(WESTPORT, CT) -- The media has almost completely overlooked one of the most important aspects of the housing debacle. What has been disregarded is the key role that investors and speculators played in creating the housing bubble and exacerbating the collapse.
An important 2005 survey taken by the National Association of Realtors (NAR) found that in 2004, 23% of the 7.7 million existing residences sold throughout the country were purchased as investments rather than to be owner-occupied. This was up from 22% the previous year. Later surveys revealed that in the three peak years of the house price bubble, investors bought 28% of all existing homes sold in 2005, 22% of all those sold in 2006, and 22% of those sold in 2007. This means that during the four bubble years of 2004-2007, roughly 7 million speculators bought existing residences for investment, not to be owner-occupied.
This speculative investing was heavily concentrated in 20 major metropolitan areas such as Chicago, Los Angeles, New York, Phoenix, Miami, Las Vegas, and Orlando. How frenzied this speculative home-buying became in these cities is best shown by Chicago. According to monthly sales figures revealed on trulia.com, an incredible 600,000 Chicago residences changed hands during the peak bubble years of 2005-2007. Because the average price per square foot for homes sold in Chicago is down 36% from the 2007 peak according to trulia.com, nearly all of these buyers are underwater now -- the outstanding mortgage debt exceeds the value of the property.
Soaring home prices were essential in enabling so many speculators to buy investment properties. The 2005 NAR survey had found that, in 2004, 30% of investors pulled equity out of their residences through refinancing or a home equity loan to purchase an investment property. Refinancing soared in the three bubble years of 2005-2007. Freddie Mac figures show that homeowners pulled a total of $820 billion in cash out of their primary residences through refinancing in these three years. It seems safe to extrapolate from those NAR surveys that a sizeable percentage of these homeowners used some of this money to purchase one or more investment properties in 2005-2007.
Although the rapid increase in foreclosures since 2007 has been well-reported, it is important to understand that a major factor in the foreclosure calamity is the role of underwater investors who are defaulting on their mortgages in droves. As early as August 2007, the Mortgage Bankers Association had reported that investors accounted for 32% of all prime mortgage defaults in Nevada, 25% of defaults in Florida, 21% of defaults in California, and 16% for the nation as a whole. Real estate research firm Applied Analysis found that roughly 60% of all foreclosures in Las Vegas in 2007 were on residences owned by investors. Research by The Real Deal published in their May 2008 issue revealed that 60% of the 15,000 foreclosure filings in New York City in 2007 were on two-to-four family houses owned by investors and multi-family buildings. An important, well-researched article posted online in November 2009 by the St. Petersburg Times found that 44% of the 11,967 residential properties foreclosed in 2007-2009 in Hillsborough County, Florida were owned by investors who did not occupy these homes.
There is clear evidence that the likelihood of an investor defaulting on his/her mortgage depends upon how far underwater the investment property is. First American Core Logic found that relatively few investors stopped paying on the mortgage if the property was only slightly underwater. But the default rate rose steadily as the home sank in value. Once the property was worth 30% less than the mortgage owed, the default rate soared to 14%. This rising default rate curve strongly suggests that if home prices keep eroding, a growing number of the millions of investors who bought properties during the bubble years of 2005-2007 will default.
The big question, then, is whether or not home prices will continue to fall.
Since we know that sales of foreclosed homes in 2008-2009 were a major factor behind the slide in prices, will foreclosures begin to moderate any time soon? Without a doubt, the most important factor in how likely a homeowner is to default is whether the home was purchased or the mortgage refinanced during the bubble years of 2005-2007. This is shown by the fact that according to the California Foreclosure Report, 91% of California foreclosed homes sold by banks in September 2009 had mortgages originated between January 2005 and December 2007.
Because home prices have declined sharply from their peak in every one of the 20 major metropolitan areas which experienced the most speculation, the vast majority of the roughly 5.2 million existing homes purchased by investors and speculators in 2005-2007 are badly underwater now. Worse still, practically all of the investment properties purchased in 2008 are underwater as well.
Compounding the problem is that several million of those residences refinanced during the bubble years of 2005-2007 where the owner pulled equity out of the house are now underwater. Freddie Mac figures show that the median age of fixed-rate loans which were refinanced by these homeowners in 2005-2007 was only 3.3 years and the median appreciation of the property over the life of the prior loan was only 25% at the time of refinancing. Because borrowers took out 29% of total refinance originations in cash in 2006, the peak year of equity "cash-outs", and this left little equity in the property. The problem was nearly as bad for homeowners who refinanced in 2005 and 2007.
Finally, we know from those NAR surveys that 39% of the 19.2 million existing homes sold during the peak years 2005-2007 were purchased by first-time buyers with a median down payment of only 3%. Consequently, nearly all of the roughly 7.5 million first-time buyers who bought an existing home in 2005-2007 are also severely underwater.
Taken together, these three groups comprise roughly 15 million residences whose owners are seriously at risk of going into default on their mortgage. It is this enormous group of homeowners with mortgages originated in the years 2005-2007 which is the driving force that has pushed the mortgage delinquency rate to a record 10.4% at the end of 2009.
Foreclosure filings are now extremely concentrated in the 20 major metropolitan areas which had witnessed the most speculation in 2004-2007. Roughly 53% of the 938,000 foreclosure filings announced by RealtyTrac for the third quarter of 2009 were recorded in these large metropolitan areas.
The number of foreclosed residences on the market now would be much higher had the banks not been so reluctant to put their repossessed homes on MLS listings. The latest statistics from Lender Processing Services, the mortgage processing services firm with a database of 40 million active loans, revealed that slightly more than one million foreclosed homes were in the inventory of banks at the end of January 2010. RealtyTrac estimates that 600,000 of these foreclosed homes have not yet put on the market. Furthermore, many of the nearly 1.5 million homes that, according to RealtyTrac, banks put into default in 2009 have still not been foreclosed and repossessed by these banks. Banks are also not putting into default borrowers whose loans are delinquent for more than 90 days. That is why the number of these seriously delinquent loans has almost tripled in the last two years to nearly 2.9 million according to Lender Processing Services. Since the average time that these loans have been delinquent has climbed to nine months, nearly all of these loans will end up in default and foreclosure.
This potential avalanche of foreclosed properties awaiting the housing market will put tremendous downward pressure on home prices. Until this foreclosure tsunami begins to subside, the housing market in those 20 major metropolitan areas which created the bubble will continue to erode.