keep getting worse.
So what does all of this mean? To many of us, the news of a multibillion-dollar loss by a large bank does not make us weep all over our Wall Street Journal. It’s similar to when we hear that our national debt rose by a few billion dollars; it seems like just a drop in the hat and it doesn’t directly affect our personal lives or finances. But in my opinion, these issues should not be taken lightly.
It’s not necessarily the write-downs that keep me up at night. But, more importantly, I worry about the actions that these financial institutions have been taking in response to the write-downs. They appear to be desperate, and that’s a sign that there’s much more bad news to come. For instance, many of our largest banks have recently received major cash infusions from foreign investors or other central banks. These infusions have generally been extremely costly, either in the form of significant equity, or very steep payback rates.
To be clear, I am not opposed to free trade and investing between countries. On the contrary, I realize that foreign money has had a very important place in the strength of our economy, including our national and local real-estate markets. But many of the deals that we are seeing now seem like very hasty decisions, and I do fear that they are acts of desperation by our own financial giants. Down the road, I predict that we will look back at some of these decisions and wonder what some of the CEOs and board members were thinking.
Or, maybe we won’t. Maybe 2008 will be a year when we come to the realization that some of our largest financial institutions have gotten themselves into some very precarious situations. The seemingly desperate moves to access cash and solidify balance sheets might suddenly appear more acceptable because they were, in fact, absolutely necessary for survival. Thus far, the issues have been fairly confined to, or at least blamed on, bad mortgage bets. But what if there are many more issues out there that have the potential to be as serious as the mortgage mess?
What if the same consumers who are defaulting on their subprime mortgages decide not to make their car payments? What if millions of people stop making minimum payments on their credit cards this year? I have a friend who likes to personally test credit standards when he is solicited through direct marketing. Late last year, he received a call from a credit card issuer, saying that he would be approved for a card upon answering a few questions. After replying that he was on his way to prison, didn’t have a job or any income, and has terrible credit, the issuer replied that they would still be happy to mail a card to his desired address. Unfortunately, that’s not a joke. Financial institutions extended very aggressive credit in all facets of consumer finance.
That’s what worries me. The mortgage and credit crises could still be in their infancy and there could be further bad credit issues around the corner. What if many of our financial institutions are facing serious problems they can no longer blame on subprime mortgages? To me, their recent desperate actions indicate that this is likely the case.
This view is, of course, speculative. I truly hope that the current credit crisis is under control and can be put behind us in the very near future. If that happens, we should see a return to normalcy throughout 2008 with adequate funding available from competitive sources. If my fears of continued credit issues are correct, however, the crunch will get louder and the supply of credit will continue to tighten. Time will tell.
The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. Mark Levine is a vice president in the San Francisco office of ARCS Commercial Mortgage. He can be reached at 415-981-9700 or Mark_Levine@arcscommercial.com. Copyright © 2008 by SF Apartment Magazine. All rights reserved.