The risk profile of what was once considered the safest investment in the land has taken a dramatic swing in the last 18 months.

During the peak of the U.S. housing market between 2002 and 2005, bullish forecasters and industry boosters promised that the most prudent investment in the world was U.S. home buyers. Investors from around the globe agreed, investing wildly in the residential mortgage market.

What investors did not realize is that while the housing market had performed magically for decades, lenders were underwriting crazy loans to borrowers who often did not understand what they were getting into and whose financial security depended on home-price appreciation.

A loan is only as good as the borrower and the underlying asset, which in this case is the value of the real estate. Both have wreaked havoc for investors in the last two years.

When the market began to collapse in 2006, investors discovered a dirty little secret that local real estate agents and mortgage brokers had known about for a couple of years. Loans were being made to unqualified borrowers on property that was rising too rapidly and could not hold its value.

Trillions of dollars in losses have quickly turned the tables on the perception of the safety and security of U.S. home loans.

So who will lend to future home buyers? The options are shrinking for four specific reasons:

  • The secondary mortgage market for nonconforming and subprime loans has collapsed, so those who do underwrite these loans have fewer options for selling them. Discouraged by the risk, lenders are squeezing their loan volume.
  • The wholesale lending market has disappeared: Big wholesale shops have gotten out of the business with the decline in the private secondary market (MBS), which was the golden goose for large loan aggregators.
  • Without liquidity, mortgage brokers and originators have fewer sources of capital, so they are originating fewer loans.
  • The number of traditional originators has declined dramatically. For example, Countrywide has been sold to Bank of America and WaMu is hanging on for its life. Other big lenders such as Wells Fargo are narrowing their lending band and taking fewer risks in this ugly market downturn.

These trends add up to a major credit squeeze for home buyers, shrinking the overall size of the pool of borrowers as the supply of listings grows dramatically. This supply-demand imbalance puts greater downward pressure on home prices, aggravating the cycle.

Where does the housing market find relief?

The Federal Housing Administration has seen a dramatic rise in demand for its loan guarantees, thanks to higher loan limits and relatively low down-payment requirements. HUD reports that in May, FHA was guaranteeing loans at the rate of 818,000 a year — a nearly 15 percent share of the market. That compares with 289,000 mortgages guaranteed in 2007, or 4 percent of the market.

But FHA cannot fill the void.

The enactment of Treasury Secretary Henry Paulson’s bailout plan could help. Once bankers are relieved of their "bad" home loans, they will have more leeway to boost lending. But the volume of these loans may ramp up very slowly as lenders cautiously return to the market — making very conservative mortgages to borrowers who have perfect credit and large down payments.

You can imagine a geographically bifurcated housing market in which lenders will redline troubled areas where foreclosures are high and prices continue to tumble at double-digit rates. The hardest-hit areas will get worse.

Oddly, the bright spot in this mess is declining home values, making housing more affordable as mortgage rates remain low and government subsidies like the newly enacted $7,500 tax credit for new buyers attempts to prop up the market.

Ironically, subprime loans momentarily solved the affordable housing problem that festered after 10 years of price appreciation.

All of this portends a very slow recovery as the market continues to search for a bottom.


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