Every day I drive down from the hill where I live in my half-remodeled exurban mansion cum ruined shack and into the valley where the repos live. Sometime about 5 years ago our little town of about 2000 people unexpectedly developed its own suburbs. They’re really Austin suburbs, but they’re inside our city limits and add to our tax base and our crime rate, so they’re ours. They string out along an old country road in what used to be farm land, laid out in a pattern of increasing home value the farther you get from downtown. They’re perfect examples of what’s at the center of the current real estate and mortgage banking crisis. We don’t have as big a problem as some other parts of the country because our regional economy is still booming, but they make a perfect study of what was going on at that time and what led to the current problems.
What makes these developments relevant is that they were built for a market of low-middle income families who were looking for their first homes. As a result the houses were built relatively simply and inexpensively and the prices were kept as low as possible, but most importantly they were offered for sale with very attractive alternative financing options to encourage people who might otherwise not buy a house to take the plunge a few years before they normally would, or to go for more of a house than they might otherwise be able to afford. That means letting people who would normally be renters get into a house for a price per month comparable to what they might be paying in rent, ideally with no money out of pocket, and in some cases with less of a credit check than you’d face as a renter in most areas.
The financing options for homes in these developments included all the clever and profitable tricks you may have heard tales of woe about in the financial news, including: 80/20 ‘no money down’ mortgages where you take a second mortgage to pay your downpayment, ‘front-end-loaded’ mortgages where you pay mostly interest for the first couple of years, variable APR mortgages where the interest is lower but fluctuates with changes in the rate, non-qualifying loans where the interest rate was high but credit rating and even family income weren’t even looked at, ‘teaser’ rate loans where the interest starts low and then increases, and just about any other goofy way to lower payments and increase profits for the lender that you can think of. The result was that you could get into a ‘starter home’ with a price as low as $80,000 a year and payments as low as $700 a month including insurance.
Now, these aren’t exactly Biltmore House, but then you aren’t George Vanderbilt. They’ve got paper-thin walls, no trees in the yard, ‘contractor quality’ fixtures and grass planted on topsoil three inches deep. But they’re a roof over your head, you’ve got some elbow room, there’s central air for the Texas heat and you’re a 20-minute commute from downtown. All things considered they’re still better than living in an apartment.
They even have garages for the car you can’t afford and took on a lease with a balloon payment. At local developments run by D.R. Horton and other developers, the prices and offerings are typical. For $80K you get a 2/1 900-square foot house. For $100K you can upgrade to a 2/2 1100-square foot model and at $120K you can get a 3/2 1300-square foot house with some features like walk-in closets. The floorplans are all similar and look like they were designed by a high-school junior for his class project, but there are variations in appearance and layout including two story options and bonus features like fireplaces and appearance upgrades which can be added for a price.
The marketing of these homes when they were first built heavily aimed at first-time buyers with little or no experience with mortgages or home ownership, targeting minorities and young working people who under other circumstances might not have been able to afford a house until they were in their 40s. Often this meant they didn’t even have to qualify for the loan in normal ways. Credit could be ignored and income cut-offs were flexible. If you had a halfway decent job you could get a house, even if it was kind of small and horrible like the bottom end model shown in the picture to the right.
An easy to enter home market is not necessarily a bad thing. Buying a house at a price you can afford and building up equity is probably better than renting. That may even be true if you have to pay a slightly higher interest rate or finance your down payment, assuming you buy within your means. But the higher costs associated with these so-called ‘marginal’ loans can put you right on the edge of what you can really afford, and if you’re on the wrong side of that line or the payment’s higher than what you’d be paying in rent, then there might be a problem. A few reversals or a bit of financial mismanagement or just overextending your revolving credit can put you in a situation where the home becomes an expense you can’t justify any longer.
When the short-term cost of the home outweighs the long-term benefits of building up equity then it’s time to get out, and when you put no money down, it’s awfully tempting to just walk out on the mortgage, despite whatever ethical objections you might have. If this starts happening all over the area, the irony is that you can walk out on your mortgage and then come back and rent the same house or something very similar in the same area for about what you were paying on that mortgage or even less when the banks, homebuilders and speculators get desperate. Here in the Austin area we don’t have anywhere near the foreclosure rate you see nationwide, but you do see these repo homes coming back on the market at a discount of 10 to 20 percent off their original new price, or showing up as lease-to-own or straightout rental properties. In other parts of the country where developers were more overextended and the economy isn’t as strong the selection is better and the prices are even lower. Ultimately the market takes care of everyone and supply will adjust to meet demand.
The problems with this whole situation come when it’s looked at on a nationwide basis. The level of foreclosures, repossessions and abandonment of homes is at the highest level in 20 years, with as many as seven million of these starter homes up for grabs. There are two main areas of concern:
First, there is a lot of handwringing over the fate of the poor homebuyer who was suckered into buying a house they couldn’t really afford, taken advantage of in their inexperience and saddled with a terrible and exploitative loan, and ultimately put in a situation where they were better off losing the house and even declaring bankruptcy than staying in it. To make matters worse, these buyers were disproportionately members of minority groups who many feel have suffered and been exploited enough.
Second, there’s the problem which the mortgage banks which were heavily involved in this market face. Some large banks like Countrywide and Washington Mutual were involved in this market and although only a few of the smaller players have actually gone bankrupt, they’re all cutting back on loans, consolidating and have reduced dividends and seen a corresponding decline in their stock values. They in turn have put pressure for credit to cover their losses on the larger banks which back them, putting stress on their reserves and creating a problem which has spilled overseas to international banks and raised the concern of government regulators, who responded last week by pumping $38 billion into the banks in the form of federal credit.
The first problem is one which is very emotionally appealing, but doesn’t ultimately mean very much. Sure, some people made a mistake and have been inconvenienced. But contrary to the claims of alarmists, these folks aren’t being thrown out in the street or bankrupted in large numbers. Their liability for walking out on a mortgage is limited. In most cases the lenders will have made them take out Private Mortgage Insurance because the loans were high risk and that absolves them of any financial responsibility. In some cases they might have to declare bankruptcy, but this doesn’t seem to be happening. There’s been no significant increase in personal bankruptcy since the ‘crisis’ started. They likely don’t even face any tax liability because the debt they owe on the home renders them temporarily ‘insolvent’ in the eyes of the IRS.
These are people who were renters before, had a chance at a house and ultimately blew that chance, but usually at little or no real cost to them, and they can just go back to renting and buy a house ten years down the road as should have been their goal in the first place. The only price they pay is a hit on their credit, and forclosures are discounted by credit agencies remarkably quickly. Plus they’re probably better off not going into too much debt and learning a lesson from their homeowning experience. And don’t forget that the glass is half full. For every person who lost their cheap entry-level home there’s another person who still has theirs and with any luck they took advantage of the low interest rates from two years ago to refinance at a better rate and with more normal terms. Plus all those repo homes are now selling at discount prices for those who waited and are ready to buy a slightly used entry level home. So don’t shed any tears for the supposed victims.
The banks are a different story. On one hand, they’re the villains of the story, taking advantage of the poor little, ignorant consumers. But on the other hand, they’re the real victims. It’s their money that financed building the houses and they’re stuck with collateral with a reduced value that’s hard to sell quickly. Eventually they’ll be okay, but if they didn’t have sufficient cash reserves to carry those empty houses for a while, they’re in some trouble and that’s bad for everyone who wants a loan or owns stock in a bank or a business that operates on credit. There’s no reason to feel sorry for the banks, because they made these high risk loans and deserve to suffer for it. But we certainly can be pissed at them as stockholders and business people and taxpayers, because their high-risk behavior is slowing the economy and probably costing us money. It’s not going to devastate most of us, but it was their greed and we’re all paying for it. Let’s hope they learned a lesson.
All of which leads to the ultimate question, which is what can be done to prevent this kind of problem in the future? Certainly one answer is better consumer education. If these buyers had known their options and had more of an idea of what they were getting into and what they could afford, they would have behaved more responsibly. It’s a great argument for personal finance classes in the public high schools. Another option might be closer regulation of bank lending practices, something which is probably in the hands of the state legislatures. It goes against some of my libertarian inclinations, but it might not be a bad idea to just prohibit some of the more ridiculous lending practices which got these banks into trouble. ARMs and even 80/20 mortgages aren’t so bad, but some of the other behavior like lending money without any qualifications were just stupid and irresponsible.
This isn’t a banking crisis as some have claimed. It’s a responsibility crisis. Over-eager borrowers have paid their price for their irresponsible borrowing. Now it’s time for the irresponsible banks to pay their price. If the government doesn’t put the banks on the right track and they don’t learn from this experience, then their shareholders ought to demand more responsibility, which is sort of what they’ve done by dumping their stock like it was infested with fire ants all last week.
You can see the limits of the crisis by looking at the stock of the responsible banks that weren’t involved in this market. I own stock in a bank which didn’t engage in speculative lending or backing high-risk lenders and as a result during a week when some other banks lost 50% of their share value, its shares went up almost 10%. There’s a lesson there for lenders and for their shareholders.