Two major Bear Stearns Hedge Funds face foreclosure due to their significant exposure to the subprime lending market. While this does not fall under the category of real estate investor, I spent last summer working for Bear Stearns and interacting with many of their hedge funds. Based on the very limited details of the stories out now, I cannot be certain if I have worked with these two particular funds. I can be certain; however, that it would not be a good time to be in the mortgage space at Bear Stearns.
In my three months at Bear Stearns, I met some of the smartest people in the businiess. While this is not an advertisement to work at Bear Stearns, I think they are a very well run organization with smart people. This of course begs the question, how could something like this happen to such smart people? Furthermore, with all of the subprime lending issues out there, what does this mean for borrowers who are less creditworthy?
Simply put, in my humble opinion, the subprime market will be doomed for some years (at least five or more). Since I know this site is filled with a ton of very smart mortgage brokers, I will outline my reasoning.
Consider the following information:
1) Many subprime lenders have filed for bankruptcy
2) Major buyers of Mortgage Backed Securities (like Bear Stearns) are having issues with subprime mortgages
3) Despite what the National Association of Realtors says, the housing market seems to be taking a slow and steady turn for the worse
4) Major Banks have tightened their lending policies
Lets take an example of a typical transaction before the subprime fallout. A low creditworthy borrower applies for a subprime loan. Some intermediary or mortgage broker, supplies them with the best loan for them from either a bank or a conduit lender. The bank/conduit lender then sells the loan to an investment bank (like a Bear Stearns or Goldman Sachs) to free up more money to lend and to remove the risk off their books. Finally, the investment bank packages this loan in the form of bonds that investors looking for high rates of return are eager to purchase. While this seems like a complicated cycle, it actually works quite smoothly as long as there are investors looking to buy these loans.
Now reflecting today’s market conditions, the picture has a lot more holes. When the low creditworthy borrower applies for a subprime loan, many of the intermediaries no longer exist. Even if they try to go to a mortgage broker, they will be hard pressed to find a lender. If they do find a lender, this lender will have trouble moving the loan to an investment bank. Investors, who have been burned by heavy defaults (i.e. Bear Stearns Hedge Funds), will not be looking to buy high yield bonds backed by subprime loans. Additionally, those who are looking will expect to pay deep discounts.
To put the final nail in the coffin, consider areas like California where subprime lending was a driver of the housing market. With very few alternatives, a lot of buyers will be sucked out of the market. Additionally, these buyers will probably not be back for a while. For those buyers expecting a quick rebound, think again. Until prices get to levels buyers deem affordable (meaning they can afford the down payment), a recovery simply cannot happen. I would love to hear from others who have different opinion, but as an investor, I am looking into apartments more now then ever. If buyers cannot afford to buy, they will have to rent.
Jeff Brown says:
Michael – What an incredible experience, working on the inside of such an operation. One might surmise you didn’t arrive at school riding the little bus. 🙂
Your conclusion re: buy residential income property is mine too. I’ve been salivating at the future of high quality, well located rentals of all shapes and sizes.
I’m not as sure as you are about the general housing market. It’s my guess we’ll be seeing empirical signs of a slow recovery next year, or, at the latest, ’09.
Can’t wait to hear what Brian and Morgan have to say.
Great to have you back – you were missed, and this post shows why.
June 20, 2007 — 8:55 am
Russ says:
Michael: Regarding your question about how this could happen to such smart people. Easy, the mortgage business eliminated common sense in the name of short term profits. Quality and common sense underwriting took a back seat to loan volume. Honestly, if they had gotten out of their ivory towers and talked to loan orginators in the street, they would have known what was coming regardless of the fancy financial models.
Much of the stupidity of some of the subprime programs was covered up by rising home values. As long as home values kept rising, people could always refinance themselves out of trouble or speculators could afford to make payments on multiple properties by borrowing against others without renters.
Much of the analysis of loan performance was probably skewed because of rising home values which made it look like the borrowers would actually pay their loans and the risk wasn’t as great. Once the cover was pulled from in front of OZ (rising rates and stagnant home values), the early payment defaults started rising and the investors realized they were buying garbage loans made to deadbeats. So they no longer would buy loans from the subprime lenders hence the elimination of all the loan programs and the lenders going out of business.
What this means for the housing market is the marginal buyers have all but been eliminated from the mortgage market. In addition, we will probably see foreclosure continue to rise because homeowners on the cusp will no longer be able to save themselves by refinancing.
You are graduating during the RE implosion… when I graduated finished my MBA from Kellogg it was at the height of the dotcom madness. I could not believe some of the dumbass ideas that got millions of dollars in funding, let alone the stock prices. Same stuff, different industry.
I guess my only question now is what industry is next?
June 20, 2007 — 10:22 am
Brian-Logan Reid says:
Michael –
I love your vantage point and agree with almost everything.
As a Realtor and an economist, my largest concern with the current state of the market is that prices have risen so much, without any of the fundamental drivers present, such as rising wages or growing employment; it has been pure speculation. As a result, one of two things has to happen – property prices need to fall, or wages/household income needs to rise significantly…which do you think is easier and more likely to occur (and what are we seeing across the country)??
There once was a time, after careful diligence and research, when a property could provide a cash-flow positive return for the owner. I don’t know about other places, but that scenario is long since gone in my market (Nantucket, MA).
We need to return to equilibrium! And it’s not going to be pretty. The good news, I guess, is that now that a lot of those subprime buyers cannot purchase, rents should rise…
Russ – which industry is next you ask? I’m rather terrified of a currency implosion…there is WAY WAY too much liquidity flying around the world…virtually every day there is another merger or another company being bought out by private equity. I think an exogenous force like an hedge fund blowing up (hopefully not like LTCM…) would cause people to stop and reflect on their risk tolerance…but of course…who knows?
June 20, 2007 — 10:48 am
Russ says:
Brian you may be right. I was actually thinking about LTCM when I wrote about talking to the street instead of just listenign to the financial model. Private equity is definitely on the radar screen as the next coming implosion.
I am sure Michael can relate, but there was a study that was done a few years ago that showed that top tier MBA career choices were an indicator of which industries were overheated and due for a correction. Basically, whatever industry MBAs are clamoring to get into means that all the gains have run its course as MBAs tend to be followers, not innovators. Most of my clients are MBAs and a very large percentage of them work at or are going to hedge funds and private equity firms because that is where the money is right now.
When I was in school it was anythign related to the internet and VCs. before that it was managmeent consulting. Prior to that it was investment banking and so forth.
How are things on Nantucket? I am going to Martha’s Vineyard next week.
June 20, 2007 — 11:29 am
Brian-Logan Reid says:
Russ – I agree entirely about the MBA as followers…perhaps a lagging indicator? I previously pondered getting my MBA but I feel that, as does all schooling, they train you to be employees (even very well paid ones) and not entrepreneurs, which is what I’m working on.
Nantucket is good. The RE market is still moving relatively strongly, albeit at a slightly slower pace than last year, and definitely behind 2005.
I’ve only been to MV once…you ever make it to Nantucket?
June 20, 2007 — 11:41 am
Jeff Brown says:
Brian – you said >my largest concern with the current state of the market is that prices have risen so much, without any of the fundamental drivers present, such as rising wages or growing employment;
Arizona is and has been among the leaders in job growth, which continues even now.
What’s your take on the Phoenix market? Do you expect it to recover more quickly because of their rosy job picture?
June 20, 2007 — 12:25 pm
Michael Cook says:
Russ wrote, “I am sure Michael can relate, but there was a study that was done a few years ago that showed that top tier MBA career choices were an indicator of which industries were overheated and due for a correction.”
It saddens me that this is true. Everyone wants to go into private equity now (including yours truly). I do agree with all of you who have said it could be the next industry to go belly up; however, I cannot pinpoint a catalyst event for that to happen. Right now those guys are making a lot of money and they have a very tight network.
June 20, 2007 — 12:35 pm
Brian-Logan Reid says:
Jeff – my mistake. As this example proves, ALL real estate markets across the country are unique and have different factors that, when compounded, result in different scenarios in each case.
I cannot really speak to the Arizona market (as I live and work in MA), but generally speaking when there is strong job growth (and in turn lower unemployment), housing markets tend to do alright. My only thought with AZ, though, is that it appears that there has been quite a lot of speculative building, resulting in higher inventories, which puts downward pressure on prices. Add to that any foreclosures that may be occurring, which will add even more inventory to the market, further depressing prices.
June 20, 2007 — 12:39 pm
Michael Cook says:
Brian wrote, “I previously pondered getting my MBA but I feel that, as does all schooling, they train you to be employees (even very well paid ones) and not entrepreneurs, which is what I’m working on.”
Based on my recent experience an MBA is what you make it. I came in with the idea of coming out a Real Estate entreprenuer and I feel like I got exactly what I wanted. I built a lot of great real estate modeling skills and really sharpen my eye for market trends. If you are an entreprenuer, an MBA cannot take that away from you. I personally think it helps you focus and really flush out what you want to do and how you can do it. At worst, its a nice a vacation.
June 20, 2007 — 12:41 pm
Brian-Logan Reid says:
Michael –
While I applaud your ambition to get into P.E., I would only caution you that you don’t want to be the last one in if/when a PE firm breaks down or collapses…think about all the young college grads jumping into those hot IPO companies that ended up back on the street when the market crashed.
The way that I look at it, and what I’m pursuing, is NOT what everyone is doing. NOT going to where everyone is making money…nascent industries and technologies – THAT’s where to get going. Imagine seeking out a young Google, or Microsoft, or even Apple. Going to places that are high risk and high reward.
Is it really so easy to get into PE and start making sick money? I mean guys like Henry Kravis of KKR or Schwarman of Blackstone have spent YEARS doing their thing, especially when it was unpopular, and now they are rolling in the dough as they should. But I would think that they didn’t just step into PE and start making money…
June 20, 2007 — 12:49 pm
Matt in Portland OR says:
I am a Mortgage Broker as well as a real-estate broker and have been for 15 years now. I have been through this cycle before but I think that this is a lot different than what we have experienced before. This will get a whole lot worse before it gets any better but I am constantly amazed at the number of people in our own industry that are willing to ignore the obvious.
Let alone politicians that don’t even understand the tip of the iceberg let alone the full scope of the problem.
(Having just lived through the Banks in Oregon trying to legislate mortgage brokers out of business)
Yes we do have a lot more people that have “purchased” homes but why is that? Why did our values increase so much since 9/11? Have our incomes increased at the same pace as home appreciation? It all comes down to simple economics, Supply and Demand. The values went up because there were more borrowers. There were more borrowers because the Fannie Mae and Freddy Mac guidelines were loosed up after Sept 11 in an effort to help stimulate the economy, and it worked. The problem was that the banks & Wall Street got greedy and rode that pony too far.
The Supposed “Sup-Prime” loans are only the tip of the iceberg because this dose not even reflect the crappy job of underwriting that was done on the “Prime” of “Conforming” loans. Does anyone remember when your debt to income ration used to be 38% unless you were doing an FHA loan and it was 42%. When you did those loans you had to actually PUT MONEY DOWN, giving you a vested interest in the home and a reason not to just walk away from it when things went bad. You also had to pay closing costs. So generally the people that you were making loans to had to have some level of responsibility having saved up (most of the time) enough money to put down and pay closing costs on a home. People that were not smart enough to budget them selves and save money were not able to get in to a home. This left a barrier to home ownership that kept the industry in check and healthy. Once you removed all of that, every idiot could by a home with out having to think about how they were going to afford it, if they should, what the not so obvious costs of owning a home are. (Having to work on it when things break, and things like you can only use your Sponge Bob Square Paints sheets as window coverings for so long before you actually have to by real ones)
You could go to 100% LTV with no mortgage insurance with the seller paying all of your costs because you wrote the EM for more that what the sellers were asking and then had “them” pay the costs for the buyer. So it was cheaper upfront to buy a house than to rent an apartment (even they would ask for some kind of security deposit) I am not talking about “Sub-Prime” loans I am talking about “Conforming” loans. The loans got more an more aggressive as the lenders ran out of candidates for the last round of aggressive changes that they made to loosen their guidelines, but rather than downsize and wait for the market to catch up, they just go more and more aggressive. In the meantime the home values shot up so high (and the incomes did not) that now even fewer people could qualify so they did more and more “stated” or “No Ratio” loans. I had several loans that I closed were we put in $1 for the borrowers monthly income, but because they were putting down money and had liquid assets the loan was approved “conforming”
With the banks doing all of these loans that used to fall under the “Sub-Prime” lenders territory, what were they left with? They had to do really stupid loans because that was all that was left. Most of those loans should have never been made, but there are a ton of them out there and they are all getting ready to have their rates adjust. It usually takes about 6 months before you start the foreclosure after payments start to get late. So far banks have been trying to hide the delinquency’s by re-writing the loans to incorporate the late’s but this is only stalling the problem. With out that sub-prime lender out there (114 lenders have imploded to date) who is going to bail these people out of foreclosure now?
Why are there so many homes sitting on the market now? Is it because there are not enough banks willing to make loans? Is it because they are finally being forced to rethink their underwriting? Or is it simply because, things are way too overpriced because of the bubble that was created by removing all the stops on common sense for a while?
All of these jobs that have been lost by these banks going under, were very good paying jobs, but that is only a small portion of what this will affect. Think about how many parts of our economy this will impact.
Builders, Realtors, Escrow, Title, Banks/ Brokers are the obvious ones (also some of the biggest spenders of their cash) What about the delivery service, office equipment, Office Suppliers, Land lords (usually funded by pension funds) Furniture, appliance, Home Depot, electronics stores.
Our Economy has been based on something like 58% Consumer spending. Is that from their awesome pay checks? Or from the Equity in their homes? The endless cycle of running up all of your credit cards and then refinance to make it all affordable again is now over for 90% of the population (most lenders will no longer even do a Home Equity Line of Credit) With all of that, what will the Back to school shopping numbers look like this year? How about Christmas?
What do you think next February is going to look like?
Yes it is going go be a rough ride, but this bitter pill has been coming for a while and it has to happen to get things back to being sustainable.
Any “help” from politicians at this point I think will only for long the pain and ultimately hurt us more.
Rip that Band-Aid off and lets get through this thing as soon as possible.
You thought Enron looked bad? What is going to happen when the public gets to hear about the types of loans that the quazi-governmental agencies (Fannie/Freddy) have been doing with government money? Is this who is going to get left holding the bag with this all goes down, because that is ultimately the general public.
Their are a lot of good things that will happen as a result of all of this. Ethics will be brought to light and more emphasis will be placed on them (at least until we forget about this round and make the same mistakes again.
This will shake the tree and hopefully shed some of the Rotten apples out of the industry.
The players that survived will be stronger if they can learn from this.
I realize that much of this rant has sounded like “the sky is falling” Chicken Little speak. Keep your heads up, there will be plenty of opportunities ahead of us but you need to consider everything to find them.
Buckle Up, it is going to be a bumpy ride!!
Matt
August 9, 2007 — 1:39 pm
Michael Cook says:
Very well said.
August 9, 2007 — 2:55 pm