A Case for Mortgage Principal Reductions by Mark Hanson

by 31 Dec 1969
I believe that the housing market will 'fix' itself over time and constant meddling only prolongs the inevitable. But regulators, politicians and banks are hell-bent on 'saving' us with programs that will just not work. In my opinion, the only way to 'fix' the housing and mortgage markets and consumer?s balance sheet is to undo 2003-2007. To 'undo' means to: a) Force de-levering the home owner/consumer through mortgage principal balance reductions based upon what the borrower really earns using market-rate financing b) Make it so home owners can freely refinance and sell their homes c) Make it so the vitally important move-up buyer comes back d) Significantly reduce defaults and foreclosures without making home owners underwater, fully-leveraged, renters for the rest of their life, as the present mortgage modification plans do e) Allow home prices to fall to attractive multiples of rents and incomes without exotic loan programs or artificial, temporarily, government induced low mortgage rates This can all be accomplished quickly if the right steps are taken. HOME OWNERS AS A GROUP ARE NOT TO BLAME This greater housing and mortgage crisis is not a result of millions of borrowers going wild, buying beyond their means. Nor was it caused by gangs of mortgage brokers cruising the streets with 1003's and pens in hand recruiting straw buyers to steal homes. The greatest real estate bubble of all time was only able to occur because of the investment and commercial bank?s constant re-engineering of loan programs focusing on low monthly payments and the virtual elimination of income and assets as a variable. This extraordinary leverage created through these exotic loan programs never existed before. The problem going forward is that most do not realize that during the bubble years, everything was exotic - even 30-year fixed, fully documented loans. PEOPLE VIEW THEIR HOME AS AN INVESTMENT - NOT A PLACE TO LIVE What?s worse is that over the past five years, there was a fundamental shift of how people viewed their home - from ?a place to live? to their single ?largest investment?. How could they not when all loan programs from Subprime to Prime allowed 50 percent of gross income (greater when considering limited income doc loans) to be used towards debt. When housing was viewed as a place to live, financing was sound with down payments required and no more than 28 percent of gross income going towards housing debt. When home prices fell it was alright because home owners could still save money. There are many who can not afford their payments because of an ARM adjustment. But at one time they were qualified by the bank and given the way the loan was structured they could, in fact, afford the home. Banks and real estate professionals in every city in the nation used high-leverage exotic loans in order get people to qualify for ever increasing loan amounts. By 2005, interest-only was the industry standard, as well as stated income. Lenders did not worry over what would happen to the loan after a few months because the loan was sold and they lose all liability after six months. The 2/28 Subprime ARM was a perfect example of a loan program not designed to hold over the initial teaser period and one that the lender didn?t care about because most were sold and securitized. Even the securities investors never planned on holding these long. Exotic loans with teasers were sold as a ?way to get into the home more cheaply? or a ?way to improve your credit, then refinance into something better a couple of years from now?. The high churn rate out of these loans was what kept money flowing into this sector. They were short-term, high yield investments. This philosophy was not isolated to Subprime 2/28?s either - Prime 5/1 interest only ARMs and Pay Option ARMs were also sold the same way. ARMs were the majority of mortgages in the bubble states through the bubble years. REALITY But now it is obvious that the past six years was an illusion and none of the easy credit, high-leverage programs exists any longer. Prices are coming down to the real affordability levels using 15 and 30-year fixed rate loans and a down payment, which has rendered the nations financial institutions and millions of home owners instantly insolvent. The same household that earns $85,000 per year that two years ago could buy a $650,000 home with no money down can now buy a $275,000 - $300,000 home with 10 percent down. It now takes at least $150,000 a year income and a large down payment to buy a $650,000 home. 100 percent stated interest only and Pay option ARMs will not return; nor will 100 percent HELOCs. They were doomed to fail from their creation. The banks had modeling systems that they never stress tested. You mean to tell me that it never occurred to the smartest guys in the room to plug into the model that home prices could actually fall? That was a fatal error that the world is paying for. ARTIFICIALLY LOW RATES WILL NOT HELP EITHER Who Can Really Benefit From a five percent conforming (=<$417K) Mortgage? With a 69 percent home ownership rate at the peak, values down around 50 percent in the bubble states, negative-equity at an epidemic level, base-rates for most loans only available to those with high credit score and low LTV?s and Jumbo money still in peril, who is left to take advantage of these low rates? While for those that qualify, low rates are a great thing. It is very possible that the excitement over low mortgage rates will end up being exactly like the excitement surrounding the previous 20 bailouts, acts, proposals over the past year -- the light at the end of the tunnel is a train. Within the states that need the most help and are most beneficial to the macro-economy, the vast majority can not refinance due to negative-equity. In California for example, 60 percent of mortgagees are either upside down or near upside down and will not be able to take advantage of the rates. Nevada, Florida and Arizona are even worse. Most home owners in the top 10 trouble states in the nation are in financial hardship with their homes, unable to move or refinance. Rates are lower than last week for sure, but these ?low rates? that are being heralded are only for the best borrowers with 80 percent CLTV?s and 740 scores. This represents a small fraction of borrowers. As a matter of fact, most borrowers with this profile did not participate in the past several years of serial refinancing and many already have low 30-year fixed rates at five percent attained in 2003-2004. These rates are not for anyone with a less than perfect profile; two years tax returns, a current pay stub, great credit and sizable equity. This profile represents a small minority of borrowers. Until mid 2007, lenders actually funded 75-80 percent of all loan applications! Now, lenders are funding 40-50 percent of applications. That is serious fall out. With respect to purchasing, since over half the market is distressed, sales of foreclosure related properties, rate does not matter as much - home price does. five or six percent interest rates will not change things - it?s about how cheaply they can buy. Renters and first time home buyers should see some benefit to lower rates and will either save money or qualify for slightly more house. . But remember, first time home buyers and renters are the weakest portion of the market and have always been. What is missing is the all-important move-up buyer, which lower rates will not help to any great degree. This is because of the gross amount of negative equity in their homes and because without all of the exotic loan programs and easy qualifying, many can?t even afford to re-buy the home they live in now. Two important segments that made up 80 percent of all housing activity are the refinance borrower and move-up buyer. Now they are the minority. This is a major problem. We need to get these people back into the market. Investors, vacation home buyers, renters and first-time home buyers have always been the smallest segments of the market and now they are its primary participants. LOW MORTGAGE RATES MAY HASTEN HOUSING & SENTIMENT BUST Everyone wants to refinance right now - that's a fact. Home owners and loan officers around the nation have not been this excited in years over the low rates. Loan officers and banks are very busy taking new loan applications, as reflected in the MBA loan application survey data. In the past, the mortgage process involved getting a completed loan application, ordering the credit report and appraisal and processing the loan. In a couple of weeks when the appraisal came back from the appraiser, the loan was submitted into underwriting for approval. Everything went smoothly because the appraisal always came at or above borrower?s estimates. These days, the process has changed a bit. Now the first thing done after the loan application is taken is to call the appraiser for a comparable sale check to see if the value at which the home owner states the house is worth is on target. Therein lays the rub. From early reports since rates fell sharply in early December, 80 percent of the loan applications are not getting out of the starting gate easily. Loan officers are all saying the same thing ? ?appraisals are not coming at value because ?all of the foreclosures and REO sales have taken the value down?. In the majority of these cases, this kills the loan. The loan officer then notifies the borrower of the news and they are in disbelief. All home owners think that their home is worth the most on the block. Everyone trying to refinance into lower rates at once should hasten the national reality that the largest portion of the home owner's net worth has evaporated in the past year. One loan officer I spoke with equated this call to a Doctor notifying a patient that he has a terminal illness. The other two top reasons that loans are not making it out of the application phase are because of credit scores coming in too low, interest rates not really being what the borrowers are hearing hyped and Jumbo money is near all-time highs. With respect to credit scores, many have been negatively affected by creditors bringing revolving lines down sharply over the past several months. If the outstanding balance on a credit card is over the 30 percent it negatively affects the score. Lately, banks have been dropping available credit to just above the outstanding balance, which creates a large credit score hit. Additionally, when borrowers with loan amounts over $417,000 find out that 30-year fixed rates are anywhere from 6.5 percent to 9 percent, the reality will set in that they are stuck in that loan and that home indefinitely. 42 percent of home owners are upside down and unable to refinance. And about 65 percent to 70 percent in the bubble states The only thing that can be done to fix this quickly is to waive appraisals for Agency and FHA loans as Lockhart has suggested. "James Lockhart, Fannie and Freddie?s regulator, said last week they were considering waiving the requirement to get new home price appraisals before refinancing loans they hold ? a move that could greatly increase the scope for refinancing? But ?no appraisal? refinances could be a disaster that takes the housing crisis to an entirely different level because now the tax payer will be on the hook for trillions in mortgages that are essentially unsecured credit lines. Nobody will ever buy these loans or securities derived from them. But given the extent of the negative-equity in America with no way to fix it other than aggressive proactive loan modifications allowing principal balance reductions, my money is on them seriously considering this. THE SOLUTION The solution is not about the regulators forcing interest rates down to artificially low levels for a brief period of time. That?s what got us here in the first place. That being said, sustainable low rates are good for the housing market. But low rates mean very little when millions will default and lose their homes over the next few years because all of that added supply can't be absorbed by the available buyers. The fact is that there are much fewer buyers than ever before given home ownership was at 69 percent a couple of years back and now the largest sector of the purchase market, move-up buyers, are all but non-existent. If not for the unregulated institutions providing unlimited and irresponsible credit and leverage to every household in America this never would have happened. I am a fan of letting the market work and the housing/foreclosure crisis clearing itself up on its own. We are already seeing positive signs that the Subprime crisis is on the other side of the hill mostly on its own. The problem is that the Alt-A, Jumbo Prime and Prime mountains lie ahead. However, if the government and banks are hell bent on modifications and saving people, they ought to do it the right way. This blame does mostly lie with the banks, law makers, and regulators (including Greenspan) who branded and endorsed exotic loans as mainstream until 80 percent of all loans in the state of California were exotic by definition in 2006. This is very similar to the cigarette makers not telling the American consumer for decades that Cigarettes were highly addictive and cause cancer. Prices are coming down fast and the market will clear at some point and at some level. But that level could be years away. The banks, regulators and lawmakers with all of their highly exotic loan modification plans will ensure it takes two decades for this to happen. The re-default rate after loan modification is over 50 percent because most loan modifications keep the borrowers levered in their homes. The plans by Fannie, Freddie, FDIC, banks and lawmakers do exactly this. My plan will achieve the same within a couple of years. Yes, there will be pain, but much less. As with the financial institutions, the quicker the borrowers de-lever and raise cash, the better for the housing market and macro-economy. It is worth spending a few more trillion on quickly de-leveraging US households so they are free to save and spend money on other things besides an over-financed house. The present mortgage modification structure takes care of the institutions at the expense of the very same tax payer that is bailing them out in the first place. Undoing the Past 5-Years It is time for the very same financial institutions that created all of this to do what?s right and re-underwrite every loan originated between 2003 - 2007 using prudent underwriting guidelines. Then, they must reduce the principal balance to what the borrower really earns using a 28 percent housing and 36 percent total debt-to-income ratio (DTI) at a market rate 30-year fixed loan. When home owners are levered to 28/36 DTI they are able to save money and live a decent lifestyle. If reducing the principal balance to 28/36 on a market rate 30-year fixed loan winds up being $100,000 lower than the present value of the home, the bank should receive the differential through an equity warrant to 90 percent of the value of the property. This way the home owner is not upside down in the home, they can freely sell or refinance. But the home owner gets all of the upside. Anything less and the program will fail. If the borrowers can not prove income through bank statements at the very least, then they need to leave the house and rent. They should have been renters all along. For the small percentage of folks who can afford the payments just fine with DTI's under 28/36 but are underwater solely due to house price depreciation, principal balance reductions to 90 percent of the present value of the property is likely in order with a full-recourse provision to thwart fraud. For the minority with equity who may owe fifty percent of the home value or have no mortgage at all, they should receive a multi-year tax break. Many of them already have 5 to 5.5 percent rates. By de-leveraging and stabilizing the consumer, you will stabilize house prices much faster, which will benefit the economy. These things will not prevent housing prices from coming down over the next few years to reach a level of affordability consistent with present mortgage rates and lending guidelines. But at least it would be the best way to begin to undo the irresponsibility of the past five years and get back to basics where house prices and affordability are based primarily on traditional factors such as rents, incomes, interest rates, macroeconomic conditions and sentiment. Mark Hanson Field Check Group, Real Estate & Finance Managing Director/Principal Mark Hanson is a 20-year mortgage banking veteran, specializing in wholesale and correspondent sales and sales/operations management and bringing financial institutions into new lending markets. Since 2006, his primary focus has been upon his work as an independent finance and real estate sector analyst, consultant and ?risk enlightener? to investment funds, banks, mortgage bankers, the public sector and the media. He owns one of the leading online mortgage/housing internet sites called Mr Mortgage?s Guide to the Truth located at http://mrmortgage.ml-implode.com



Is TILA-RESPA a good or bad thing long term?