Investment Banks Shoulder Bigger Share of REO Burden

The bullish stock market began showing some cracks in the foundation in late July as fresh evidence revealed that real estate woes on Main Street are inflicting a bigger-than-expected toll on debt-weary homeowners and their lenders — and by extension on Wall Street investment banks with portfolios that invested heavily in securities backed by risky mortgages.


Mirroring the weak state of the real estate market, these banks saw defaults and foreclosures on those mortgages swell and the value of their portfolios fall. On July 16, New York-based Bear Stearns — one of Wall Street’s largest investment firms — said that two hedge funds that made bad bets on subprime mortgages were wiped out, erasing $3.2 billion in investor money and fueling more evidence that the turmoil in the subprime mortgage meltdown was spilling over into other sectors of the economy.


Now foreclosures on those subprime mortgage loans are creating a rising tide of repossessed foreclosure (REO) properties for Bear Stearns and other Wall Street firms that lent it money to invest in subprime mortgages — firms such as Citigroup, JP Morgan Chase, Merrill Lynch, Morgan Stanley and Lehman Brothers.

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“The credit losses associated with subprime have come to light and they are fairly significant,” Federal Reserve Board Chairman Ben Bernanke told the Senate Banking Committee on July 19. “Some estimates are in the order of between $50 billion and $100 billion of losses associated with subprime credit problems,” he added, referring to a segment of the mortgage market that caters to borrowers with shaky credit.


For real estate investors and homebuyers, the chance to purchase foreclosure properties owned by Wall Street investment firms is a once-in-a-lifetime opportunity that could translate into finding deeply discounted deals on properties the firms — who have little or no experience in the world of REO servicing — are ill-prepared to manage and sell in a declining market. Many real estate investors are therefore preparing to take advantage of the mortgage meltdown after the biggest boom the housing market has ever experienced.


Michael Krein, owner-broker of Nevada Real Estate Services in Henderson, Nev., and president of the National REO Brokers Association, has so much bank-owned foreclosure business these days he can hardly handle any more. Krein said he has 700 bank-owned foreclosure properties and expects those numbers to increase because adjustable rate mortgages will soon reset at higher rates. He said all signs point to a lot more of them coming onto the market.


“This is the tip of the iceberg,” predicted Krein, who said the final meltdown is still on the horizon. “Seventy-five to 80 percent of the properties here in Nevada are not owner occupied. They’re owned by speculators. Soon their payments will double and triple. With the market down, they can’t refinance. So they’ll lose the house to foreclosure.”


In the first six months of 2007, Nevada reported 25,208 foreclosure filings on 14,687 properties, more than double the number of foreclosure filings reported in the previous six-month period and nearly triple the number reported in the first half of 2006, according to RealtyTrac. The state’s foreclosure rate during the first half of 2007 — one foreclosure filing for every 40 households — was highest among the states and more than three times the national average.


“You had postal workers purchasing three or four houses,” said Krein, a 17-year veteran broker who sells lender-owned REO real estate. “These amateur speculators got caught before they could flip their properties. The amateurs are all gone now.” 


Krein added that many speculators, who bought at the crest of the boom, were counting on homes to appreciate. Instead, the market turned downward, and lenders tightened their lending standards.


Las Vegas was once one of the hottest housing pockets of the country, spearheading an unprecedented building boom. Now it’s going through a painful contraction after the tremendous growth busted, according to Krein. He said that as foreclosures climb in Nevada and other areas across the nation, Wall Street investment banks and conventional lenders are claiming a bigger chunk of real estate. According to the Federal Deposit Insurance Corp., the value of U.S. homes held by commercial banks swelled 53 percent nationwide to $2.3 billion at the end of March, compared to $1.5 billion a year earlier.


The dilemma facing the investment banks is whether to pay maintenance costs and hold on to the growing inventories of distressed properties or dump the properties at fire-sale prices.


“The New York investment banks are going to take a huge loss,” predicted Frank Orozco, a California real estate agent and loan manger who owns “It’s a double-edged sword. The secondary market is taking beating. A lot of the 80/20 loans in the secondary market are getting 60 cents on the dollar. The investment banks can’t sell the REOs because the market is in decline and saturated with homes for sale. Either way you slice it, the investment banks lose.”


Bear Stearns — the second-biggest U.S. underwriter of mortgage-backed securities and the nation’s fifth-largest investment bank — is reeling from the worst housing decline since the Great Depression. The firm did not seem prepared to deal with the 1,280 foreclosure properties it took possession of nationwide in the last six months.


According to an analysis of RealtyTrac’s foreclosure database, Bear Stearns’ foreclosure repossessions have almost quadrupled since last year, skyrocketing from 339 foreclosure properties in the first seven months of 2006 to 1,280 foreclosure properties in the first seven months of 2007. JP Morgan Chase’s total foreclosure repossessions have more than tripled, growing from 930 foreclosure properties in 2006 to 3,157 foreclosure properties in the first seven months of 2007. And Morgan Stanley’s total foreclosure repossessions have jumped from 232 properties to 1,384 properties.


Orozco — who owns five rental properties in the high desert community of Hesperia, Calif. — predicted that the shakeout would continue for two more years. California had the third highest foreclosure rate in the nation in the first half of 2007, and real estate experts believe the situation is going to get worse before it gets better.


“Right now it’s a buy-and-hold strategy — not flipping,” Orozco said. “In the San Bernardino high desert there’s a tremendous increase in short sales and foreclosures.”


Orozco noted that the real estate market is caught between buyers waiting for the price to come down and foreclosures owned by bankers who think their distressed assets are still worth what they were a couple of years ago.


Miami real estate investor Manuel Suarez said the local market in South Florida is flooded with bank-owned properties. Suarez said there is more than a year’s supply of houses on the market in Miami-Dade County, up from a three-week supply at the height of the boom.


“I think now’s a good time to buy,” he said, adding that he thinks the Miami market will turn around in three years. “You can buy properties now at a 20 to 30 percent discount.”


Florida documented the nation’s fifth highest state foreclosure rate in the first six months of 2007, one foreclosure filing for every 81 households. The state reported a total of 102,213 foreclosure filings on 64,250 properties during the six-month period, up 84 percent from the first six months of 2006. In South Florida, foreclosure filings have more than doubled, growing from 17,043 in the first six months of 2006 to 35,995 in the first six months of 2007.


Suarez said bargain-hungry investors should turn their attention to the growing pool of bank-owned foreclosures flooding the market. But the sweet deals, he stressed, come with plenty of challenges, in part because many investors have unrealistic expectations about what it takes to buy a house owned by a lender.


Because the rapid expansion of subprime lending has linked the fortunes of Wall Street to the fortunes of Main Street, the national housing slump could lead to billions of dollars in losses for Wall Street investors — and the Wall Street bankers who financed the real estate boom. Moody’s anticipates that more than 1.2 million first mortgage loans will default this year and another 1.3 million will follow next year. That compares with about 900,000 defaults last year and about 800,000 in 2005.


“We do expect losses in the subprime market to be very severe,” Moody’s chief economist Mark Zandi told the Associated Press.


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