Matters of Interest

I continue to be disappointed by experts not knowing what they don’t know. Each time one of these “experts” parrots the phrase “mortgage meltdown” in the media, it extends the life cycle of the problem. They stumble across the commercial paper aspect of the problem. Lenders are supposed to disclose according to the Truth-in-lending Act- why can’t we get some truth in reporting on lending. It would require some homework, or they could interview some real mortgage experts.

1. “Alt A” loans are not Sub-prime loans. Thornburg for example is an “A” paper lender, caught in a break down of commercial paper markets. Has anyone asked them if their assets are performing? Talk about the actual relative performance of assets by risk grade instead of just saying, “mortgage meltdown”? Talk about specific relative mortgage segment performance: A-paper, Alt-A, Sub-prime, home equity, Jumbo prime paper (Thornburg)?
2. Our grandparents had little choice but to put down 20% because there was no risk-based pricing model based on credit like there is today. The Fannie and Freddie engines are working just fine. Today we can substitute good credit for cash and lending can be sound. American Home Mortgage, among others, invested heavily in the “exotic mortgages” that are often characterized as “sub-prime”. These loans were NOT 100% loan-to-value programs and required good credit borrowers (typically 680+ credit scores). The deferred interest potential is offset in a typical appreciation market of 5-6%, and required a minimum 5% down (115% growth cap), most 10% down (125% growth cap).
3. As an investment real estate is: non-liquid; has no guarantee of principal; and gives no rate of return on additional principal contributions. The only strengths are in tax advantages and leverage. Take those away and we are all better off renting.
4. These loans were not the product of booming real estate values per se. This is chicken and egg. The abuses of these were consumer responses to achieving a certain lifestyle. In other words, borrowers weren’t satisfied with moderate housing, so they went upscale with an “Option ARM” to keep up with the Jones. The borrower may have been coached, or the transactional mortgage broker (living from transaction to transaction with no regard for the client’s future) may have lied, but one read through the disclosures and the borrower would have an understanding or enough fear to ask questions. Yes, conspiracy. Title and Attorney Closing agents even do a quick overview of the note at closing. Do they see borrowers with glassy eyes signing these notes? Are they notarizing documents they don’t review or ask if the borrower understands? When these show up in court, will the authors of the Truth-in-Lending Act be named in the suit? Call it immediate gratification or greed or whatever you like from borrowers- this is not new behavior.
5. Legislators created permanent budgets on the cyclical rising property values and therefore taxes have created an affordability problem that is as much to blame in most markets as adjusting mortgage rates for defaults.
6. Insurance costs have contributed to rising home costs and have an impact on defaults.

I heard one analyst as if he were doing an exposé describing how he repeatedly asked lenders if the had relaxed their underwriting standards over the course of the last couple of years- “And they said they had not”. I’m hoping as an analyst he was fired, because one cursory look at the lender’s matrices over the course of two years would have clearly demonstrated they had.

By the way, let me describe a loan program to you. 10% down required, payment rate of 2.5%, with an actual note rate of 8%, so the potential to defer interest (add back to the loan balance) is 5.5%, but this can change as often as month an annualized basis. The loan can grow to 125% of the original balance over a 5-year period, when the loan is subject to recast. Your experts they are probably thinking “Option ARM”, one of those new exotic loans that sprang up during the roaring 2001-2005 real estate boom. They would be right; but, they would also be right if they were recalling the mid 1980’s and a loan called the “Flex”, that had been very popular during the days of 14-16% mortgage rates in the day that sparked a refinance wave back then. History repeats itself?

Approximately 65% of the licensed mortgage brokers in business today have less than 5 years of experience. These loan originators were taught how to get people qualified under the most profitable program available. These inexperienced originators were focused on the transaction today, not the client down the road.

The easiest sales were Adjustable Rate Mortgages (ARMs) with profits hidden in the margin, especially the Cash-flow Option ARMs, offering a payment rate as low as 1%.

When a loan rate adjusts, it adjusts based on the Index (a benchmark which reflects current market rates, i.e. the One Year Treasury Bill, or the London Interbank Offer Rate (LIBOR), or the Prime Rate (the Fed Funds Rate plus 3%). To this benchmark, one adds the Margin- that is, the Profit Margin for the Lender/Bank. Margins typically range from 2.25 to 2.75, but often can be as high as 3.25 or more.

When distracted by a Payment Rate of 1%, the typical borrower can easily forget that the real rate of interest is that Index Rate (LIBOR today is around 5.34%) plus the Margin could result in a real rate between 7.54% and 8.59%. Originators make money selling the closed loans to Lenders. Lenders make more money when the loan has a higher Margin, therefore they pay more to the originator to encourage higher margins.

This abuse has created an unfortunate backlash against good loans improperly used. A Harris Interactive poll of 2,383 U.S. adults released last month indicated the a hugh majority don't trust mortgage advertising and most do not like ARMs or Interest Only loans.

Indeed, a renewal of "Depression Era Thinking" is occurring that will cost the average borrower $25,000 over a five year period when compared with proper debt and equity management.

This "Depression Era Thinking" is the practice of prepayment of loan principal and shorter fixed term loans. Prior generations were taught that owning one's home free of any debt would protect the ownership and value of the home because early mortgages were callable- the bank could simply call the loan because they needed the cash, even if the borrower had a perfect payment history. This is no longer possible, but this nonetheless started the practices. Like the tradition of cutting off the ends off a roast passed down through the generations, a grand-daughter preparing the family dinner one night asked how it effected the roast's flavor. The grandmother recalled that she actually did that because her old oven was too small for it to fit the whole roast- it had nothing to do with the present day rationale for the practice.

The $25,000 mistake that most borrowers make is in prepaying their mortgage. If one were to put down $20,000 and buy a home for $100,000, and realize no appreciation for 5 years, and then sell the home for $100,000, they would walk away with $20,000 (less the cost of sale). The $20,000 had no rate of return.

If the same borrower bought for $100,000, with $20,000 down, and realized 5% appreciation, they would walk away with $47,628. The appreciation of $27,628, plus their original $20,000, which again had no rate of return. In other words the rate of appreciation has nothing to do with whether the property has a mortgage, and additional payments to principal earn no rate of return. In fact, the build up of equity makes the home more attractive to the bank in foreclosure, and gives the bank less reason to work with a borrower in distress. It is easy to conclude then that prepayments actually reduce the bank's risk while increasing the borrower's risk.

The prepayments are plowed into an "investment" that has no rate of return, can lose value and is not liquid. Not the kind of "investment" that a prudent saver would use!

Consider two brothers with identical income and the same amount of savings, $100,000. One buys a $500,000 home with a 15 year fixed loan at 5.875% APR using all of his savings for a 20% down payment. His payment is $3,348, but after tax deductions feels like $2,983. He also adds an extra $200 per month to prepay the loan.

His brother also buys a $500,000 home, but with only 5% down, he takes a 6.375% Interest Only 30 year loan. His monthly payment is $2,523, which after tax deductions feels like $1,690.He leaves the remaining $75,000 in  a safe, guaranteed, money-making Investment Account earning 6%. Every month he sends the monthly payment savings difference of $1,293 plus the same extra $200 his brother does into his Investment Account.

Five years later, the first brother has received $33,796 in tax savings, but has no Investment Account.

The second brother has received $49,955 in tax savings and his Investment Account has grown to $205,330. This strategy will ultimately allow the brother to pay off his loan more quickly than the first brother anyway.

Now, which would you rather be if you suddenly lost your job, or became disabled. Both brothers have equity in their homes, but neither could qualify for a loan to extract it! Brother Two has a significant cash reserve to sustain him through difficult times.

The facts are that the average first-time homebuyer owns a home for an average 3 years; a move-up buyer averages 7 years; and the average life of a mortgage loan is 5 years. For the average borrower, a 30 year loan is a waste of interest, and the principal paid over these time frames is much less than the lost investment opportunity.

The answer lies in the fact that the best loan is the lowest rate on the right loan. These are rarely short term ARMs with monthly, 6-month, or even 1 year adjustment periods. Many Clients can be well served by intermediate term hybrid ARMs with guaranteed 5, 7, and 10 year fixed periods with annual adjustments after the fixed period, and with Interest Only options for the right Clients. Rates could cycle lower during the term or the savings will more than offset the cost of a refinance if the Client wants to extend the term or separate appreciation equity from the home.

The best loan scenario will match the Clients goals for how long they want to own the home, how aggressively they want to save, and will match income trends and life cycle changes (marriage, kids, college, retirement). This is best accomplished by a Certified Mortgage Planner with several years of experience, who uses a regular process of annual review to assure the plan continues to meet the client's goals.

Troubling times for many in the mortgage industry.

When I first entered the industry, over 20 years ago, rates were just coming down from the 16% range. People had been taking off from work to wait in line to refinance. Many clients were getting out of a loan known as "The Florida Flex", that they had taken to avoid those 16% fixed rates.

The "Flex" Loan was a loan that had a low payment rate that was not enough to pay even the interest due on each payment. The remaining interest was added back on to the loan balance as "deferred interest", or negative amortization. Nobody liked that name- it was too , well, negative.

Sound familiar? It should if you've heard of the "Option ARM", or those commercials for 1.25%, or borrow a million dollars for only $1,000/month. The old is forever new.

There were some problem loans, and everyone got excited. The "Flex" went away. Rates continued to improve (which they have for the past 40 years). Credit guidelines constrict and relax. Banks and mortgage companies come and go.

The "meltdown" is the down part of the cycle. This one is worse in my opinion, than the last two such cycles I've been through for some convergent reasons.

After 9/11, there was a "flight to safety" in real estate. Real estate is diverse, spread out, easy to touch, hard to misplace. And, in this rush, unrealistic and sustainable appreciation occurred. This drew many inexperienced investors into the market now seeking huge profits.

Most of these investors did not look at real estate as an investment objectively, and poured to many resources from already savings poor budgets into an investment whose greatest advantage is in utilizing leverage.

More people, with less investment sophistication, with less reserves, borrowing more on leveraged assets that were unrealistically appreciating and rapidly becoming overvalued.

Add in some overzealous lenders with sales people acting as loan advisors and one finds greed and get-rich quickness driving a market quickly beyond reason.

Among the last straws are our elected officials who took the tax revenue windfall from this cyclical and exaggerated event and spend it on long term budget projects as if the rise were going to continue.

What were they thinking? Continued appreciation? A plateau at levels that drive people from the State because they can't downsize out of there high taxes into less home with the same high taxes? The gap in housing affordability places wage pressure on employers to attract good employees which ultimately results in inflation.

The difference from the refinance era of the 80's is that people could still afford to refinance and qualify. They didn't get the option of exaggerating their "Stated Income" the first time around.

Ultimately what it means you, and me, is that we need to run our personal finances like a business for the long term. We will need to balance our budgets and defer some gratification. We will put off the extras and take care of what we have so it will last. Market pressures will return us to a balance within the next 12-18 months. Appreciation will normalize at 5-6% after we pay back some of the extraordinary gains we perceived. Rates will top out around 7% and moderate over the next 18 months, while meandering in the 6-7% range for the rest of this year. Some of the market losses will result in higher borrowing costs for certain borrowers. We will have to earn rather than expect progress.

Hopefully we will seek out wise counsel. My goal as a mortgage planner is to serve as one member of the Personal Board of Directors of each of my clients. To work in concert with CPAs and Financial Planners to optimize each client's resources to take every advantage to save at each opportunity that arises. And for those who don't have their Personal Board elected, to start with the basics of savings, real estate and life insurance to build a foundation from which to grow.

It will take time to turn these market conditions. The shortest route to recovery will come via sound planning, discipline, and smart decisions.