I recently received this stream of consciousness from Tim Fiero, Senior Loan Consultant with First Capital Corporation, workaholic, and all-around great guy. While it was intended as an informal primer for Prudential agents unfamiliar with the recent lending goings-on, I loved the way he summarized our current mortgage mess in lay terms and felt it was worthy of a few consumer eyes (and may be of benefit to other agents) as well. With Tim’s permission, I reprint his remarks here.
(Keep in mind – The style is very charmingly conversational. He admittedly penned this while his toddler son was napping, and it is therefore it just another example of how agents and mortgage professionals tend to get crazy when faced with a little discretionary window of time.)
Hedge Funds, Private Equity Funds, Derivatives, Credit and Liquidity Crisis in the Mortgage Market and ………..What Does All This Mean to a Prudential California Realty Agent?
I took a personality test once and it listed optimism as one of my faults. I took that as a positive. The opposite (pessimism) does not seem like something I’d like to be known for.
So, with that being said, I would have to say last weeks changes in the mortgage market were historic in nature. Whether you call it a Tipping Point or an Inflection Point only depends on which book you have read. (Both are the titles of books, in case you were wondering). It does not matter what you label it, the point is, there were some major changes in lending and there are more to come.
Why were the changes historic in nature and how does that affect you? Like the environment, the economy in intertwined in many, many ways. But first, a quick dissertation on what is a hedge fund, what is a private equity fund, what is a derivative, what is a liquidity crisis, and what is a credit crisis?
Derivatives
Derivatives are the most complex to explain, so I will stay with the simplest example. (I have to be simple because that is all my mind can handle).
If a business, in the US, buys copper from Peru, there are things that affect the price of the copper. To keep it simple let’s just say the two things that affect the price are the commodity itself and the cost of the Peruvian currency. A change in the value of the currency could make the cost of copper increase. Companies therefore buy a forward contract on the Peruvian currency in order to keep the cost of the copper the same.
The offset helps create cost stability for the commodity.
The amount of derivatives in our economy is mind numbing and many are very complex. As you can see by the above example they can be very good things, if used correctly. They can also be risky if used incorrectly.
Private Equity Firms
Private firms funded by wealthy people and/or institutions. The private equity firms take the investors money and keep it as an asset. They then borrow additional money form large commercial banks. They then take the borrowed money and buy publicly traded companies. Their goal is to reorganize the company they just bought, make it more efficient and profitable, they resell it in a few years at a huge profit. One such company just bought Chrysler. The keep here is to understand their use of leverage. They borrow the money from banks to buy the company. They use the investor’s money as a form of collateral. So, they are leveraging the investor’s money.
Hedge Funds
Hedge funs operate in a similar manner. They take investors money and at the same time they borrow from banks in order to leverage their investments. Hedge funds tend not to buy business, but they hedge their money in commodities, stocks, and bonds both foreign and domestic. They tend to widely use derivatives!
Credit and Liquidity Crisis in the Mortgage Market
This situation started off the year in the meltdown of the sub-prime mortgage market.
Hedge funds, using the above example of how they operate, borrowed money from banks. From there they funded the operation of sub-prime lenders as well as Alt A lenders. (Alt A are borrowers one step up in the pecking order from sub-prime).
So the hedge funds and some private equity firms fed the lenders the money to loan out. Once the loans were funded, they turned around and sold the loans to other investors.
They were making huge profits, so in a low interest rate environment there was huge demand for these mortgage backed securities. More demand for these securities from Wall Street, more demand to fund more loans.
How do you increase the loans you do? Reduce credit/underwriting standards. If you reduce standards, more people can qualify. If more people can qualify more people can buy homes. Not a great idea, to increase the speed of the train as you get closer to the bend!
First the sub-prime market was affected and now, in the last two weeks, the Alt-A market got hit. What do I mean got hit? The companies underwriting and doing Alt-A loans could not sell their loans. Why, Wall St. investors do not trust the credit quality. Here is an example.
(Where the investor might by a $500,000 loan from a lender for $505,000, because they are buying the future cash flow, they may now only offer $490,000 for the same loan. They only offer $490,000 due to the credit risk. You multiply that example by a large portfolio; you can imagine the losses that have been incurred.)
Wells Fargo and Indy Mac were two of many lenders hit by this last week. One company, American Home Mortgage, was hit so hard they went out of business. AMH was not doing anything really wrong; they just got caught with the wrong business model in the middle of a rapid shift in the way the world works. They could not sell the loans they had and the hedge funds, funneling money to them for operations, cut off their source of additional funding sources. That is why some people who were getting loans from them had to go find someone else to do their loan.
How will this continue to play out? Well it will be interesting to say the least. Remember the part about Leverage? Now, remember the hedge funds that pulled their money back from the mortgage companies? Well their investors want their money back and guess who else wants their money back? The banks who lent the hedge funds the money to do their leveraging! Oh the drama of it all! Soon to be playing out on a computer screen near you! (watch the stock market).
So, how does this affect us at Prudential and the rest of the real estate market?
The biggest affect for us will be in the jumbo or non-conforming loan amounts. (Non-conforming meaning loans greater than $417,000 or non- Fannie Mae/ Freddie mac loans).Guidelines and pricing changed, in the last two days, faster than my wife asking me to do the dishes after dinner. Add to this that Fannie Mae did issue new guidelines stating that, interest only loans must now be qualified at principle and interest payments.
More than likely stated income loans will be tightened also, we will just have to wait and see.
I personally am very optimistic (are you surprised?). Prudential is a great company and First Capital is positioned well for these changes… (We) have been through tough times before, (remember the S&L crisis?) we learned to adapt and charge forward… Lending will be done more similar to the way it was done in the past. Assets and income checked and guidelines will need to be met! Loans could take more time to process. This is where experience and competence will show through.
Why did I take the time to write this letter? Well for one, my son Lucas is asleep for his nap, so I had the time. The main reason is, if you chose to keep informed and want the readers digest version ( meaning short, not written on a 8th grade level ), I hope this helps. We will have to be realistic about the lender process as we move forward, but I for one believe optimism rules over pessimism any day!
ABOUT THE AUTHOR Kris Berg is Co-Owner and Designated Broker of San Diego Castles Realty. If not-so static web sites are your thing, go here at once where you will find loads of real estate information including homes for sale, market trends, floor plans and more. Kris's hobbies include fencing and spot welding. She likes kittens. 
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{ 5 comments… read them below or add one }
It’s actually a little more simple than all that. The secondary mortgage market (mostly fueled by Hedge Funds) for the Jumbo loans completely dried up last week. Even prime loans don’t have buyers. This means that a company who issued a jumbo loan has to hold it while looking for someone to buy it. This reduces capital and means they can’t issue as many new loans, hence they raise the price and reduce the availability of non-conforming loans.
To say this was unprecidented is to ignore every bubble blogger who’s been predicting this for 3 years. When only 10% of the population can afford the median house in a region and a huge percentage are buying with pay-option loans that are going to give structured payment shock at set intervals, it doesn’t take a rocket scientist to see what’s going to happen.
I think everyone who follows the industry saw this coming a mile away, but if you are making money off the industry, there’s no money in calling it out.
Sven,
I would watch this story unfold over the next 1 to 2 months. We are seeing a little panic attack, but let’s agree to check back.
I’ll offer an analogy to the knee-jerk lending reaction we have seen from some. When the fires occured in Scripps Ranch a few years ago, we had a virtually moratorium on fire insurance for all Scripps homes… for about a month. Once the dust settled, insurance companies stepped in and wrote, wrote, wrote those needed policies. When Wells Fargo says that their Jumbo loan rates are 8%, this is a knee-jerk reaction. “We are not making loans until things have settled down”, they are saying. Speaking from a broader perspective, it will certainly take awhile to sort this out. But, the freak-out mentality will undoubtedly pass more quickly.
People are still buying, and people are still selling. That is the reality, spoken from a girl in the trenches. Our current market is cyclical, not cataclysmic. It, too, shall pass.
I agree, things will come back to a healthy market, but I think you are a little optimistic on your timeline. At this point it’s not the buyer’s opinions that need to change, it’s the investors that need to feel that property is a rock solid investment again. The investors fuel the mortgage industry. Just ask anyone with money if they want to buy a dot com stock if you want to see how slowly people snap back from being burned on an investment.
In the end, a truly prime buyer (someone with good credit, 20% equity, and enough verifiable income for the purchase price) will always be able to get a loan on a house. It’s the closing off the other sectors that will cause some pain. From what I understand, this last week a lot of Alt-A mortgages were turned down because investors don’t like stated income anymore.
Here’s something I haven’t said before. I think early next year will be a good time to start shopping for a home. It’s not going to be a bottom, but I think that’ll be the best time if you want to have the best selection to choose from.
>I think early next year will be a good time to start shopping for a home.
Sven, Are you working for NAR now?
Who knows when the market will come back? I don’t
I do know that comparing a dot com bubble popping and subsequently dropping NASDAQ into a tailspin to the recent RE market correction (or enter your own adjective here) is a bit of a stretch. Investors everywhere lost their money and went home with tail between legs and still haven’t come back to the party with regards to dot coms. On the other hand, savvy investors are already keeping their eyes peeled for the perfect place to make their next mark in RE.
I just don’t see the connection between the two.
Nice post.