2007/03/23

Subprime = Suboptimal

The crisis in the so-called "subprime" lending market is reaching the boiling point. Now our presidential candidates are calling for summits and task-forces to attempt to deal with an anticipated wave of foreclosures. Members of Congress are asking why the Federal Reserve didn't exercise oversight while banks and mortgage lenders loosened credit to sub-prime borrowers. And finally, 20 of those lenders have gone under as their business model--financing sub-prime mortgages, selling those mortgages that in turn finances more loans--collapses. But the one thing that nobody's talking about is that correction in the real-estate sector may be a good thing.

First, the fact that numerous sub-prime lenders are going under removes (or at least whittles down), one source of predatory lending. Second, home ownership in America per capita is higher now than at any time in our history, but is that good for the economy? Sure it's great to be a homeowner but not when one risks financial ruin to achieve that goal. Remember that taking out...say...an interest only loan to finance more house than you really need, is merely another name for rent with property taxes. It's nothing more than wealth transfer to your mortgage company. Third, if there is any sector of the economy in need of some correction, it's the real-estate market, and I say this as a homeowner. People who go into home ownership believing that the purpose is to turn a quick profit don't have their priorities straight. And it's this attitude that has driven prices into the stratosphere. Correction is needed, if for no other reason than to drive the quick-buck artists from the market.

Now I don't want to sound needlessly cruel, but when it comes to buying a home--probably the most complex financial transaction you'll ever undertake--your best defense against financial ruin is yourself. Concerned about predatory lenders? Then hire a real-estate attorney or broker to act on your behalf, to scrutinize everything. I did, and I have very good credit. Worried about payments? Stay within your budgetary limits and take a long view. Get a financial planner to give you an accurate assessment of what you can afford.

To the extent that we have a crisis in real-estate, it's a crisis of our own making--greed on the part of lenders combined with greed on the part of borrowers. Correction may be painful, but in the end the industry and market will probably be stronger for it.

31 Comments:

I worked at a mortgage company during the beginning of the boom around 2002/2003. I saw interest-only and reverse mortgages being given to people who had no way of paying a fully indexed rate. But mortgage brokers are very shady. They frequently used "stated income" loan programs that don't require any income variation. So they could tell the bank you make $6K per month when you actually make $2K. I always knew this would happen...
Hey! I'm online, but not enough to know what the hell is happening. Give me a week to catch up.
Don't mean to get all serious, but you've hit my sore spot. WHY ARE OUR HOMES TAXED? They don't generate income. It's some kind of throwback to agrarian days when your land/home was an indicator of your income. Which it still is, but in some places (like Seattle, like the Bay Area) home prices are totally out of hand, and people with modest incomes now have huge property tax bills (c'est moi). Seniors complain about being on a fixed income--well isn't everybody who isn't in the richest 1%?

Property taxes on one's primary residence (the more expensive one, if you have more than one) should be abolished, and replaced by an income tax if the state doesn't already have one.

There. Now back to the Funny.

And Bush will propose single payer health insurance, and Cheney will give all his money to charity, and monkeys will fly out my butt.
I would also add, don't listen to the Realtor when they tell you how much you can afford. Set up a budget that includes a decent life and figure how much you can pay to buy and keep a home. If you don't know how to do this (I sure didn't) find a professional financial counselor who does. You'll be happy you did.
Comandante... My broker actually was the savior of the deal at the end when the real estate agent thought that they were basically done. It was the broker's patient explanations of everything that allowed me to understand, and feel comfortable with the deal. Of course, we weren't at risk for a predatory lender.

Cartledge... No sympathy man. Git yer head back in the game! ;-) (Just kidding...glad to see you're back.)
Mr_Blog, I'm sympathetic, but considering the mortgage interest deduction, I'm not willing to take any position that would rock the boat.

As a percentage, property taxes in the Bay Area are quite modest thanks to 25 years of Prop 13, but as an absolute number? Horrific.

Peacechick... No truer words. Figuring out what you can afford and then sticking to it rigidly is perhaps the most important calculation you'll make with respect to home buying.
Good advice.I only wish I had it before I took a dive.
I'm waiting till later this year to buy, hopefully hit the market at the bottom of the trough. Glad I didn't get a house last year when my wife was pushing me.
Ron... Sorry to hear that.

I have to admit that I was tempted by larger properties and loans with shorter terms. In the end, I got lucky and fell out of contract on a more expensive property, only to find a better (if somewhat smaller) property.

Loan-wise, my opinion is that our parents never saw rates as low as we have now and have had over the last 5 years. So you can't sweat a half-a-percent when it's the difference between a 3 year ARM and a 7 or 10 year ARM.

Fred, I think you're wise to hold on just a little bit longer. Rates will go down I think to stimulate the market, and you should be in a good position to buy.
kvatch, you wrote:

"But the one thing that nobody's talking about is that correction in the real-estate sector may be a good thing."

What do you mean? The fact that it took about two minutes for the subprime lenders to sell their mortgages or their entire operations confirms the opposite of your statement. There are plenty of buyers out there who smell opportunity in the troubles of these lenders.

You said:

"First, the fact that numerous sub-prime lenders are going under removes (or at least whittles down), one source of predatory lending."

Predatory lending? Really? A borrower with lousy credit does not get a mortgage from a bank like World Bank (a San-Fran-based bank you might know). With lousy credit you go to Country Wide Credit or any of the others beating the bushes for people looking for mortgages.

Should people with crappy credit pay the same low rates offered to people with good credit? No.

Conservative financial managers would say that lenders simply should not lend to people with questionable credit. Guess who those people with questionable credit would be? Mortgage lending is already portrayed as a racist plot to keep home ownership out of reach of black and hispanic borrowers.

You wrote:

"Second, home ownership in America per capita is higher now than at any time in our history, but is that good for the economy?"

Yes. Unconditionally, yes.

You wrote:

"Sure it's great to be a homeowner but not when one risks financial ruin to achieve that goal."

Says you. Are you suggesting you can decide for others whether their home purchases are possibly ruinous? Because that suggests you would block loans to all the people who would then sue for discriminatory lending.

You wrote:

"Remember that taking out...say...an interest only loan to finance more house than you really need, is merely another name for rent with property taxes."

Baloney. The owner still builds equity if the real estate market rises. But whether or not it rises immediately after the purchase is not terribly relevant. Property values in all decent regions of the country rise OVER TIME. That means borrowers can almost always refinance in a beneficial way eventually.

Meanwhile, I disagree with your characterization of an interest-only mortgage as "rent with property taxes." First, any money paid for shelter funds property tax payments.

Second, an interest-only mortgage is more accurately characterized as an option on rising real estate prices. You make money if home prices rise, or you lose money if they fall -- but in both cases you must SELL the property before the gain or loss is realized. Moreover, during the first five years of any treaditional mortgage, principal reduction is hardly noticeable.

Furthermore, you didn't mention the downpayment. If the downpayment is small and prices decline, the owner might find himself in the hole. But that doesn't matter unless a property is sold.

You claimed:

"It's nothing more than wealth transfer to your mortgage company."

Nonsense. If that were true, none of the mortgage companies you referenced would have suffered as they have. You've got it backwards. The mortgage companies prosper if the borrower makes his payments. They founder if the borrower defaults. Mortgage companies do not want your house.

You wrote:

"Third, if there is any sector of the economy in need of some correction, it's the real-estate market, and I say this as a homeowner."

How can you tell? Is there a "correct" price for a house? How do you determine the market price of a house? Valuing commercial properties is easy. Cash-flow analysis. Residential homes are trickier. Many more intangibles.

Real estate prices in NY City are astronomical, yet people keep buying. The buying goes on in areas that were once less desireable. But today they're hot because they have something buyers want. Maybe the hook is good subway service to Manhattan. Access to the good roads. Maybe the neighborhood itself is suddeenly hot because the housing stock is good but needs a lot of work. Doesn't matter.

You wrote:

"People who go into home ownership believing that the purpose is to turn a quick profit don't have their priorities straight."

Why is that your concern? There are fools everywhere. What of it? Anyway, first-time buyers have to jump in somewhere, sometime. It's always a plunge into the deep end of the pool.

Behind it all, you seem to imply that buyers should have a license to purchase real estate, or pass a course in the subject. Whatever, most parents tell their kids to buy a little place somewhere and hang on. It's a good strategy.

You wrote:

"And it's this attitude that has driven prices into the stratosphere."

More nonsense. There's no single motive for buying real estate. I've owned a couple of places. Life-style and sensible financial thinking was behind my purchases. That's what drives the vast majority of real estate sales.

You concluded:

"Correction is needed, if for no other reason than to drive the quick-buck artists from the market."

Utter nonsense. Every market has its speculators. That's forever. Meanwhile, are you sure you know when the bottom will arrive?

Try out the flip side. Like advising your dopey pal Fred to wait longer for prices to bottom. Suppose he does, but after he buys, prices continue to fall. First, is he greedy for waiting for a lower price so he can profit more in the future when prices rise again?

Is the guy who waits longer even greedier than Fred for thinking he'll do better by buying lower?

Of course, they are both exercising their greed.

In the investment world there are bottom-feeding vultures who aim to buy assets at rock-bottom prices to capture gains during a short-term rebounds. There are also speculators who buy when prices are relatively high to capture the last surge before a retreat. What of it?

You apologized:

"Now I don't want to sound needlessly cruel, but when it comes to buying a home--probably the most complex financial transaction you'll ever undertake--your best defense against financial ruin is yourself."

First, buying a house is not complex. There may be paperwork, but all the verbiage boils down to your obligations and responsibilities, and your rights. However, anyone buying a house for the first time needs advice.

You wrote:

"To the extent that we have a crisis in real-estate, it's a crisis of our own making--greed on the part of lenders combined with greed on the part of borrowers."

YOu have described a "market". It was never any different, nor will it be.

You ended:

"Correction may be painful, but in the end the industry and market will probably be stronger for it."

More nonsense. You continue to assert that some prices are "incorrect" but market forces will "correct" them. Your theory attempts to explain the motives of every buyer, even those who bid over the asking price and pay cash for their properties.

Real estate prices, more than anything, reflect interest rates. Since WWII, they've been all over the map. In recent years, we've seen the lowest rates since the 1960s. And we set the record for the highest rates in the 1980s.

Rates drive prices in every market. But location drives prices within regions. Of course locations can improve when new highways are built. Or locations can be exploited when new housing is built near subway stops, as is now occurring all over New York City.

Of course, we could kill it all if we choke oil out of our system. That would cause more than a "correction." That would cause a worldwide "depression."
It's nothing more than wealth transfer to your mortgage company.

Period.

Good to see someone saying so, Kvatch.
michaelbains, you wrote:

"It's nothing more than wealth transfer to your mortgage company."


Really? How? If wealth were transferred to the mortgage company, mortgage companies would not collapse as they are these days.

To claim mortgage companies benefit in times like these demonstrates an absence of financial and accounting knowledge.

Defaults are murder on mortgage companies. They don't book any profits as a result even if the property is sold for more than the amount owed.

Period.
If wealth were transferred to the mortgage company, mortgage companies would not collapse as they are these days.

And those same companies will be screaming for a bailout. And they will get it. Socialism is okay if it for cooperations.
station agent, you wrote:

"And those same companies will be screaming for a bailout."

Your claim is utterly baseless. Once again, if it were true, the plea would have already been made. Rarely does the government bail out a handful of companies when the market does a far better job of cleaning up the situation.

Can you name a circumstance in which the government bailed out a company or an industry?

You claimed:

"And they will get it."

Really? When? Some of the first mortgage companies to falter have already made deals to sell their mortgage portfolios. Your first problem is knowing nothing about finance or accounting.

You claimed:

"Socialism is okay if it for cooperations."

There is no doubt big businesses love big government. The concept is known as "rent-seeking."

But you will have little luck finding examples of companies that have been "bailed out" by the government.

However, if one of your examples is the Savings & Loan Industry, you will have to accept the reality that the chief reason the S&L industry suffered was due to a foolish change in government regulation of the industry.

To make a long story short, the government eliminated "Regulation Q". Regulation Q set some controls on interest rates at Savings & Loans. When the regulation was ended, S&L managements got themselves into a bind that proved to be a death spiral.

The S&Ls and the country had to rely on Banks -- which are somewhat different from S&Ls -- and Bank Managements to save the day. The bankers knew how to navigate without Reg Q. With the aid of the government, the bankers fixed the problems.
Gee No_slappz, I'd really like to spend the next three hours composing responses to the books you've written here, but frankly I've got better things to do.

Suffice to say, that someone who has many valid points to make--I particularly like your comparison of sub-prime borrowing to options trading--but who can't resist relentlessly insulting the people he argues with, isn't encouraging anyone to bother responding.

Have fun clogging up my comment section. I suspect you'll be shouting at the bleachers for quite some time. The floor is now yours to tell me what an idiot I am. ;-)
Michael...thanks. The interest-only loan is a pernicious little trap. I've watched real estate agents here in Sodom by the Sea, push them as the key to home ownership. Especially suseptable are people with variable incomes--people whose income is derived from commissions, small business owners, the like.

Station Agent... I believe that they already are screaming for a bailout.
I'm in Cali right now, and seeing it all first hand is giving me quite an education.

N_S,

Yeah, what he said. But seriously, correction doesn't mean that it finds the "correct" price, but you know that. Why play dumb?

Secondly, ever heard of Chrysler?

Are you playing dumb, or is there another explanation?
Praguetwin... You're here? In the Bay Area by any chance? If not, will you be travelling up this way?

If you'd be interested in meeting some fellow bloggers, I'm sure that we could convene the BARBARians (Bay ARea Bloggers And Readers) and arrange to left a few in honor of your trip to the Left Coast.
Good post. A couple of points about your points.

My first real estate purchase was in the late seventies and the loan was 11%. Current rates even though they are going up, seem a bargain.

Interest only loans only make sense if you are speculating in a boom market. When they spread to the average home buyer, to "pay" for more house than he/she could really afford, the crisis got closer.
Great advice kvatch. We were pre-approved for twice what we could afford. We bought a house we could afford and put 20% down. It ain't a McMansion, but it's a nice home with a big yard for the kids in a safe neighborhood. Can't ask for more than that.
Dave, I agree. I remember my parent's loans and the rates were at levels I can't imagine borrowing at. As for "interest-only" loans, they're pushed here on people with variable incomes: "Pay down your principal when you can". Craziness.

Pam... Thanks. The Frogette and I approached things much like you and your spouse. We put in a large chunk on our downpayment and kept ourselves below the maximum we could afford. Gives us a good sense of security, but it also reinforces how precarious it is for many homeowners in the Bay Area.
praguetwin, you wrote:

"Secondly, ever heard of Chrysler?"

You had to go back 27 years to find an example of a government "bailout" of a company that many government leaders -- including Wyoming representative Dick Cheney -- were willing to send into bankruptcy.

You might also have mentioned the bailout of the Penn Central Railroad.

In other words, you made my point. The government does not often bail out failing companies or industries.

Chrysler received loan guarantees in 1980. Interest rates were soaring. The economy had been in horrible shape for several years and Chrysler was about to declare bankruptcy.

A Chrysler bankruptcy threatened to put over 100,000 autoworkers -- blue-collar and white-collar -- out of work.

Factories would have been shut and entire towns in Michigan would have collapsed financially as a result of Chrysler's failure.

Given the inescapable pain to Michigan and the ocuntry, the federal government gave LOANS to
Chrysler to enable it to re-engineer itself and return to financial health. The plan worked, though it was far from flawless.

Today, Chrysler is once again in trouble. Interestingly, Magna International, a Canadian auto-parts company is considering the purchase of Chrysler. Good luck to Magna.

Meanwhile, the mortgage industry is nothing compared with a major industrial operation.

The mortgage business is intangible. No factories, no hard assets. Just office space, phones, relationships with banks and a workforce of people working mainly on commission. When business booms, lots of people beat the phones and earn commissions. When business slows, they quit.

In dire periods, they're fired as mortgage companies shut down. There are no union contracts binding the parent company to pay employees who aren't producing revenue. No factories to shut. No towns dependent on a single company or single industry to sustain the citizens.

There will be no bailout of mortgage companies. In fact, the concept is meaningless in this industry. However, things may work out better than expected for those who default. It's in the interest of the mortgage companies to keep people in their homes until they are sold even if they don't pay a dime.

Vacant homes invite vandalism. Maintenance is left undone, which often leads to the start of delapidation. Eviction often brings out the worst in those evicted. Sometimes they damage their former property before departing.

This time, lenders seem willing to let them stay in their homes. Maybe the occupants will get back on their feet and find a way to resume payments or find new and affordable financing.

No government bailout, however. Not happening.
When I bought, I had a 3-yr adjustable, 27 yr fixed mortgage. The first 3 years figured that I would get raises, I did, and now the payment is comfortable. In 15 years the condo will be mine.

Anyone who chooses an "Interest Only" loan is a fool, IMNSHO.

A few years ago when they stopped building small 2 & 3 bedroom homes and started building the "McMansions" here, many of us wondered "who is buying these things??? How can they afford them?"

Turns out the "who" is greedy fools and the "how" is - they can't. I really won't be even the slightest bit sorry to see these pompous, self-aggrandizing fools being tossed out of their braggart homes. All those stay-at-home-mommy leeches who acted so "better than thou" at grade-school functions will have to get jobs...

*snicker*
sewmouse,

Based on your preceding comment, you are the queen of envy and schadenfreude.

Not a word of what you wrote has any link to the mortgage market or housing. But your seething envy and vicious delight at the misfortune of others screams out.

By the way, did the buyers and sellers of the "McMansions" consult with you about their financing strategies?
I absolutely agree that this is a good thing. I know several people who flipped houses and intentionally took out interest only loans, etc., in order to buy high and sell even higher. It was a business transaction pure and simple.
Kathy... Agree that correction in the industry is a good thing? I'm a little confused then by your next statement which seems to condone--or at least be neutral--about real estate speculation.

I think that if we're all willing to concede that speculation is just business as usual--that real estate is just another commodity--then the next logical step is to do away with the government (and popular) fiction that promoting home ownership is somehow "good for the nation" or that it promotes family and middle-class stability. Using that argument we could easily choose to get rid of the mortgage interest deduction.

Sewmouse, sorry No_slappz seems to be gunning for you. But from the mouth of the man (woman?) who has written books of off topic commentary, this:

Not a word of what you wrote has any link to the mortgage market or housing.

...is really quite amusing.
No worries, Froggie.
I consider the source. Then I laugh AT him.

*smiles sweetly*
Silverado scandal. Gov bailed out the S&Ls. Was it United or some other airline or who that got their pension plan taken over by the government recently? That was in the past couple of years, but I can't recall the details. I think the law that allows the bailout on pensions was created in response to the RCA pension scandal.
Mr_Blog, I'm sympathetic, but considering the mortgage interest deduction, I'm not willing to take any position that would rock the boat.

Ah yes. The mortgage interest deduction. Because of that I can afford to pay some of my property taxes. I take the refund from the IRS, and turn it over to the county.
dbk, you wrote:

"Silverado scandal. Gov bailed out the S&Ls."

Once again, you hang your hat on a term -- bailout -- without any knowledge of the actual events. The Silverado S&L went down in flames, and it took a brother of the president along for the descent. He wasn't the cause. He was hired on for his name.

Meanwhile, the S&L Crisis was precipitated by the repeal of Regulation Q. Reg Q was a regulation that set certain limits on interest rates S&Ls could offer depositors. You can thank Jimmy Carter for his part in bringing on the S&L debacle, though the industry fell further while Reagan was in office.

Nevertheless, the end of the S&L Crisis marked the start of the housing boom that rolled on from 1992 until recently.

At the heart of the S&L Crisis was the deposit insurance backing accounts. The premiums were too low to cover the risk. The FSLIC was merged into the FDIC and premiums were raised to cover the losses.

Yes, the government stepped in. But you'd have to understand accounting for financial institutions to understand why it was a smart move. The government will not let backbone industries collapse. It's one thing when a single company fails. It's something else when the industry that provides a big slice of the country's mortgage loans starts to collapse. Moreover, the collapse was due to a loosening of government regulations.


You asked:

"Was it United or some other airline or who that got their pension plan taken over by the government recently? That was in the past couple of years, but I can't recall the details."

Every airline eventually faces bankruptcy. Most face it sooner, rather than later. It's a brutal business fraught with failure.

As for pensions, well, the government does not absorb the pensions of operating companies. If a company cannot cover its pension obligations, it is insolvent.

Anyway, pension laws are poorly designed. Pensions should involve cash payments into individual accounts, like 401-Ks. Instead, pensions are actually liabilities that companies may leave unfunded. They may even withdraw "excess" funds.

You wrote:

"I think the law that allows the bailout on pensions was created in response to the RCA pension scandal."

I don't recall which pension was first, but the government agency is the Pension Benefit Guaranty Corporation. Through it, taxpayers cover the pension obligations of insolvent companies. But the benefits from the PBGC are always less than the benefits previously collected from the operating company.
All those words, all that explanation, and you wind up pretty much saying I was right. Why don't you just say that to begin with instead of yammering on and on?

Oh, and how did it take a brother of the president along? GWB wasn't a president at the time. His FATHER was vice president at the time. Neil was never indicted and his entire damage was a $50,000 payment in a civil settlement. Where was he taken?

Add a comment

Links to this post:

Create a Link