Friday, December 07, 2007

News Flash -- Mortgage Sky NOT Falling

Default. Foreclosure. Evictions. Every media venue is clogged with stories about people who are behind on their mortgage payments, who have defaulted, who are facing foreclosure and eviction from their homes.

How bad is it?

According to today's (12/7/07) Wall Street Journal:

"Subprime adjustable-rate mortgages continued to have the most problems, with 4.72% of those loans starting the foreclosure process during the quarter. Those mortgages represent 6.8% of loans outstanding but accounted for 43% of new foreclosures during the quarter."

Okay. The Journal claims that 6.8% of all mortgages are Subprime Adjustable-rate Mortgages. Thus, out of 1,000 existing mortgages, the Subprime Adjustables financed 68 homes. The Journal also states that 4.72% of the Subprime Adjustables went to foreclosure in the latest quarter.

In other words, 4.72% of the 68 homes purchased with Subprime Adjustables entered foreclosure. That's 3.2 mortgages out of 1,000. Or, since it's not likely a fraction of a mortgage is in foreclose while the remainder is healthy, 32 out of 10,000 mortgages went into foreclosure in the latest quarter.

The article also says the 32 troubled Subprime Adjustable Mortgages amount to 43% of the total entering foreclosure. Thus, out of 10,000 mortgages, 74 entered foreclosure.

Is this a problem?

Putting it another way, the numbers show that 99.26% of all mortgages are performing. More significant is the fact that as foreclosures rise, the number of non-performing mortgages will decrease as the foreclosed homes are purchased by solvent buyers.

Where's the problem?

A small group of former owners may once again become renters. Meanwhile, it's just as likely that a small group of former renters will become owners if they purchase the foreclosed homes at discounts to recent neighborhood prices.

Where's the problem?

How did we get here?

There was a time -- a few decades ago -- when a bank issuing a mortgage held that mortgage on its balance sheet until the home was sold or paid off. Secondary markets did not exist. Thus, if a bank issued a mortgage to a borrower who later defaulted, the bank was stuck with real estate it did not want.

To minimize the risk of defaults, banks offered mortgages to only their most creditworthy customers. Banks further insulated themselves against real estate risks by refusing to lend money to purchase houses in questionable neighborhoods. The upshot of these sensible policies was twofold. First, non-whites were far less likely to meet the credit standards of banks. Thus, they got few loans. Second, whole neighborhoods were judged as bad bets for lenders. Hence, red-lining.

Banks are in business to make money for their owners. To lend money to borrowers who will return it with interest. Better to be safe than sorry is the banking mantra.

What did these policies bring?

Polarized enclaves. New York City evolved into a collection of neighborhoods that were either good, starting to decay, or in some state of despair and delapidation. The race of residents usually told the story.

But today, NY City is a city of well over 8 million citizens, all of whom are living in neighborhoods that have been on an upward economic trajectory for the last 15 years.

What changed?

Mortgage lending. Why? Declining crime rates, improving economy. But a key change occurred in the credit process. Securitization became the standard practice. Secondary markets for all forms of financial assets arose. Thus, bankers were able to issue mortgages and sell them in new secondary market, freeing the banks from certain risks. Investment companies were able to buy those mortgages and bundle them into huge pools of interest-paying securities, minimizing the impact of the occasional defaulted mortgage.

Banks were free to issue mortgages on properties in troubled neighborhoods. They were relieved of the risk of holding mortgages on questionable properties. But they were able to obtain funds for buyers and earn fees. The arrival of secondary markets and securitization was the end of red-lining. No neighborhood was off-limits to buyers who needed a loan to acquire property.

Moreover, other antiquated banking rules were repealed. Many banking rules put geographical limits on lending by individual banks. Thus, a bank often held a near monopoly on lending in the neighborhoods surrounding its branches. But secondary markets, securitization and new banking regulations that increased competition changed all that.

Buyers had choices. Instead of one or two local banks from which to seek a mortgage, buyers were faced with too many to count. Commercial banks, savings banks, savings & loan associations, credit unions, mortgage banks, mortgage brokers, Wall Street brokerage firms, credit card companies. All of them in the mortgage business.

There were still questions, however. Buyers were rated. What's today's most often asked question? Once it was your zodiac sign. Today it's your credit score. Like it or not, almost everyone has been profiled for creditworthiness. As consumers we might have a long history of borrowing and repaying. Or no history.

Either way, there's a lender willing to supply capital to almost any borrower. For a price.

There's also another factor in play. When it comes to the price of an object, its price reflects the amount of money available to pay for it. Thus, housing prices will rise in tandem with the number of people able to obtain mortgage money. Therefore, it's no surprise that home prices have risen a lot over the last 15 years.

Will housing prices drop due to foreclosures? If so, how much? Sure. So what? The downside isn't really a downside at all. It's nothing less than a temporary sale. A January White Sale for housing. When prices are perceived as bargains, buyers will rush in and prices will begin to rise again. Does it matter if it takes two years before prices set new records? No.

Meanwhile, for years many elected officials charged the lending industry with bias and accused it of discriminatory lending practices. The arrival of secondary markets, securitization and heavy competition among lenders solved that problem. Home ownership among blacks and hispanics has increased faster than home ownership among whites.

Ironically, with defaults and foreclosures rising, the same politicians are accusing lenders of a new form of malfeasance. Easy credit, no questions asked. The old crime was tightfistedness. The new crime is improvidence.

There ought to be signs of indignance coming from blacks and hispanics about this. The subtext of the new crime implies the victims of these easy credit schemes are too dumb to know they should not borrow money to buy homes. Apparently the troubled borrowers were expected to believe that getting a mortgage fell into that "too-good-to-be-true" cateogory of offerings.

Were some people scammed? Certainly a few were. But no lender can earn profits from people who fail to repay loans. However, there are critics who seem to think some businesses can make money by losing money.

Why are people in default? Lots of reasons. Some simply cannot afford the payments they face after the Subprime Adjustable Mortgages adjust. But what is unclear is the percentage of people who refinanced existing homes with Subprime Adjustable Mortgages as a strategy to extract equity from their appreciated properties. How many of them are in trouble now? On what did they spend the money they obtained through refinancing? It matters.

How many borrowers borrowed everything, including their downpayment money? Many programs exist to help buyers get their first homes. They usually include downpayment cash. Thus, borrowers often kick-off their home-ownership with zero or even negative equity to cushion them against setbacks. If a buyer with no skin in the game loses his house, he simply returns to his previous life as a renter without losing a dime out of his pocket. Thus, he speculated on home-ownership and failed. At no cost to him. In other words, many defaulters have shown full understanding of the value of OPM -- Other People's Money.

Hey, for them, things could be much worse. They could have wagered their own money. But they didn't. Quite a few homes were financed with 100% OPM. Donald Trump applauds. Who wouldn't want to purchase valuable assets financed entirely with OPM?

Enter the Government. Washington has reluctantly agreed to step in. That's bad news. However, it appears that help for troubled homeowners will come in small doses. That's better. But any safety net will encourage more people to jump. Today it appears that only people who have not defaulted will be eligible for assistance. Imagine the surprise when people who had been prepared to pay the higher adjusted rates of their mortgage contracts opt for the free pass offered by Washington. Oh, I can pay my introductory teaser rate of 1% for another 5 years? Yippee. Where do I sign?

We are deep in the grip of a media-driven hysteria. The only role for Washington in this time is one aimed at keeping order while the private sector develops strategies to solve the problems. Unfortunately, this is the same federal government that lacks the will to reduce the threat of punishing oil prices by expanding oil drilling in the US.

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