It’s difficult to believe, but it has now been five years since Lehman Bros. — once the fourth-largest investment bank in the U.S. — filed for Chapter 11 bankruptcy protection after the loss of most of its clients, a collapse of its stock, and a devaluation of its assets by credit rating agencies.

Lehman had been holding on to large positions in subprime mortgage securitizations, and became the last guy left holding the bag when that market collapsed. The shock waves of this collapse were felt for several years throughout Wall Street.

And since then, the real estate market has gone through numerous and profound changes.

A New World for Mortgages

For three years after Lehman Brothers collapsed, the mortgage market tightened up and made borrowing more difficult. For instance …

• Conventional 30-year mortgages, which had formerly required no down payment, were suddenly requiring as much as 10% down — even 20% down on properties in declining markets.
• Credit score requirements ballooned from 560 to 640, and have only recently pulled back to 620 on owner-occupied property.
• FHA increased its MIP fees and made PMI (which once could be eliminated once a borrower paid off 80% of their loan) a permanent entity for the life of the loan.

Also, new regulations in the mortgage industry have totally changed what lenders can offer their clients, as well as the borrower’s ability to qualify for a loan.

The Dodd-Frank bill created the Consumer Finance Protection Bureau, which has formulated new rules and regulations that will go in effect January 2014. Some of these rules restrict the amount of money that loan officers can make, and severely regulate the ability of home builders and real estate brokerages to form affiliations with title companies and lenders.

Lenders now must follow specific guidelines to produce “qualified mortgages.” Former loan products — such as interest-only, 40-year terms, negative amortization, and no documentation (“no doc”) — are gone. Changes in good faith estimates and other loan documents have been made, too.

Home Prices

As you can see in the accompanying chart, home values swooned from 2008 to 2011.

Some states, such as California, Nevada, Arizona and Florida, which had the highest number of subprime loans and subsequent foreclosures, saw home values drop as much as 40%. Foreclosures were selling for 25% to 30% of their 2006 values, and the sales of these properties were negatively affecting the values of non-foreclosures as well.

But other areas of the country — such as the Midwest and Northern Plains, which did not have price bubbles from 2000-07 — reported only modest price declines. States that have had the lowest unemployment, such as Texas and North Dakota, have continued to see steady sales numbers and stable prices.

Following the Lehman Brothers collapse, “real estate” became a dirty term in the popular media, and politically motivated blame was hurled among the lenders, real estate agents, appraisers and investors for declining home values. To discourage inflated appraisals, the federal government created a brand-new system for how lenders hire appraisers.

Lenders no longer could call their favorite local appraiser to review a property. Instead, they had to utilize a Centralized Appraisal Service, which auctions the homes out to hundreds of appraisers for online bidding. The intent was to make appraisals more fair, but the result was appraisals by persons with no knowledge or understanding of the local markets, and thousands of home sales have not closed due to ridiculously low appraisals.

However, despite all of the difficulties, a slow and steady rise in real estate values began in late 2011, and has been sustained nationwide.

Looking Ahead

As I reported recently, the real estate market, which began a turnaround in 2012, has really been gathering steam in 2013. A confluence of lower prices, miniscule interest rates, improvements in short sales, depleted inventory and the ability of owners of previously foreclosed home to qualify again have been contributing factors.

However, a larger-than-usual percentage of these sales has been to investors with cash. The areas previously cited that were hit the hardest have seen a tremendous rebound in prices, due in part to large numbers of hedge funds buying up foreclosures to rent out in those locales.

While investor sales have sparked the real estate market, more first-time and step-up buyers are required to sustain the recovery going forward.

Real estate in 2013 still faces several challenges. For several years, banks have been holding on to a “shadow inventory” of millions of foreclosures in an effort to artificially raise values. With so many homeowners upside down on their mortgages and unable to sell their homes, this has produced historically low inventory rates in many larger cities.

But the low inventory levels may have bottomed this summer. Some areas are beginning to see a rise in the foreclosure numbers, as banks feel more confident in releasing them. Many early hedge fund investors have completed their purchases of rental properties. In addition, the 12% nationwide increase in home values, coupled with a decline in principal owed, has reduced the number of upside-down borrowers.

High levels of unemployment continue to put a lid on real estate sales, and many of the jobs being created are only low-wage or part-time, and not conducive to home ownership growth. In fact, home ownership rates have continued to decline in recent months. Amid the march toward the Affordable Care Act, employers have reduced workers’ hours and have shown reluctance to create new jobs. If this trend continues, it will impact negatively on future real estate sales.

Bottom Line

Five years after Lehman, the real estate market has been to the bottom and back. Where it goes from here is subject to a myriad of economic, political and social forces.

As of this writing, Ethan Roberts did not hold a position in any of the aforementioned securities.