I make no secret of my disdain for the behavior of bankers during the housing bubble. I’m not so extreme that I consider all borrowing and lending to be evil; however, I draw a clear distinction between what I consider good debt, useful for economic efficiency, and bad debt, useless and unproductive that results in misallocations of capital and human suffering. Surprisingly enough, the line separating the two is clear and easy to calculate and quantify.
Signatory versus asset-backed debt
Not all debt is created equal. asset-backed debt is collateralized by a cashflow-producing asset. The income stream is being used to repay the debt with interest, and if for some reason the borrower unwilling to pay back the loan, the lender can take back the property and obtain a cashflow equal to or greater than the payment on the debt.
I had the good fortune to meet a gentlemen who provides asset-backed debt from a major lender. His company provides debt for property, plant, and equipment to other major corporations. When he analyzes the collateral for a loan, he considers it’s useful life, the recovery and resale value, and the cashflow the asset may generate (if any). He assumes the debtor’s word means nothing and any recovery of capital will come solely from the collateral pledged to cover the loan. In his world, there is no signatory assurance of repayment. There is only collateral repossession, cashflow, and resale.
Asset-backed debt is essential to the functioning of our economic system. Many businesses could not raise the equity to obtain the property or equipment necessary to it’s operations. Lenders can loan against working capital at very low rates with little risk. If businesses have their money freed up to grow the business, our economy grows and prospers. In short, asset-backed debt is useful and freeing.
On the other hand, signatory debt is slavery. Signatory debt is money given to a borrower simply based on the borrower’s promise to repay. It has nothing to do with an asset, and if the borrower chooses not to repay, recovering signatory debt can be very difficult because it is not backed by tangible collateral.
Signatory debt provides no useful purpose. It provides a short-term economic boost as demand is pulled forward, but once it is consumed, money that would ordinarily have been spent by the borrower on consumer goods is instead diverted to the lender for debt service. It’s only when signatory debt is expanding that the economy is stimulated. The expansion of signatory debt is a Ponzi scheme.
Signatory debt creates Ponzis
The problem with signatory debt is simple: people don’t want to keep their promise to repay when it is inconvenient. Ponzis live to consume. They will take money under any terms offered, and when it comes time to pay the bills, they will seek more borrowed money to keep the system going. Borrowing money to repay debt is the essence of Ponzi living. Has anyone been watching events in Greece unfold?
Ponzis will inevitably spring from signatory debt. Not everyone who borrows with no collateral is a Ponzi, but Ponzis could not exist without signatory debt. The losses created by Ponzis are the only deterrent from lenders giving out free money. In our current home mortgage lending system backed by the government, without strict controls, Ponzi borrowing with home loans is inevitable.
Signatory debt is unnecessary
Someone will invariably argue that signatory debt is necessary and beneficial because it stimulates the economy. This is nonsense. Signatory debt allows buyers to accelerate purchases they otherwise would have had to defer until they had sufficient savings, but it doesn’t add anything. In fact, once consumed, the borrower must pay the bank interest rather than put the money into savings and earn interest. The difference between what they pay and what they could have earned is a net loss to spending — a loss that goes into the pockets of bankers.
Signatory debt is a crutch. It’s the only way those who don’t save can make discretionary purchases of assets costing more than a small portion of a single paycheck. If everyone saved money, signatory debt would be unnecessary as people would simply wait until they had sufficient savings to make a purchase. The proliferation of signatory debt shows just how poorly educated most Americans are when it comes to personal finances. Even the lenders have to spend money “educating” borrowers on how to use their “products” responsibly. I think people should be educated on how not to use their products at all.
Conflating asset-backed debt and signatory debt
Lenders are keen to conflate the distinction between asset-backed debt and signatory debt by over-loaning on assets. The housing bubble is a classic example, but lenders do this with car loans, commercial loans, and personal property loans.
A home loan has a component of asset-backed debt. The portion of the cost of ownership (payment, interest, taxes, insurance, HOA) equal to rental is asset-backed. If the loan balance is limited the size supportable at rental parity, the property could be rented for an income stream capable of sustaining the debt service.
However, once the cost of ownership exceeds the cost of a comparable rental, the only assurance the lender has of getting repaid is based on the signatory promise of the borrower. Therefore, the loan is part asset-backed and part signatory. When lenders cross the line from asset-backed to signatory debt, they turn good debt into evil debt and inflate asset bubbles. Lenders did this in both the residential and the commercial real estate markets during the 00s.
Once lenders cross the line from asset-backed debt to signatory debt, they are inflating an unsustainable Ponzi scheme. Inevitably, prices will crash back to asset-backed levels determined by rental parity. it’s not a matter of if, only when. We are seeing this play out across America right now with the deflation of the housing bubble.
The evil that lenders do
Lenders don’t want to make a distinction between good debt and bad debt because they profit from both kinds of loans. And since some debt is useful and productive, lenders are keen to ignore the evil they do when they cross the line. They even have the temerity to chastise the borrowers they enslave when the surfs rebel and quit paying. Lenders need to look at the distinction between good and bad debt, asset-backed and signatory debt, before they start pointing fingers in judgement when a borrower defaults. If lenders only made “good” loans, defaults would not be a cause for alarm because they could recover their capital from collateral. The lenders who complain the loudest about the bad behavior of borrowers are the lenders who provide “bad” debt only backed by the “good word” of the borrower. If signatory debt were eliminated, lenders would have far less to complain about, and a nation of debt slaves would emerge from their self-imposed bondage. That would be a good thing.
Coto de Caza is a hotbed of Ponzi living
Coto de Caza consistently ranks near the top of my monthly ratings for the best bargains in Orange County. Prices there are more than 50% below their historic relationship between prices and rental parity. There’s only one reason for this: Coto de Caza is loaded with Ponzis.
The Real Housewives of Orange County with their pretentious ways call Coto de Caza home. As it turns out, most of them were faking it, creating an image through Ponzi borrowing and blowing their future for a moment of conspicuous consumption. Since Ponzi behavior was so common there, many of these people have exhausted their sources of new credit to sustain their fake lives, and they are succumbing to the enormous and unsustainable debt burdens they took on during the housing bubble. The former owners of today’s featured property are one example of the easy-money Ponzi lifestyle rampant in Coto de Caza.
- Today’s featured REO was purchased on10/8/1998 for $595,000. The owners used a $476,000 first mortgage and a $119,000 down payment.
- On 4/13/2000 they refinanced with a $508,000 first mortgage.
- On 12/2/2002 they refinanced with a $630,000 first mortgage.
- On 5/14/2003 they refinanced with a $638,000 first mortgage.
- On 6/30/2003 they obtained a $150,000 stand-alone second.
- On 10/15/2003 they obtained another $150,000 stand-alone second.
- On 6/15/2004 they refinanced with a $901,250 first mortgage.
- On 12/27/2005 they refinanced with a $1,000,000 first mortgage.
- On 10/19/2006 they obtained a $125,000 HELOC.
- Assuming they maxed out the HELOC, the total property debt was $1,125,000, and the total mortgage equity withdrawal was $649,000.
They quit paying the mortgage in early 2009, and they were allowed to squat for three and a half years because the banks knew there was no market for houses in this price range. By the time the bank took back the property, the first mortgage debt had ballooned to $1,189,993. The bank is going to lose over $300,000 on this one.
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Proprietary OC Housing News home purchase analysis
$899,900 …….. Asking Price
$595,000 ………. Purchase Price
10/8/1998 ………. Purchase Date
$304,900 ………. Gross Gain (Loss)
($71,992) ………… Commissions and Costs at 8%
$232,908 ………. Net Gain (Loss)
51.2% ………. Gross Percent Change
39.1% ………. Net Percent Change
2.9% ………… Annual Appreciation
Cost of Home Ownership
$899,900 …….. Asking Price
$179,980 ………… 20% Down Conventional
3.48% …………. Mortgage Interest Rate
30 ……………… Number of Years
$719,920 …….. Mortgage
$167,405 ………. Income Requirement
$3,225 ………… Monthly Mortgage Payment
$780 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$225 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$95 ………… Homeowners Association Fees
$4,325 ………. Monthly Cash Outlays
($717) ………. Tax Savings
($1,137) ………. Equity Hidden in Payment
$198 ………….. Lost Income to Down Payment
$132 ………….. Maintenance and Replacement Reserves
$2,801 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$10,499 ………… Furnishing and Move In at 1% + $1,500
$10,499 ………… Closing Costs at 1% + $1,500
$7,199 ………… Interest Points
$179,980 ………… Down Payment
$208,177 ………. Total Cash Costs
$42,900 ………. Emergency Cash Reserves
$251,077 ………. Total Savings Needed