Whoa! - Part 2

Last week I talked about the lack of brakes on the housing industry that has normally been provided by the mortgage lending community. Let’s talk about the big picture first.

For as long as I can remember, the housing industry has been creating new housing for sale to consumers at a rate less than the rate of household formations. This imbalance in supply and demand has generally help push pricing that everyone has experienced.

This has not been lost on the bankers who lend money to builders so they can build new homes. Most builders have been able to borrow all the money they want, being limited in production largely by the long time it takes to get projects through the city or county planners.

For many years in the more active housing markets the constraints on supply have meant that buyers sometimes have to endure the pain and suffering of a lottery among prospective buyers. If you were lucky, you’d be chosen.

Of course this same pressure exists in the re-sale market too. In some over-heated areas, there were multiple-offer situations, the successful bidders having had to bid well in excess of market value just to get it.

But the imbalance hasn’t just been due to a constraint on supply. In the last two years the mortgage industry has created many more buyers as a result of loosening of underwriting and credit standards. This has added fuel to the fire. Last year in Southern California , the average increase in home value from Nov 2003 to Nov 2004 was 23%. One could sure make the case that this hyper-increase in value has been fueled in part by the mortgage industry’s attempt to grow the market.

I will make the point that there are huge forces at work that will sell you a home or a car or anything else, and if it turns out bad for you, they don’t care. Caveat emptor!

Are there potential problems? There certainly can be. The most popular loans today are the interest-only and the negative-amortization loans that have abnormally low start rates. With the low payment rates, these are the loans that many people are using to leverage themselves into a home. A reader asked me to examine the potential consequences.

I made the assumption that a borrower started out with a $200,000 loan with a payment rate based upon a 1 percent start rate. It’s not 1 percent of the loan amount, but the payment based on a 30-year amortization at 1 percent. That would be $632 in our example. The actual interest due at current rates is over $700 so there is a short-fall of $65, which added to the loan balance at the end of the month.

I made the assumption that rates will move up one-half percent per year, not unreasonable considering that the Fed has raised rates already over 1 percent, not all of which has been reflected in current rates. The payment rate can increase only 7.5 percent per year, meaning in the second year they can go from $643 to $692. This is obviously very attractive from the standpoint of a borrower with minimal resources.

At the end of five years, however, the loan balance has increased from $200,000 to over $209,000. You’d hope that they get some appreciation – NOT GUARANTEED – or they will be under water. Of course, the reps selling this loan just say, “Oh, you can just refinance it then.”

The result, of course, is the at best these borrowers will be in hock to our industry forever. They will be on a series of these and when they finally retire, they will still owe a bundle while their shrewder neighbors will actually own their homes!

In the worst case, maybe we do have a bubble here and real estate values could do as they have done before sometimes, stay flat or go down! Not only don’t they have any equity, they’d have to pay the real estate commission just to get out from under it.

The point here is that the mortgage industry is pandering to the American consumers’ love affair with instant gratification without regard to long-term consequences. If you have friends who are all excited about this type of loan, urge them to be look carefully before they leap.

I hate to go into the Christmas season on this note, because I do not want to leave you with sour feelings. The good news is that more homebuyers than ever are actually learning more before they make choices and that many, many happy, thoughtful people are being helped into their dream homes by our industry’s practices.

They will have a Merry Christmas, and I hope that you and your family do to.

Be joyous out there!