What is the genesis of our current credit crisis? 1% credit from the US Federal Reserve in their attempt to hold off a potentially lethal wave of global deflation in 2002, monetary and fiscal stimulus beyond the levels conventionally implied by forecasts of future inflation and economic activity. This caused a collapse of credit markets that is today threatening the underpinnings of credit-based finance and global capital markets; and, it did so by inadvertently banning market risk for five years.
Between 2002 and 2007, implied risk faded as central banks flooded the markets with cheap money; allowing capital flows to mask losses while boosting asset values to record levels. Billions of dollars of central bank credit translated into trillions of dollars of leveraged bets elevating all asset classes—real estate, stocks, commodities, and bonds. (Excessive lending against over-optimistic asset valuations is a time-honored recipe for asset price bubbles.) But global market risks, temporarily hidden by cheap credit, have now reasserted themselves with a vengeance. As long as housing prices rose, all mortgage lending sins of the past were forgiven. Even if a borrower got into trouble, the home could likely be sold for more than it was purchased for, and the loans would be paid off.
When a real estate boom turns into a bust -- as they can do -- there is no price appreciation 'safety net' for ill-made mortgage loans. Beginning in August 2007 the mortgage market has come under heavy scrutiny. With the US housing market already in the bust mode of the housing cycle, it has become abundantly clear that -- absent the ultra-creative lending schemes that artificially supports a highly over-priced housing market during the boom years -- the owners of those once easy-to-get $500,000 mortgages are now liable for loans that were secured by assets that are really worth only $300,000.
This turn of events has sent shock waves through the banking system (not just in the United States but around the world), rendering many banks insolvent and unable to function normally. This has forced a rapid tightening of lending standards -- known as a “credit crunch” -- which has sent the housing market careening into an even steeper decline. As a growing number of “for sale” signs fail to turn up even a shrinking number of buyers, foreclosures have started spreading like an infectious disease.
The majority of our clients are in the San Francisco Bay Area; known for stubbornly high real estate prices. With the increase in home prices over the last 25 years and tremendous acceleration in those gains over the last five years, the prospect of falling home prices was unthinkable to most. According to Dataquest Information Services, the research company that has kept records since 1988, the December median price was $587,500 last month, an 11.7 percent drop from the peak median of $665,000 reached just five months earlier in July across the nine-county San Francisco Bay Area. More ominous, the total number of homes sold in December 2007 has dropped 39.5% compared to December 2006 to a 20 year low.
Many investors have urged Federal Reserve Chairman Ben Bernanke to exercise restraint in responding with monetary policy to the recent financial market turmoil. They argue that an important reason that investors have taken excessive risk was the long time perception that the Fed would reduce the fed-funds rate if prices fell. They have done this repeatedly for past two decades creating what some refer to as “moral hazard”. This would clearly set a troubling precedent and could encourage irresponsible behavior by bailing out homeowners, lenders and investors.
Another alternative is for a taxpayer bailout of distressed homeowners; this would be expensive, unfair to the vast majority of homeowners and renters who have made prudent financial decisions and set a troubling precedent that would invite more reckless behavior in the future. Those facing the greatest risk of foreclosure – and presumably those who would get most of the taxpayer aid – are those who bought a much more expensive home than they could realistically afford, spent the equity of their once affordable home or lied about their income to qualify for a loan they otherwise would not have received.
The real objective of fiscal or monetary intervention is obvious - to slow the descent of home prices and to minimize the associated economic fallout. We are skeptical of these attempts to repeal the law of supply and demand. Home prices were driven to unsustainable levels during the housing boom because imprudent loans created artificial demand for homes. It is inevitable that home prices will fall as that artificial demand is withdrawn.
What can you do? Well, that depends on your individual financial situation. For those who have little or no equity in their homes, adjustable loans resetting to higher rates, anticipated mortgage payments heavier than they can legitimately afford and weak credit scores; there is no easy way out and it may get worse ending in foreclosure. There is no shortage of anecdotal stories or articles on this subject. One I found particularly interesting is “Rising delinquencies and falling home prices are putting lenders and borrowers in a tightening bind”.
If you are on solid ground financially with a mortgage you can afford, lots of equity, a credit score above 720 or a renter with aspirations of home ownership; the coming years may offer many opportunities to refinance or buy a home on better terms. (If you are a Summit Financial Advisors client, you may find yourself in this category.) Even those in this situation can take action to help improve their overall condition:
The recent turmoil has reduced prices in the stock market to levels we find quite attractive. We would suggest you continue to save money, keep it saved…and accumulate high quality assets straight through this choppy environment.
For your long term investment portfolio and retirement accounts, do not react emotionally by shifting assets to money market or bond funds in an effort to minimize short term losses. First, the market peak was six months ago (July 2008). As of this writing, the widely-followed equity indexes are already down 15-20% and during the average bear market since World War II (we have had eleven), is 23%. We may be closer to a bottom than many expect. Second, what we have seen in our practice of twenty years is those who run to cash during these periods rarely come back to their previous (and appropriate) investment strategy. This may impair your long term portfolio performance and jeopardize your ability to fund important goals such as college funding and retirement. If you need more convincing, take a look at a recent article we wrote about “The Enemy of Investment Performance – You!”
If you have a well-diversified portfolio including high quality fixed income (treasuries, municipals and CD’s) and asset classes that have had fantastic performance for the last five years such as foreign equity, commodities and gold…consider rebalancing your portfolio to increase your exposure to high quality U.S. equity.
There are strategies you can employ to improve your credit score. This would include reviewing your credit report for accuracy, paying down outstanding non-mortgage debt and reducing the size of your credit lines. A high credit score is a real asset in any environment, especially when you want to secure additional credit or refinance existing loans to better terms.
If you have an interest in “moving up” or buying a second home, accumulate savings in high quality, liquid assets. If you plan to buy a principal residence, strive to have a down payment of at least 20%...or 30% for non-owner occupied property such as a vacation home or investment property. Opportunities to acquire distressed assets such as real estate, private businesses and financial assets may be plentiful in the coming years.