Sunday, December 14, 2008

Mr Mortgage's Case For Mortgage Principal Reductions

From the Mortgage Lender Implode-O-Meter:

The reality is that at the time most troubled loans were made, the borrowers really could afford it because everyone made $150k per year for the purposes of buying a home.

This greater housing and mortgage crisis is not a result of millions of borrowers going wild, buying beyond their means blinded by greed or some massive consumer driven multi-year mortgage fraud era where everyone lied to buy a home. This crisis was caused by fraud alright - but not by the consumer.

The greatest real estate bubble of all time was only able to occur because of the bank’s constant re-engineering of loan programs focusing on low monthly payments and the virtual elimination of income and assets as a variable. This extraordinary leverage created through these exotic loan programs and easy credit never existed before and never will again. The problem going forward is that most don’t realize is that during the bubble years, everything was exotic - even 30-year fixed rates fully documented loans.


What’s worse is that over the past five years there was a fundamental shift of how people viewed their home - from ‘a place to live’ to their single ‘largest investment’. How could they not when all loan programs from Subprime to Prime allowed 50% of gross income (greater when considering limited income doc loans) to be used towards debt. In the good ‘ol days when housing was viewed as a place to live, financing was sound with down payments required and no more than 28% of gross income going towards housing debt. When homes prices fell it was alright because home owners could still save money and do the things they wanted to in life. 50% debt-to-income ratios changed the game.

Make no mistake about it - MOST BORROWERS ARE NOT WALKING BECAUSE THE CAN’T AFFORD THE PAYMENTS. They are walking because all of their after-tax income each month is going out in bills and the largest portion is going to a home worth half of what they owe. When they are spending such a large portion of their income on such a massively depreciating asset, it makes good financial sense to dump that asset. When you can’t sell, that means walk away.

That being said, there are many who can’t afford their payments because of an ARM adjustment. But at one time they were qualified by the bank and given the way the loan was structured they could in fact afford the home. Banks and real estate professionals in every city in the nation used high-leverage, exotic loans in order get people to qualify for ever increasing loan amounts. By 2005, interest-only was industry standard, so was stated income. You could not turn on the radio or television without being inundated with ads for $350k mortgage loans for 1% and $1000 monthly payments.

Lenders didn’t worry over what would happen to the loan after a few months because the loan was sold and they lose all liability after six months or so. The 2/28 Subprime ARM was a perfect example of a loan program not designed to hold over the initial teaser period and one that the lender didn’t care about because most were sold and securitized. Therefore, who cares about creating loans that will last - just make loans that will last at least six months.

Even the securities investors never planned on holding these long. Exotic loans with teasers were sold as a ‘way to get into the home more cheaply’ or a ‘way to improve your credit then refi into something better a couple of years from now’. The high churn rate out of these loans was what kept MBS money flowing into this sector. They were short-term, high yield investments. This philosophy was not isolated to Subprime 2/28’s either - Prime 5/1 interest only ARMs and Pay Option ARMs were also sold the same way. ARMs were the majority of mortgages in the bubble states through the bubble years.


Due to the way the loans were structured, from 2003 through 2007 everyone made $150k a year for the purposes of buying a home. Teaser rates, interest only, negative amortization, high allowable debt-to-income ratios, zero down, stated income etc made all homes affordable and borrowers rich. Home prices responded by surging higher to meet the new found nationally high affordability level. As home prices surged, new loan programs were rolled out what seemed like daily to keep affordability in check.

Everyone was suckered, as these loan programs became the norm. Folks who really earned $150k a year went out and bought over priced homes based upon flawed and temporary fundamentals not knowing they were being suckered. Now they too are upside down in their home by 50% and have seen their life savings go up in smoke. They overpaid because the hourly day-laborer was bidding against them using a stated income 100% interest only combo - hey, the loan officer at the bank and the Realtor told the janitor that ‘based upon his income and credit you qualify for this loan’. Why should he argue with his bank? They know best. They are the experts.


But now it is obvious that the past six years was an illusion and none of those easy credit, high-leverage programs exist any longer. Prices are coming down to the real affordability levels using 15 and 30-year fixed rate loans and a down payment, which has rendered the nations financial institutions and millions of home owners instantly insolvent. The same household that earns $85k per year that two years ago could buy a $650k home with no money down can now buy a $275k - $300k home with 10% down. It now takes at least $150k a year and a large down payment to buy a $650k home.

100% stated interest only and Pay option ARMs will not return. Nor will 100% HELOCs. They were doomed to fail from their creation. The banks had modeling systems that they never stress tested. You mean to tell me that it never occurred to the smartest guys in the room to plug into the model that home prices could actually fall? That was a fatal error that the world is paying for.

This is why this crisis was never and will never be ‘contained’ to Subprime. This is why those who put down 20% are walking away from their homes - it makes for a sound financial decision. Negative equity is now the leading cause of loan default among higher paper grades. As house prices fall further, more will walk.

Yes, there were people who took advantage of the system. But, that was a small percentage of everyone who bought a home on flawed and temporary market fundamentals induced by easy credit and exotic loan programs that never should have existed in the first place. This five year period of absolute recklessness and blind greed on the bank’s part was the real driver of home prices. Taking that away is ‘going straight’ is the leading driver for the destruction of the housing market and consumer. It’s simple - housing prices are just going to the levels determined by incomes, rents, interest rates and the macro-economy.


The solution is not about the regulators forcing interest rates down to artificially low levels for a brief period of time to sucker people into buying homes - that’s what got us here in the first place. That being said, sustainable low rates are good for the housing market.

But low rates mean very when millions will default and lose their homes over the next few years because all of that added supply can’t be absorbed by the available buyers. The fact is that there are much fewer buyers than ever before given home ownership was at 68% a couple of years back and now the largest sector of the purchase market, move-up buyers, are all but non-existent. Please see the stories below regarding this. It is my opinion that low mortgage rates do not mean what they used to.

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