Ponzi borrowing and HELOC Abuse
Most people fail to budget properly for unexpected expenses or expenses that do not occur monthly. When these expenses occur, most will borrow the money, often on credit cards. During the year, this debt will accumulate like tooth plaque, and at the end of the year, many debtors hope for a work bonus or a tax refund to clean the debt from their balance sheets. Homeowners, particularly in California, would go to the housing ATM and add to their mortgage to pay for these un-budgeted expenses of daily life.
The sad reality is that this method of Ponzi borrowing can work as long as (1) the amounts added to the home mortgage are less than the sustained rate of appreciation and (2) if the payments are still affordable with wage income. During the housing bubble, many borrowed much more than the sustained rate of appreciation and took out every penny as it accumulated. With the steadily falling interest rates of the last 30 years and the profusion of toxic financing, affordable payments were seldom a problem. Therefore, many people have become accustomed to Ponzi borrowing on the home ATM, and that source of borrowing is shut down for a while — probably for a very long time.
Personal Ponzi Schemes
First, let’s review how personal Ponzi Schemes work:
Examine the graphic above. The first column shows a graphical breakdown of the income of a typical homeowner. Total home related debt (including taxes, insurance, HOA and other monthly expenses) is limited to 28% of gross income. Consumer debt including all other debt service payments is limited to 8%. Taxes take up about 24% (depending on income and tax bracket), and the remaining 40% is disposable income to cover the other expenses of daily life.
The second column shows what happens as people start to stretch to buy a home in a financial mania (charts are below). The increasing home debt reduces the tax burden a little, but the increased consumer spending and home debt takes a big chunk out of disposable income. The recession of the early 90s lingered for so long here in California because the people who bought in the frenzy of the late 1980s found themselves with crushing debts and greatly reduced disposable income. Prior to the increase in housing debt, this disposable income would have been spent in the local economy; instead, this money was sent out of state to the creditor who made the loan.
The big financial innovation—if you want to call it that—of the Great Housing Bubble was the nearly unrestricted use of cash-out refinancing and HELOCs to tap into home price appreciation. The third column shows the impact this new source of credit had on personal income statements. HELOC money allowed people to pay off their consumer debt while only modestly increasing their home debt. Since this income was untaxed (borrowed money is not truly income), the extracted money was entirely converted to disposable income. This incredible influx of disposable income caused our economy to explode.
Unfortunately, as is documented in the post Our HELOC Economy, the loss of this HELOC income is having devastating effects on local tax revenues and our economy. When you examine the personal income statements of borrowers in column four, you see that home debt and consumer debt have now become so burdensome that there is no longer enough disposable income to cover life’s basic needs; borrowers are insolvent.
The only solution to the problem of borrower insolvency is a monumental restructuring of both home and consumer debt. Realistically, the only way this is going to occur is through foreclosure and bankruptcy. We are not going to re-inflate this Ponzi Scheme because when sustainable loan terms are applied to real incomes, people cannot raise bids to sustain or inflate home prices—even with 4.5% interest rates. Without home price appreciation and subsequent HELOC borrowing, the Ponzi Scheme does not work.
The implications of this are clear; we are going to experience an extended recession bordering on depression here in California that is going to linger for many, many years. During this extended crisis, a significant percentage of California homeowners are going to face foreclosure and personal bankruptcy.
Lending to Ponzis
Lenders may loan to Ponzis for a time, but eventually the losses mount, and lenders realize their folly and stop making Ponzi loans. That is the market mechanism in place right now. The credit crunch was a direct result of lenders realizing they were making Ponzi loans and abruptly stopping.
The market-only solution to keeping lenders from making dumb loans is working for the most part. The US Government in cahoots with the Federal Reserve has completely taken over mortgage finance because they are the only entities willing to underwrite loans. Borrowers who try to get a jumbo loan, a HELOC or a stand-alone second right now are shocked at the qualification standards and the high interest rate spreads. The lack of a jumbo market is also why lenders are not foreclosing on anything above the $729,750 conforming limit and thereby allowing a great deal of squatting.
The problem with the market-only solution is that the mechanism that inflated the housing bubble is still in place, and the market will likely inflate another bubble once lenders believe they have no risk. Borrowers and owners would be delighted to see the lure of HELOC riches prompt a rally in prices. Lenders would also be delighted as they could sell their garbage into the rally. Without some basic reforms, our market will become very volatile as changes in credit availability take prices up and down. The ongoing turmoil and the capricious nature of winners and losers in the real estate market would be very unsettling just as it has over the last several years.
Ponzi borrowing and loan amortization
In Conservative House Financing – Part 1, I wrote about the basic loan types in mortgage finance:
There are 3 main categories of loans: Conventional, Interest-Only, and Negative Amortization. The distinction between these loans is how the amount of principal is impacted by monthly payments. A Conventional mortgage includes some amount of principal in the payment in order to repay the original loan amount. The greater the amount of principal repaid, the quicker the loan is paid off. An Interest-Only loan does just what it describes; it only pays the interest. This loan does not pay back any of the principal, but it at least “treads water” and does not fall behind. The Negative Amortization loan is one in which the full amount of interest is not paid with each payment, and the unpaid interest gets added to the principal balance. Each month, the borrower is increasing the debt.
A conventionally amortized mortgage loan pays off the principal over time — sometimes over a very long time. The best form of mortgage finance is the 15-year fixed-rate mortgage, but 30-year terms are common, and provide a reasonable balance between purchasing power and Time to Payoff. Japan experimented with 100-year loans as their housing bubble deflated. The marginal returns in the form of reduced payments get very small as the amortization length gets much over 30 years.
The interest-only loan is a Ponzi limit loan. This is the event horizon that leads to the singularity. Of course, the kool aid intoxicated think this loan is too conservative because it fails to capture and spend the inevitable and unending home price appreciation. The solution many fools employ is the interest-only loan in combination with a HELOC that can grow with appreciation. Once the cost of HELOC financing gets too high, the debt can be reconsolidated into a lower cost first mortgage or a stand-alone second. The trip to foreclosure and bankruptcy sounds very reasoned and reasonable, doesn’t it?
The negative amortization loan (Option ARM) is the pinnacle of Ponzi financing. The Ponzi borrowing is directly built in to the loan itself. Borrowers are able to spend some of their appreciation each month through a payment subsidy built into the loan. Rather than combine an interest-only with a HELOC, the Option ARM indirectly builds the HELOC into it. As long as home prices go up faster than Option ARM loan balances, these loans successfully convert appreciation to income. Work of genius, when you think about it, except that the loan ignores the reality of Ponzi financing and the inevitable collapse that entails.
The larger impact of Ponzi borrowing
The cultural reliance on appreciation and Ponzi borrowing creates a number of disturbing conditions:
- Ponzis live a life of luxury that far exceeds their contribution, and responsible people pay for it.
- California’s economy depends on borrowed money.
- The economic recovery depends on re-inflating the housing bubble and turning on the housing ATM.
- The collapse of the Ponzis will be a long-term drag on the economy.
Do you like paying the bills of the Ponzis? You are. If you are a responsible saver, the Federal Reserve has lowered interest rates to take money from you and give it to banks. If that form of theft is not enough, the Federal Reserve will keep interest rates low and steal from savers by devaluing the currency with inflation. One way or the other, the Federal Reserve is stealing from the responsible to pay for the irresponsible. If that wasn’t enough, our own federal government is stealing from you with a variety of tax incentives and bogus loan modification programs to transfer the losses from banks to the taxpayer.
The dependency of California on Ponzi borrowing is evident. Our state budget is a Ponzi scheme imploding right now, but the real reason for the state budget problems isn’t just Sacramento’s inability to say no to special interest groups. The state budget is a wreck because tax revenues rely heavily on Ponzi borrowers spending borrowed money and circulating it through the economy.
How many people do you know that are borrowing from other sources until the housing ATM gets turned on? I will tackle this subject in more detail tomorrow, but for many Californians the end of the recession will not come when they find a job or get a raise, it will come when they get a new credit line or when house prices come back enough to allow them to get more HELOC money. Our state economy is on hold until HELOC money returns.
Since HELOC riches and ATM spending isn’t coming back any time soon, our state economy will limp along with the Ponzis collapsing one at a time. With each Ponzi collapse, the money that used to go to debt service payments is freed up to circulate in the local economy. It is a slow and painful process, but weaning society off Ponzi borrowing is necessary to have a real economy based on wages and growth in productivity. Do any of you remember the lingering effects of the last bubble from 1993-1997? Unfortunately, we will probably take the short cut through Ponzi borrowing if given the chance.
Today’s featured Ponzi borrower
- Today’s featured property was purchased on 11/13/1999 for $485,000. My records say the owners used a $502,000 first mortgage, but that is unlikely. It is more likely they used a $402,000 first mortgage and a $83,000 down payment.
- On 5/13/2003 they opened a HELOC for $63,400
- On 1/26/2004 they got a HELOC for $100,000.
- On 2/1/2005 they refinanced with a $634,500 Option ARM with a 1% teaser rate.
- On 3/23/2005 they obtained a $80,000 HELOC.
- On 8/10/2005 they got a HELOC for $100,000.
- On 11/3/2006 they refinanced with a $688,000 first mortgage and a $85,000 HELOC from Wells Fargo. Since Wells owns both mortgages, they are in no hurry to foreclose on this owner and wipe out their HELOC. Look for this property to be in the amend-pretend-extend dance forever.
- Total property debt is $773,000.
- Total mortgage equity withdrawal is $484,227 plus whatever down payment they put into the property.
- Total squatting is at least 5 months.
Recording Date: 04/15/2010
Document Type: Notice of Default
This couple spent almost half a million dollars in a four-year span. That is a one-family stimulus plan. If they were an isolated case, it may be a titillating story, but I have profiled hundreds of these here in Irvine. It is a widespread practice.
California implicitly endorses Ponzi finance
Since we have done nothing in California to reform mortgage finance, we are implicitly saying this is acceptable behavior. Apparently, we want people to do this. It stimulates the economy, and since the losses are passed on to investors around the world, California gets all of the benefit and endures only a fraction of the pain. And now that the US taxpayer is covering all future losses either through the GSEs or FHA, there is no reason at all for California to do anything other than inflate another housing bubble.
Truth be told, nobody in power to do anything in California sees HELOC abuse as a problem. It is spending. It stimulates the California economy, and fills the State’s coffers with tax revenues. Few in Sacramento seem to care about the stability of the tax stream, so we will continue on this cycle of boom and bust completely dependent upon creditors. For all its economic prowess, California is the weakest state in the nation. Financially, everything here is an illusion.
What will happen to government entitlements and the individual entitlements of loan owners everywhere should lenders realize they are supporting a entire state of Ponzis? They might just cut us off.
I wish they would. California would be a much better place.