The decline of the subprime
And the effects on Austin’s real estate market
By John E. McClellan
If you hear that popping sound in the real estate market, it’s probably the noise from the implosion of the subprime lending market.
To date, I’ve counted 36 subprime lenders that have gone under since late 2006 (source: ml-implode.com), and I’ve seen predictions forecasting as many as 100 mortgage lenders will fail this year. (Doug Duncan, chief economist of the Washington-based Mortgage Bankers Association)
What is Subprime?
Subprime mortgages are given to people that won’t qualify for conventional loans, Alt A loans, or government backed loans. Typically, subprime loans carry two or three percentage points above safer prime loans, and are given to people that fall below a 620 credit score; and in some cases, first time home buyers that can’t prove income.
Over the past several years, demand has risen for homes and banks have been competing to get that business. To accomplish this, many lenders created subprime products to drive up their volume and lowered their guidelines down to around a 560 credit score.
Nationwide, subprime loans financing new mortgages were up to 20 percent of the market. That’s up from five percent in 2001, according to the Mortgage Bankers Association. Subprime loans contributed to a home-ownership rate that reached a record 69.3 percent of U.S. households in the second quarter of 2004, up 5.4 percentage points from the same period in 1991, according to the U.S. Census Bureau.
Obviously, there are quite a few people that should never have received loans, as the default rate is currently around 12 to 15 percent. Compare that to the default rate on conventional loans (around one to two percent) and you understand why there is a problem.
The second largest subprime lender, New Century Financial Corp., lost 90 percent of its market value and is on its way to declaring bankruptcy. Fremont General was ordered by the Federal Deposit Insurance Corp. to stop making subprime loans. And there are others that are on the verge of going out of business right now. I wouldn’t be surprised if we start seeing some Enron and Worldcom-type scandals from some of these subprime lender CEOs with just as many legal repercussions.
How did we get here?
The market grew this large because overall, the U.S.real estate market was very good until 2006. Even though the subprime market grew significantly during this period, we didn’t see high default ratios because most people could easily get out of their homes by selling or refinancing.
Over the last few years, the market has been flat in areas like California and these people cannot sell their homes anymore and they are going into default. With too many defaults, the subprime lenders cannot liquidate their bad debt to create new products and are therefore going defunct, and it’s having a dramatic affect nationwide.
So what does this mean for Austin’s booming real estate economy?
Austin is a little bit of an enigma, because our market is still performing well.
The most dramatic effect is that our buyer pool is going to decrease. Even though traditional loans will absorb some of the subprime market (10 percent maybe) a decreased buyer pool is bad for sellers.
Demand for housing here in Austin, however, is still going through the roof. Whereas I’ve seen speculation that nationwide it could throw us into recession, my guess is that is unlikely to have a dramatic affect on our market in the short term, and we may weather it altogether.
Austin’s investor market should benefit, and here’s why:
Most first-time home buyers that would have fallen in the subprime category look for affordable housing, which usually is located on the outskirts of town. People will tolerate a longer commute to work if they are home owners, and this is why we’ve seen big booms outside of town.
If those people cannot qualify for home ownership, they will rent properties, and will pay higher rental rates so they don’t have long commutes. So investors that own property within the city limits as opposed to the outskirts of town are probably going to see a boom in terms of rental rates, their pool of renters will go up and you’ll see values on investment properties go up because they won’t qualify for home ownership.
John E. McClellan, owner of Team McClellan, has been in Austin’s Mortgage business since 1994 and is the host of the Mortgage 101 radio show, every Sunday at 1:00-3:00 p.m. on Talk Radio 1370 A.M.
