As the Obama administration and Congress try to pass financial reform legislation, Secretary of the Treasury Timothy Geithner wrote the following in The Washington Post:
"It is simply unacceptable to walk away from this recession without fixing the system's basic flaws that helped to create it.
Thankfully, signs of bipartisan support for action seem to be emerging in Washington, including for an independent consumer financial protection agency.
That is welcome news. The best way to protect American families who take out a mortgage or a car loan or who save to put their kids through college is through an independent, accountable agency that can set and enforce clear rules of the road across the financial marketplace."
Secretary Geithner’s comments fit with what many people were saying back when the financial crisis was new and the housing bubble was first bursting: Among those to blame for the crisis were lenders and mortgage brokers who tricked people into mortgages they couldn’t afford. Home buyers were being taken advantage; that was one of the big causes of it all. And that is why Secretary Geithner is pushing for an independent consumer financial protection agency.
But were unscrupulous bankers and mortgage brokers really the problem in the real estate crash? Consider what has happened, and is happening, with one particular type of mortgage that has been particularly criticized, the "option adjustable rate mortgage". These adjustable rate mortgages started with low interest rates (often called "teaser rates"). After a period, the interest rates and the payments on these mortgages are reset. The worry and the claim was that, when the payments were reset, there would be a huge wave of defaults because people wouldn’t be able to afford to pay the new, higher payments.
So what has been happening with these loans? Is the problem going to be as big as everybody feared? Is another wave of defaults and repossessions going to occur?
The Wall Street Journal looked at these questions in late March and it appears things aren’t going to be as bad as people were saying.* The total number of these mortgages outstanding has dropped dramatically. Many borrowers, knowing what was coming, have already refinanced or worked out a modification of their loan with their lender. Others defaulted. Some probably defaulted because they knew they wouldn’t be able to afford the new payment once their mortgage was reset, but others apparently couldn’t even afford the low payment they have now. So maybe it wasn’t just evil bankers and mortgage brokers. Maybe it was something else. Maybe we need something more, or different, than a consumer protection agency for mortgages and loans.
But what was the problem? And what can we do to prevent it from happening again? Obviously, there have been lots of articles and discussions on this point. Some economists point to the long period of really low interest rates by the Federal Reserve. Others point to borrowers who lied about their incomes and debts to be able to buy a more expensive house or get a bigger mortgage than they could have otherwise gotten. And others, as I said, blame unscrupulous mortgage brokers and bankers.
Actually, there probably was no single cause. What happened was probably a combination of a number of things coming together to create a disaster. But regardless of what other causes there may have been, one comment I read sticks out: "Not everybody who has negative equity goes into foreclosure, but nearly everybody who goes into foreclosure has negative equity."** Which leads me to what I think was a major cause of the bubble – and which could, if we are not smart, lead us down the same road again.
Back in the "old days," i.e., the 70s, if you wanted to buy a house, you had to have a pretty good-sized down payment. 20% down was just about a minimum. But then things started changing. "Private mortgage insurance" came along. With PMI you didn’t need 20% down. You could borrow more than 80% as long as you paid an extra fee to the private mortgage insurance company. There were home equity loans, too, which also allowed you to borrow more.
In the 2000s new "financial products" allowed buyers to borrow even more. Instead of saving up so they could put 20% down on a house, people were getting mortgages close to 100% of the price of their house, if not a full 100%. Or they would put two or three loans together to get a 100% mortgage. With credits from the buyer, tax prorations and everything else, in some situations buyers were leaving the closing with more cash than they had going in. You’d buy a house and instead of paying money at the closing, you’d get money back. When I told that to some business people from Italy and Germany, they couldn’t believe it. It didn’t make sense to them. It didn’t make sense, here, either, but we kept doing it, anyway, because it worked – or at least seemed to.
Not only did it seem to work, but everybody liked it. Lots of buyers liked it because they could buy a house even though they hadn’t saved a proper down payment. Mortgage brokers and bankers liked it because there were more deals and they made money doing deals. Politicians liked it because they could talk about how many people were becoming homeowners and living the American dream. Investors liked it because they could earn more on these mortgages than they could on other things because of the Fed’s low interest rates. Speculators and "flippers" liked it because they could make money without having money. And sellers liked it because the easy mortgages meant there were more buyers, and more buyers meant higher prices for their houses.
But consider the first and last comments in the prior paragraph: The fact that people needed only a very small down payment, if they needed one at all, meant more people could buy a house. More people buying houses meant higher prices for houses. Prices that kept going higher and higher meant it wasn’t a risk to buy a house with virtually no down payment, because with prices going up, you’d have equity soon.
It worked fine – as long as prices kept going up. But then, all of a sudden, house prices stopped going up. In fact, they started going down in a few markets, which threw people into a panic – because they expected housing prices to always go up. As the worry became contagious and gained momentum, prices started going down in more places. It did not take long for those people with 100% loans, or close to 100% loans, to find that their houses were worth less than the amount of their mortgage. (This also happened to people who were constantly refinancing the loans on their houses, increasing their mortgage and taking the extra cash to spend.)
When people lost a job or had some other unexpected bills – or just looked at what the other houses were selling for in their neighborhood versus the mortgage they had on their house – some of them could no longer afford their monthly payments. And others decided, when their houses were only worth two-thirds, or less, of the amount of their mortgage, that it wasn’t worth it to try to pay their mortgages, even if they could. After all, in many cases the lender either legally couldn’t or practically wouldn’t come after them for the deficiency, so why pay?
But what happened in other countries? In Canada house prices went down, but they didn’t have a mortgage meltdown. According to Alex Pollock:**
"[In Canada] [m]ortgage interest is not tax deductible. [Canada] does not have 30-year fixed rate, freely prepayable mortgage loans. …
Canadian mortgage lenders have full recourse to the mortgage borrower’s other assets and income, in addition to having the house as collateral. This means there is little incentive for borrowers to ‘walk away’ from their mortgage. The absence of a tax deduction for mortgage interest probably increases the incentive to pay down debt. … Canadian fixed-rate mortgages typically have prepayment penalties to protect the lender and the interest rate is fixed for only up to five years.
This relative creditor conservatism has meant that Canada and Canadian banks have so far come through the international financial crisis in much better shape than their U.S. counterparts."
When the real estate market slumped in New Zealand, the largest bank in the country announced that it was raising the minimum down payment from 10% to 20%. The New Zealand Herald approved:
"On the face of it, this seems like a cruel blow. But it is in tune with the times. The slumping real estate market, which shows no sign of having bottomed out, urges caution on the part of lenders whose imprudence in the so-called "sub-prime" (read "high-risk") US mortgage market created much of the economic vulnerability that made the present crash possible, even inevitable. A mortgagee in the present environment who lends even 80 per cent of a residential property's purchase price is operating at the upper end of exposure to declining value. To go further would be more than simply foolhardy …."
With some of the huge drops in house prices in the United States, bigger down payments would not have solved the problem in all cases. A 20% down payment wouldn’t keep you above water when the value of your house goes down 40% or 50%. But not all prices went down 50%. Some houses went down a lot less than that 40% or 50%. And a 25% decline to somebody who put 20% down is a lot different than a 25% drop to somebody who put nothing down.
While bigger down payments would not have totally solved the problem, they would have helped. If nothing else, a buyer who puts 20% down on a house is going to feel different about abandoning a house than somebody who had a 100% mortgage. After all the problems we had, one would hope lenders would realize that giving a mortgage to somebody who is buying a house with no, or virtually no, down payment is not a good idea. If housing prices dip even a little or if somebody loses their job or the house needs a major repair, the chances of a default increase dramatically. It’s obvious. There’s no cushion; there’s no safety. And it does seem that most lenders, or at least most private lenders, have figured this out. They are requiring bigger down payments.
But there are lenders out there who are still giving out mortgages which require the buyers to put down as little as 3.5%. And that means, as I said above, with credits at closing and tax prorations, people are still able, in some cases, to buy houses with little or no money at closing. Which means, in spite of all of the problems that the bursting of the housing bubble has caused, there are still people entering into the very kind of mortgages, and taking the very kind of risks, that got us into this problem in the first place.
But where are these mortgages coming from? They are not coming from private lenders. They have figured it out. Instead, they are coming from the government. FHA, Fannie Mae, Freddie Mac. They are financing mortgages with as little as 3.5% down – and they are financing lots of them.
These mortgages are defended on the ground that they are necessary to get the housing market back on its feet again. On the ground that they are necessary for housing to recover its value. But that is wrong. If the value that these programs are trying to help us get back to is the values that houses had in 2005 and 2006, that is silly because those weren’t real values. Those were bubble values. Bubble values were not real. They were the real estate equivalent of fantasy baseball. Except that they had real world consequences.
Not only can’t we recover those values, we shouldn’t try. We need a real estate market based on a solid foundation, based on people who can afford the houses they buy and who can afford them even if the market drops a little or if they have an unexpected expense. We need a real estate market that is based on people owning some part of the house they are living in, not just, in effect, renting it in the hope that the price will go up.
Giving out mortgages which require only 3.5% down is a bet that the real estate market has hit bottom – because, if it hasn’t, the next downturn is going to leave you with even more people owing more on their houses than their houses are worth. We could be setting the stage for yet another real estate crash. I realize it is hard to believe it could happen again, but then that is what most people thought in 2005 and 2006 about it happening a first time. Is that a risk we want to take?
I realize that increasing the minimum down payment will mean that not as many people can buy a house and that those who do want to buy a house may have to wait until they can save a proper down payment. And both of those may mean that house prices are not going to go back to their bubble peaks. But that’s okay because the housing market we will have will be solid and won’t blow up in our face again, like a bad bet at a roulette table in Las Vegas.
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* Nick Timiraos, "Mortgage Increases Blunted," The Wall Street Journal, March 29, 2010.
** Alex J. Pollock, "Why Canada Avoided a Mortgage Meltdown," The Wall Street Journal, March 19, 2010.
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