I thought about writing this blog after having a discussion with my mother-in-law Jean Roberts (www.jeangroberts.com) who is a Real Estate agent herself about how slow the housing market is. Most people have a pretty good understanding on the Supply and Demand concept. Without diving too deep into the fundamental concepts of economics, I do want to touch on the Supply and Demand relationship and its effect on pricing. The housing market offers a great example. There are too many existing and newly built homes on the market putting downward pressure on the Equity Value of our existing homes and on Pricing of new homes. In other words, we have Excess Inventory/surplus of homes and not enough Creditable Buyers. Now, the problem is how to reduce both the surplus of residential and commercial properties. More importantly buildings aren’t small items, so one can just simply liquidate them. It is going to take some time before buyer’s demand depletes the existing home’s supply down to a healthy economic balance. Obviously, some areas well bounce back sooner than others and that largely depends on the local economy.
I wanted to write this blog to give the general reader an informative angle on how we got to where we are. So, we don’t broadly blame the current situation just on the economy, the government or the banks. Although there is enough blame to go around, I wanted to focus on our Fiscal Responsibility as a consumer and from a FinancingDiet view point. If we as consumer become more fiscally responsible perhaps we would see less of these crises. Through the 1990’s Banks and other financial institutions sort of over indulged in other RISKIER form of investments in order to deliver higher returns to their shareholders. Banks traditionally generated profits by taking deposits from consumers and paying them interest on their deposits. Banks then lend money to those seeking loans at a higher interest rate. The spread between the two interest rates became the bank’s profits. Banks also held the liability on their books for those consumers who defaulted on their loans; thus, banks were more stringent on their lending practices, requiring consumer higher levels of collateral and sizable down payments when borrowing money. Banks had to work harder for their profits, but it ensured their financial stability.
Deregulation in the late 1990’s allowed Banks and other financial institutions an opportunity to take higher risks for profits. So, the more profits banks made the more money they were able to loan. They did this through Securitization which is packaging consumer DEBT such as residential and commercial mortgages, auto loans, credit card debt, etc. and selling it as BONDS to other investors such as mutual funds and pension funds, insurance companies and other banks. The banks made money by charging fees to investors. The bonds were insured and rated by Moody’s, S&P and making these investments more attractive. Now, with the debt off their books banks were able to write more loans. The problem with this practice was Banks sort of ran out of Credible Consumers and they relaxed their lending practices to attract more consumers leading to what is called SUBPRIME lending. Loaning money to consumer with little to no income, no jobs, waving off the need for collateral and down payments. Reckless lending if you will.
So, what does this have to do with Real Estate Excess Inventory or surplus? The reckless lending created these artificial conditions for the laws of Supply and Demand to interact at least in the beginning. You have a wave of consumers with easy access to credit and a desire to buy homes and incur additional debt. This created a Boom in the real estate market and other sectors of the economy, new homes were built, and existing home’s values appreciated incredibly. Existing homeowners took on additional debt by refinancing their existing properties (i.e., second mortgages) others bought cars, boats, vacation homes, etc. Now, you have all this acquired Debt weighing heavily on the consumer’s Income (from jobs); the same artificial conditions that created the real estate and economic Boom led you the real estate and economy Bust. It was hard for any economy to sustain such artificial growth. The reason I called these conditions and the growth Artificial is because the banks didn’t traditionally sell derivatives and use subprime lending to generate profits. So, as the economy conditions deteriorated it created a sort of domino effect the job market contracted and people started to lose their jobs. Consequently, the consumer started to default on their loans and other debt, the banks and other financial institutions followed. The auto industry and other economic sectors that benefited from this growth were affected as well including the consumer. Ultimately, leading to the Government Bailout. Now, from a real estate view point we were left with a surplus of unsold and foreclosed residential and commercial building. It is going to take a while before the economy bounces back and as unemployment decreases we will see a systematic reduction in the real estate surplus.
I hope the information is of good use to you. I still think we have to be more fiscally responsible. Buying a home has its benefits but it can also be expensive. If you are in good financial standing and you can afford a home; then buy a home. But one can still build wealth while leasing or renting if one can’t afford to buy. Leasing and renting get a bad rap because the consumer does not end up with a home. Like I said in my previous blog Buying vs. Leasing, when you lease or rent you are only paying for the USE of the home or condo in this case. When you buy a home you are paying for the whole house, taxes, maintenance, etc. I am not trying to discourage anyone from buying his/her home what I am trying to tell you is to carefully evaluate your particular situation and make the right decision financially.
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