60 Months of Financial Chaos (Five Years Later)

Our financial markets and country have changed over the past five years (September 2008 – September 2013). But the true magnitude of the financial chaos became apparent to most Americans in September 2008.

Beginning in mid-September 2008, Lehman Brothers, Bear Stearns, AIG, Merrill Lynch, and Washington Mutual were part of the largest banking collapse in U.S. history.Since so many of these banks, investment firms, and insurance companies were interconnected by their various forms of mortgage, stock, bond, and derivatives investments, many economists and financial analysts were concerned about bank runs and severe economic depressions even worse than “The Great Depression” (1929 – 1939).

What Happened

The collapse of  Merrill Lynch, the world’s largest brokerage firm at the time with $2.2 trillion in client assets and 15,000 brokers, was quite surprising and unexpected to many people.
Bank of America later “bailed out” Merrill Lynch, and Bank of America later took over Countrywide Mortgage (one of the most aggressive adjustable and sub-prime mortgage lenders nationally at the time) after their near collapse.
The collapse and subsequent bailout of Washington Mutual (WAMU) actually wiped out the FDIC (Federal Deposit Insurance Corporation), which only had about $40 billion in cash reserves at the time.
According to WAMU’s own 2007 filings with the SEC (Securities and Exchange Commission), WAMU held assets close to $328 billion at the time.
Secretly and quite silently, the FDIC was simultaneously bailed out, so that WAMU’s losses were covered at the time. Had the FDIC collapsed, then “bank runs” would have been a real possibility due to the perceived increased risk of an insolvent FDIC not available to insure any banking customer’s losses.
What infuriates me about the ongoing Credit Crisis is that many financial analysts, economists, and TV anchors allege that this financial implosion was primarily due to the “Sub-Prime Mortgage” collapse. Frankly, defaulted sub-prime mortgage losses represent less than 1% of all financial losses as compared with derivatives (glorified insurance and financial “bets” used by so many banks, investment banks, and insurance companies) over the past six years.

High Risk Loans = High Default Rates

Between August 2007 and September 2008, the changing financial markets became apparent to people who worked in the mortgage industry, like me. What we saw and experienced firsthand was many sub-prime mortgage lenders going out of business because they were losing access to secondary market investors who were purchasing their 80% to 100% CLTV (Combined Loan to Value) loans.
Many of these same loans were available with or without income or asset verification, so these mortgages tended to have higher mortgage default rates as compared with more conventional “Full Doc” mortgages.
Due to the perceived risk of “EZ Doc” loans, bad to decent credit mortgage loans combined with the increasing short-term “teaser” interest rates were resetting to much higher rates and payments. Tragically, in many cases, mortgage payments would literally double or triple within a year or two.
As foreclosure rates started to rapidly increase for various types of sub-prime mortgage loans and adjustable mortgages, the secondary markets–like investment banks on Wall Street, didn’t want to purchase these riskier mortgage loans.
With fewer secondary market investors available to them, more sub-prime mortgage lenders began closing their doors. If a lender can’t sell off their funded loans in the secondary market within a day, a few weeks, or a few months, then they will rapidly run out of their own capital.

The Reduction of “Flipper Financing”

Between 2002 and 2007, it was quite easy to qualify for home mortgage loans. The Federal Reserve actively moved to reduce short-term interest rates down near 1% earlier this decade partly to better stimulate the U.S. economy after the Nasdaq and Telecommunications meltdowns in 2000 and 2001.
While many investors lost money in the stock market back then, many of them later made back their financial losses by investing in real estate with cheaper mortgage rates.
The combination of low rates, easing mortgage underwriting guidelines, and better access to conventional and non-conventional forms of capital led to rapidly increasing home values. In many popular regions, such as along the coast in Southern California, home prices were literally doubling in value during the period of just one to two years. This was true even for properties which were originally purchased as regular, non-distressed listed homes at market value.
How could an investor lose much money if they decided to buy homes with no money down? Owner and non-owner occupied loans back then were available up to 100% LTV. Many savvy investors might have qualified with no income verification and no money down loans for a $250,000 home using a “piggyback” First and Second mortgage loan to buy the property. The First mortgage loan was typically 80% of the purchase price or appraised value, and the concurrent Second mortgage loan was the balance of 20%.
Later, that same home may have appreciated up to $350,000 within six to twelve months. If the existing loans had no prepayment penalties, these two higher rate and shorter term sub-prime mortgage loans were refinanced into a new “Option Pay ARM” loan (1% + start rates with loan terms up to forty years). After the refinance of these two purchase money 80/20 loans into longer term and lower rate “Option Pay ARM” loans, the existing mortgage payments were literally reduced by 200% to 300% +.
When the financial “spigot” was greatly reduced beginning in the summer of 2007, then “Flipper Financing” options were quite limited. Since it is the availability of take-out mortgage capital which typically drives the direction of the U.S. housing market in both “Boom” and “Bust” housing cycles, then foreclosure rates began to increase rapidly.
As a consequence, home values began to plummet due to less refinance and purchase money options for so many buyers, owners, and sellers.

We Cannot Blame the Real Estate People for the Credit Crisis

As stated earlier, defaulted sub-prime mortgage losses represent less than 1% of all financial losses as compared with derivatives (banks and insurance companies “gambling”) over the past six years.
I warned many of my clients, readers, co-workers, family, and friends for many years about the potential severity of the perceived forthcoming financial meltdown well before the financial implosion began in 2007. I had seen and heard that upwards of 75% of jumbo mortgage borrowers in Southern California were using “EZ Doc” loans to buy their pricey coastal properties.
Once “EZ Doc” lending was greatly reduced beginning in late 2007, and more significantly in 2008, I believed that foreclosure rates would skyrocket and home values would rapidly decline upwards of 30% to 50% within just a few years.

The Strategies May Have Changed, but You Can Still Prosper

We have all seen the Dow Jones index rise from the mid-6,000 range in March 2009 to the 15,000 + range in 2013, primarily due to the financial shenanigans played by the various Central Banks worldwide. Yet, most Americans don’t own any stocks.
But some have been able to rapidly boost their overall wealth by actively investing in real estate. This is most especially true for those who were creatively purchasing discounted properties with the cheapest and most flexible third party money options possible. Amazingly, some home values have reached near their previous highs back in 2006 to 2008, which made a lot of real estate investors quite wealthy again.
While the rules of real estate investing and overall financial investing strategies have changed significantly over the past five years, those people who have lived with the mindset of “Adapt or Die” have prospered.
“Knowledge is Power.” So please keep reading CRE Online to learn more about our ongoing exponential and seemingly infinite changes to today’s financial world. What may work today may not work tomorrow. However, what once worked in the last “Boom” cycle may soon work again as the financial world evolves each and every single day.

By Rick Tobin

I have over 30 years' experience in the financial and real estate industries. As financing is what truly drives the real estate market, I provide my clients with the best forms of financing options available. I've held eight (8) different types of real estate, securities, and mortgage brokerage licenses throughout my career. I'm also an alumni from the University of Southern California. I own a mortgage company that specializes in residential and commercial lending. For residential loans, I am proud to be partnered with United Wholesale Mortgage (UWM - America's largest wholesale lender). In 2019, UWM funded over $107 billion dollars. We offer some of the best rates and terms nationwide and quickest close options that average near 15 days with completely paperless or doc-less options. I also have financial relationships with hundreds of other financial partners