A Simple Minded
of the Mortgage Meltdown
Jay B. Gaskill
Now…I’m just a ‘country lawyer’ as the saying goes, but I do understand fundamental economics and, as a split-time Californian, I understand how it is for ‘ordinary’ people to attempt to live in an ultra-high priced real estate market, and also how what a blessing is not to live in those overheated markets.
Here’s the deal. Rents are income sensitive, but – until the current meltdown – home real estate prices have been much less so. When rents and prices for the same commodity diverge too sharply, you are on notice that there is a “correction” ahead.
The movers and shakers among the elites tend to forget the basics, from time to time. For example: Ordinary folks can only use their real incomes – those after tax, after withholding dollars we actually get to spend – to buy or rent a place to live.
Therefore, whenever there is a huge disparity between rents and real estate prices in a given area, you can be reasonably sure that there a speculative bubble has been driving up home purchase prices.
This condition is easily detected. Assume a three bedroom home in your area can rent for, say, $2000 per month, but that same home, when sold last year required mortgage payments (assuming for the purposes of my example, a fully amortized, conventional 30 year mortgage) of $4,521 per month. The new owner could not possibly rent the house, in that market, for enough to cover the mortgage. That is the bright line clear signature of a price bubble, because at some point, incomes always fail to keep up.
Most buyers in these hot housing areas already knew that dirty little secret, but went ahead with the deal anyway. What was going on? The buyer really, really wanted to live in a nice neighborhood and willfully bought into the expectation that the sale value of the home would continue to inflate (presumably along with the buyer’s income) for the foreseeable future. To be fair, that gamble did not seem unreasonable as recently as the year 2000. In fact, it worked very well for thousands of home buyers throughout the 80’s and 90’s.
The housing speculative bubble is like all the price/value bubbles of the past, with one major exception. Most speculative bubbles, especially those in the stock market (think of the internet commerce bubble of 1998-2002), pop quickly and dramatically. But a housing bubble like the present one can fester for more than a decade and collapse more gradually.
This housing bubble was caused by the perfect storm of five converging forces:
(a) Brutal urban commutes for everyone who wanted a nice homes for the kids;
(b) a concentration of high paying jobs in urban areas – and in may instances employers whose recruitment incentives included ‘excessive’ compensation to lure good people into an overheating housing market;
(c) a subgroup of people who could almost, but not quite play the game in the traditional way;
(d) an institutional disconnect between lender accountability and loan failure; and
(e) novel financial instruments and devices that were designed to “help” subgroup (c) beat the game in the (ultimately vain) hope that future appreciation would bail them out when needed.
These were the ingredients of a pyramid game in which the collapse of the entire scheme was so deeply tied to the American financial system that the ripple effects could trigger a much worse calamity that a large number of loan defaults and evictions, as tragic as that scenario might seem to those whose lives have been disrupted.
Why this general financial vulnerability? Let’s examine (d), the “institutional disconnect”, more closely. In the old days, your original lender remained on the hook for the loan essentially forever. This meant that the loan was given real scrutiny by the bank or other lender who actually would be required to take the property back in the event the borrower defaulted. Accountability wonderfully concentrates one’s care and attention, especially when large sums of money are involved.
But the current practice is different. Real estate loans are made by broker/“lenders” who never plan to remain on the hook. These loans become assets to be acquired by the real lenders who buy the “paper” (consisting of the terms, the financial profile of the borrower and the appraisal of the home). And these paper assets are sold and resold, finding their way into the asset portfolios of your pension fund and your local bank.
The operating myth has been that home real estate loans are a secure asset, comparable, say, to gold bullion. So this “paper” (greatly exaggerated in value and security) not only found its way into the asset portfolios of banks, pension funds, it became a big part of the asset structure of the super lending institutions, “Fanny Mae” and “Freddy Mack”. These two semi-private super-lenders collectively own – and are on the hook for 5 trillion dollars worth of mortgages.
For a concise history of these behemoths, originally chartered in 1938 to help provide home loans when most private lenders were out money, go to – http://www.fanniemae.com/aboutfm/charter.jhtml .
Fanny and Freddy are deeply entangled with the federal government. Given the immense sums involved, the entire financial house of cards is placed at some risk, and – because of the federal entanglement with Fred and Fan – the taxpayers and the federal deficit are tied to this vessel should it ever sink.
This is a good time for concern but not panic.
Here are the three core principles to keep in mind: (1) Risk takers are necessary for the larger good; without them, things gradually stagnate and progress grinds to a halt (think of the former Soviet Union). (2) Risk should be contained to the risk takers; we shouldn’t tinker too much with their occasional rewards or mitigate their losses too much or we transfer their problems to the rest of us who are not as well equipped to handle the consequences.
Political leaders tend to ignore the third principle:
Like water seeking the lowest channel in any hydraulic system, greed seeks the most easily exploited transactions in any monetary system: Floating un-vetted loan papers as assets was an open invitation to greed-driven fraud and greed-enabled foolishness.
This raises the major public policy question of the day: Who, if anyone, should be protected against their own foolishness?
Many purchase money real estate mortgages that result in a default do not result in a loan deficiency debt collection from the evicted or defaulting home owner. The lender is simply stuck with the property and the borrower is free to walk away, leaving behind the asset, but without worry of being sued for any deficiency even when the asset is revealed to be worth less than the debt.
Ah, would that life were always that simple.
Deficient second and third mortgages and real estate secured lines of credit still must be paid back. Moreover, many of the “creative financing” vehicles designed to give the buyers temporary low payments expose these borrowers to ongoing liability, even after a foreclosure/repossession sale. And not all jurisdictions protect purchase money mortgage holders equally against a post-default deficiency.
Still, only a relatively small fraction of all mortgages are at risk. The rest of the homeowners had a large paper surplus asset and now have a much smaller one. They have a poorer resale value but the home market is now full of bargains for qualified buyers.
So what’s the big deal you ask? Here’s the analogy: You sell most of the grain for the town, and broker the rest. You suddenly discover that a small percentage of all your grain is bad. The entire town finds out. Rumors start. Pretty soon all the grain sellers you have dealt with freak out. The town freaks. You can see where this is going. No new grain. Not enough rice. Depression hysteria.
As a result of the mortgage crisis we will have to live through some uncertainty, alleviated in part by federal actions to shore up key lending institutions. The last major depression really took hold when the money supply dried up. That simply will not be allowed to take place. We did learn something from the last one.
But we should not lose sight of the larger picture. Prices are set by supply and demand and demand is limited by income.
I’m hearing hysterical voices urging us to “do something” to stem the “collapse in home prices”. One expert even proposed we try to entice foreign investors to acquire empty houses as second homes in order to keep the prices up! Am, I the only one who thinks this proposal sounds a bit perverse? We’re not facing a collapse in housing prices but a several year gradual correction. Where prices were reasonable (in relation to local incomes) in the first place, we’re seeing gradual appreciation.
Here are my main recommendations:
(1) Yes, by all means, we should take those actions minimally necessary to head off irrational panic.
(2) And we need to protect home purchasers from a deficiency judgment whenever the buyer didn’t commit fraud and the loans were used in the initial purchase of a primary residence.
(3) We should prosecute fraud whenever it is clear enough to make a winning case. [This is not a time for expensive show trials ending in minor convictions or acquittals.]
(4) We need to hold the risk takers accountable without any bailout except for the measures in (1) and (2) above.
Whatever else we do, we need to let the housing market correction proceed until prices self-stabilize.
We can – and should in my opinion – provide some help in the form of credit support and tax breaks for first time buyers (or post-eviction second time buyers) who want to take advantage (as the actual home occupants) of the new real estate bargains, provided that there is a sober, realistic appraisal of real income and home resale value. But we need to make certain that the original lenders cannot escape responsibility for making a bad loan.
Buyer Beware: This simple minded analysis was infected with common sense and old fashioned values. As I said earlier, ‘Accountability wonderfully concentrates one’s care and attention, especially when large sums of money are involved.’