As our stock market begins to recover, Covid-19 cases seem to be "slowing" down, and the economy seems to be through the worst of this pandemic, I am far from convinced this is even close to over. 

It seems we are seeing a type of systematic breakdown of the current system. Does that mean end of the world? No. 

But it does mean significantly lower prices and dismantling of the euphoric drivers of optimism into all markets. It surprises me to see no posts about worries about our financial markets or how these types of environments can create the domino effect that could roll over into real estate and creating deflationary pressures in real estate over the next several years which should be equivalent if not worse than 2008-2009. 

The 2008-2009 subprime crisis was a direct result of real estate literally being the driver that almost brought the global economy down. I don't think we'll ever see a subprime crisis again. CDOs accounted for $800 billion and single handedly drove the economy into the worst recession since the Great Depression. Sure it won't be the exact same cause, but most likely the same effect. Lower prices.

Although we don't have to worry about CDOs, we do have another serious issue which could be potentially worse for real estate. Mortgage Backed Securities (aka MBS).  MBS make up 8 trillion dollars of our economy! Almost 10 fold what CDOs were. If that doesn't concern you, I'll let you be. But liquidity getting sucked out of these indexes will affect housing prices.

I began posting about drivers in real estate in major metropolitan areas, discussing some of the main drivers in these areas (hint: foreign buyers). This demand shock drove prices to astronomical levels since ~2014. However, we began to see real estate begin to cool off in major cities as these buyers began to disappear. 

It is here I believe the second phase of the problem begins. Not only has demand fallen since the end of 2018, but now we are going to see major issues with MBS. The issues with our economy will eventually roll over into Real Estate. Real Estate tends to move in a lag as a result of recessionary and deflationary (prices going down) pressures so these effects will not be see the full effects for months, even years. I do not think all markets fall by 30-60%, but I do see a lot of major metropolitan areas (Seattle, Bay Area, New York, LA) falling around this much. Areas with smaller markets that experienced linear growth rather than exponential growth should fair well and shouldn't see significant drops in prices.

1) How do Mortgage Backed Securities (MBS) work? 

Answer: To simplify it as much as possible let's use an example.
Bob wants a loan for a house. He goes to his Mortgage Broker, Johnson for the loan. Johnson goes to the bank on Bob's behalf, and the bank sends Bob the loan.

The bank then sells Bob's loan to Fannie and Freddie. Fannie and Freddie then give the loan to the bank, where the bank profits off the difference in interest rates from Fannie and Freddie.

Fannie and Freddie take a bundle of loans like Bob's which they've collected from all sorts of banks all over the US and create this Mortgage Backed Security. Is this Mortgage Backed Security determined based off anything like creditworthiness, risk, etc.? Nope not at all. 

Fannie and Freddie then put this Mortgage Backed Security in the MBS Open Market where a buyer usually buys this bundled security. Typically it's pension fund or investment bank like (Morgan Stanley & Goldman Sachs). Here's a list of the 22 biggest MBS Funds to give you an idea.

All in all, this theoretically allows everyone to benefit. Off a couple of important assumptions: Prices rise and we have buyers for Mortgage Backed Securities. 

If prices continue to go up. The banker makes money off the spread, Fannie and Freddie sell the MBS' at a profit, the mortgage banker gives out loans and gets his commission, and the home buyer benefits from a rising housing prices. 

What happens when no one wants the MBS? This leads to a domino effect of freddie and fannie not collecting bank mortgages because no one will buy the MBS, so in effect credit gets tighter. Housing stays on market longer than normal and there are less buyers. 

In addition many of the MBS are on margin accounts so when prices of the MBS fall enough it forces the investor to make a margin call (or a basic decision); you can either deposit more money to keep the fund liquid, or sell assets (in this case, MBS). 

All in all, we are seeing the signals of a slowing real estate market. 

Home supply is expected to increase once the Covid-19 virus is lifted.

Credit is tightening (banking standards and the amount of loans Fannie and Freddie can issue), less home buyers to fill this demand side.

MBS selling pressure and margin calls will in turn suck out liquidity that's already exiting with tightening credit that goes directly to people like Bob or you and me. 

To summarize what should follow is this: selling pressure, lack of buyers, and sudden shock to business and commercial real estate MBS' will have a roll over effect into all real estate. This lag has more to do with how long it takes housing to catch up to the wits of the economy. Prices begin falling over a longer haul and perhaps we can begin looking for opportunities in 2-4 years. 

Have a good one everyone, and as always please feel free to discuss.