Why is the real estate market “broken?” The symptoms are obvious. Every homeowner feels the pressures of plummeting home prices caving in around them. But what really caused this economic disaster, and what will it take to fix it?

The overriding cause of the bursting of the bubble was the strident insistence that there was a bubble. The bubble burst because buyers of all sorts, both for the real estate as well as the underlying securities, left the market due to a feeling of uncertainty, fear, panic, or insecurity. This initial bursting of the bubble led to a series of dominoes falling. As each domino fell, recovery was pushed further and further away. Though there were a few steps between the initial burst and the topic of this article, this article will address the primary reason that recovery will take a terribly long time and intervention is a necessity.

The prime mover in any market is capital. Without capital, no one has the ability to buy anything. Capital for the real estate market is primarily obtained through mortgages. The banks and investment houses who provided the mortgages to buyers of real estate obtain their capital from investors. Mortgage Backed Securities (MBS) are the primary vehicle for investing and providing capital to lenders. MBS come in many shapes and sizes with various levels of risk and return for an investor. The riskiest tend to be sub-prime MBS and the safest were considered to be Mortgage Backed Securities underwritten and guaranteed by Fannie Mae (FNMA) and Freddie Mac (FHLMC).

The primary marketplace for the trade of non-Fannie/Freddie Mortgage Backed Securities was a periodic auction held by the investment houses that assembled the MBS. In February of this year, the investment houses closed down this auction due to a lack of buyers. As a result, these Mortgage Backed Securities became illiquid and impossible to value. Many of the institutional investors sought recourse against these investment houses. The SEC has since settled the claims with these investment houses by requiring them to buy back these MBS at the purchase price paid.

Illiquidity and regulatory action make it highly unlikely that any mortgages backed by this capital structure will return to the market anytime soon. This functionally removes all sub-prime and alt-A loans from the market. The removal of these mortgage products effectively removes a significant portion of buyers from the real estate market as well. These mortgages funded many first time homebuyers, self-employed buyers, and jumbo loans (any loan greater than $417,000). If you do not have 20-30% down, excellent credit, and fully documented income and assets, you likely will not qualify for a loan in today’s market.

Since markets are driven by capital and the lending market has now removed a large portion of buyers’ ability to obtain capital, there are fewer buyers for homes that are for sale. As anyone with a basic understanding of economics knows, a greater supply with a decreased demand leads to rapidly falling prices. This puts many private sellers in a position of being unable to sell their home for the amount they owe on the property. This consequently leads to short sales and foreclosures. As more and more homes are foreclosed upon by the banks, private sellers and banks continually cut prices to unload unwanted real estate. This race to the bottom perpetuates the problem by continually devaluing all real estate that acts as security for all mortgages.

This ultimately leads to a significant amount of residential real estate being owned by lenders. In fact, in the metro-Las Vegas area, statistics indicate that 60% of residential real estate is owned by banks and lending institutions. The lack of buyers for even the deeply discounted real estate makes assessing the damage very difficult. Most mortgages have a series of insurance products and guarantees attached to them to indemnify the lender or investor from loss. These guarantees made mortgages “safe” and liquid investments for large institutions, pension funds, and others looking for a reasonable return. In order for a guarantee to be paid out, there needs to be a quantifiable loss. Until the real estate is sold, it is impossible to determine the amount of the loss.

Fannie Mae and Freddie Mac are two of the largest guarantors of mortgages in the world. Combined, they hold or back more than $5 trillion dollars worth of mortgages. Their combined total liquid assets amount to only approximately $60 billion dollars. If a $200,000 home that had a $160,000 Fannie/Freddie mortgage has declined in value by 40%, it is now worth $120,000, or $40,000 less than the mortgage amount. In this example, Fannie/Freddie would be liable for $40,000, or 25% of the insured loan amount. If every home were to be foreclosed upon and lost a similar percentage, Fannie/Freddie would have $1.25 trillion in losses. Since the banks that own foreclosed real estate have not yet sold the properties, none of those losses are on Fannie/Freddie’s books. Fannie and Freddie only have capital sufficient to absorb a 1.2% loss. This realization led to the government take-over and taxpayer bail-out of both institutions.

The question many are asking is, “Why?” Allowing Fannie/Freddie to fail would, in effect, destroy the US economy. Fannie/Freddie funds or guarantees 75% of the mortgages currently being issued. If there were suddenly no mortgages available, home values would continue to fall drastically, sending the entire economy into downward spiral.

There is a misconception among many that by bailing out Fannie Mae and Freddie Mac, we are bailing out investors that funded high-risk loans for buyers that purchased multi-million dollar properties beyond their means. This is not the case, as mortgages backed by Fannie/Freddie follow some of the most stringent guidelines with larger downpayments required, fully documented income, good credit scores, and loan amounts up to only $417,000.

As illustrated above, the structures that provided the capital that drives the real estate market are “broken,” and repairing them will take significant time. No amount of government regulation will repair the market. The market will only be repaired by a return of investor and homebuyer confidence in the value of real estate and entrepreneurial institutions and individuals creating new and innovative structures for capital deployment. Those individuals and institutions that successfully develop this model will make significant profits as the market turns back around and buyers that aren’t currently able to obtain mortgage funds return to the home buying market. In the meantime, a Fannie/Freddie bailout prevents a few more dominoes from falling and brings us one step closer to a rebound.