8 Jul 2021, 15:21

2008 seems so far away yet the painful experiences of investors still remain fresh in the memories . The last financial crisis was caused by a not-commonly knowned asset class called Mortgage-Backed Securities (MBS). Until the fall of the financial crisis, not many people even heard of this.

The idea behind MBS sounds novel at first. Essentially, this allows ordinary investors to act like a bank and make loans to home-buyers. This creates a win-win situation for the homebuyers, investors and the banks who sell these MBS. Homebuyers have easy access to debt to purchase their dream home. And the MBS holders receive dividends from their investment. And the bankers, of course, earn their commissions from selling these products and lending the money.

The only problem is when these home-buyers start to default and not pay back on their mortgages. This was what happened during the 2008 financial crisis when homebuyers could not afford the interest of their loans anymore and defaulted. This triggered the greatest stock market crash in history. The question is: will history be repeating itself today?

According to this CNN report, low inventory and high demand are sending housing prices surging despite the on-going Covid-19 pandemic.  

https://edition.cnn.com/2021/06/18/investing/premarket-stocks-trading/index.html

In fact, real estate agents have reported that demand has been so hot that potential buyers are bidding $1million over the asking price to deter other bidders. With many people throwing silly money buying real estate, is another bubble slowly building up?

Take a look at the chart in Figure 1 below. This chart details the amount of MBS held by all commercial banks.

 

Figure 1: Mortgage Backed Securities, All Commercial Banks (fred.stlouisfed.org)

While the numbers have increased steadily ever since the 2008 financial crisis, what is striking is the rate of increase in 2020. Despite the Covid-19 pandemic raging on and many jobs been lost, the demand for MBS has skyrocketed!

To put this increase into perspective, take a look at Figure 2 below.

Figure 2: Rate of Change of Mortgage Backed Securities, All Commercial Banks (fred.stlouisfed.org)

Before 2020, the annual rate of increase in MBS never went above 15%. But in 2020, the amount of MBS held by the banks shot up to nearly 20%. This was the greatest rise in more than 10 years. Why are the banks selling more MBS to their clients now? Could it be known that the bubble is silently building up and they are hyping up the attractiveness of this asset class? Cashing in while they can before the bubble bursts like just before 2008?

Whatever the motive, one thing that is clear is that home prices in the US are at their all-time high. The Case-Shiller Home Price Index increased 14.9% in April 2021 (see figure 3 below). Demand for suburban homes remain high amidst low interest rates. However, it could be for this very reason that could prick the bubble.

Figure 3, Tradingeconomics.com

When could the real estate bubble burst?

In the last Federal Reserve meeting in Jun 2021, Chairman Jerome Powell announced that they could bring forward interest rate increase as early as 2023, 1 year ahead of previous projections. This would signal a long-term death spiral for the real estate markets. Home-owners who had previously bought their homes on cheap interest could now find immense difficulty paying higher interests. This could lead to massive defaults, just like in 2008. MBS investors would then be unable to see returns on their investments if they don’t pay up.

What could we do?

 

While nothing is certain in the investment world, this real estate bubble could grow bigger and bigger for a long time and not burst. However, we could see that the risk are getting higher. Therefore, why not take some precaution if you are a home-owner or investor? We would probably reduce our exposure to real estate investments and start shifting to other forms of asset classes. Then, we could wait till a real estate crisis reduce home prices to a rubble before we consider buying acres of real estate again. If we are home-owners, probably it will be a good time to ring up our banker and explore some re-financing options. Before interest rates start to rise, and it will be too late.

 

Join our community!

To get more regular market updates, insights and strategies, simply join our community list by clicking here now! 

EmSociety is a community that aims to empower you with knowledge & strategies to confidently invest in the financial markets as well as our vision of making financial freedom accessible to everyone. 

If you have any queries, feel free to contact us at [email protected] for a complimentary 1-on-1 consultation.