Wednesday, November 16, 2011

Bad Loan Deals

What are these bad loan instruments we keep hearing about?

In the recent Real Estate meltdown, we've heard a lot of terms bandied about, such as "Liar's Loans" or "Toxic ARMs" or "Optional Payment"  - and most people don't know what they mean.

The common denominator of these loans was that they "qualified" people to buy more house than they could afford.  And as more money was made available, prices went up.

For example, in Ft. Lauderdale, Florida, simple houses that sold for $250,000 to $400,000 in the 1990's suddenly skyrocketed to $800,000 to over a million dollars.  People shopping for houses were told, by helpful Real Estate Agents, that they could "qualify" using one of these funny new loan types.

So, instead of walking away from overpriced homes and saying "That is too much to pay for a house like that!" they instead got the loan, which they thought they could afford, based on monthly payment (ouch!) and bought the house.

If such loans did not exist, fewer people would have the money to pay the outrageous prices and guess what?  Supply and demand would have kicked in, and prices would have dropped.

And when funny-money loans went away, well, guess what happened to housing prices?  That is the "pickle" we are in today, and it is called a realistic market, not a "downturn".

So what are these loan types?  There are so many it is hard to track them all.  And many have hybrid terms of varying terms.  But here are a few I am familiar with:

Liar's Loans:  These are often called "Stated Income" or "Stated Assets" loans.  Instead of proving you made such-and-such money by providing tax returns or W-2s, you simply wrote down a number on a piece of paper and said that was your income.  And with "Stated Assets" you did the same thing with your stocks and bonds.  You write down that you are a millionaire, and they don't even check it out.  So long as your credit score is OK, you get the loan.

Insane, no?  And yet, I got a loan like this from Bank of America, at a very good rate.  And in a similar manner to the stated income and assets, they used a "zip code appraisal" to appraise the property.  They type in the zip code into a computer, and if the property is within range of the average housing price in the area, you get your loan.  Totally insane!

Today, these types of loans are no longer available - or are very rare.  Banks need to see proof of income and assets, and want a real appraisal of the home.  Seems like common sense to most folks.  But mortgage lenders, working on commission, back in the day, cared less about loans being good or bad, so much as making them.  You create an incentive system that rewards loan-making and all hell breaks loose.

One reason Liar's Loans backfired is that many of the applicants were, in fact, liars - and indeed often real criminals.  Mortgage fraud was used to buy and flip houses, using straw-man transactions, where organized criminals pocketed millions of dollars.  Liar's loans were their best friend!

Of course, I paid back my "Liar's Loan" when I sold my Florida properties.  I obtained another loan like it, in Georgia, also though Bank of America, which I have since paid back.  Proponents of such loans would look at my example and argue that these are good instruments - sometimes.  But the default rate on such notes was indeed very high.  One person paying them back doesn't make them OK.

Toxic ARMs:  Oftentimes, to entice a buyer into a property, a bank might offer an initial reduced interest rate on a loan.  Back in the days of 10-14% interest rates, these "buy downs" were often used to "get people into homes" on the premise that over time, their incomes would rise up and they could afford the higher rates.

For example, my house in Alexandria, which I bought in 1989, at the height of both the last bubble and also high interest rates (which helped dampen that bubble somewhat), we had a "3-2 buydown" on the rate.  The mortgage started at 8.625% then graduated to 9.625% the next year, and so on, until the final "real" rate of 11.625% was reached.  Believe it or not, that was considered a good rate back then!

Kids today - they don't know how lucky they have it, being able to get sub-5% mortgages!

But that was the other theory behind the "buydown" mortgage - that interest rates would fall over time and that we could then refinance, which we did, at what we thought was an astounding 6.5%.  Those were the days.  Of course, I had a fixed-rate mortgage and always have.  But the effect was the same.

These types of mortgages vanished in the 1990's but reappeared in the 2000's as housing prices started to soar.  In order to "get people into homes" the mortgage lenders started offering exciting new "products" such as toxic ARM loans.

ARMs - Adjustable Rate Mortgages, were always problematic.  If interest rates skyrocketed (which they did back in the late 1970's) you literally could be priced out of your home.  And the reason banks went to ARMs was just that.  In the 1970's and early 1980's, banks were stuck with fixed rate mortgages at 5-6% that they wrote before interest rates took off.  In an era of 10% inflation, they were now losing money on these deals, and that is one reason banks started to shy away from fixed rate notes.

So ARMs were offered with attractive rates, and fixed-rate mortgages, as my example shows, remained high.  For people willing to take the risk, an ARM could get you a much lower mortgage payment, or conversely, allow you to pay more for a house.  Most people chose the latter.

In the 2000's though, a new beast emerged - the Toxic-ARM.  This loan had a nearly non-existant interest rate as a "teaser" or "come-on".  In an exaggerated version of the "buydown" the rate for the first year would be as little as 1-2%, allowing a person to buy far more house than he could afford.  The missing interest was often tacked onto the "tail end" of the loan.  But the terms of the note specified that the interest rate would climb quickly to market rates - and beyond - which on their face were unaffordable for the homeowner.

The premise of this loan was not that the young couple starting out would have an increased income over time, or that they could afford to refinance later on (no one offered 2% fixed rate mortgages back then, or even now!) but rather that the house would appreciate in value so much that the buyer could simply sell it and make a big profit, and pay back the mortgage before the higher interest rates kicked in.

Nice theory.   Didn't work out.  As home prices plummeted, no one wanted to buy over-mortgaged mini-mansions, and people ended up headed for bankruptcy in a hurry.

It should be noted that property taxes were like gasoline on this fire.  In South Florida, these overpriced homes had low taxes - for the first year, based on the previous assessed value.  But once the house sold, it was reassessed at the new, inflated sales price, and suddenly the homeowner had a tax bill , in the second year, in the five figures.  Adding $500 to $1000 a month to your mortgage payment, just in taxes alone, helped sink many of these marginal deals.

Optional Payment loans were often combined with Toxic ARM loans which in turn may have been Liar's Loans as well.  A real triple whammy!  These loans offered the homeowner a "choice" of payment terms - either at the low, fake, discounted rate, at the "regular" adjustable rate, or at a fixed rate or some combination of terms.   Some loans were "interest optional" in that the homeowner paid no interest at all.  And even others had payment terms where the principal paid was less than the amortized amount!

Of course, these shortfalls in payments were tacked on to the "tail" of the loan, and as a result, the balance on the mortgage went UP over time.  And since most homeowners could not afford the regular payments (why else get such a loan?) they paid the least amount offered as a "choice" and their equity in their homes actually went down over time.

Worse yet, as the balance increased, the loan payments - even the artificially lowered ones - went up over time.  Throw in a property tax increase and a staggering hurricane insurance increase (the 2000's were bad for Florida, weather-wise) and pretty soon the homeowner is priced out of the home.  Once housing prices tanked, it was a "perfect storm" of intractable debt.

* * * 

Of course, none of these loan instruments (or "products" as the financial industry likes to call them.  They also like to refer to banking as "the financial industry" - both implying that something is actually being made here) made any sense at all.  In fact, they were quite insane.

But regardless of the mechanism used in these loans, it was the presence of "funny money" that was the main cause of our problems today.  If people are told that they can "qualify" for a million-dollar home, based on a $100,000 a year income, they will buy that home, and not think about whether a basic tract home is really worth a million bucks, even if it has a sun nook.  People tend to focus on monthly payment and whether the bank will "give them the money" - usually to their regret.

So you throw easy money around, and not surprisingly, a lot of people spend it.  And when they do, prices go up.  Overpriced houses and sleazy mortgages go hand-in-hand.  Tight money and lower housing prices mate up as well.

And the same is true for overpriced educations.  If an 18-year-old is told that, if he signs some papers, he can go off to college and party for four years, have a car, get laid and drink beer, well, chances are, he will do it.  And many do.  Just that.  So long as there is funny money around, no one complains about the price of college.

Car leasing works the same way.  "We can get you into this car" the dealer says, "through leasing!"  So the guy who can't afford a new car, leases one instead, looking only at monthly cost and not the overall transaction cost. 

(Isn't it kind of funny that the people trying to sell you these bad bargains are always trying to "get you into" a car or a house?   Funny terminology.  I heard a car salesman say the other day, to a customer, whether they wanted to "stay in" their current car.  Whatever happened to owning things?)

Or take prescription drugs.  I know people who buy brand-name prescription drugs (they don't perceive themselves as "buying" them, so much as they are prescribed of course!) when a generic will do.  Why?  Their insurance covers it.  Funny money. Of course, they cry foul when the company raises their rates "unreasonably".

The bottom line is just this:  Getting rid of funny money is the key to improving our economy.  And it will be a painful process to do so, as our government has invested great effort in subsidizing and guaranteeing all sorts of bad debts.  But for the long run, we will all be better off with bad loan deals!