Jul062016

Should homeowners be allowed to risk their house?

Over 6 million foreclosures were caused by mortgages with risky terms few borrowers understood. It’s government’s role to protect people from themselves, particularly when taxpayers fund the bailouts.

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Flying high is dangerous; just ask Icarus. Everybody was flying high on free money but they got too close to the sun and got burnt. When they fell back to earth, their impact created a debt crater that the rest of us are being asked to fill in.

Borrowers took on enormous risks during The Great Housing Bubble. If this were not the case, US lenders would not have completed 6,324,545 foreclosures over the last ten years. Legislators accurately identified the risks assumed by borrowers that caused them to lose their homes, and legislators enacted Dodd-Frank to limit or reduce these risks in the future. Dodd-Frank was necessary for one simple reason: taxpayers who did not take on these risks must pay the price. The benefits of these risks are privatized while the losses incurred from these risks are being socialized.

The foreclosure crisis of the Great Depression was caused by a number of related factors. First, there was systemic mortgage related risk. At the time almost all mortgages were interest-only loans with very high equity requirements (50% down was the norm). Loans were interest-only because banks wanted to pass interest rate risk on to the borrower, and equity requirements were very high to insulate the banks from risk of loss if people defaulted. Despite the lenders low risk tolerance, many banks failed during the Great Depression.

The foreclosure crisis of the Great Depression was triggered by mass unemployment causing borrowers to default. As these defaults caused banks to lose money, it imperiled our entire financial system. It caused a contraction in lending and created an economic contraction that resulted in even more unemployment; a downward spiral ensued. Avoiding this result is why the federal reserve printed about $4 trillion and used $1.2 trillion of that to buy home mortgages.

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The Great Depression exposed the risks of the debt-service mentality. Since the primary loan program of the Great Depression was the interest only loan, most people did nothing to retire their debt. If people are not retiring their debt, lenders have an ongoing problem with risk. This lending risk is so great that even the high equity requirements of the pre-depression era were not sufficient to save the banking industry. Everyone who analyzed this problem realized that a new loan program that retired debt was needed.

After World War II lenders embraced a new loan program, the fixed-rate conventionally-amortized 30-year mortgage. This loan program had a mechanism to pay back the principal and retire the debt. This retirement of debt compensated the banks for the interest rate risk they were taking on. Also this allowed banks to lower their loan-to-value ratios because over time their risk was being reduced. The lower loan-to-value ratios opened the housing market to many new people and contributed to the housing boom immediately following World War II.ruined the market

Our foreclosure crisis, the one resulting from The Great Housing Bubble, is caused by a failure of finance. Numerous unstable loan programs were introduced that inflated house prices to unprecedented levels. These loan programs encouraged people to take on numerous risks that most people were either ignorant of or did not believe would become a problem — and they were wrong. Removing these loan programs caused the house price collapse. Part of these unstable loan programs is the mindset that debt can be endlessly serviced — the same problem that plagued the Great Depression. The unstable loan programs and the debt-service mindset prompted copious borrowing. People were allowed to take on risks that cost them their homes.

The risks borrowers took on are easily identified. These risks include:

  1. interest-rate risk,
  2. mortgage-availability risk, and
  3. increasing-payment risk.

Interest-rate risk is caused by the use of adjustable-rate mortgages. The Federal Reserve is working hard to artificially manipulate mortgage interest rates to deal with this problem. Lowering interest rates may help if the payment is simply resetting but it does nothing for those facing a recast of their loan from an interest-only to a fully-amortized payment. This loan recast is the root of the problem.

It is amazing to me that former Fed Chairman Alan Greenspan actually suggested people take on interest rate risk and use adjustable-rate mortgages. It is debatable whether or not he was a great central banker, but it is clear that he was a very poor financial advisor as most people who followed his advice from 2004-2006 lost their homes.

People are not capable of managing their own interest rate risks as Mr. Greenspan had suggested. In reality everyone is merely betting on lower interest rates. If this bet moves against them, the government or the Federal Reserve is asked to step in and bail everyone out. Again, the rewards are privatized and the risks are socialized.

Mortgage-availability risk is the problem being faced by those who assume they can serial refinance from one teaser-rate mortgage to another. Everyone who has a mortgage that is going to require refinancing before it is paid-in-full has assumed mortgage-availability risk. Of course most people simply presuppose that favorable loan terms will be available forever and they will always have access to capital. Our recent credit crunch has shown how serious this risk really is.

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Increasing-payment risk is caused by loan terms where the borrowers payment may go up over time. Loan terms that have increasing payments have high default rates; people cannot afford the increased debt-service burden. This commonsense fact seems to have eluded lenders as they developed these unstable loan programs. This increasing payment forces people to refinance which in turn exacerbates the mortgage availability risk when people find their ability to refinance curtailed.

Borrowers should simply not be allowed to take on these risks. Once the downside of these risks comes to be, it leads to a foreclosure crisis. This leads to government bailouts which in turn leads to the prudent paying for the sins of the irresponsible. The borrower risks described above can be eliminated.

We can require high down payments. Initial equity in the form of a down payment provides a buffer in case house prices fall so homeowners do not go underwater. We can limit the debt-to-income ratios of borrowers. If people are not over extended under mortgage debt they are far less likely to default. Statistics bear this out. And we can limit lending options to the fixed-rate conventionally-amortized mortgage. It is the only product that pays down debt and does not face an escalating payment. Fortunately, Dodd-Frank instituted these last two points.

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There was a 30-year era were borrowers were not permitted to take on these risks. From 1948 to 1978, we experienced price stability (after the brief price recovery following the Great Depression and WWII). House prices were relatively stable even when the economy was not. The era ended with the hyperinflation of the late 70s and the first California housing bubble which coincided. This ushered in an era of price instability and experimentation with affordability products (See Robert Shiller’s chart above).

Our modern era of experimenting with affordability products has been a dismal failure. The Great Housing Bubble is a direct result of this failure. We must return to the lending practices of the 1948 to 1978 era. Many will view this as a big step backward. However, when lending steps off a cliff, perhaps a step backward is a good thing.

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