Conservative House Financing – Part 2
What they are saying about The Great Housing Bubble
“The author does an excellent job in showing how various commercial and investment banks sought to create a speculative market for home loans by the process of securitization. The main tool was collateralized debt obligations (CDO’S).The idea is purely speculative since real estate is a nonliquid durable asset. The bundling and selling of trillions of dollars worth of the subprime backed bonds that were not only highly risky, but of uncertain value, created the bubble that deflated just as every other banker financed, speculative bubble has deflated in world history.
The author does a good job in demonstrating that low interest rates were not the cause of the problem. The main cause of the problem was the loan practices of various financial institutions that threw overboard their own clearly specified creditworthiness criteria and standards for borrowers seeking loans.”
Michael Emmett Brady – PhD Economics
Stated Income Loans
One unique phenomenon of the Great Housing Bubble was the utilization of stated-income loans, also known as “liar loans” because most people were not truthful when stating their income. Loan documentation is usually a routine part of obtaining financing. Lenders ordinarily require a borrower to provide documentation proving income, assets and debt. However, during the final stages of the Great Housing Bubble, loan documentation was seen as an unnecessary barrier to completing more transactions, and loan programs which circumvented normal documentation procedures flourished. The fact that these programs existed at all is remarkable proof of the risk lenders were taking through the relaxing or outright elimination of lending standards. Eighty-one percent of Alt-A purchase originations in 2006 were stated-income, and 50% of subprime originations in 2005 and 2006 were stated income (Credit Suisse, 2007). Stated income loans increased from 18% of originations in 2001 to 49% in 2006 according to Loan Performance. In a related study by the Mortgage Asset Research Institute, 60% of stated-income borrowers had exaggerated their incomes by more than 50%.,[ii] Obviously, lying about one’s income to obtain a loan is not a conservative method of financing a property purchase.
The stated-income loan was originally provided to borrowers such as the self-employed who most often do not have W-2s to verify income. When these loan programs were first started, they were not made available to borrowers with W-2s as the transparency of the lie would have been obvious to all parties. During the bubble rally, this loan was made available to anyone, and lying was not only encouraged, borrowers were often assisted in fabricating paperwork by aggressive loan officers and mortgage brokers. [iii] Since the loan could be packaged and sold to investors who had no idea what they were buying, there was a complete lack of concern for whether or not the borrower actually made the money stated in the loan application and thereby could actually make the payments on the loan. Everyone involved was raking in large fees, the borrower was obtaining the real estate they desired, and for a time, the investor was receiving payments from the borrower. [iv] As long as prices were rising, everyone benefited from the arrangement. Of course, once prices started to fall, borrowers did not want to continue making payments they could not afford, and the whole system collapsed in a massive credit crunch
Figure 5: National Home Ownership Rate, 1984-2005
The risk management measure not related to the mortgage terms is the downpayment. Most people do not think of downpayments as a way of managing risk, but lenders do. Downpayments reduce risk in two ways: first, they lower the monthly payment, and second, they provide a cushion ensuring the borrower can refinance (if necessary) should the house value decline. The problem with downpayments is obvious: few people save enough money to have one.
Eliminating downpayments through the use of 80/20 combo loans was another massive stimulus to the housing market. Subprime loan originations in 2006 had an average loan-to-value ratio of 94%. That is an average downpayment of just 6%. Also, 46% of home purchases in 2006 had combined loan-to-value ratios of 95% or higher (Credit Suisse, 2007). Lenders used to require downpayments because they demonstrated the borrower’s ability to save. At one time, having the financial discipline to be able to save for a downpayment was considered a reliable indicator as to a borrower’s ability to make timely mortgage payments. Once downpayments became optional, a whole group of potential buyers who used to be excluded from the market suddenly had access to money to buy homes. Home ownership rates increased about 5% nationally due in part to the elimination of the downpayment barrier and the expansion of subprime lending.
In simple accounting terms, equity is the difference between how much something is worth and how much money is owed on it (Equity = Assets–Liabilities). [v] People who purchase real estate use the phrase “building equity” to describe the overall increase in equity over time. However, it is important to look at the factors which either create or destroy equity to see how market conditions and financing terms impact this all-important feature of real estate.
Figure 6: Types of Equity
For purposes of illustration, equity can be broken down into several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Initial Equity is the amount of money a purchaser puts down to acquire the property. Financing Equity is the gain or loss of total equity based on the decrease or increase in loan balance over time. Inflation Equity is the increase in resale value due to the effect of inflation. This kind of appreciation is the “inflation hedge” that provides the primary financial benefit to home ownership. Finally, there is Speculative Equity. This is the fluctuation in equity caused by speculative activities in a real estate market. This can cause wild swings in equity both up and down. If life’s circumstances or careful analysis and timing cause a sale at the peak of a speculative mania, the windfall can be dramatic. Of course, it can go the other way as well. If a house is purchased at its fundamental valuation where the cost of ownership is equal to the cost of rental using a conventionally amortized mortgage with a downpayment, the amount of owner’s equity is the combination of the above factors.
The initial equity is equal to a purchaser’s downpayment. If a buyer pays cash for a home, all equity is initial equity. Since most home purchases are financed, this initial equity is usually a small percentage of the purchase price, generally 20%. A downpayment is the borrower’s money acquired through careful financial planning and saving, gifts from family members, or from the profits gained at the sale of a previous home. Downpayment money is not “free.” This money generally is accumulated in a savings account, or if a buyer chooses to rent instead, downpayment money could be put in a high-yield savings account or other investments. There is an opportunity cost to taking this money out of another investment and putting it into a house. This cost and its impact on home ownership costs are detailed in later sections.
Financing equity is determined by the terms of the loan. With a conventionally amortizing mortgage, a portion of the payment each month goes toward paying down the loan balance. As this loan balance decreases, the owner’s equity increases. This is a substantial long-term benefit of home ownership. With an interest-only mortgage, the loan balance does not decrease because only the interest is paid with each payment. With this kind of loan, there is no financing equity. One of the major drawbacks of using an interest-only loan does not become apparent until the house is sold and the seller wants to take the equity to the next home in a move-up. Since no financing equity has accumulated, the seller obtains less equity in the transaction. This means the move-up buyer will be able to afford less. Over the short-term, financing equity is not significant because the loan balance is not paid down by a large amount, but if the house has been held for 10 years or more, or if the loan was amortized over a shorter term, the financing equity can be a large amount. This can make a real difference when the total equity amount is to be put toward a larger, more expensive home. Also, financing equity is a great reservoir for retirement savings. In fact, it is the primary mechanism for retirement savings of most Americans outside of social security. [vi]
The worst possible loan is the negative amortization loan because of its impact on equity. As noted in the figure on the next page, if a negative amortization loan is utilized, it will consume all equity in its path. It is a form of cash-out financing that reduces equity. This loan relies on inflation and speculative equity to have any equity at all. The negative amortization loan will only begin to build financing equity after the loan recasts and becomes a fully-amortized loan and the payments skyrocket–assuming the borrower does not default. Most people cannot afford the fully-amortized payment, or they probably would not have used this form of financing initially. Even after the recast and the dramatic increase in payments, the loan does not get back to the original balance for many years.
Figure 7: Negative Amortization Loan Equity Curve
House prices historically have outpaced inflation by 0.7% nationally. [vii] In a normal market, this is the only appreciation homeowners obtain. This appreciation is caused by wage inflation translating into higher housing payments and the ability of borrowers to obtain larger loan amounts to bid up prices. In areas like Irvine, California, where wage growth has outpaced the general rate of inflation, the fundamental valuation of houses has increased faster than inflation. The related benefit to home ownership obtained through utilizing a fixed-rate, conventionally-amortizing mortgage is mortgage payments are frozen and the cost of housing does not increase with inflation. Renters must contend with ever-increasing rents while homeowners with the proper financing do not face escalating housing costs. Over the short term this is not significant, but over the long term, the monthly savings accruing to owners can be very sizable, and if the owner owns long enough or downsizes later in life, housing costs can be nearly eliminated when a mortgage is paid off (except for taxes, insurance and upkeep). Although this benefit is attractive, it is not worth paying much of a premium to obtain. The long-term benefit is quickly negated if there is a short-term additional cost associated with obtaining it. For instance, if a property can be rented for a certain amount today, and this amount will increase by 3% over 30 years, the total cost of ownership–even when fixed–cannot exceed this figure by more than 10% to break even over 30 years. The shorter the holding time, the less this premium is worth. In short, capturing the benefit of inflation equity requires a long holding period and a minimal ownership premium.
Speculative Equity is purely a function of irrational exuberance. [viii] It has become a common element in certain markets, and capturing it is the dream of every would-be speculator who buys residential real estate. It is a loser’s game, but it does not stop people from chasing after it. Will the markets bubble again? Who knows? Human nature being what it is, the delusive beliefs of irrational exuberance may take root and the cycle may continue. In the aftermath of the Great Housing Bubble legislators may pass laws from preventing it from happening again. Of course, such laws require enforcement, and when greed takes hold, enforcement may simply not occur. For those that purchased at the peak of the bubble, they need another bubble or they may not get back to breakeven in the next 20 to 30 years. [ix] If however, there is another bubble, those who purchased at rental equivalent value after the crash will have an opportunity to reap a huge windfall at the expense of those who purchase at inflated prices in the future. As PT Barnum is credited with saying, “There is a sucker born every minute.” [x]
The speculators who purchased at the peak of the Great Housing Bubble who put no money down (no Initial Equity) and utilized negative amortization loans–and there were a great many of these people–will have a painful future. The loan balance will be increasing at a time when resale home prices are falling. They will be so far underwater; they will need scuba equipment to survive. Plus, during the worst of their nightmare, their loan will recast, and they will be asked to make a huge payment on a property worth roughly half their loan balance. What default rates will these loans see? Realistically, they will all default. The only reason they purchased was to capture speculative profits which did not materialize. Even if some of these people hold on, and there is another speculative bubble similar to the last one, it will take 10 years or more for them to get back to breakeven, not including their carry costs. If there is no ensuing bubble, it will be 20 years. If you factor in their holding costs, they may never get back to breakeven.
Equity is made up of several component parts: Initial Equity, Financing Equity, Inflation Equity, and Speculative Equity. Each of these components has different characteristics and different forces that govern how they rise and fall. It is important to understand these components to make wise decisions on when to buy, how much to buy, and how to finance it. Failing to understand the dynamics involved can lead to an equity graph like the one for the peak buyer who purchased at the wrong time and utilized the wrong terms. Nobody wants to suffer that fate.
Figure 8: Peak Buyer, No Downpayment, Negative Amortization Loan
 This data comes from the Credit Suisse Report (Credit Suisse, 2007). The source of their data was Loan Performance.
[ii] This data comes from the Credit Suisse Report (Credit Suisse, 2007). The source of their data was Mortgage Asset Research Institute.
[iii] Anecdotal evidence indicates the practice of fabricating loan application income was common. There were a few high-profile arrests, as is always the case with this kind of phenomenon. As of the early 2008, no definitive studies have been undertaken to assess how widespread was the practice of intentionally fabricating loan application data by mortgage brokers.
[iv] Payments to investors from collateralized debt obligations were actually made by the servicer. If the borrower failed to make payments, the servicer would make them to the investor. When the loan was discharged through sale, the servicer would then recoup the money, plus interest, on any payments made on behalf of the borrower.
[v] (Libby, Libby, & Short, 2004)
[vi] Numerous reports have been compiled on the savings adequacy of Americans. In the report Lifetime Earnings, Social Security Benefits, and the Adequacy of Retirement Wealth Accumulation by Eric M. Engen, William G. Gale, Cori E. Uccello (Engen, Gale, & Uccello, 2004), the authors detail the savings patters on various generations preparing for retirement.
[vii] Robert Shiller constructed a graph of housing prices from 1890-2005 for the book Irrational Exuberance (Shiller, Irrational Exuberance, 2005). The rate of appreciation during this 115 year time period is 0.7% over the rate of inflation. The data from the US Census Bureau shows a 2.0% increase over inflation since 1940, however much of this increase was during the baby boom right after WWII and it does not reflect the improvement in house quality during this time. The 0.7% statistic is referenced a number of times in this work.
[viii] Robert Shiller titled his groundbreaking book Irrational Exuberance (Shiller, Irrational Exuberance, 2005) after a phrase in a speech given by Alan Greenspan, FED chairman from 1986-2006, in a speech at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996 (Greenspan, The Challenge of Central Banking in a Democratic Society, 1996). The term “irrational exuberance” is used synonymously in this writing to describe the behavior of buyers in creating an asset price bubble.
[ix] Human nature being what it is, another real estate bubble will form unless measures are taken to prevent one. The projections of how long it will take markets to recover vary depending on the variables analyzed. Later chapters explore this question in detail.
[x] Joe Vitale in his book There’s a Customer Born Every Minute: P.T. Barnum’s Secrets to Business Success (Vitale, 1998) disputes the contention that PT Barnum ever uttered the phrase with which he is credited.