The most used word in the world of mortgage financing during the past few weeks has been “surprise,” as in, “oh my, cover your eyes and turn away from those poor wretched loans.”
“The U.S. mortgage giant Freddie Mac said it would no longer buy those high-risk home mortgages that it deems to be the most vulnerable to foreclosure. The surprise move came amid a deteriorating market for subprime loans affected by slumping home prices and rising interest rates.” (See: Freddie Mac tightens home mortgage standards, The International Herald Tribune, Feb. 28, 2007)
But the fact is that home prices are not slumping in some local markets and interest rates are plainly at the low end of historic norms. Such factors are simply not the root cause of today’s mortgage instability.
Instead, problems in the subprime mortgage market — and a growing sense of problems in other parts of the mortgage universe — are the result of dicey loan concepts that turned out to be exactly what any lucid person would expect: risky beyond reason.
Who could have known such things? Anyone with common sense, including readers of this column.
Let’s begin with interest-only loans. These are mortgages where borrowers do nothing to reduce the principal for the first several years of the loan. Once the interest-only “start period” ends then the loan must be repaid at the fully indexed and fully amortizing rate. Given that most interest-only loans are adjustable, and given that fewer years remain after the end of the start period, it follows that such financing will inevitably require higher monthly payments.
“There’s no doubt,” it said here in 2004, “that the newest trend in real estate financing is the interest-only loan, a trend which needs to be examined with care by anyone who prefers to avoid poverty.”
Moreover, said the column, “with an interest-only loan your initial monthly cash payments each month will be — and be sure to read the rest of this paragraph — lower than with a self-amortizing loan of the same size and with the same rate and terms. However, the interest-only borrower has more debt for a longer period and thus higher total costs. And if rates rise, monthly costs and overall interest costs could be substantially larger than with fixed-rate financing.” (See: The Beauty Of Interest-Only Loans — And The Beast, November 30, 2004.)
The reality is that buying homes with little down has always been risky, something that should neither shock nor surprise anyone. Just look at what the New York Times wrote — in April, 2000.
But what happens if housing values or the economy head south — particularly if a homeowner has a huge mortgage and no appreciable equity? Experts like Peter G. Miller, author of ”The Common Sense Mortgage” (Contemporary Books), warn that buyers who suddenly need to sell will face brokerage fees and related costs that they will have to pay out of pocket. ”Where do you get the cash?” he asked. (See: PERSONAL BUSINESS; Zero Down, And Maybe Something To Gain, The Sunday New York Times Business section, April 2, 2000)
Home prices have risen substantially since 2001 and thank goodness. While those in real estate prospered the stock market largely took a snooze during the same period. The catch, as noted in 2005, was that “the only way we’re supporting high real estate prices is by fudging traditional rules. We allow people to buy at levels that would have been unaffordable under past lending standards.”
“Playing mortgage roulette is fine as long as everyone realizes there are massive opportunities to lose.” (See: Are We Facing A Recession? September 13, 2005)
Is anyone “surprised” that a number of lenders are now in trouble — and that their backers are also taking losses? Why? Some of the risk represented by “non-traditional loans” can be offset by rising home values. But two years ago it was pointed out that if home values do not rise — and they plainly have not in many areas during the past year — then “lenders may be using ARMs to offset future rate risk, but what about future asset values? Is it worth originating loans today which may sink lenders tomorrow? A large number of foreclosures won’t look good on anyone’s books, reason enough to tighten ARM loan standards.” (See: Wrong-Way Borrowing Threatens Borrowers, Lenders, June 7, 2005)
One of the most widespread of the new financing concepts seen during the past few years has been the use of “stated-income” loan applications.
In the summer of 2004 it was explained that “stated-income loans represent too much risk for lenders — and too much temptation for borrowers. Perhaps a little rigidity in the lending process is not so bad. After all, how hard is it to produce tax returns and pay stubs? (See: Should Lenders Dump No-Tell Loans? July 27, 2004)
“What’s obviously best is to get the numbers right when making a loan application,” it said here in November 2004. “It’s equally obvious that ’stated income’ mortgages open the vault to temptation. Such no-tell loans ask borrowers what they earn and the borrower then puts down a number. Unlike a typical mortgage application, the lender usually does not verify the figure with tax returns, pay stubs or calls to employers.”
Of course, if it happens that those self-estimates of income are off a touch then lenders will have problems.
“With a growing number of stated income loans on the books, financing with exaggerated numbers could quickly become a lender concern if home values dip, the economy slows and monthly payments don’t show up. That’s the point at which stated income loans will come home to roost.” (See: How Much Is Too Much? November 16, 2004)
It’s hard to look at the tough times now facing the mortgage industry without mentioning the worst of the worst, the option ARM combined with little or nothing down plus a stated-income loan application.
Here’s a loan concept which gleefully allows borrowers to make payment after payment that will not even cover interest costs. Obviously — no “surprise” here — the loan must be repaid at some point which means that monthly costs must rise if the loan is held past the start period.
As stated here in 2005:
“In the next two to four years we’ll see elective payments end for many option loans. Then we’ll find out who should not have bought and who should not have loaned. Don’t be surprised if a lot of cheap real estate floods the market — and don’t be shocked if the value of your home is impacted as a result. As to lender share prices and dividends, how attractive will such companies appear when huge numbers of loans are unpaid, especially if in many cases the size of the debt exceeds the value of the underlying properties?
“Alternatively, if we restrict option loans now by regulation or lender choice, the pool of buyers will shrink and home prices will be under far less pressure to go up. We will see less appreciation and even price declines in some local markets. Acting now we may face moderate and tolerable declines in market activity, an opportunity which should not be ignored in the face of the financial calamity which looms ahead.” (See: The Case Against Too Many Options, June 28, 2005)
The growing number of loan failures has produced a rising volume of foreclosures. RealtyTrac.com reports that foreclosure actions rose from 885,468 in 2005 to 1,259,118 in 2006 — a 42 percent increase.
The huge number of foreclosure means that we have a growing supply of distressed properties, properties which are often available at discount. Even a small number of foreclosures can drag down local real estate prices.
“To believe that an increasing number of foreclosures will not have a marketplace impact is neither logical nor believable. Just ask the people in the subdivisions and condo projects where developers have recently cut prices on just a few units. (See: Foreclosures — No Worries, No Vision, May 5, 2006)
At this writing we have evidence that home values have fallen in about half of all major metro areas. The problem, of course, is that we really do not know the extent of value declines and thus cannot project future loan failures and foreclosure levels.
“While unit sales are easy to track, data regarding recorded prices is less certain. If you have a strong sellers market you can bet that sale prices are indeed what people paid because sellers have no need to offer discounts and buyers will not pay any more than required. But if you have a market that’s losing steam, the same assurance is not plausible.
“The problem with slowing markets is that sale prices may not tell the whole story. Sale prices may be discounted, and the extent of those discounts cannot be reliably estimated.” (See: A Time For Yellow Flags, November 28, 2006)
A major part of the problem has been the untenable view that home prices only rise. Does anyone believe that? Apparently a lot of people did, which is unfortunate:
The prevailing theory seems to be that higher monthly costs are not a problem because one can just sell the underlying property. But such thinking assumes that property values will rise — and that is not guaranteed. If property values merely stay the same large numbers of people in the next few years will be both unable to make monthly payments and unable to sell for enough to pay off growing mortgage debt. (See: Exit Strategy: What If There Is No Way Out? November 1, 2005)
The news today is concentrated on the subprime market, but guess what? This is not a problem that can be contained to poor and marginal borrowers. A lot of well-funded entrepreneurial people bought with toxic loans and they too will be facing tough times as required payments rise and in too many cases property values fall.
“We now have a large percentage of loans that involve negative amortization and potentially huge payment increases. It’s impossible to believe that some portion of these loans — and perhaps a large portion — will not result in financial disaster.” (See: Toxic Loans Threaten Home Values, February 14, 2006)
In fact, it’s not just borrowers and lenders who suffer when loans fail, it’s also neighbors and communities who suffer. How? Just think about what will happen to the value of your home if a neighbor is foreclosed. As I said in a 2006 speech to the Association of Real Estate License Law Officials (ARELLO):
A growing number of recent property owners will find that they have homes and investments which cannot be sold at a profit — as well as homes and investments which cost too much to carry. The fruits of this impossible dilemma will be more properties for sale, more supply, more pressure to moderate if not lower prices, more foreclosures and more bankruptcies. Even those without a mortgage may find that the value of their home will drop as neighbors who financed imprudently rush to dump their properties on the market.
If “nontraditional” mortgages are so great, how come loan buyers and regulators are now demanding a return to long-time lending standards? More importantly, why did they accept such risky concepts in the first place? Surely no one will be “surprised” if lawmakers start asking pointed questions as foreclosure rates rise and increasing numbers of lenders fail.
Published originally by Realty Times on March 13, 2007 and posted with permission.