Will the Sub-Prime Crisis Reach Manhattan? by Charles Geisst, Sep 10, 2007 Twitter The current crisis in the sub-prime mortgage market has pundits wondering what the effect of the turmoil in the financial markets could be. Will it result in a recession, a crisis in consumer confidence or the failure of a major financial institution? While the future is uncertain, effects will certainly appear within a few months. And one vulnerable spot is likely to be the real estate market, even in previously immune Manhattan. The immediate problem has been created by homeowners taking out mortgages that were ill-suited for their needs. Many were adjustable with sweet interest rates for the first several years - designed to entice homebuyers with low rates - that adjust higher in the future. A number of the banks creating those mortgages sold them to Wall Street firms that packaged them as bonds and resold them to investors. Since interest rates fell sharply in the early 2000s, the Federal Reserve has raised them. Investment bankers doing the packaging have reaped enormous rewards from all of the activity. Those rewards have benefited the economy in the major financial centers around the country, especially New York City. Now, though, more and more homeowners cannot meet their higher monthly payments. Adding to the problem, many of those mortgages were awarded to individuals with less than decent credit. Compounding the misery, lenders doled out incentives not normally available to those with even good credit ratings. The result is what is currently called the sub-prime mortgage crisis â€“ mortgages are going into arrears in record numbers with no end in sight. This has caused a glut of houses waiting to be sold and falling prices. But the problem extends beyond those with sub-prime mortgages. The major danger in plummeting real estate prices is what economists refer to as "negative equity." A drop in prices means that the current market price of a home is less than the mortgaged amount, suggesting that the homeowner cannot pay off the mortgage even if the home is sold. This situation has occurred rarely, if ever, in the United States, but the current mortgage market crisis suggests that it is beginning now. The situation is ideal for the potential buyer willing to pay higher interest rates than those that prevailed over the last five years. It is, however, a potential disaster for many sellers. New York’s Real Estate Boomâ€¦. The New York property market has remained aloof to troubles in the rest of the country. A limited amount of housing, especially in Manhattan, has kept prices stable while the boom on Wall Street has propelled the market forward in more desirable residential areas. But even a limited supply of housing does not explain the $1.5 million two-bedroom co-op or condo. Wall Street salaries and record bonuses have contributed to the dizzying levels witnessed over the last five years. The spillover has affected all levels of housing in the metropolitan area, most severely in Manhattan. A similar effect has occurred in London, where the financial services industry has triggered a record boom, sending property values to levels that make Manhattan actually seem sensible. But the run-ups can only be sustained if Wall Street earnings continue to increase at record levels. The current market crisis suggests that the boom is over. â€¦and Bust? Wall Street salaries and bonuses are only part of the story behind the giddy housing market. Many brokers and bankers benefit from generous mortgage packages provided by their employers. While those packages differ, they need to continue if the market is to remain robust. Without them, trouble will appear quickly. And the spillover effect here should not be underestimated. Wall Street traditionally contributes about 20 to 25 percent of New York City’s economic output. (No wonder Mayor Michael Bloomberg worried about the U.S. markets losing business to London and other overseas markets.) Jobs are at stake, and less employment on Wall Street has consequences for the city. The phenomenon has happened before. After the 1987 stock market rout, the market for one and two bedroom condos and co-ops in Manhattan was hard hit, with prices falling significantly. It took several years before they recovered and began an upward spiral fueled by low mortgage rates. Apartments of that size were frequently bought by younger traders and investment bankers - the first casualties of securities firms feeling the pinch of losses and lower revenues. That market problem also caused many securities firms to trim back their staffs, contributing to the recession that followed. The problem lasted a few years and was felt across the board in the real estate market. The popular joke circulating at the time was that pigeons were leaving the only deposit on BMWs in Manhattan. Today the problem is a bit more complicated, just like the markets themselves. So far, the major damage has been in the market for sub-prime mortgages and all of those who make a living from it - from investment bankers to securities lawyers and accountants. The junk bond market has also felt the pain as investors who once bought every new security in sight quickly readjust their risk tolerances. These bonds have been among the most profitable lines of business on Wall Street over the last five years. It is no coincidence that during the same period the amount of mortgage debt outstanding in the U.S. has exploded exponentially as well. Recent government statistics show that Wall Street and Fairfield, Connecticut, have income levels 10 times the national average. A week or two's salary in those places can easily equal a year’s salary in other parts of the country where people do not work in the financial services industry. That multiple is about to fall due to the current crisis, and the real estate market undoubtedly will feel the pinch. Whether the higher end of the market is affected remains to be seen, because its values are attainable by only relatively few investment bankers, traders and hedge fund managers. After the 1929 crash, a photo of a Wall Streeter trying to sell a car with a sign requesting $20 has become an enduring memory. Real estate brokers tend to be a bit subtler, but the fire sale prices will soon start appearing in Manhattan as the fall in prices whipsaws on many who helped create the problem in the first place. Charles Geisst is a professor of finance at Manhattan College and an author of several books about Wall Street, including the New York Times Business Bestseller, "Wall Street: A History." 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