What does the Bailout Mean to Real Estate?

 Everything.

Number of Adjustable Loans to Reset in 2009 is Looming Large

The resetting of interest rates for sub-prime loans is the source of foreclosures nationwide and in the Sacramento metro, and the subsequent decline in home prices. The chart above shows sub-prime mortgage resets in gray. By December 2008, the number will drop to nearly zero.

By December, 2008, most of the sub-prime mortgages will have reset to market interest rates or higher. Any homeowner who cannot afford the reset interest rates will be identified and be working their way through the short-sale or foreclosure process.

I fully expected this drop in subprime mortgage resets to begin  healing the real estate market. Unfortunately, the toll that sub-prime mortgages took on the financial system pushed it past the tipping point, creating a new barrier to the real estate market.

Reduction in "loanable" funds

The home mortgage problem has become so acute that it has reduced the amount of money which banks have to loan. This is directly related to the "reserve system" monitored by the Federal Reserve. As mortgage loans default, a bank is required to reserve those funds from their loanable deposits, dramatically reducing the cash available for credit. It's important to know that about 90% of your bank deposits are considered available for loans. When a loan defaults the bank has to withhold a portion of the defaulted loan from its current deposits which can be lent out.

Now the bank has three problems: 1.) They are loosing interest on the defauted loan (loss of income), 2.) New deposits, which the bank pays interest on, must be held in reserve, and are not earning interest (increases the banks expenses),  3.) The foreclosing on the collateral property costs the bank huge amounts of money to process and maintain until the assets are sold. Each of these problems takes big chunks of cash from the bank's income, which is based on a very small percentage of deposits.

Collateral damage from these defaults takes a further toll on the financial system, as home owners make decisions about which bills to pay, including whether to make the credit card payment, which may be at the same bank. Also, many decide to file for bankruptcy, erasing the debt for the consumer, but also erasing the loan from the bank, which came from someone else's deposit.

New Alt-A Loan Resets about to Start

As the subprime mortgage problem subsides, a new crop of three- and five-year adjustable rate mortgages are about to reset. Many of these loans will see interest rate increases and will re-amortize interest-only loan balances to a 25-year payoff. Many of these borrowers qualified for the loan based on false income, or, are self-employed and qualified based on "stated" incomes which may have been reduced by our reduced economic activity.

Many feel that as these loans reset, it will trigger another round of defaults, leading to required short-selling, or foreclosures. In many cases these defaults can't be avoided. Those that can be saved will be based on stable home prices and improving economic conditions.

Why the Bailout is deemed the right solution

Removing these defaulted loans from a bank's books allows the bank to loan more of each new deposit. This improves the earning power of the bank, allowing it to stay in business. If big banks go out of business, it traumatizes the entire banking system. If enough banks fail,  the US Treasury must pay anyway, because that's who underwrites the risk of the FDIC.

The Bailout also provides an investor (namely the US Treasury) who has the staying power to wait out the repayment of the loans, rather than having to dump the investment at fire-sale prices. When banks have to raise cash to pay depositors, they must sell their investments (loans) at distressed prices, getting pennies on the dollar, causing even greater problems and perpetuating a downward cycle resulting in the inability to pay depositors.

If depositors began to feel their deposits aren't safe, they will attempt to withdraw their funds, causing a "run on the bank". This topples banks instantly, as happened with IndyMac Bank in July, and more recently WAMU. This exact scenario created the Great Depression.

What "The Bailout" means to homebuyers and property owners?

If The Bailout is successful, banks will return to profitable operations as homebuyers  again have access to mortgage loans, allowing them to buy homes, which will in turn reduce inventories of existing homes, and eventually stabilize the market. The "investment" which The Bailout represents could create a positive return to taxpayers if the the real estate market stabilizes, and the mortgages are paid back. 

There are huge numbers of people who currently want to buy or sell real estate, but are waiting for signs that the market has stabilized.  If this demand is unleashed by renewed consumer confidence  the market will stabilize, causing prices to flatten and even move higher. Inventories will adjust downward, and the number of homes being sold prior-to-foreclosure increases.

Ultimately, that means the market will become friendly for doing business and begin to repair real estate's credibility as a long-term investment.

Finally, based on the mathematical ability of this lowly realtor, the cost of The Bailout, at it's projected maximum cost of $800 billion, would create a debt of $6,000 per taxpayer. A big expenditure. But the alternative is a country rife with poverty, crime, and starvation.

Also keep in mind the reason we find ourselves in need of The Bailout.

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