Last week I wrote about How the new mortgage rules will impact the housing market. Since then, even more regulations were announced. After thinking about the ramifications of these new regulations over the last week, I am surprisingly relieved by what I see. I think these new regulations really will prevent future housing bubbles.
With any regulation, there is fear that it will either be changed or enforcement will be lax. While it’s still possible future generations may forget the folly of the last decade, it’s unlikely our generation will. These new regulations are here to stay. A far larger concern is the lack of enforcement and oversight. And if the issue were left up to the agencies or the federal reserve, that would still be a big concern, but that’s not where enforcement will come from. Civil lawsuits from future loanowners decrying their inability to repay the loans is what will keep lenders in line.
What would inflate another bubble?
Housing bubbles inflate for one of a few reasons:
- Unstable loan products with rising payments allow borrowers to increase their loan balances beyond what their incomes can support. This usually happens in response to rising prices when borrowers want to raise their bids to obtain a better property but they can’t qualify using an amortizing loan. Interest-only and Option ARMs are Ponzi loans doomed to fail at some point in the future.
- Debt-to-income ratios get out of line. During the 1970s, lenders allowed very high debt-to-income ratios because both they and their borrowers assumed the borrower would obtain 10% or better raises every year due to inflation. A 60% debt-to-income ratio becomes affordable after three or four years of 10% yearly raises. In the 1990s, lenders allowed borrowers to stretch again, and they underwrote many interest-only loans which took the debt-to-income ratio to unsustainable heights.
- Another way housing bubbles can get inflated is to abandon underwriting standards altogether. Obviously, in the Great Housing Bubble lenders did everything they did wrong from the first two bubbles and added negative amortization, teaser rates, and liar loans to boot.
It all comes down to borrower leverage. If borrowers are not allowed to take on debts they cannot successfully service and repay, housing bubbles won’t happen. Wall Street might believe residential mortgages are the best investment available again, but without interest-only mortgages, Option ARMs, seconds, and HELOCs to pump money into those mortgages in an unstable way, housing bubbles won’t inflate.
How do we prevent another housing bubble?
Let’s review my recommendations for preventing future housing bubbles from The Great Housing Bubble:
Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
- 1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
- 2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
- 3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
- 4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.
The new regulations specifically ban interest-only and negative amortization loans, so #1 happened.
The debt-to-income ratio limits are not as low as I proposed, all loans, including jumbos, now have a maximum allowable debt-to-income ratio. The standard today set by the GSEs is 31% of gross income, and since all attempts at higher limits failed, it’s unlikely this will go up. So provisions two and three happened.
The combined loan-to-value has not been regulated yet, but regulations concerning minimum down payments are expected soon. There is the risk that second mortgages and HELOCs may rise back to 100% of value or higher, but given the magnitude of the losses on these loans from the bubble, it will be a while before lenders start making those stupid loans again. Plus, with rising future interest rates, demand for HELOCs and seconds will not be what it was during the bubble when lower rates allowed borrowers to refinance larger sums with the same payments.
Any sums loaned in excess of these parameters do not need to be repaid by the borrower and no contractual provision is permitted that can be interpreted as limiting the borrower’s right to exercise this right, make the loan callable or otherwise abridge the mortgage agreement.
This last statement is the most critical. This is how the enforcement problem can be overcome. Regulators are pressured not to enforce laws when times are good, and decried for their lack of oversight when times are bad. If the oversight function becomes a potential civil matter policed by the borrowers themselves, the lenders know exactly what their risks and potential damages are. Any lender foolish enough to make a loan outside of the parameters would not need to fear the wrath of regulators, they would need to fear the civil lawsuits brought by borrowers eager to get out of their contractual obligations.
Given the legal environment favoring loanowners in response to the collapse of the bubble (loan modification entitlements, Loanoweners Bill of Rights, and so on), lenders will not be eager to stick their necks out and make loans outside the parameters of a qualified mortgage. Imagine what will happen if they do. Let’s say a lender makes a loan with a debt-to-income ratio that makes the loan unaffordable to the borrower. At the first sign of trouble, the borrower will petition for a loan modification. If they are denied, they will find an attorney to bring suit to force the lender to favorably modify the mortgage, and they will win because the loan is outside the “safe harbor” of a qualified mortgage. The threat of future lawsuits from borrowers — lawsuits the lenders know they will likely lose — will prevent them from loaning outside the parameters of a qualified mortgage. If lenders don’t loan outside those parameters, borrowers will be able to afford their mortgages, and a housing bubble and associated collapse will not occur.
Another million dollar bank loss
The losses the banks must endure on jumbo loans is truly staggering. Today’s featured property was likely a new build on a vacant lot. That’s why the initial purchase price is so low. On 10/7/2003 the owners borrowed $1,000,000 likely to cover the construction costs. On 11/16/2004 they refinanced with a $1,350,000 first mortgage and extracted $350,000 for furnishings (I don’t know, but what else did they spend it on?) On 8/16/2005 they got a $250,000 HELOC, and they followed that with another on on 3/10/2006. But in the final act of banker and borrower stupidity, they were given a $2,320,000 Option ARM on 9/28/2006. There’s no telling exactly how much these people borrowed and spent from this property, but it was likely well over a million dollars which is about what the bank will lose when this loan is closed out. In this instance, there is a clear winner and a clear loser.
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Proprietary OC Housing News home purchase analysis
$1,349,000 …….. Asking Price
$350,000 ………. Purchase Price
9/27/2001 ………. Purchase Date
$999,000 ………. Gross Gain (Loss)
($107,920) ………… Commissions and Costs at 8%
$891,080 ………. Net Gain (Loss)
285.4% ………. Gross Percent Change
254.6% ………. Net Percent Change
11.9% ………… Annual Appreciation
Cost of Home Ownership
$1,349,000 …….. Asking Price
$269,800 ………… 20% Down Conventional
3.97% …………. Mortgage Interest Rate
30 ……………… Number of Years
$1,079,200 …….. Mortgage
$257,032 ………. Income Requirement
$5,134 ………… Monthly Mortgage Payment
$1,169 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$337 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$6,640 ………. Monthly Cash Outlays
($1,254) ………. Tax Savings
($1,563) ………. Equity Hidden in Payment
$370 ………….. Lost Income to Down Payment
$357 ………….. Maintenance and Replacement Reserves
$4,551 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$14,990 ………… Furnishing and Move In at 1% + $1,500
$14,990 ………… Closing Costs at 1% + $1,500
$10,792 ………… Interest Points
$269,800 ………… Down Payment
$310,572 ………. Total Cash Costs
$69,700 ………. Emergency Cash Reserves
$380,272 ………. Total Savings Needed