Submitted by Edward Harrison of Credit Writedowns.
Yves said her piece about the new affordable FHFA program to allow home ‘owners’ in negative equity to stay in their homes. And I had a crack at it yesterday as well. But, I have some thoughts to run by you here using a specific example of an American homeowner named Maria.
Enjoy. Oh, and feel free to comment.
Let’s say you’re an American named Maria living in Southern California. The year is 2006. You make $45,000 and your husband David makes another $40,000. You have two children aged six and four and your two-bedroom apartment is getting too small. So you decide to consider buying a house. Eventually, you and your husband find a new home. Now, granted you know nothing about mortgage finance. But, your guy at New Century Financial hooks you up and with the help of a teaser-rate adjustable rate-mortgage you are able to afford the home. In the end, you shop around and get another bank you consider more reputable to match New Century’s terms. Sale Price $390,000. As you have no money down and roll up some fees into the mortgage, the final mortgage price is $390,000 with a second piggy back mortgage of $10,000 for a grand total of $400,000 of debt.
Fast forward to 2009. The economy is in tatters but you and your husband have your jobs. You’re doing alright. And, as it turns out, you have picked wisely by buying the smallest house on the block in a really up-and-coming neighborhood. The only problem is that house prices in your metro area are down 40%. Your house, while down less, is still down 20% and is only worth $320,000. This is a big worry because your mortgage was a 3-year ARM and the rate is about to go way up.
Enter the federal government’s “Making Home Affordable” plan. Just the other day HUD Secretary Shaun Donovan announced that mortgages owned or guaranteed by Freddie Mac and Fannie Mae can be refinanced up to – get this – 125% loan-to-value. That means, you can take out a refinance loan on your house now valued at $320,000 for up to $400,000. Bingo! That’s exactly what you need to keep your house. Do you do it?
Debtor’s Prison
If you do go ahead, we might as well stick you in the King’s Bench because you are about to find yourself in debtor’s prison. The Blog Seattle Bubble has this nailed (with some nifty charts to boot):
Let’s take a look at some hypothetical home borrowers who currently owe $400,000 in various mortgages with difficult terms or high rates, and whose home is presently worth $320,000. They jump on the new FHFA Home Affordable Refinance Program and refinance into a single 30-year fixed-rate loan at a 5.75% interest rate with a 125% loan-to-value ratio…
With the home value appreciation tweaked to a slightly less rosy scenario, it takes 17 years before our couple can break even selling their house.
Nice, huh? Their comment on this is dead on:
If the goal of this new 125% loan-to-value program is to financially imprison people in their current homes for a decade or more, then it looks like it could be a rousing success. However, I’m not sure how many currently struggling home borrowers would really consider that to be much of a “help.”
I have a post from last year describing circumstances in Japan that are eerily similar. Take a look. It’s called “A cautionary tale: story from 1994 Japan.”
Predatory Lending?
I have another angle too. You’ll notice I mentioned Maria is no financial wizard. She probably does not appreciate the intricacies of mortgage finance. Here are two points to consider.
- In the state of California, you can just walk away because first mortgages on primary residences are non-recourse. That means that the mortgage is only secured against the house you have bought.
- However, in the state of California, refinance mortgages are recourse loans. What does that mean? It means you are on the hook for that loan. You cannot just walk away. The bank can come after you and take your car and the stocks in your E-Trade account. They can garnish your wages. They can even take your clothes and the shirt off your back, literally. The only thing they can’t touch is your 401-K. But it’s down 40% anyway.
Why would you trade a non-recourse loan from which you can walk away for a recourse loan that guarantees you’ll end up as bad as some poor slob at Tappahannock? It doesn’t seem like an incredibly appealing choice, does it?
But, of course, this is a classic case of asymmetric information because you don’t know that you are getting a poor trade, but your bank and the government do. In fact, the bank makes more money this way because of incentives it receives for refinancing these loans – incentives, I might add that come straight from the taxpayer to the bank via the Federal Government (see my post “How refinancing helps the likes of Bank of America and Wells Fargo”).
So, to recap, you get shackled to a house with a recourse loan because you don’t know what the bank and government do. Meanwhile, your bank gets to forgo a writedown (remember, your loan was for the same amount as before). And the bank gets a refinance fee which is goosed by government incentives.
Is this predatory lending? Sure sounds like it to me.
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The non-recourse to recourse aspect of refinancing your home loan needs to be broadcast far and wide. Each person choosing to refinance should have to sign a disclosure agreement that they were informed of this risk.
Flip side is you can still BK and walk away, right?
As I posted in the other thread, I just don't see how this helps anyone. Rates on ARMs are falling now. Refinancing into a 30yr fixed is unlikely to save anyone money on their monthly payment.
Maybe they're just gearing up to announce they will now be offering teaser rates and non-fully amortized payment options?
–RueTheDay
Can you hear the drum beat, stroke, stroke, all whilst watching your betters on the LCD/Plasma TV in your lounge…ohh look honey we could live like that some day or go there if we work hard.
Skippy…love that new pop song "messing with my delirium" and yes they are.
Welcome to the New Society where our government is quietly and deliberately enslaving all but the very, very wealthy. Taxes, especially the regressive type, are rising, while resources for the poor or disabled quickly diminish. Credit is increasingly unavailable – when credit limits are slashed, FICO scores fall as the percent of debt-to-limit increases. Those with student loans are permanently indebted to the lender, often for a degree that is essentially worthless. Inflation has hit our every day consumables, while deflation erodes the value of our investments and the global dollar. All the Maria's out here may not understand the whys, but they are surely feeling more and more desperate, making these loans most attractive. They would never suspect that their government would offer loans that could and would happily take their last dime. Shame on us!
We have the perfect storm coming, it's just a matter of time.
Thanks Ed! Information like this needs to be spread as far and wide as possible. There are lots of great posts about the economy, but it's the more personal ones like that this that mean the most. Great job.
The program is designed to enable people to pay back money they owe.
Paying back money you owe has become an unfamiliar concept which is well worth being reconsidered.
While I have great regard for your intellect, I do not imagine that others could not have seen the same dangers.
I assumed in Bureaucratic style this idea passed up several layers and was bounced around elsewhere.
So is pushing it out onto the American public (rated #1 in some international poll of gullibility)
a matter of institutional mindset or an attempt to deceive?
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Vinny G.
gpp — with all due respect, you don't seem to understand the nature of the word nonrecourse. The fundamental (and clearly bargained for, when considering the legal constraints in place at the time of contract) aspect of a nonrecourse loan is the choice of the borrower to either repay the money or deliver the asset to the lender. A nonrecourse debt specifically and absolutely places the risk of loss when the asset value dips below the amount owed on *the lender.* So whether or not this concept you speak of is unfamiliar, reconsidering it seems pretty foolish when the choice to walk away is not just legal, but an obviously contemplated and bargained for right in the basic terms of a nonrecourse loan contract. Or perhaps the lender was duped when he handed the form contract he prepared to the borrower?
This business of the 125% LTV loans is over the top. Academia and the industry have produced tons of research that prove that.
It would be interesting to look at the State laws on what constitutes "Predatory Lending", or even better "Lender Liability". In Massachusetts the AG just settled a case like this with Goldman Sachs. The finding then was that the loans made were predatory and liability was assessed. The lucky 600 borrowers will get an average of 35% reduction in their PRINIPAL as a result of the settlement. Dumb lenders deserve to be penalized.
Part of 'curing' the system will be to establish clear laws on what a lender can do. When mortgages loans are made with no equity they create a systemic problem. It is not just a matter of the borrower and the lender losing what they have. The defaults that bad lending create devalue whole neighborhoods. It impacts people who were not over leveraged. Victims. We thought 'we' were protected from the follies of bad lenders like Countrywide. But we found out the hard way that was not the case.
My observation is that the private sector high risk mortgage window is closed. It will not reopen any time soon.
The D.C. lenders are making $100b per month of 97.5%++LTV loans. They have not learned from their mistakes. They are 60% of the total $12T market. They are 85%+ of the new market. And they are continuing to make bad loans. Is that systemic risk?
WTF does it mean for a loan to be predatory? Does it mean targeting someone you know won't be able to pay it back? In that case then predatory is short for "bad business decision?"
I think you are taking an extreme approach. We don’t even have debtors prisons in the US other than for not paying the IRS. You are correct about it being a poor decision. If they do lose income and eventually end up needing to get out of the house, they would be much worse off. I’m in a similiar situation in SoCal only on the bad side of it. My house was purchased for 380k and is down 65%. I also put nothing down just like the story. At that point is there any reason to even make the payments?