Saturday, November 06, 2004

The Bankruptcy Society

One of President Bush's more idiotic ideas is his plan to encourage home ownership to low income families through the "American Dream Down Payment Act of 2003", whereby $200 million per year will be directed to down-payment assistance to up to 40,000 low income borrowers. A nasty little secret of the recent housing boom is that close to 20% of down-payment assisted mortgages are in bankruptcy. Home prices are at historic, and unsustainable highs, fed by record low interest rates and loosened underwriting standards. Richard Benson describes the rotten foundations propping up today's real estate bubble:

The good news is that home ownership rose 2 percent to an all time record of 67.2; the bad news is what had to be done to get it there while the labor force participation rate has dropped 2 percent! In other words, easy credit and record low interest rates have boosted home sales. In previous economic cycles, the boost to home sales came from rising incomes and more jobs!

Easy mortgage credit has been fostered by new mortgage products. New types of mortgages have been introduced over the past couple of years that transfer interest rate risk from the financial institution (mortgage owner), to the borrower, while allowing the borrower to take out the largest possible mortgage. Long gone are the days when a borrower borrowed what was considered a safe, prudent amount that they could actually pay back. Today, the borrower takes every penny that lenders will lend. In turn, lenders have “gone crazy” because at the end of the day, the lender is not lending “his” money. The loans go to a GSE security, or into a rated mortgage security, which in turn is bought by a bank or Hedge Fund that is invested just for a short term in the “Cash and Carry Trade”.

Today, the new mortgage lenders are offering various types of mortgages to keep mortgage volume and quick origination profits up. These mortgages include Adjustable Rate, Interest Only, 40-Year, and Piggy Back. A Piggy Back mortgage is a senior mortgage combined with a junior mortgage that can leave the borrower owing more than 110% of the cost of the house. Moreover, these lending tactics leave the borrower more than a bit stretched and short liquidity, so it is no surprise that new mortgages that allow the borrower to skip payments and add the interest to principal are becoming popular. What will lenders who don’t lend their own money think of next?

If these new types of mortgages aren’t good enough to stretch a consumer’s buying capacity, a few years ago special charities sprang up to give a home buyer his 5% down payment. (Since a home builder was giving the charity their funds anyway, he could easily “give back” 5% of his 30% profit to charity. Clearly, charity starts at home!


Anyone with common sense can predict that this cannot last. There are signs in certain markets that the real estate bubble has peaked. So how is it a good thing to facilitate the entry of low income families into the home market at the peak of a bubble? Would it have been a good idea to encourage low income families to invest in internet stocks in 1999? This can only end badly for many of these families, who will be stuck with variable rate mortgages that will eat them alive as interest rates rise, and force them into bankruptcy or forced sales of their overpriced property at a considerable loss. Alan Greenspan's endorsement of variable rate mortgages for new homebuyers earlier this year must rank as one of the most irresponsible acts yet commited by a government authority.

President Bush has a historic opportunity to come clean with the American people about the considerable economic challenges facing the country over the next decade. If the bottom of the economy falls out during Bush's second term, and if millions of low income borrowers are driven to bankruptcy by these irresponsible programs, then he will have handed the Democrats a potent weapon that they will be able to use to gain the White House, and possibly the Congress in 2008.

50 Comments:

Blogger Hey Skipper said...

Robert:

Wow. I learned more about the mortgage industry in the last 5 minutes than in my previous 49 years.

Two words: Moral hazard. The way out is to expose the lenders to the full force of the risk they assume: you screw up, you pay.

However, I can see the merit in the (far) less advantaged owning their homes. For the same price as rent, you get equity. People who own their own homes invest in their infrastructure. They deeply care about what kind of mayhem the neighbors have in mind.

In short, they have a stake in the outcome. That is all to the good. Squaring the circle requires predatory lenders don't talk borrowers into more than thay can reasonably expect to pay.

Which brings us right back to moral hazard.

November 09, 2004 2:19 PM  
Blogger Michael Herdegen said...

There are a dozen or so markets where it's fair to say that a "real-estate bubble" exists, or at least, that it's at the top of the cycle there.

However, the vast majority of housing markets are not overpriced, and further, many of the markets that are will recover in a decade or two.

In the 80s, the Denver real-estate market crashed, but anyone who held on for ten years was handsomely rewarded. Buying at the top of a cycle, especially if one can simply live in the investment, is not necessarily fatal.

The notion that shoe-horning low-income people into home ownership will end ruinously is part of a larger, negative view of the American economy as a whole.

As long as people are employed, and continue to make their mortgage payments, it doesn't really matter if they're temporarily upside-down on their loans.
It's only if one believes that there will be chronic high unemployment in the future, that problems emerge with the programmes.
Further, as long as the population of America continues to grow, probably through robust immigration, the cost of housing, and the potential for profit to homeowners, will also continue.

Sure, 20% - 30% of those who are able to buy homes thanks to special programmes will ultimately fail, but that leaves 70+% who will SUCCEED, and enjoy the lifestyle of homeowners, as well as potential profits.

I well approve of trying to maximize home ownership via special programmes. The good outweighs the bad, in the end.

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