Tuesday, November 11, 2008

Foreclosures Unaffordable Mortgages and Home Prices

In areas of the country where house prices moved in parabolic fashion, extending light years beyond affordability and the rise in income levels, Wall Street and the mortgage industry came up with ways to move the product by creating exotic mortgages.   The goal was volume and price, since the mortgage brokers  and companies would receive income just for originating the loans and for servicing them, with the loans packaged for resale to investors and the risk of repayment thereby transferred to other parties.   Many of these mortgages could not have conceivably been paid by the homeowners.  There is a story in today's NYT about a city in California where 90% of the homeowners owe more on their mortgage than the house is worth.NYTimes.com  The average homeowner is $120,000 under water.  How does this happen?  I think that you need two events occurring simultaneously, a parabolic rise in home prices that make homes unaffordable and lenders willing to extend credit irrespective of the borrowers' ability to pay the loan, with the latter being the pre-condition to the parabolic rise in home prices.  An example is given in NYT article.  The Martinez family bought a house selling for $630,000 in early 2005, the very height of the real estate bubble in states like California, Florida and Nevada.  The house is now worth $420,000.  Although I am not familiar with this town, I suspect that the original price tag was the result of a bubble lasting many years where prices were escalating 20% annually when real incomes of potential buyers were barely rising at all.  In other words, $630,000 was just an inflated price and the market is now adjusting to the real price.  But the Martinez family is stuck with the mortgage on the $630,000 home.  How was the loan structured?  It was an interest only loan, with payments apparently rising yearly until they reach $12,000 a month in 2015.  One way to avoid this kind of nightmare is for the homeowner to just say no.  I can not afford this house and just walk away.  This would have solved the problem and housing prices would have had to adjust to falling demand. In that event,  homebuilders would have been hurt as well as the companies supplying products and labor for the construction of new homes.  The problem would be containable and would not be causing such dire repercussions throughout the world.  The other way would have been for lenders to refuse to extend credit to those who could not afford to pay it.  This would mean that the borrower would have to come up with at least a 5% down payment and no exotic mortgages like interest only and Option ARMS.  If the buyer could not afford a normal mortgage, meaning payments that reduce principal each month thereby increasing equity, then the loan would not be made.  None of this was in fact done.  The homeowners wanted to move into the house and the mortgage lenders wanted the fees and commissions that would be paid only if the potential homeowners got what they wanted, a new house.  

For people my age, it would have been impossible to buy a house this way when I was a young man.  The community bank, which lent the money and had to keep the loan on its books, or sale it as a conforming loan to Fannie, would have looked at me as some kind of deranged fool if I had said that I wanted a house with no money down, an interest only loan, with low payments in the early years so I could afford to pay it-and then, when the payments rose in year five or so we would all pray that my income had risen way way way above what I am earning now so that I could qualify for a better mortgage,  or if not, then I would  just sell the house in a market rising at a twenty per cent compounded annualized rate and make a lot of money.  That sounds crazy but four year ago the lender would just say sign at the dotted line-everyone will make money and some unknown sucker would buy this loan packaged with thousands of others in a CDO and that entity will assume the risk of non-payment.  

The current estimate is that 7.6 million properties are under water in the U.S. with another 2.1 million or so teetering at the edge.  NYTimes.com  Four million homeowners are at least 1 month late in their mortgage payments and 500,000 are already in the foreclosure process. Yahoo! Finance  Then there are the millions who are currently meeting the payments, just barely, in situations where it is starting to make sense to them to just walk away from it.  These problems will fester and take another year or more to resolve, I suspect.

I would also suggest that the rise in GDP during the first three years of W's second term was not due to his tax cuts so much but by the easy credit prevalent during those years.  Easy credit created an artificial demand for housing and products and that increased GDP.  Large tax cuts for the wealthy, with a few peanuts thrown to the middle class, primarily increased the gap between the very rich and everyone else. CBS News Between 2002 and 2006, the top 1% saw their real incomes grow at 11% whereas the remainder of the country grew less than 1%. - Yahoo! News Income gap between rich and poor is huge and growing, warns UN reportNation & World | U.S. gap between rich, poor widening | Seattle Times Newspaper

It was easy credit that just created a false sense of prosperity.

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