Unfortunately for buyers, Maine’s real estate market has not experienced anywhere near the price drops seen in many other regions of the country. Houses here may stay on the market a little longer, but they eventually sell — particularly in the Portland area. While we may have a glut of brand new McMansions in planned developments, nice old homes in great neighborhoods are still valued. Throw in a partial water view and prices are pretty firm.
The majority of the real estate swoon has been contained to the Sunbelt states, where people were buying brand new houses to sell them, trying to imitate the reality show “Flip This House.” In fact, a report from Bear Stearns estimated that a quarter of all sub-prime originations happened in California. The sub-prime sector is where most of the defaults have been. The recent buyers may soon be auditioning for the new, edgier, Gen-X version of the show, “Burn This House.”
Buying an overpriced house in an over supplied market is never smart, but lending the money for these purchases is insane. Who made these bad loans? As we saw in part 1 of this article, (www.themaineswitch.com/dollar_signs), the business of lending money is unrecognizable from the simpler times of the Bailey Building and Loan, run by the saintly Jimmy Stewart in the classic movie “It’s A Wonderful Life.”
Since the entity that approves the loan no longer lends its own money, underwriting standards weakened. Meanwhile low interest rates flooded the markets with money and made applicants suitable for ever larger loans. Housing prices soared, leading to increased demand as everyone wanted to get on the gravy train. In the financial world, this classic combination of overextended borrowers chasing an overpriced commodity is known as a “bubble.” The popping of a bubble is not pretty — as anyone who owned internet stocks in 1999 through 2001 can tell you.
In George Bailey’s day, a spate of bad loans would have caused a run on the bank. Today the loans are packaged and sold using fixed income products like CDOs. When mortgages began to default, the owners of CDOs stopped buying them. Many tried to sell their holdings. This led to a near collapse of the fixed income markets. This cut off the flow of funds for future loans, which further slowed the housing market. One consequence was an event that many believed could never happen — a decrease in housing prices. Another has far worse implications.
Many of the CDOs are owned by investment companies run by large banks known as “structured investment vehicles” or SIVs (the geeky acronym of the day.) These entities occupy a corner of the market few people know exist, yet their influence is huge. SIVs borrow money by selling short-term corporate paper — the kind used in money market funds. The proceeds are invested in highly rated medium and long-term, fixed-income assets like CDOs. The idea is to profit from the difference between the low borrowing rates and the higher returns from the CDOs.
This works when markets are humming along. As mentioned above, there are not many buyers of CDOs lately. The SIVs now own bonds whose market value — to the extent that it can even be ascertained — is plummeting. But they still have to pay the interest due on their short-term loans. Which is why SIVs, and NOT individual home buyers, are being bailed out by the U.S. Treasury. More on that next time.
Terry Davies is a portfolio manager at Investment Management & Consulting Group, a registered investment advisor in Portland. IMCG provides comprehensive financial and investment guidance to individuals, families, endowments and businesses. He welcomes your feedback by phone 800-605-6552 or email tdavies@imcgrp.com. The analysis of the financial markets in this column is not meant as investment advice.