Copyright by John T. Reed

My middle son was surfing the Net today and found people discussing WWJD regarding the subprime loan situation where WWJD refers to “What would John Do” where John is me. More specifically, they were asking what would John T. Reed say about the subprime situation.

One guy tried to extrapolate my feelings about the subprime situation from things I had said about Robert Allen and his Nothing Down book. Jesus H. Christ, folks! I am neither dead nor even unhealthy. You might try asking me what I think.

First, the subprime situation is rather simple, notwithstanding the fact that many sleazy gurus are trying to get rich by telling you it’s a great opportunity for you to get rich by paying them thousands to learn about subprime stuff.

Supply and demand
Basically, the number of people who could obtain mortgages and the terms on which those mortgage can be obtained has shrunk significantly. Substandard borrowers who could get a mortgage to buy a home in 2004 no longer can. Stronger buyers who can still get a mortgage, cannot get terms as attractive as before. Those two changes reduce the number of buyers who can actually get a mortgage and buy. That reduces the effective demand for homes. Effective demand is the combination of desire to buy a home and the ability to do so. People who want to buy a home but who cannot are not demand for the purposes of determining the supply-demand-price equation.

Why did this happen?

Basically, what happened was what investment historians call a speculative mania. Irrational exuberance is another name for it. Greater fool theory. Etc. When prices go up by extraordinary amounts, dopes start to think they always will. Arugably, everyone in the above chain of responsibility could be convicted of criminal activity and/or civil negligence or fraud. It appears however that only the borrowers and the Wall Street companies are taking hits. And there is agitation to have the taxpayers bail them out in part.

Increased investment opportunities?
Does the subprime situation mean there are increased opportunities for real estate investors?

There are more foreclosures than normal. That increases the number of pre-foreclosure situations, foreclosure auctions, and repossessions of foreclosed homes by lenders. How to make money in each of those is discussed in some detail in my book How To Buy Real Estate for at Least 20% Below Market Value, Volume 1.

Generally, if the number of such situations has grown faster than the number of investors trying to take advantage of them, there should be increased opportunities to make bargain purchases (defined as paying 80% or less of current market value) in those situations. Has that happened? I don’t know. Go to a foreclosure auction and see if you can buy properties there for less than 80% of current market value.

If Donald Trump and others beat the bushes enough with ads about the great opportunity in the subprime situation, it is possible they can actually make pre-foreclosures, foreclosure auctions, and repos less of a bargain because of too much demand for such properties. That seems to have happened in the note and tax lien certificate businesses in recent years: too many novice investors chasing too few assets.

The most professional investor I ever knew was the late Paul Thomson. He bought foreclosures at auction. During a prior period of heightened foreclosures, I asked him if this was good for him. He said it made it easier to buy them, but also harder to sell them, so it was more of a change than an improvement. Overall, he was not able to make more money or easier money. He simply had to work harder at selling his foreclosure-auction purchases in a weak market after finding it easier to buy them on the courthouse steps. I would expect the same is true now only more so.

World come to an end?
Another concern some people have is whether the sky will fall because the system is overstretched.

The problem seems to relate only to:

and not to:

Market will take care of it
If the market is allowed to deal with the problem, it will. Borrowers who cannot make their payments will, if they have equity, generally sell their properties at a loss and move on. Borrowers who can make their payments but who have no equity will probably let their homes go to foreclosure for lack of incentive to prevent it.

The homes in question will then become owned by new owners who paid lower prices that relate better to the rents that can be obtained for them and to the prices that can be obtained by selling them to others. This is usually called “stronger hands.” While that is probably true, the key is that the new owners purchased the properties for the correct price rather than paying too much. “Stronger hands” are no more interested in making payments on a home in which they have negative equity than “weaker hands.” The key corrective action of the market is to reset the prices to current market value. That’s normal and the market would then be normal again.

Panic?
It is possible that the population as a whole might panic from too many media stories about it. I cannot predict that or its consequences. No one can. Generally, nowadays, the federal government intervenes when that is even a possibility. Indeed, they seem to have done just that in recent months with the federal program that promises to help many subprime borrowers.

Justice
If there were justice, the appraisers, loan agents, and real estate agents who got rich during the boom would have to give back the portion of their commissions attributable to doing deals they should not have done. But no one is even trying to do that.

Wall Street firms and others who did not take appropriate care are taking big losses. That is justice that no one need enhance. The same is true of the many subprime borrowers who are in financial difficulty. They deserve it. They lied in many cases on their loan applications. They borrowed more than they could pay back and if they were too dumb to understand that they should have guardians appointed to handle their financial affairs henceforth. They were also gambling that they could get rich on the home going up in value before the bubble ended. Had values continued to go up, they would never have complained about being abused by the lenders.

Can’t time markets
I wrote a number of articles about the subprime situation in my newsletter Real Estate Investor’s Monthly in 2007. One was about whether you should wait until the market hits bottom to resume investing. I said no because no one can tell when that is. Rather, you should invest continuously and that way you will benefit from good timing some times and bad timing other times. Trying to time markets, real estate or securities, is a formula for financial disaster. No one can do it. For example, had you been investing in the early part of the Twentieth Century, would you have been smart enough to know that 1932 was the bottom and start investing then? Most likely, you would have thought you should wait longer which was incorrect. Similarly, you probably would not have known at the time that 1929 was the worst time to buy. On the contrary, everything seemed to be going great then.

Locusts
In short, it does not appear that the subprime situation is as big a deal as people are trying to make it. I am 61. I saw this same pattern in the 1970s with the real estate investment trusts debacle, in the 1980s with the limited partnership debacle, in the 1990s with the savings and loan debacle, and now in the 2000s with the subprime debacle. It’s like the coming of the locusts every seven years. Only in financial markets, people have short memories. When the locusts return, the public does not recognize them as locusts and inflict more financial pain upon themselves.

Don’t overreact
On the 20th anniversary of my becoming a newsletter writer-publisher, I went back and looked at all my stories over the years. One observation I made was that I and the rest of the world generally overreacted to the various real estate-related events. I stopped doing that. The rest of the world has not.

Calm down. Were there some investment opportunities in the wake of the REIT, limited partnership, and S&L debacles? Yep. I wrote about them. But they were niche markets as is the present situation. I wouldn’t get excited about the subprime stuff one way or the other. Should you try to buy at any of the three stages of foreclosure? Sure. It may fit you as a strategy. Are you crazy not to? Nope. There are now and always have been lots of different ways to make money in real estate. The key is to match your strategy to your strengths and weaknesses, not to chase the fad of the moment.

‘The rules have changed’
One of the mating calls of the kick me crowd that falls for this stuff every decade or so is “This time it’s different. The rules have changed.”

In my article on nothing down, I said it is not prudent to make a mortgage loan of more than 80% of the value of the property unless the mortgage is accompanied by a guarantee from a high credit borrower or guarantor like the FHA, VA, or Private Mortgage Insurance company. Numerous people wrote to denounce me as an old guy who did not understand that the rules had changed. No, they didn’t. It still is not prudent to lend more than 80% of the value of a property without a guarantee from a high-credit borrower or third-party guarantor. It never was prudent to do so. The so-called subprime crisis is the proof, but only the most recent proof. Such proof follows every visit from the real-estate-boom-and-bust locusts.

I appreciate informed, well-thought-out constructive criticism and suggestions.

John T. Reed