Subprime mortgage mess; what does it mean to the settlement industry?

As dedicated readers of my structured settlement blog are aware, I have been saying for over two years now that we were looking at a cyclical peak in real estate pricing back in September of 2005 ( The original post is available for reading here ).

I followed up that prediction and warning back then at the top of the real estate mania with another column entitled, " Tried to sell that investment property lately?" In that commentary from last summer I discussed how for about 5 years I was constantly confronted by settlement award beneficiaries who kept talking about how they would rather invest their settlement proceeds in real estate as the gains were far superior to anything a structured annuity could produce.  

Well, now here we are two years later and as the collapse of the sub prime real estate market is all over the newspapers it is abundantly clear that all of those properties bought with easy and careless loans are defaulting at record rates, and that the ability of the mortgage market to continue to prop up the real estate markets value through constant refinancing has probably come to an end. Much like past market declines that I lived and suffered through, we have once again had the classic pattern followed by most stock and real estate market collapses:

1. Denial in the months and years leading up to the peak that the lax lending and crazy pricing evidenced in explosive real estate price increases were an investment risk. Remember, any time you hear "experts" saying, " Yes, but this time it's different...." you can pretty much be assured of a market peak and subsequent crash. There is nothing new under the sun, and while the names may change, REIT's in the 70's, Junk Bonds and S&L's in the 80's, CMO's and Subprime in the 90's the results are usually pretty much the same. Careless lending fuels asset valuations, followed by a speculative stampede to buy and build more real estate, with the last people in, typically smaller investors, ending up crushed when the market inevitably slows down and declines and they can't flip their property to the next greater fool who will pay a higher price.

2. A 12 to 18 month period of flat sales, modest declines and people scrambling to try and sell into a dead market, all while doing what it takes to keep their loan payments current on the highly leveraged property they own. Thats the phase we have been watching for the last year or so in most US markets as people try creative approaches to sell their homes, work to get appraisals that match what is needed to get the next buyer a mortgage, and in particular in this cycle, refinanced to pull cash out so that they could keep up with payments or improve the property so that they could wait out the slow down. The ability of the mortgage market to keep people refinanced and pulling out cash probably held off the inevitable carnage as people were able to access cash they typically wouldn't be able to find. However, all it did was delay and probably increase the pain of the correction that is about to occur.

3. There is a triggering event that suddenly makes clear the denial the market was in and then there is a rush for the doors. In the 1970's it was the impact of successive oil shocks, a major stock market decline and the blow to our then very industrialized economy. In the 1980's it was the 1986 tax reform bill knocking the legs out from under the tax shelter industry that drove most real estate investment and then the subsequent S&L collapse that resulted as the loans went bad. Now in the 1990's and 2000's we have the collapse of the sub prime mortgage business and impending waves of defaults on the loans that make up the CMO's that are bought, sold and traded by hedge funds, pension funds, mortgage companies, etc.  Once the realization sets in that the assets backing up loans aren't what people thought they were, or that they aren't sufficiently liquid, you are typically faced with a crisis in confidence which only deepens the depth of the downward cycle.

I wish I could take credit for the above wisdom but it's all pretty much available in text books and literature on investing, in particular David Dreman's classic book, " Contrarian Investment Strategy" which lays out the foundation of market collapses and group thinking. It's a great read for any investor looking to get a better grip on how not to fall prey to market bubbles of any type.

So what does this all have to do with the structured settlement industry? Well, as you all know the structured settlement annuity is, has been and should continue to be the foundational planning tool for the vast majority of personal injury award recipients. It is safe, guaranteed, life time money that can't be out spent, dissipated or outlived if properly designed and set up, all with the proceeds being paid income tax free to the annuitant.  However, for the last 15  years we in the settlement industry have had to deal with the financial planning and mutual fund "experts" telling our clients they can do so much better in managed funds, which was true for a short period of time until the stock market collapsed for 3 years, with many of the people who took these experts advice experiencing declines in their portfolios of 30% to 70% of their assets, and as a result are now looking at reduced income and uncertain futures. Then with the explosion in real estate valuations during the late 1990's and 2000's  I constantly was told by "real estate experts" that our product couldn't compete with real estate as the "best investment" for injury victims, most of whom had no other source of income due to their injury, couldn't afford to lose their money or wait out a market cycle, and whom most definitely needed a risk free source of funds. Now with the apparent collapse of the real estate markets we can probably look for 2 to 3 years of serious pain until it bottoms out and starts back up again after the excesses have been wrung out of this particular market. The problem is that many foolish and misguided people who should have been in structures are now going to be in serious financial straits as a result of listening to the conventional wisdom of the time that real estate can't go down in value.   

So, at the end of this third installment of my warning to injury victims, trial lawyers and others may I ask you all a simple question? When are you going to stop listening to professionals trying to appeal to your clients greed and ignorance by seducing them into investments they don't understand, from advisors who don't realize the seriousness of these peoples financial situations, just to try and get " more money then a structure." The fact is that for the vast majority of injured people a structured settlement is the single best use of their funds to insure a safe, predictable cash flow to support them and their family. 

IIn closing 'll ask again what I asked last year. Have you tried to sell that "investment property" you bought instead of a structured settlement lately? If so, I'm guessing you or your client are among the people who would trade their can't miss real estate for a structured settlement right about now.  

Comments

[Jack]

Do you think this will touch any of the life companies that own mortgage backed bonds, like AIG or Allstate?

[The Settlement Channel]

Jack,

There was a very good article earlier this week in the WSJ outlining the AIG situation in some detail. It was more interesting then alarming as I don't think from what I read that they have enough exposure to make it a concern for our industry. AIG is just too large, too diverse and it's portfolio too well balanced for this to impact them in an appreciable fashion. However, it did point out the issue that really is at the heart of the market collapse and that is that these are exceptionally difficult to "mark to value". In other words, there isn't an effective way of pricing the value of these pools of loans, so the companies really don't know the asset value or market value of the mortgage pools they are holding. I would expect the CPA's and NAIC to address this in pretty short order, but I know I won't be losing a lot of sleep over this as far as our industry is concerned.

[David]

"It was more interesting then (sic) alarming as I don't think from what I read that they have enough exposure to make it a concern for our industry. AIG is just too large, too diverse and it's portfolio too well balanced for this to impact them in an appreciable fashion." - August 2007

August 2008: The arrogance of pretend. Too large? Ask Lehman (158 years in business), Freddie Mac, Fannie Mae, Merrill Lynch (since 1909), etc. Of course, Enron, WorldComm, and the rest was a long time ago - not.

What about the structured settlement annuities that were NOT re-insured? How will they fare when AIG goes bankrupt?

[The Settlement Channel]

First of all, I don't think AIG is going bankrupt unless grossly irresponsible people precipitate a run on the company. They have the assets in their life subsidiaries to meet and pay all claims, they are adequately reserved and the problems of the corporate parent would at worst lead to the sale of American General or it's assignment company to a large life market as has happened in other liquidations. Structured settlement annuity blocks of business are highly desirable assets to acquire and even if the parent company of AIG went south, those contracts would in almost all certainty keep on paying as promised.

I'm not losing a lot of sleep over the structured settlement side of the business at AIG, but if I was a bond holder, preferred stockholder or employee I would definitely be losing sleep. The common stock holders have already been wiped out and the animosity toward AIG's management is intense at the moment, and with good reason. I just hope that animosity doesn't cause and irresponsible and unnecessary panic in the annuity contracts as the life companies are a totally different matter then the larger corporate entity.