Normally, real estate agents don’t see gloom and doom in the real estate market.  Nor do they see it now.  But they like to be prepared so they can help you  stave off potential problems — and since everyone is asking questions right now, we’re running a series of articles that look forward to anticipate potential challenges and provide advance solutions.

Since experts in all media have begun talking about a “sub-prime crisis,” that’s what we’re talking about this month.

In late February, the stock market fell about 500 points in one day.  Even though 500 points is only approximately 3% of the value of the stock market, investors were in a momentary panic.  Experts got on all the financial news shows, provided opinions, and talked about other “looming” dangers.

Including the sub-prime “crisis.”

Experts are mentioning the sub-prime crisis in media practically every day.

The great majority of homebuyers obtain an “A-Paper” mortgage to buy their home. A-paper mortgages are loans intended for those that meet standard industry guidelines for income, savings, credit, and property.  Approximately 10% of buyers get “sub-prime” or Alt-A mortgages.  The reason they obtain those loans is because something about the real estate transaction does not meet standard guidelines, usually credit.

Lenders that specialize in sub-prime mortgages do so because they can charge a higher  interest rate than on normal loans.
Sub-prime loans earn more money.  Sub-prime loans also have a higher risk of default.

What does this have to do with you?  Be patient, we’ll get to it.

The reason there is a “crisis” in sub-prime lending is because a larger portion of sub-prime loans have gone into default than expected.  Delinquencies on sub-prime mortgages normally run between 4.5% and 5.5% of the total portfolio.  Suddenly, the delinquency rate is running much higher, around 13% on sub-prime ARMs (adjustable rate mortgages) at some institutions.  Higher at others.

The question is…

“Why?”

There are a variety of problem areas, but one key reason is “flipping.”  When the real estate market got ridiculously hot in 2004 and 2005, investors came out of the woodwork — determined to “flip” properties and make some money.  Amateur flippers buy a home, expect appreciation to be immediate and rapid, then “flip” the house to a new buyer — earning an excellent rate of return — even though housing is a non-liquid investment and flipping is a strategy that can get investors in trouble.

Typically, flipping occurs in higher priced areas, not medium to lower priced neighborhoods.  That way the investor makes more money.

As long as new buyers come along, flipping works.  Unlike the stock market, however, buyers are not always available.

Suddenly, there weren’t as many new buyers.  Some flippers got desperate to unload their properties. What’s an enterprising and ethically-challenged investor to do?
Well, sub-prime loans came to the rescue.  A new buyer could borrow up to 100% of the value of the purchase without documenting their income or assets, and they didn’t need perfect credit.  All the seller had to do was inflate the purchase price and manufacture a buyer.

The new buyer would get a cut of the profits and never make a payment on the new loan.

First-payment default.

This is fraud, of course.

Add this problem to other defaults in sub-prime lending and you have problems.  A crisis. 

Some lenders specializing in sub-prime loans have recently gone out of business, closed branches, laid off  employees, filed bankruptcy, been sold, and the rest have tightened up on their lending guidelines. 

Since ten percent of homebuyers finance their purchase with sub-prime loans, fewer homebuyers qualify for purchases. 

None of that tightening has yet hit the housing industry, but it will soon.  If the sub-prime crisis were to remain limited to sub-prime loans, it would be a manageable problem even though it could result in as much as  a 1% decrease in homebuyer  demand. That has NOT happened and is only a possibility.
However, recent home-buyers with adjustable rates may soon see rising payments.  They will be looking to refinance. Most refinance loans require appraisals.  Because loose lending in sub-prime also included lax appraisal review, values may have been more artificially inflated than previously thought.  This could result in declined loans, not because of borrower inability to make the payments, but because values aren’t there to justify the property as collateral for a new loan. 

If refinancing becomes more difficult on A-paper loans, homeowners may not be able to reduce their payments and defaults on A-paper loans could begin to increase, too — or more properties for sale may flood the market.  This has the potential to further devalue home prices in higher-priced areas.

Smart lenders SHOULD institute Streamline Refinance programs now. A streamline refinance would allow an occupying homeowner to get a new loan with favorable terms provided they had made all payments over the last year on time, period.  No appraisal.  No qualifying.  No documentation.

That way people who live in their property are protected and investors are the ones taking the highest risks.