In 2010, the U.S. Congress successfully passed new legislation, courageously recomposing century-old U.S. financial rules. It seems our buddies in D.C. had acquired great economic know-how, unseating 80 years of financial thought in a single, 24-hour session. The method of the attack dealt with added regulation in derivative trading, and more specifically – Credit Default Swaps (CDSs).
In this write-up, I will explain CDSs, their influence on U.S. real estate, and how this legislation drastically affects everyone, from the mighty real estate investor to the common renter. So, get involved and find out how this revolution in financial rules will affect both your personal and professional world.
Regulation of Derivative Products
Most critical to the real estate market is how the bill imposes derivative regulation on all U.S. banks. Certain types of derivatives, such as Credit Default Swaps, are used by banks to hedge or protect against the risk of default or non-payment on loans. In essence, CDSs reduce some of the risk associated with providing loans and, for our purposes as rental market investors – mortgages.
With a CDS, third party will offer a bank to pay the amount left on the loan if the borrower is no longer able to make the loan payments. To make the third party willing, the bank will pay a premium similar to premium payments made to insurance companies. Here is an example:
- Bank A decides to provide Minesh (the borrower) with a 30-yr fixed mortgage of $250,000 to purchase a home.
- Bank A cannot afford to lose $250,000 if Minesh is unable to pay. However, the bank can afford to risk losing $100,000 of the principal on the mortgage.
- Now, since Bank A still cannot afford to lose the remaining $150,000, it offers to pay a third party company $1000 every three months if the third party company agrees to pay Bank A $150,000 in the event Minesh is unable to pay his mortgage.
- It is similar to insurance, without the insurance regulations – a way for banks to hedge against loss due to default.
The added security of CDSs to our mortgage lending environment instigates and encourages lending to home buyers. Mortgages protected with CDSs are more likely to be issued and are more marketable for re-sale. Anything that makes mortgages more appealing facilitates approval, thereby making home purchasing more frequent and attainable. In many situations, loans cannot be made without credit default swaps.
So, what does this all mean? The added regulation on CDSs may remove their safety net from mortgage lending, increasing associated risk. In order to balance or reduce risk, costs to borrowers will increase. At times, the lack of credit default swaps will lead to such an increased default risk that any prospects of bank profitability are eliminated, leading to declined mortgage applications.
Why are Credit Default Swaps the target of legislative assault?
Large corporations exposure to certain credit default swaps–such as America’s insurance giant AIG–led to corrosion of corporate balance sheets. AIG sold a number of CDSs to banks all over the world, providing bank protection in the event of mortgage default. With nearly $440 billion of coverage provided in the form of CDS’s to banks, AIG faced a crisis when Americans simultaneously began defaulting on their mortgages. The climbing of the federal funds interest rate provoked many newly issued floating-rate mortgages to blunder.
Without enough cash to maintain its side of the CDS agreement to cover the loss on mortgage default, AIG liquidated many other profitable assets out of necessity, killing the company’s financial well-being. Unable to provide banks in need with the promised cash recuperation and maintain the promise of a security blanket against default to other financial institutions, this sent the banking system into a frenzy.
As a result, banks had to deal with mortgage default losses by themselves. Additionally, banks not yet facings mass defaults were forced to look elsewhere to protect their mortgage assets against default. However, the protection was now significantly more expensive, considering the shift in the perceived risk surrounding mortgages.
The poor investing of AIG funds corrupted its primary line of business – insurance. This called for government intervention as too many Americans depended on insurance benefits from the giant corporation. Tax dollars were required to protect the insurance benefits, since the company was no longer able to secure funds elsewhere.
How does CDS regulation affect the real estate market?
Wave goodbye to the ease once associated with CDS issuance and trading. Banks are no longer to engage in “risky” derivatives trading to prevent catastrophe exemplified by AIG – a situation relying on taxpayers for correction.
Now that banks are no longer able to deal in potentially risky derivatives trading, the government is, in essence, lifting the ability of banks to offer mortgages to anyone other than the most capable home purchasers. Effectively, banks will only have the availability to approve mortgages with significant down payments (a minimum of 20%) and only to borrowers with outstanding credit. Such borrowers are not in need of any form of default insurance, considering the debtor’s financial strength.
The Mistake
The stated goal of those drafting new legislation was to eliminate the use of Credit Default Swaps as a means of speculating the quality of a loan/mortgage. They used the AIG example as the evidence of potential catastrophe with speculation in Credit Default Swaps.
It seems Congress had misinterpreted the fundamentals of American financing – it was not bank speculation that led to the problem; it was the speculation of the companies investing in CDSs like AIG who put the system in jeopardy. I submit that government regulation is imposing harsh regulation on a mistaken culprit. The banks simply use the vehicles to purchase security, but the companies supplying the CDSs speculate that they will collect enough premiums to counterbalance any claims on defaults they may one day need to pay.
There is no speculation on behalf of the bank, only hedging for safety measures. To reduce speculation in derivatives trades involving banks, the regulation should be imposed on those actually speculating, such as AIG. It is more appropriate to regulate the third party who offers to pay the loan in the event of a default.
AIG’s mistake was acquiring too many CDSs of similar complexion – all with sub-prime borrowers, similar start dates, and floating interest rates. So, a catastrophe could affect all at once, and for AIG, the catastrophe was a progressive climb in interest rates. I submit, that regulations preventing companies from pursuing too many of one category of CDSs could protect companies, banks, and individuals from the risk of catastrophic loss.
Who’s Affected?
As a result of stringent regulations, the mortgage game will be more challenging. Loans without the security of a Credit Default Swap are less marketable, and therefore, less attractive to banks. There is little money to be made off of non-CDS supported mortgages, unless the borrower brings accompanying financial strength that dispels the need for added hedged security.
Also, the loans will only be designed with strength, including only financially strong debtors and loans built off strong equity positions (large down payments). Practically everyone in the real estate arena is affected by regulations on credit default swaps, whether you’re an investor, agent, property manager, or tenant.
Investors:
The practice of flipping houses will no longer have short-term profitability, as the buyers market will be a fraction of what it once was. Consequently, the frequency of real estate purchase will thereby decline.
Real estate investment will shift from seeking gain on house value, to designing strong revenue from cash flow – income properties. With cash on hand and appropriate ratios of debt equity, investors with cash retain access to low interest rates, unavailable to others, and should be able to use their cash-rich situations to design a cash flow from rent.
Interest rates will remain low, as few will have access to the low rates. With a limited group actually able to take advantage, the widespread demand for borrowed money will never be great enough to quickly drive up interest rates. The wealthy will be able to borrow for cheap, and likely rent for a lot, as home ownership will decrease dramatically, and the American dream of home ownership will turn to distant fantasy. The situation is ripe for the rich to get richer.
Renters:
You will soon be greater in numbers, as many American will revert back from ownership into the conservative life of renting. Without available funds, young professionals will no longer be afforded the opportunity to leap into early home ownership. Furthermore, some homeowners of the past will be sent back to the minor leagues, presented with new obstacles on the path back to the top.
As previously mentioned, increased renting will drive up monthly rent prices (another reason why the investors mentioned above may want to take advantage of income property).
Property Managers:
Prepare to expand your business at lower prices to your clients. In the coming years, an increasing number of houses and various other units will be used for rental activity. Start strategizing on how to accommodate the new renting generation, as they will likely seek the quality of a home in rental form.
These are long-term renters with likely heightened demands for quality. Keep the complexion of the incoming tenants in mind, and adjust your business plans to accommodate for the surplus in renters.
Real Estate Agents:
Depending on your niche in real estate, you will likely need to alter your approach to profitability. The purchasing power will now rest primarily in the hands of investors, and after the houses on the market now are unloaded, there will be no quick turnover on homes as we have grown accustom to over the past 40 years.
Ownership will remain constant, so it is important to focus sales efforts in cities with substantial investment capital and great rental demand. Housing purchases will come from investment for the purpose of generating cash flow, requiring a renting population. Personally, I suggest cities containing large colleges and universities.
Next, you will likely need to incorporate property management into your business model, as it will be the best way to secure consistent income in the long-term. However, many agents will also shift into property management, so be sure to provide a competitive advantage.
Use new technology available such as property management software to create an efficient management company. Remember, the current state of the industry has little technological influence, and requires too much leg work to function properly.
