The Associated Press economics writer Martin Crutinsinger reports today that the median price of a new home in the U.S. has had its largest drop in 35 years:
“The Commerce Department reported that the median price for a new home sold in September was $217,100, a drop of 9.7 percent from September 2005. It was the lowest median price for a new home since September 2004 and the sharpest year-over-year decline since December 1970. ”
This news underscores the importance of ensuring that loans funded for mortgages be collateralized by real estate in which the borrower has substantial equity, a point the Federal Reserve makes in a study conducted last year. In a May 2005 study by the Federal Reserve Bank of St. Louis entitled, A Dynamic Look at Subprime Loan Performance, the bank reported that “The current equity status of the property is a key determinant of whether a delinquent mortgage will prepay or will default.” At a LTV of 75%, (or 25% equity) this study shows the probability of default is less than 2%.
Consequently, if you invest in pools of mortgages that are supported by high equity collateral, your portfolio should be able to withstand a general decline in values as long as they don’t eat away the equity, for at that point the risk is that the borrower will default.
Of course, several other conditions relative to the portfolio need to work in the investor’s favor as well. It’s important that there’s diversity in geography (markets) and rate structure; that no loan is a significant portion of the portfolio; and that borrowers have the means and intent to pay their loans.
One final point is a common refrain: All real estate is local. Despite the up or down direction that the averages may report, what’s most important is what’s happening in the real estate market where you’re invested. Some areas remain stable despite what happens elsewhere.