With lots of toxic assets still on books, treat real estate gently
by Phil Hardwick
Published: July 27,2009
Most of the so-called toxic assets are still on bank balance sheets even though trillions of dollars have been allocated to deal with them. So, why are toxic assets so hard to clean up? The answer is that most of the toxic assets are real estate, the nature of which is significantly different from other financial assets.
As you surely know by now, one of the major causes of the current financial distress in our economy was the overextension of credit to non-creditworthy individuals causing spending that drove the economy for several years. Much of that credit was is the form of mortgage loans that were made to borrowers who could not afford them. Those mortgages were sold in the secondary mortgage market and then resold time and again in a variety of packages. With each sale and transfer of a mortgage, the financial instrument on which the mortgage was a part of became more complex. This situation drove up real estate prices and created a bubble that eventually burst when borrowers began defaulting on their mortgages. According to a recent article by Kenneth Scott and John B. Taylor, both of whom are professors at Stanford University and are authors of “Getting Off Track: How Government Interventions Caused, Prolonged and Worsened the Financial Crisis,” about 80 percent of the $2.5-trillion subprime mortgages made since 2000 went into some form of securitization pool. The government is now in the process of buying those toxic assets, which are essentially loans secured by real estate that is not worth the mortgage balance. Originally, the $700 billion of Troubled Asset Relief (TARP) funds was supposed to be used to buy the toxic assets. Well, that did not exactly happen. The government instead used TARP funds to buy preferred bank stock. At least, the government is trying. So what’s the problem?
For starters, real estate is not a commodity. Every parcel is unique if for no other reason than because of location. A commodity is something that is usually produced and/or sold by many different companies and is so uniform in quality between companies that a person cannot tell the difference between one firm’s product and another. Some examples of commodities are agricultural products, natural gas and other energy products, precious metals, etc. There are several commodity trading exchanges.
Imagine that you are an investor/lender who buys mortgages or some form of financial instrument secured by a residential mortgages. As such an investor/lender, there are two primary things that concern you. The first is what would happen if the borrower stops making payments. The second is whether you can sell the mortgage and move on to the next investment. Like most investors, you want an asset to be available that you can take possession of should the borrower stop making payments. If the borrower/homeowner stops making payments, then the chain is pulled, so to speak, and somebody must take possession of the asset and resell it. Scott and Taylor examined a $1-billion portfolio of such loans and discovered packaging after repackaging of mortgage loans. After all was said and done, in their analysis the mortgage loans remaining in the pool had a 20 percent delinquency rate.
Now, imagine that you are the investor/lender and that you have 200 residential mortgages in your portfolio. That means that you have 200 separate parcels of real estate, probably with 200 different owners. Each of these properties will be in various stages of physical condition. Some will be in excellent condition, and the owners will be making their payments. Obviously, these are not the toxic assets. Let’s say that just 10 percent of the properties are considered as toxic assets. Someone will need to physically inspect each of these 20 properties and a determination made as to what repairs need to be done to get the property in marketable condition. It will not be unusual to find that some of the owners abandoned the property and destroyed some of it in the process. Stories abound of owners who were upside down and facing foreclosure not only walking away from their properties, but doing damage to them, as well. Of course, it would be possible to get a judgement against such homeowners — and I would not discourage anyone from doing so — however, if they were not qualified to be homeowners in the first place, it might be difficult to enforce a judgement. After all, some of them got mortgages without any documentation of their employment, etc.
Even if every piece of property could be inspected immediately, who knows how long it will take to market the property and close the sale? Of course, the new buyer will probably not be paying cash for the property, which will necessitate financing and a whole set of requirements that the next lender insists upon. Such real estate transactions are complicated. There must be inspections, certificates and appraisals. And speaking of appraisals, what is the property worth in its present condition?
All of this illustrates why the unique nature of real estate toxic assets will prolong the buying and selling of same by whatever plan the government comes up with and institutes. To reiterate, real estate is not a commodity. Attempts to treat it as such are now causing difficulties in attempting to sell or dispose of it.
Phil Hardwick is coordinator of capacity development at the John C. Stennis Institute of Government. Contact him at firstname.lastname@example.org.
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