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Real Estate's Fault Line

By Barbara Kiviat / Denver
Time in partnership with CNN

First come the billboards. As you head north, away from downtown Denver, they flip by like flash cards, advertising houses by Lennar, KB Home and Richmond American, from the $100s, the $170s, the low $300s. What they don't tell you is that should you wander into one of the new subdivisions popping up from the prairie, you're likely to be offered tens of thousands of dollars in incentives to buy, and to buy now. At a recent conference of Colorado builders and real estate agents, one speaker counseled salespeople to stop acting so desperate. "It sends the signal that the market is bad," he said, "and to wait for the bottom."

Yet as Denver richly illustrates, there is plenty of bottom left to wait for. It's a far cry from the days of double-digit home-price gains and mass speculation in hot markets like Las Vegas--where 40% of the houses up for sale now sit vacant. What's astonishing about this particular real estate bust, though, is the way the damage has pinballed across the financial universe: mortgage companies in Los Angeles, banks in Seattle, hedge funds in Australia, the European Central Bank, Wall Street investment houses and Main Street stockholders have all had the American real estate market fall on them.

Call it the international house of pancaked leverage, built on the proliferation of subprime and exotic mortgages that did away with many of the safeguards built into the classic 30-year fixed rate with a 20% down payment. Riskier loans originally designed for a narrow band of home buyers--interest only, adjustable rate, balloon payment, no documentation (of income, that is)--took off broadly in the last rising market, and Denver was one of the many areas where they were hot.

The demand was coming not so much from borrowers as from Wall Street, which packaged the loans into securities to sell to investors looking to pile into "low risk" real estate. So mortgage brokers found ways to squeeze buyers into first and second mortgages even when their finances were questionable. Consider the appellation NINJA, used to indicate a buyer with no income, no job and no assets. "Capital was made available to every Tom, Dick and Harry," says Zachary Urban, who runs the Colorado Foreclosure Hotline.

Urban is now dealing with the fallout: 18,000 calls in the past 10 months. Calls from people like Essie Kemp, who lives in the hard-hit neighborhood of Montbello. Kemp is faced with losing the home she has lived in for 23 years, since she can no longer make the payments on her refinanced mortgage. She wanted to have money to buy an air conditioner and fix her pipes. What she got was an adjustable-rate mortgage that spiked after two years. It wasn't until she went to see a housing counselor that she realized her income was listed as $4,000 a month--more than twice what she was making from a part-time job and Social Security. "I've done all I can do to keep my end of the bargain," says Kemp, "but it just didn't work."

And it's not working for about 25,000 people who will receive a first notice of foreclosure this year in the seven-county Denver metro area, according to the housing-analytics firm the Genesis Group. That's about half the number of people who could be expected to put their homes up for sale in a normal market. The most distressed neighborhoods are seeing foreclosure rates rivaling those produced during the state's oil and gas bust of the 1980s--except these days, there aren't mass layoffs to blame. Just flat house prices and tighter credit standards, which make it harder for homeowners to sell or refinance their way out of trouble.

Green Valley Ranch, to the east of downtown Denver, is one neighborhood having a particularly tough time. Houses are still going up in the massive multiphase development, but within the new construction lurk bus benches advertising foreclosure assistance. Many of the people who have run into difficulty are first-time buyers who jumped into mortgages they couldn't afford in the long term. Now, as they endure the heart-wrenching saga of slowly losing their homes, the whole neighborhood suffers: according to a study by Dan Immergluck at the Georgia Institute of Technology, a house loses 1% of its value for each foreclosure within an eighth of a mile (200 m).

Foreclosed Is Forewarned

DENVER IS JUST ONE PIN ON THE NATIONAL map. Looking across the country, the foreclosure problem is worst in areas where house prices went wildest (southern Florida, California), where local economies are depressed (Cleveland, Detroit) and where regulators paid little attention during the go-go years (before a new law took effect in January, mortgage brokers in Colorado didn't have to be registered). But it is important to point out that while Colorado has one of the nation's highest foreclosure rates, according to property tracker RealtyTrac, many parts are doing just fine. Prices in Denver's newly hip Highlands neighborhood, a community full of bungalow homes and yuppies, were up 13% last year, according to listings data crunched by real estate agent Ed Tomlinson. And ski resorts like Copper Mountain can't build enough pricey condos.

But troubles that exist in distinct pockets can ripple outward. In the northern suburb of Thornton, Stephanie Brown is trying to sell her four-bedroom house for $445,000, just enough to break even on her investment, since she's eager to move closer to her new job. Yet in a month on the market, she's had only a single showing. On one side, she is up against home builders who are knocking $100,000 off the price of houses similar to hers. On the other, she faces a market flooded with foreclosed properties, like the hundreds up for sale at two different auctions in Denver on a recent weekend, some of which started with bids of half the estimated market value. "It's hard to sell a house if you can't even get people in the door to look at it," says Brown.

This local malaise, repeated in city after city, has ballooned into trillions of dollars in losses around the world, thanks to the magic of Wall Street's financial engineers. Blame it on one of the Street's recent innovations, the collateralized debt obligation, or CDO. The recipe: buy home loans, blend them, then slice up the result into different securities (reflecting different levels of risk) to sell to investors. Many such securities carry AAA or "investment grade" ratings despite subprime mortgages being in the mix. From there, things get really complex--CDOs created from other CDOs, synthetic CDOs crafted from credit-default swaps, none of which had experienced a down market. "The problem is that CDOs were untested. There was not much history to suggest CDOs would behave the same way as AAA corporate bonds," says Richard Bookstaber, a hedge-fund manager and author of A Demon of Our Own Design, who views market palpitations as a predictable by-product of complex financial products like CDOs. (For the author's take on the subprime disaster, go to

Now that the foundation is shaking, there are scant buyers for the lower-grade issues built on top of the pooled mortgages, and the values of those CDOs have plummeted. Losses in the subprime market drove Bear Stearns to declare two of its hedge funds, once topping $1.5 billion, all but worthless, and banks as far afield as Germany and France have frozen funds or received bailouts because of exposure to U.S. mortgages.

The Looming Disaster

FOR REAL ESTATE, NEXT YEAR COULD BE EVEN worse if interest rates don't fall. In 2008, some $680 billion worth of adjustable-rate mortgages are due to reset, according to Bank of America. That's $165 billion more than this year, and of those loans that are likely to carry higher rates, nearly three-quarters are subprime. Since many adjustable mortgages change rates after two or three years, the loans due for reset would have been written in 2005 and 2006, the years underwriting standards were bent the most. "It's clear that the performance of loans will be worse," says Mark Adelson, recently departed head of structured finance research at Nomura Securities, "but it's not yet clear how much worse."

One way to think about it is to consider how much more homeowners will have to pay to keep their mortgages current. According to an analysis by First American CoreLogic, a firm that tracks real estate and home loans, a typical subprime first mortgage that was originated in 2004 to 2006 will face a monthly increase of $407, and a typical teaser-rate loan, the type often sold to people based on their ability to pay the introductory rate and not the reset, will see monthly payments jump by $1,512.

Back in Colorado, people are reacting. This summer, three laws went into effect that, among other things, require anyone selling a home loan to make a reasonable inquiry into the buyer's ability to repay it. In recent years, as a growing percentage of loans have been generated by brokers rather than the banks that ultimately owned the mortgages, best interests have been at odds: brokers can make more money with higher-rate loans, even if buyers qualify for a better deal. And that doesn't even touch the lending arms of home builders, which come with their own special conflicts of interest once you consider pressure from shareholders to get people into houses and book those profits. Establishing a fiduciary duty for mortgage sellers, which Congress is considering as well, is meant to realign interests. In the meantime, many banks are working with homeowners to renegotiate loan terms to avoid foreclosure. Still, the EZ Credit addiction is tough to cure. Drive through Green Valley Ranch, and you still see signs for 0 DOWN PAYMENT, 100% FINANCING.

In early August, American Home Mortgage, a mortgage lender with little subprime exposure, declared bankruptcy, stoking speculation that troubles are bound to spread to securities backed by higher-quality mortgages. It didn't help when lenders Countrywide and Washington Mutual subsequently issued dire warnings about losing liquidity because so few people want to buy mortgages on the secondary market right now. "One of the most interesting things is, we don't know who's going to suffer," says Karl Case, a housing economist at Wellesley College. "Obviously, the people who get foreclosed against suffer. That goes without saying. But who bears the losses ultimately is really complex." We can start with the stock markets around the world, which have surrendered $3 trillion in value over the past month, thanks in large part to the mortgage monster beginning to come undone.

But houses don't trade like stocks, so when it comes to correcting the system when it gets out of whack, we're talking years, not weeks. "Real estate," says housing economist Thomas Lawler, "is a slow, tedious process." In July, after the two Bear Stearns hedge funds first ran into trouble, bond guru Bill Gross of Pimco wrote a foreboding investment outlook, pointing out that hedge funds tied up in trading are the top layer of the problem, not the root. That can be demonstrated in the Mile High City and, as Gross wrote, "in the Summerlin suburbs of Las Vegas, Nevada, and in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida." It's a big problem. How big, we're still waiting to find out.

[The following descriptive text appears within a diagram]


For generations, U.S. house price appreciation largely tracked inflation. But around 1995, home prices began rising at an unprecedented pace. The boom created wealth throughout the economy, but also created risks that spread far beyond the housing market. Here's how:

• Real House Price Index

• Change in housing prices, adjusted for inflation

• Source: Center for Economic and Policy Research Everyone Into The Risk Pool

To bring in more home buyers, lenders began offering mortgages with only a cursory scrutiny of the borrow's qualifications. Many of these loans - including subprime mortgages going to people with weak credit - had low starting interest rates that would rise over time. • Subprime mortgages as a percentage of all mortgage originations

• Source: Inside Mortgage Finance

The Trouble With Bubbles

As long as home values rise and interest rates stay low, everyone's happy. But once prices flatten or fall and interest rates creep up, those once-manageable house payments can jump quickly. Subprime borrowers are most vulnerable. Many can't sell or refinance because they owe more than their home is now worth.

• Median sales prices, existing homes

• Source: National Association of Realtors

Spreading The Risk

In decades past, the trouble would end with a borrower in default and a bank foreclosing on the home. But today few banks hold onto mortgages until they are paid off. Most loans are bundled together and sold as mortgage-backed securities. • Mortgage delinquency rate

• Source: Mortgage Bankers Association

Raising The Risk

The new owner of the mortgages can use them as collateral to issue bonds to finance other deals. Money from thousands of homeowners covers the interest payments on those bonds. To attract investors, the bonds are rated by risk groups, called tranches (the French word for slices). The more secure the bond, the lower the payoff for investors. Those who buy the riskiest pool of bonds - the ones backed by the riskiest home mortgages - are promised the highest return. • Mortgage-backed securities • Pool of mortgages • Bond tranches • Risky bonds re-rated in a CDO

Compounding The Risk

To further complicate the picture, some firms create new "structured finance" products, called collateralized debt obligations, from pieces of other mortgage securities. These new bonds are re-rated, creating illusion of safety even though the top-rated bonds may include very risky original loans. Last year nearly $500 billion in CDOs flooded the market. Many hedge funds invested heavily in them, often using borrowed money, and thus increasing their exposure. The Contagion

At its core, the entire process is based on using borrowed money (home mortgages) as collateral to borrow more money (mortgage-backed securities) to borrow yet more money (CDOs), and hoping the payment chain doesn't break. Once home-mortgage defaults rise, the whole system can unravel.

• Dow Jones industrial average

• Since Jan. 3 1 Without the payments from homeowners, the issuers can't pay off the bonds.

2 The bonds lose value, and the hedge funds that borrowed money to buy the bonds must put up more collateral or try to sell the bonds, which can cause their value to drop even more.

3 The rout begins. Banks tighten credit, raising the cost of financing corporate and private-equity deals. Other investors then want to reduce their risk. Stock prices fall, and bond prices rise. With global markets so closely linked, fear spreads rapidly around the globe.

4 Back on Main Street, tighter credit means fewer people getting home mortgages, further depressing the housing market and perpetuating the cycle.

Posted on Wednesday, September 12, 2007 at 03:59PM by Registered CommenterElaine in | CommentsPost a Comment | References1 Reference

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