*** Linked below is a newpaper article which I wrote for the Palisades Post (Pacific Palisades, CA) back on June 11, 2008 as I tried to explain the early stages of The Credit Crisis.
"There is really no true precedence for what is happening in the world's financial markets and the impact of the ongoing credit crisis. Today's financial markets are far more complex than in the past, thanks to the fact that Main Street has essentially merged with Wall Street over the years.
The flaws in the efficiency of the 'globalization' of our world's financial markets began to show last year. A high percentage of subprime mortgage loans started to default, partly because of the Federal Reserve's 17 separate rate hikes in recent years. Many property owners saw their adjustable payments increase, and late payments began to skyrocket.
The 'domino effect' of credit losses then followed the subprime credit meltdown around the world. Let me try to explain some of the key issues involved in this complicated mess, and how our credit crisis has evolved since 2007.
Let's begin with a brief explanation of Collaterized Debt Obligations (CDOs), which are derivatives--a synthetic financial instrument derived from another asset. CDOs may be a combination of bridge and mezzanine money, notes, equity and debt. CDOs are converted into bonds and later sold off to Wall Street, hedge funds, or foreign investors.
Before the CDOs were sold off to investors, they were assigned a specific bond rating by a major credit rating agency. These rating agencies would rate the potential risk of these various forms of investment pools. AAA is considered the highest and safest investment rating, and is the same rating these agencies give to a U.S. Treasury bond. Traditionally, financial ratings are based upon true market value and actual market prices. However, these artificially created securities rarely had firm values, and were difficult to liquidate quickly.
Sadly, many of the largest pools of Mortgage Backed Securities (MBS) were rated as AAA. As a result, investors from around the world purchased them in bulk. The rates offered were higher than a U.S. bond, and yet they were rated as the 'safest' investment in the world. What could go wrong?
Structured Investment Vehicles (SIVs) use short-term funding such as asset-backed commercial paper to purchase longer-term assets like Mortgage Backed Securities. Many banks and investment firms took their lower yielding money-market funds and invested them in higher yielding mortgage pools. The banks then profited from the difference. Many banks used SIVs as 'off balance sheet' investments, meaning that most banks did not report these gains or losses. Once the credit crisis began, this market 'froze' because it was difficult to determine the true value of these 'off balance sheet' investments.
Some experts believe the greatest risk to the world's financial markets is tied to the status of the estimated $45 to $62 trillion worth of Credit Default Swaps (CDS). The unregulated CDS market dwarfs the entire U.S. stock market (estimated current value $21.9 trillion), the U.S. mortgage security market ($7.1 trillion), the entire U.S. treasuries market ($ 4.4 trillion), and is significantly larger than the combined value of all bank accounts in the world.
A CDS is essentially a counter-party agreement that allows the transfer of third-party credit risk from one party to another. One party in the swap is a lender who has credit risk from a third party. The counter-party in the swap agrees to insure the risk in exchange for insurance premium payments. If the third party defaults, the party who provides insurance will have to buy the defaulted asset from the insured party. The insurer, in turn, will then pay the remaining interest on the debt as well as the principal.
Many of America's largest bond insurance companies that supposedly will 'guarantee' any losses incurred through a defaulted CDS contract may already be technically insolvent right now. These same bond insurance companies may have assigned their insurance risk to off-shore bond reinsurance companies that may not have the proper cash reserves either to cover any losses. The unwinding of assets in the world's 'shadow banking system' is truly the root cause of the credit crisis.
The record number of Southern California foreclosures is forcing most banks to tighten their underwriting guidelines tremendously. Lenders have also been 'freezing' existing credit lines due to the high default rates. Many banks are facing insolvency issues themselves. They may not have the funds or the secondary market investors available for the larger jumbo loan amounts.
Many of the mortgage loan products used by Pacific Palisades residents have disappeared recently. Non-conventional financing methods should now be considered as a way to beat the credit crisis.
Optimistically, we may just be experiencing the 'growing pains' of the globalization of all types of credit markets (home, business, credit card, auto and student loans). You still should learn as much as you can about this historic economic time period so your family may prosper.
In terms of the Westside housing market, what do I foresee this summer? Pacific Palisades and other coastal areas may soon experience drops in median home prices due to a variety of factors.
Even though Fannie Mae and Freddie Mac recently raised their conforming /jumbo guidelines from $417,000 up to $729,750 in Los Angeles County, the vast majority of all jumbo loans these days require full documentation, excellent credit and lower loan to values. A high percentage of homebuyers in the pricier coastal regions the past decade were 'stated income' borrowers who chose more affordable adjustable rate loans. Most of these loan products are not now available.
Always remember: the availability of financing will always be the number No. 1 reason affecting real estate because the vast majority of home buyers need loans."