(Presented before the Association of Real Estate License Law Officials (ARELLO), April 7, 2006, at Jacksonville, FL.)
It’s been a very good century for real estate, at least so far. According to the National Association of Realtors, the typical home that sold for $139,000 in 2000 was worth $208,700 in 2005.
Not only have home values increased, unit volume has also grown. There were 5,152,000 existing home sales in 2000 compared with 7,072,000 in 2005. The National Association of Home Builders says new home sales rose from 877,000 units in 2000 to 1,285,000 in 2005. Average sale prices increased from $207,000 to $295,100 during the period.
If you do the math you see something else: Home sales involve a lot of money. The gross market, units x cost, was $897.7 billion in 2000 versus $1.78 trillion in 2005.
While everyone likes to see increased sales, these numbers hide an impending problem. Homes which may have been affordable in 2000 were less affordable in 2005. In fact, in February the NAHB/Wells Fargo Housing Opportunity Index reached a record low — “only 41% of new and existing homes that were sold during the final quarter of 2005 were affordable to families earning the national median income.”
So how is it possible that sales and prices are at record levels while affordability is in the ditch?
The answer for large numbers of buyers is that they bought real estate with the presumption that monthly costs — not purchase prices — were the key to future wealth.
Essentially the strategy has been this: Since real estate was presumed to be an eternally-appreciating asset, it made sense to buy as much as possible. For instance, if values are going up 10 percent a year buyers benefit by purchasing a home priced at $500,000 rather than $300,000. Why? Because at the end of the year their equity would have increased by $50,000 rather than $30,000.
With such thinking, what counts are monthly costs. The concept is to buy, hold for a few years and then sell. Even better, buy, flip the contract, pocket the cash, and do it again.
If you look at the numbers you can see that for many buyers the pricing gamble has been a huge success during the past few years. Home values have risen substantially in most areas. The odds are overwhelming that if you bought in 2000 or before and sold in 2005 or thereabouts you made money. A lot of money.
But looming in the background is the potential for financial disaster that will impact home values nationwide, spur foreclosure rates to new highs and devalue insurance funds, pension holdings and investor accounts. The value of your home, no matter how you financed, is at stake.
How could such a good plan go wrong?
The whole theory of wealth accumulation as it has been practiced for the past few years relies on two constants: Home values must rise and monthly payments must remain affordable. Unfortunately, neither constant is assured.
If it happens that appreciation slows that’s not an instant issue. Most owners at any given time do not want to sell and do not have to sell as long as payments are affordable or the property can be rented on at least break-even basis.
However, prices do become a problem if appreciation slows and weaker owners begin to unload their properties because they cannot carry the monthly costs. A cascade effect sets in: Seeing that values are not rising, owners with shaky financing begin to sell. Marketplace inventory increases. More inventory creates additional supply at the moment of slower demand. As prices slow or actually fall, more units become available for rent. Rental rates fall and an increasing number of investors seek a way out.
You can see the changes by tracking local MLS statistics: Average days on the market will increase. Average appreciation will slow or decline. The number of units for sale will grow. Sale prices as a percentage of list prices will decline.
Or you can just look in the paper.
In my area there have been recent builder ads offering homes with discounts of $70,000 to $100,000.
These ads are enormously important because many small investors have purchased condo units and new homes. They buy when projects are first announced and then hope to sell as the property is built out and builder prices rise.
However, if builders are offering discounts it means that contract holders and recent buyers must now compete with developers who are offering like units at lower prices. The only options are to hold properties and hope for higher prices or sell at a loss.
The new theory of investment has been to get in and get out quickly. Since values always rise under the new thinking, pricing doesn’t matter as long as monthly payments are as low as possible. However, if values stagnate or actually decline, then properties must be occupied, rented or sold.
Across the country we now see a general softening of prices. NAR reported that in January the median price for an existing home was $211,000, up 11.6 percent from a year earlier. In February that same home sold for $209,000, up 10.6 percent from 2005. In other words, prices fell from January to February.
Some will say that month-to-month price changes are irrelevant, but that’s not how the game of expectations is played. Can you picture a buyer broker telling a client, “well, you know now is the time to buy, before the price of the home drops any further.”
The public during the past few years has come to expect rising home prices; any change from the accepted script is troubling. However, lurking below the surface are those monthly payments.
The issue is not that ARMs or interest-only loans are new, it’s that they’re available to a larger percentage of borrowers than in the past.
Monthly payments are not an immediate financial issue for 40% of U.S. homeowners, those who hold property free and clear.
Nor are changing payments a concern for those with fixed-rate financing. According to the Mortgage Bankers Association, half the loans originated in the first six months of 2005 were fixed-rate products.
And the other half?
Adjustable-rate loans — excluding interest-only products — represented 34 percent of all mortgages originations for the period, says MBA.
MBA divided interest-only loans into two categories, fixed and adjustable. Fixed-rate interest-only loans represented 2 percent of all originations in the study while adjustable interest-only loans amounted to 14 percent.
When you look at the dollar amounts, however, the study shows something different. Fixed rate loans are 40 percent of all originations, ARMs are 36 percent and interest-only products are 23 percent. The dollar value of adjustable interest-only loans is more than 10 times greater than fixed-rate interest-only products.
In other words, riskier ARMs loans are disproportionately larger than typical fixed-rate mortgages. Equally important, fixed-rate loans are disappearing.
According to a recent Federal Reserve study the use of fixed-rate financing is declining at a rapid rate. As the Fed explains, “roughly 85 percent of first mortgages were fixed-rate in 2001, slightly more than 10 percent were adjustable-rate, and the rest were balloon.” Now, of course, fixed-rate loans by dollar value are just 40 percent of all originations.
You can also see more risk in the marketplace in terms of qualification standards. As an example, consider FHA financing. Qualifying ratios last April went from 29/41 to 31/43. You have to wonder why this happened: Do you think borrowers now represent less risk? Or, could it have anything to do with the decline in FHA originations, from 1.53 million in 2003 to 556,000 in 2005?
Perhaps the FHA revised its standards because incomes are up. Whoops, that can’t be right. According to the Census Bureau, real household income — money expressed in terms of buying power — actually has declined since 1999.
But FHA mortgages are not a core concern. Instead, we need to look at stated-income loans, option or hybrid ARMs, interest-only mortgages, and excess equity financing. These are the financing options of choice for today’s real estate gamblers — those who buy property on the basis of monthly costs.
Between 1990 and 2003 interest rates fell overall. ARMs were generally safe because principal was being reduced and interest levels, by and large, were falling. Figures from the Federal Housing Finance Board show that the national average contract mortgage rate stood at 13.74 percent in May of 1980 and reached 5.34 percent in July 2003.
But rates have been rising from the lows seen in 2003 and we will soon see if the presumptions which powered risky mortgages are correct. Let’s look at the four types of loans most likely to fail.
1. Stated Income Financing
Historically lenders have been extremely concerned with loan application data. For many borrowers, it seemed that getting a national security clearance required fewer verifications and less paperwork than a new mortgage. But with “stated income” loans we have a new theory: We check credit scores and tell borrowers that whatever income they claim will not be verified.
The result is that with stated income financing a loan officer might say: “Mrs. Johnson, you have certainly found the home of your dreams. I can easily see how you and your family will really enjoy this house. We can finance your lovely home with a stated-income loan. With this type of financing you tell us how much you earn and we will not check. To buy this wonderful property you need a household income of $90,000 a year to qualify. So tell me Mrs. Johnson, how much is it that you earn each year?”
What do you think Mrs. Johnson will say?
Unfortunately, the loan officer did not tell the whole story. Stated income loans are sometimes examined when loans are packaged, sold and audited. And if a home is foreclosed, do you think a lender will not review the application?
2. Option ARMs
Option loans are ARM products where during the first three, five or ten years borrowers can pay on the basis of four choices: A fully amortizing payment that will retire the loan in 30 years, a higher payment that will amortize the loan in 15 years, an interest-only payment, or a low, low payment that creates negative amortization and adds to the loan amount. After the initial phase, the mortgage typically becomes a one-year ARM for the rest of the loan term.
Imagine that you have a $300,000 option loan. The margin is 2.75 percent and the 11th District COFI index is 3.347. We’ll say the initial rate is 1.25 percent and the annual rate cap is 7.5 percent.
Here’s what happens with a $300,000 option loan: The minimum payment is $997.78. The interest-only payment is $1,524.25. The 30-year amortizing payment is $1,817.40. The 15-year amortizing payment is $2,547.32.
If our borrower makes minimum payments then in month #60 the loan balance will be $328,812 and the monthly payment will be $2,284. These numbers assume that the interest rates have not soared. But what if the rate goes to 7 percent or 7.5 percent or 8 percent? By historic standards, these are not high interest levels.
Of course, the owner can sell. But after five years the loan balance has increased. Hopefully the value of the home has also gone up and is greater than the remaining mortgage debt. But as I tell folks, there are no stone tablets which say the value of real estate must rise.
3. Interest-Only Loans
Interest-only loans can be fixed-rate or adjustable mortgage products where the borrower’s debt never increases. However, during the interest-only payment period, typically the first five years of the loan term, the debt never falls.
The risk here for lender and borrower is two-fold: First, monthly payments can rise for those with adjustable rates. Second, once the loan begins to amortize the payment can rise significantly.
Consider a $500,000 interest-only with a 6.5 percent fixed rate. In the first five years the monthly payment for principal and interest is $2,708. For the next 25 years the payment is $3,376.04, a higher payment created by the fact that the remaining loan term has been reduced to 25 years.
4. Excess Equity Loans
Excess equity loans allow borrowers to obtain financing equal to more than the appraised value of a property — 104 percent, 107 percent, 110 percent, 125 percent and even 145 percent. Plainly the interest rates for such financing soar as the loan becomes increasingly unsecured, but this has not deterred borrowers.
If you look at the four loan options discussed here you notice they all have a common root: Borrowers have good credit and qualify on the basis of short-term calculations.
But the loan which is affordable at $998 a month may not be affordable at $2,300 a month. No less important, mortgage payments do not exist in isolation. Borrowers may also face ballooning utility bills as well as rising property taxes.
The Coming Storm
We now have a situation where stated income loans, interest-only financing, option ARMs and excess equity loans have begun to season. That means we will soon begin to see more and more of these mortgages convert to phase two, a time when monthly payments must be substantially higher to amortize the loan.
The result is that 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.
How substantial is this problem? USA Today has reported that an estimated 7.7 million adjustables have been issued in the past two years — and that up to 1 million may wind up in foreclosure during the next five years as a result of rising monthly costs. (See: “Some homeowners struggle to keep up with adjustable rates”, April 3, 2006)
According to the Mortgage Bankers Association the percentage of homes being processed for foreclosures at this time is about 1 percent of all loans. If the projection reported by USA Today is correct, then we’re looking at a foreclosure rate for recent ARMs — the loan category which includes most toxic mortgage products — that’s 13 times higher than normal.
John C. Dugan, the Comptroller of the Currency, framed the issue this way last December:
“Too many consumers have been attracted to products by the seductive prospect of low minimum payments that delay the day of reckoning, but often make ultimate repayment of growing principal far more difficult.”
“At the same time, too many lenders have been attracted to the product by the prospect of booking immediate revenue without receiving cash in hand, a process that often masks underlying credit problems that could ultimately produce substantial losses.”
“Is this an appropriate product,” Dugan also asked, “to mass market to customers who may be looking at the less than fully amortizing minimum payment as the only way to afford a larger mortgage — at least for the five years before the onset of payment shock? And are lenders really prepared to deal with the consequences — including litigation risk — of providing such products in markets where real estate prices soften or decline, or where interest rates substantially increase?”
The problem with regulatory concerns at this point is that huge numbers of non-traditional loans have already been issued. Surely this matter would have been better addressed several years ago, when toxic financing was relatively rare and the stakes far smaller.
But we must deal with what is rather than what might have been.
High-risk loans have allowed many individuals to buy property who might otherwise not have the chance, thus increasing demand and pushing prices higher. And in many cases high-risk loans have enabled borrowers to make substantial profits.
But at no time has the marketplace been without risk. Today, more than in the past few years, we see a market in transition. For those who assist buyers and borrowers the question regarding toxic loans is this: Are individuals really being helped with financing which allows them to buy property today — but may lead to financial distress tomorrow?
Over the years one of the most helpful trends in real estate has been the expanded use of disclosures and waivers. They protect consumers — and they also protect brokers and lenders.
And so I would make a modest suggestion: A few minutes of consumer education should be the responsibility of every broker and every lender. In other words: disclosure and waiver. All it takes is some discussion and a few print-outs which show projected monthly payments for several baseline mortgages: Say a 30-year fixed, 3/1 ARM, 5-year interest-only loan and option ARM financing. The material should at least cover the start-rate periods plus the next two years. The best case and the worst case scenarios should be shown.
In addition, consumers should be plainly told that interest rates can rise, that increases in home values cannot be guaranteed, that past performance does not assure future results and that information provided for stated income loans must be verifiable — just in case the loan file is ever audited.
And for the protection of brokers and lenders it would be a good idea to get a signed and dated receipt showing that the information was provided.
Does anyone doubt that consumers need such information? A study released in March by the Federal Reserve explains that “in 2005 the payments on many ARMs were governed by ‘option’ or ‘hybrid’ features that were largely unknown in 2001.”
The Fed report also shows that 35 percent of all ARM borrowers do not know how much payments can rise month to month and 41 percent don’t know the maximum interest level for their loan. For that matter, 20 percent didn’t know the original rate for their ARM.
The idea of better explaining newly-emerging loan concepts is not to drive away buyers and borrowers, rather it’s to assure that consumers have a strong stake in the homeownership process. While toxic loans may produce sales in the short term, they may also demolish long-term notions of value and benefit that are essential to real estate.
In the same way that mandatory disclosures regarding agency and condition were first opposed, I expect that the notion of toxic loan disclosures and waivers will also generate little support.
The alternative is that one day foreclosed homeowners will turn around and take brokers and lenders to court claiming they knew full well that borrowers could not afford inevitably higher payments and that, essentially, they engaged in the encouragement of default. The motive: Quick commissions and fees.
Think it can’t happen. Think jurors won’t buy it? Are you willing to bet your company and your career on the answer? Somehow disclosure seems a lot more attractive.