Foreclosures reached epic proportions for much of 2007 because the real estate market suffered an unprecedented global credit crunch during which many traditional lenders stopped lending money and started chasing late payers and non-payers and foreclosing on their properties.
This turned foreclosures, essentially a balancing mechanism within the real estate market, into a ticking time-bomb which threatened the global economy and which was fast becoming an issue because of liquidity.
Liquidity means that as investor and saver confidence started waning banks were facing the possibility that should there be a run they would be unable to sell all the mortgages they owned fast enough to cover the amount of money borrowers would want to withdraw.
Liquidity causes issues because to forces banks to be really careful with the money they lend as they may have to pay it back to those who have put it in the bank in the first place. Liquidity, however, is a transient problem. Yes, it does undermine investor confidence and shake the real estate market but it is a problem of time.
Simply put, given sufficient time, most banks facing a liquidity problem have enough capital in their books to meet their commitments to savers. The global finance rescue package that was announced by the Fed and the Bank of England as well as the national banks of Canada and Switzerland will together see the banks inject at least $600 billion.
This will go a long way towards addressing liquidity fears but it will not be enough if solvency starts to become an issue. Solvency is a far more difficult problem to deal with. Simply put solvency happens when the price of real estate and property begins to drop to a level where the mortgages that are owned by a bank are not enough to cover its commitments. At that point the bank itself begins to exist on a wing and a prayer.
For solvency to become an issue foreclosures need to continue at the rate we see now and house prices will have to start to drop at a rate that will be called ‘alarming’ by the press. This will create negative equity and a sense that real estate no longer is a fit vehicle for investment which means we will have a real freeze of the market which will not be able to be jump-started even by real estate investors working foreclosures.
Thankfully we are not there yet but there are some worrying signs which should it prove they are real will make the real estate market and the global economy even tougher than it is at the moment.
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