I put the word "market" in quotation marks because it is being used very loosely lately. But enough about that.
Discussions involving the current state of the economy can be pretty complex, but they don't have to be. Sure you can get down to the nitty gritty and discuss the intricacies of mortgage-backed securities or sub-prime lending standards or discuss the finer points of the effects of commodities speculators. Or, you can simply discuss some of the things that you observed on a regular basis over the past 10 years and have an equally significant discussion on the state of the economy.
I sort of pat myself on the back for acknowledging at least a couple of things that were going wrong. A question I used to regularly ask myself is, "How can I be told house appreciation is 4 or 5% when I am also being told that inflation is around 2.5 to 3%?" Assuming that wages increased with inflation (which is a bold assumption considering data showing they have not kept up at all), then appreciation rates exceeding inflation rates is a recipe for disaster, right? I mean, at some point no one in the world would be able to afford a house. This is simple 9th grade math at worst. So all things being equal - if appreciation is 5% and inflation is 3% then the increase in the cost of housing will exceed the increase in the cost of goods (and wages) by 2% per year. This may sound like no big deal, but it turns out to be pretty significant when compounded.
For example,
If I recall correctly the future worth equation is something like F = P(1 + i)^n
Where, F = future worth, P = present worth, i = interest rate, n = number of terms
Lets pretend that someone making $80k per year can afford a $200,000 house...
So if you take a $200,000 house and assume 5% appreciation over 25 years it would be worth $677,270
If you take an income of $75,000 and assume a 3% increase in wages based it grow to $157,033 in 25 years.
So in 25 years the same house went up in value almost 3.5 times its original price, but the job that paid $75k now only pays just over double what it did 25 yrs ago. Talk about a drop in living standards.
Obviously this is not sustainable. A correction HAS to happen assuming all other variables remain constant. HOWEVER, all things did not remain constant. What changed was the demand. All of a sudden lending standards went out of the window and arrays of teaser loan options became commonly available. Couple that with the most aggressive rate cuts we have ever seen (thanks Greensapn) - so instead of having to make $75k to "afford" a $200k house - now you could pretty much get in one with an income of about $40k with no money down. How many new potential buyers did this add to the demand pool? At the bottom end you have people buying houses that couldn't afford to buy at all previously, and at the top end you have people buying houses worth twice as much as they could afford a few years prior. The overall demand skyrocketed across the board, which artificially inflated appreciation even more. Enter the house speculators (aka flippers) and it gets exacerbated.
Now you have appreciation pushing double digits and little to no income growth. Its obviously going to bust at this point. It's just a question of when. As a person living in this country you are either witnessing (or ignoring), obliviously involved, or playing the game. Either way it all boiled down to timing. If you got caught with the hot potato, you lost. If you tossed it in time, you won. If you had the lead but didn't cut and run - you are currently losing one day at a time.
I'm out of time but I'd like to continue this in a part 2 post....
1 comment:
Here, I think they refer to those as "stated income" loans. The buyer simply states his or her income on the loan application and no backup is required. It is my understanding that most of these types of loans have gone away.
I am no expert, but what I have read seems to provide an answer to why the banks allowed this to happen. Do you recall the term "mortgage backed securities"? Basically, the way I understand it, is that the banks issued loans which were then sold off and subsequently bundled together with other loans. These bundles of loans were then sold as a package deals by selling shares, or securities.
Since the loand were being purchased by from the banks as fast as they could get them, there was no vested interest in the banks to filter their borrowers. Same thing with the mortgage brokers, only worse. They get paid on commission by the banks so they are even further removed from the risk.
The big losers are the people who invested in the securities that were backed by these mortgages, the financial institutions underwriting the loans, and the financial institutions in the middle (servicing, etc).
There was also a lot of deceit going on apparently. They would bundle the loans into packages and give them a rating that was supposed to reflect the amount of risk associated with that particular bundle of loans. Well, it was being manipulated somehow so that very very risky loans were being included in investment packages that were getting really high ratings. This sort of tricked investors into thinking they were getting high quality investments with good returns and low risk.
I don't know, the whole thing sounds like a mess. Throw in the hedge fund managers and their intrests and deceit and it gets even worse.
Right now banks are hardly loaning money to anyone. They are all scared to death and any loan they make has to be very liquid. They want a big chunk of money down and you have to be rated as a very prime borrower (high credit score and low debt to income ratio).
We'll see how it ends up eventually.
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