Are Jumbo Mortgages the New Subprime?
Are Jumbo Mortgages the New Subprime?
Why Regional Banks are Systemically Vital to Luxury Real Estate
On the eve of the Great Financial Crisis, I was still hustling research and investment banking deals to institutional clients at Merrill Lynch, while my counterparts in the retail division were bellyaching that the firm needed to buy a bank. Their prayers were answered when then CEO Stan O’Neal went on a bank buying spree and in September of 2007, he bought First Republic Bank for $1.8 billion.
Why did the retail sales force want a bank so badly? The juicy fees. The fees associated with buying and selling securities on behalf of customers were heading to zero. Stockbrokers were desperately trying to reinvent themselves as “wealth managers.” Having a competitive bank was critical to tap into the fee-rich liability side of their clients’ balance sheets – i.e., lending money to their clients. First Republic was a perfect fit.
Fast forward to today. In the wake of the downfall of Merrill Lynch, First Republic went on to become a standalone regional bank. In recent years, First Republic aggressively expanded their asset management business and emerged as a top wealth management firm.
First Republic has been swept up in the current banking sector turmoil. The Wall Street Journal reported that depositors have recently withdrawn roughly $70 billion from the bank. That’s a big deal when you consider that at year-end, the bank had total deposits of $176 billion. This is in the context of the Federal Reserve discount window being wide open and competing banks recently depositing $30 billion into First Republic in an attempt to calm fears.
Stockbrokers Get Their Hands on a Bank – What Could Go Wrong?
We keep hearing over and over about how exceptional the service is at First Republic, implying that good service somehow makes the bank systemically important. We wonder how good service is measured. Are the phones answered on the second ring? Are the monthly statements that much better? Or is “good service” code for making loans that other banks won’t?
A few weeks ago, we highlighted a handful of high-end real estate transactions. We questioned if they were truly arms distance transactions or whether there was some kind of market manipulation going on (see “Are Real Estate Prices Manipulated?”). We didn’t mention it at the time, but every single one of the mortgage loans behind those transactions was courtesy of First Republic. At the time, we figured that it was just a coincidence.
Last week, a group of Boston realtors and developers released a statement in support of First Republic, stating that the bank “…is especially intertwined in the fabric of the real estate community…” Maybe it wasn’t a coincidence - are the real estate brokers in bed with the bankers? We’re beginning to think that good service is about holding your nose and putting loans on the books that other institutions wouldn’t consider.
Jumbo Mortgages – The New Subprime?
We’ve been very cautious on the downtown Boston luxury real estate market. People are probably sick of hearing us repeat that “when interest rates go up, asset prices go down.” This rule applies to both the value of the underlying assets (the properties), and to the value of mortgage loans which are carried as assets on the bank’s books or sold off as securities to investors.
Lending aggressively when fed funds were zero and inflation was rearing its ugly head was reckless by our way of thinking. When you have a bunch of “wealth managers” collecting fees by telling clients to pile on low coupon debt so the clients can go out and further bid up already inflated real estate – it’s a perfect storm.
Leading up to the Great Financial Crisis, cracks in the foundation first appeared in the subprime mortgage space. Today it looks like we may be seeing cracks at the opposite end of the wealth spectrum – the jumbo mortgage market.
The risk today isn’t that jumbo borrowers will default on their loans like we saw in 2008. The problem is that many banks (particularly banks that cater to wealthy individuals) are sitting on large portfolios of 3% long duration loans while the fed funds rate is now 5%. In the case of First Republic, Bloomberg reported that the bank has portfolio losses on the books of roughly $26.8 billion, implying negative common equity of about $13 billion.
Balance sheet problems create serious issues for banks, just look at their share prices. Buyers of luxury real estate need to recognize that hiccups in the jumbo loan market will choke off liquidity to some extent. That spells lower prices.
It’s widely accepted that artificially low teaser mortgage rates contributed to the Great Financial Crisis. We wonder if history will look back at the zero percent fed funds era as the mac-daddy of all teaser rates. We remain cautious on residential and commercial real estate values.
About Batterymarch Group LLC – Batterymarch Group is an independent full service real estate brokerage and advisory firm focused on the downtown Boston high-end residential market. We represent both sellers and buyers with a sharp focus on valuation. We also offer sub-advisory and owner’s representation services to financial institutions, family offices, and trustees.
About Andrew Haigney – A 25-year Wall Street veteran, Andrew held senior positions at leading global investment banking institutions where he routinely valued and negotiated complex securities transactions on behalf of institutional clients. Andrew has been an outspoken advocate of a universal fiduciary standard. In founding Batterymarch Group, Andrew brings that same discipline and passion to real estate brokerage.