Lenders destabilize housing with failed bubble-era loan products
With memories of the housing bust fading, lenders embrace loan products proven to destabilize housing markets and cause foreclosures and lender losses.
One of the main factors preventing further home price inflation is the lack of down payment savings among the buyer pool. With super low mortgage rates, even the meager incomes emerging from the Great Recession can finance amounts in excess of the conforming loan limits, which also inhibit higher home prices. Pressure will mount to raise the conforming loan limit, and pressure will also mount to find ways to accommodate potential homebuyers with less than 20% down.
During the housing bubble, lenders gave out second mortgages to anyone who didn’t have a 20% down payment. A common product was the 80/20 loan which had a conventional 80% first mortgage and a higher interest rate 20% second mortgage. Lenders rolled the risk premium into the interest rate on the second mortgage. Unfortunately, lenders and investors in these second mortgages greatly underestimated the risk because they failed to recognize that the proliferation of these products destabilizes the housing market.
Rather than learn this difficult and painful lesson, lenders and investors offer the same loan products that cost them billions and ruined the economy less than 10 years ago.
While most lenders require mortgage insurance on loans with smaller down payments to compensate for their extra risk, there are several options that do not. A few new programs have become available postrecession, while some older strategies have been resurrected, including the piggyback loan. All let borrowers avoid the added monthly expense of insurance, which generally costs from 0.3 percent to more than 1 percent of the loan amount annually. But borrowers may pay a slightly higher interest rate instead.
I can’t say I am surprised this is happening. Back in November of 2012, I wrote about the financial opportunity of investing in second mortgages in the post FHA = subprime, 12.4% interest cost of FHA insurance, 50% risk premium. Another way to look at the cost of an FHA mortgage is to consider it a 80/16.5 mortgage because the incremental cost of the FHA insurance is only required if borrowers need to borrow the last 16.5% to complete the transaction.
At the time, FHA borrowers were in effect taking out 12.4% second mortgages. Any lender offering second mortgage debt at rates less than 12.4% would be competitive with the FHA. The FHA lowered it’s fees since then making the competitive comparison less lucrative, but the basic math still offers opportunities for second-mortgage lenders — and now they exploit it.
Avoiding mortgage insurance won’t always be possible. Nor will it always be the best or most economical decision. But the good news is that prospective home buyers have options, whether through a traditional bank, a credit union or a newer alternative lender.
“Where we’ve seen the biggest change is in the appetite of jumbo lenders in the private sector to allow for 90 percent financing, which we hadn’t seen be this widespread since before the crash of 2007 to 2008,” said Mark Maimon, a vice president with Sterling National Bank in New York.
In other words, lenders finally forgot about the perils of poor lending they learned during the crash, and they embrace the toxic loan products that cost them billions. Brilliant! Not….
The piggyback or second mortgage — not to be confused with the versions misused during the housing bubble, which permitted up to 100 percent financing — can take different forms. The second loan may be a home equity line of credit, which typically carries a variable rate that is based on the prime rate plus an additional margin set by the lender. It generally requires only interest-only payments, but adjusts to a principal and interest payment after 10 years. (Fixed-rate second mortgages, say over a 20-year term, may be also available, but rates are usually higher than the line of credit.)
How are these loans not to be confused with the versions misused during the housing bubble when they carry most of the same terrible characteristics? An interest-only HELOC with a variable rate is better? WTF? How do people not see this as a huge red flag?
Stunning! That’s what I was thinking when I learned this week that for the first time in eight years, big-boy second mortgages are back.
You can now get a fixed-rate second mortgage all the way up to $500,000 bringing just 5 percent to the table. This offers you extraordinary buying power.
Does the market need more buying power and more leverage, or does it need lower prices and higher incomes?
For example, now you can buy an Orange County home for up to $1,184,736 with a $59,236 down payment, receiving fairly priced money (not highway robbery rates).
You do a Fannie Mae first mortgage up to $625,500 and a $500,000 piggy-back second for a combined total loan amount of $1,125,500. You will need a 760 middle credit score for sure to get this lean, mean, leverage machine.
Say you already own your home. Go bigger!
You can cash out up to $500,000 by taking out a new second mortgage, allowing you to keep an existing first mortgage of up to $1 million on the first, with a total loan-to-value of 95 percent. You can squeeze out almost all of your home equity if it’s needed. Nice!
Nice? Are you kidding me? This is a disaster waiting to happen. Perhaps it’s time to refresh everyone’s memory on how the credit cycle works.
Housing Markets and Drag Racing
My father is a motor-sports enthusiast. I spent many evenings in my youth attending auto races at the oval short-tracks across Central Wisconsin: Dells Raceway Park, Golden Sands Speedway, State Park Speedway, Madison International Speedway, Rockford Speedway, and the Milwaukee Mile Speedway. I have many fond memories, and to this day, the smell of burning rubber and the uproar of racing motors reminds me of those exciting evenings. For several years we attended drag races at Great Lakes Dragaway, where I watched the stars of the sport compete.
Each drag race begins with a ritual; first, the drivers warm up their tires with a crowd-pleasing, high-power tire burn, and as the anticipation builds, the drivers position their cars near the starting line. From that point on, the drag strip’s Christmas Tree lights direct the show.
The starting line has two sensors: the first lets a driver know they are near the starting line, and the second tells them they are on the line. Once both cars are staged (both lights are on), the Christmas Tree begins a countdown through three yellow lights followed by the green light signal. (Have you been on the Xcelerator at Knotts?) If a racer starts too soon, a red light appears, and they are disqualified.
So what does this have to do with housing markets?
Some of the cartoons I create contain valuable conceptual teachings (and some are just silly). The graphic below illustrates the stages of a loan-induced housing bubble by comparing the stages of the process to the beginning of a drag race.
Housing bubble rallies are just like drag races. First, the preconditions for a bubble must be established; like drag racers positioning themselves, the housing market must first stabilize and prices must start rising again. Without these preconditions, lenders won’t loosen credit standards, offer toxic loan products, and inflate a housing bubble. At this stage, the 30-year fixed-rate mortgage, the only stable loan product known, forms the bedrock of the market. We just completed this stage over the last four years.
The very first sign of a housing bubble is the increased use of adjustable-rate mortgages. People generally use ARMs because they can’t afford the higher interest rates of a fixed-rate mortgage; in other words, they are buying houses they can’t afford. We haven’t seem much of this yet because mortgage rates are still near record lows, but it’s coming.
The second sign of a housing bubble is the use of interest-only mortgages. In the past, the housing market would proceed to this stage without hindrance or hesitation, but with the new Dodd-Frank qualified mortgage rules in place, rules which ban interest-only mortgages, the inevitable progression to this toxic form of financing should at least be slowed down. Ideally, the next housing bubble will not inflate because its growth will stop at this stage.
If we are fortunate, private equity won’t embrace interest-only mortgages again and cause it to proliferate, but the first step toward that end is embracing interest-only HELOCs and second mortgages, which the story from today demonstrates is already occurring.
The final stage is the widespread proliferation of toxic loan products like Option ARMs. Once financing crosses the Ponzi threshold of interest-only loans, the market destabilizes, mortgage defaults accelerate, and a credit crunch becomes imminent; it’s only a matter of time before lenders realize their folly and abruptly stop making bad loans. Once that happens, credit tightens, and lenders retreat to the stability of 30-year fixed-rate mortgages.
Do we really want to repeat the mistakes of the housing bubble?
Come join us on Thursday
The homebuying season started early this year due to the low mortgage rates. If you or someone you know are considering buying this year, I invite you to come out to our event at JT Schmids on Thursday. We provide free appetizers and drinks and great presentations. I hope to see you there.