Unless you live in a remote village on a remote island in a remote part of the world, you are well aware of the boom in real estate that the United States and many other developed countries of the world have experienced over the past 5 to 7 years. Many real estate "experts", economists and other financial gurus have been saying that the markets have been overvalued for some time. Yet, as with many other things, the need for people to keep up with the "Jonses" takes precedence above rational thought and behavior. You see, I am one of those people that has been saying the real estate markets have made no sense for investors looking for cash-flow (what I was at the time). People were buying for irrational reasons...reasons that could not be backed up by anything other than statements like "Real estate will always go up."
It is obvious now that those days are over and we are now looking at a different landscape. Forclosures are up to levels we have not see since 2002 and from the looks of it, will move up to record levels soon. Why is this? Simple, tremedous liquidity in the markets looking to invest in real estate backed securities. Okay, you say. But, what the heck does that mean? Well, let's talk a little more about how real estate lending really works in the United States.
Deposits are where it all begins. You open a checking and a savings account at your local bank. They give you a better deal if you keep a minimum balance in your savings and/or checking account(s). Banks can lend a certain amount of their deposits based on federal banking laws and regulations. They do this in order to make money, it is that simple. For example, a person comes in looking to buy a house for $125,000. The bank gives him a loan for $100,000 at 10% interest and he puts the balance into the deal in cash. The bank underwrites (aka evaluates and packages) the loan according to a certain set of guidelines (typically Fannie Mae) to make it marketable. The bank then packages up all of the loans they made that month and they sell them to investors on Wall Street who are looking to invest money in real estate backed securites. The bank sells the loans at, say, a 9.75% interest rate making .25% on the entire package of loans. So, if the package was $100 Million in loans, they would make .0025 x 1,000,000 = $2,500. Obviously, banks are making more on the deal than that, but that is basically how they do it. They then get all of their money back, with the interest "spread", and re-loan the money out and do it all again.
So, here is where things get interesting. These days, there has been a tremedous amount of liquidity in the secondary mortgage market (where the loan packages are bought and sold). This means that there are a lot of institutional investors competing to buy a limited number of real estate backed security portfolios. So, banks slowly start to ease their regulations on how they underwrite loans and package them up into different classes. A paper, Alt-A, Sub-Prime, etc. But, since there is so much demand, they can pretty much loan to anyone and the markets will absorb the loans. That is until trouble starts.
Well, everything is honkey dorey when the market is appreciating everywhere. This is great for borrowers, as their equity grows in the property and it is great for banks as they have a better asset as collateral. Well, when the appreciation slows or stops altogether, trouble can happen. Many of the people who purchased homes over the past couple of years have been doing so with very high leverage loans. In other words, they are able to get loans with higher than normal debt amounts. Many have purchased homes with little to no money down, leaving a small buffer of equity for the banks and lenders. The other problem is that many of these people have been living off of this new equity that has come along with home ownership (recently) and using the money as disposable income. They continually refinance, pulling out more cash, depleting the equity in their home and increasing the amount of debt they are on the hook for. To make matters worse, banks have been offering Option Pay loans which allow borrowers to pay less than the full amount of interest they owe for that month and add it to the balance of their loan. This has made for a very bad situation for thousands of home owners across the United States today. Unfortunately, this is why we are seeing such high levels of defaults and forclosures and the trend is likely to increase in the near future.
For the people who have little to no equity there is really only one of two ways they can go. One, they can sell their home. This is not what most people want to do for a myriad of reasons. However, it is the best solution in just about every situation. Most of these people still have enough equity to pay off the bank, pay real estate sales commissions and fees and walk away with a few bucks in their pockets. I am amazed at how many people simply will not do this. The other option is to use some kind of hard money lender or private money lender who can base a loan primarily on the equity in the property. But, private money / hard money lenders typically need to see MORE equity than a typical conventional lender does. They will however typically lend to borrowers who have sub-500 FICO scores and poor financial histories. Most hard money lenders really are not able to help the people that we are talking about here. There is simply not enough equity to be able to secure financing.