Sunday, February 5, 2012

How Credit Affects Markets.

Until fairly recently, home mortgages were hard to obtain in Mexico.  As a result, homes often took years to build, as homeowners had to construct them, slowly, over time.

About a decade ago, we decided to drive our motorhome to Mexico, and spend nearly a month there.  The experience was so stressful, I was never able to complete our journal of the trip.  Things have changed in Mexico since then, and while we did go back to Zihuatanejo, I haven't been back since, other than a brief stop in Cozumel on a cruise.

Cruises suck, by the way.  Save your money and just fly somewhere - unless you think being trapped in the Marriott in Wilkes-Barre Pennsylvania for a week is fun.

Of course, a lot has changed in Mexico in a decade.  Back in 2002, the only criminals you had to fear were the Police.  Today, the Police are outgunned by drug gangs, who mostly kill each other, but occasionally kidnap tourists.  It is a very sad state of affairs for a country with so much promise.

But getting back to our story, what intrigued me at the time was the fact that so many homes in Mexico seemed to be in a state of half-completion. The Mexican economy was just recovering from some really stupid moves - the government had decided to devalue the peso in 1994, basically wrecking the economy.  Things were just starting to recover in 2002, and Citibank was bravely opening branches there - one of the few banks competing against the State bank.   Bear in mind that the Party Revolution International (PRI) that had been running Mexico for 70 years (!) was basically a Communist party. Communist in the sense of "Let's give all the money to our friends" - like most Communist countries. So a very few prospered and everyone else struggled.  Communism sucks.

But the Mexican people are hard-working and used to struggle and deprivation.   And I think that is why overweight, lazy, fatuous tea-partiers hate them - they are constantly being shown up by folks who will give 8 hours of work for 8 hours of pay.  As opposed to say, 1 hour of work, four hours of whining and 3 hours of "breaks" - that you get from your average 'murrican.

But getting back to our story (I digress yet once again) the banking situation in Mexico was chaotic.  And long-term mortgages were almost unheard of.  So Pedro would bring a cinder block home from work, mix up a small batch of cement, go up on the roof, and cement it in place, before settling down to supper.  In 10 years or so, maybe he would have a second story on his house.   Meanwhile, you saw houses with re-bar sticking out, usually with coke bottles on the ends, to keep them from rusting (or keep people from poking their eyes out!).

Today, you can get a mortgage in Mexico, and many immigrants here are working to pay off that mortgage, so that when they retire, they can move back to Mexico (where they have free health care and a lower cost of living) and have a paid-for house.  In the meantime, their family has a place to live.  This is a harsh life to live - being away from your family for 10, 20, or 30 years.  And yet I know a lot of Mexicans who do just that, to put food on the table for their family.  And yet so many Americans hate them.  I don't get it.  If anything, they deserve our sympathy and support.  After all, we do have it so well.  And they do work so cheap.  Who the hell else is going to mow your damn lawn?  Not an American.

But I digress, yet once again.

When there is no credit, people have to pay cash, and prices are kept artificially low as a result - or people have to resort to oddball finance techniques or strategies.  For example, in 1979, when mortgage rates went to 14% - making homes unaffordable - many people signed "land contracts" with sellers, where they would make payments, over time, but not own the home until the last payment was made. Many people ended up losing the home over these, as if they missed a payment, they got tossed out, with no equity whatsoever.   Others got purchase money mortgages, once rates declined, and bought out the contracts.

You also see this in the used car business.  If you buy a used car that is, say, over five years old, it is harder to get bank financing for it.  Shady used car dealers may be able to get you financing at high interest rates.  But a car being sold by an individual?  He has to hope someone with CASH comes along. And this is why an older car, with relatively low miles, can be a good deal - if bought from an individual seller.  The market pool of buyers - cash buyers - is very small.  Demand is low, so prices drop.  Even if you could get financing, rates are higher on older cars - which again dampens prices as it raises monthly payment proportionally.

And that is one reason cars depreciate so rapidly in the first five years of ownership.   Financing is readily available at low rates for new and late-model used cars.  As a result, prices are higher.  Why?  At least three reasons:
1.  Since financing is more readily available, there are more potential buyers.  The looser financing standards are, the more potential buyers there are.  
2.  The incremental monthly increase in payments on a loan seems trivial, even when the price goes up a lot. 
3.  Changing the terms of a loan can often offset apparent price increases, making something seem more affordable than it is.   
In the car business, these three terms can be used to jack up prices on cars.  Taking the first one, it is easier to sell people cars when they can get loans.  And the more people you can finance, the more buyers you have, and demand goes up, and you can ask higher prices.  This is how new-car dealers can ask 10-20% more in retail price that a car is worth immediately after purchase.

Similarly, this is how "buy here pay here" dealers can ask far over book value for clapped-out heaps.  A poor person might not be able to come up with $2000 cash to buy a junker.   But they will pay $5000 in inflated price and onerous financing, for the same car, sold at $50-a-week.

With regard to the second term, the difference in the monthly payment between a $10,000 car and an $11,000 car, over five years at 6% is "only" $19 a month.  So people are often willing to spend more, when the offer is couched in terms of monthly payment.  A salesman can sell you the "LE" or "GT" model this way - telling you that "for only $20 more a month, you get leather interior!" or whatever.  Why buy a Sally Stripper, when you can have Onstar and XM radio?

Which brings us to the third term - playing with financing.  You can make that upgraded car even more attractive by stretching out the financing another year - or two.  By going to six years - 72 months, the monthly payment might actually be less.  But in reality, what they rather do (and do) is raise the interest rate.  At 7% interest - two whole points - the loan amount on $11,000 is the same as $10,000, if you add an extra year to the term of the loan.

And of course, there are other funny money games you can play - adjustable rates, rate buy-downs, interest only, payment optional, etc.   And we saw how that worked out.

Humans are weak, and we tend to look at things in terms of monthly cost (cash flow) instead of overall cost (net worth).  So if we see a shiny Camaro for $399 a month, we bite on it - after all, we will be able to drive around and "impress the girls" with it, right?  Never mind the fact that we've signed on to a depreciation and cost nightmare that will make us eat Raman noodles for six years or more.

In the housing debacle, we saw all three effects take place.  Lax financing standards meant that anyone could buy a home.   I bought my present home with a "stated income and assets" mortgage - at a very good rate, too!  At the time, I owned four houses already, too!  I was fortunate in that I sold the other homes and paid off this mortgage.   Others were not so fortunate.

And others were hoping to "buy and flip" homes for a profit - buyers who would not be IN the market if not for this lax financing available.  Demand increased, and prices shot up - too far.

And since the increase prices were shrouded by the mortgages - which presented only small increases in monthly payments - particularly as rates dropped - people kept buying.  And when prices went higher and higher, well, funny-money mortgages would disguise the increases even further!  You could get into a house with a "1.9% mortgage" - but it was a fake rate an the excess interest was being folded into the balance - increasing debt over time.

Student Loans are another example where these three effects serve to pad prices.  The government guarantees student loans, so everyone qualifies, even if they will never have the ability to pay them back, based on their humanities degree.

And in the case of student loans, since there are no monthly payments until you graduate, the borrower really doesn't understand the overall amount due, the payments that will be due, or have a clue how hard it will be to pay it back.   After all, we are talking about 18-year-olds here - people just barely old enough to get a loan and sign a contract (below the age of majority, you can't get a loan without a co-signer, as any minor can repudiate a contract upon reaching the age of majority).

And of course, helpful student loan companies will offer to refinance 10-year loans on 30-year terms, effectively making four years of beer and bong-hits a perpetual mortgage on their career and life.

* * * 
So what happens when there is no financing available?  Or only limited financing?  Prices plummet - dramatically.  When your pool of buyers is limited to cash buyers, you have a lot of supply and little demand.  And this is why, in situations where you can pay cash, you can get stellar deals.

For example, in Florida, circa 2009, there were a host of foreclosure homes for sale in places like Cape Coral.   Banks wanted to unload homes quickly, and we saw homes that only a few years earlier were selling for $500,000 going on the auction block for $75,000 - cash.    The few people who had cash in 2009 made some really strategic buys.  No one was loaning money, and in an auction, it is cash-and-carry, not "Let me get a mortgage and I'll close in 8 weeks".

Similarly, as I noted before, when you buy an older car that banks won't loan on, from an individual seller, you can get a very good deal.   Your credit union may be reluctant to loan money on anything over five years old - and that is why prices fall off dramatically at that point.  A well-cared-for car, however, could be a good value - if you buy it from the owner.

On the island here, there is a condo development that has a land lease, like every other property on the island.  For some reason, however, their lease was not extended to 80 years as mine was (I placed a bet there, and won) and as a result, it is hard to get financing for these condos.  Banks will write mortgages for land-lease properties, provided the term of the lease is at least 10 years more than the mortgage.

So, to buy one of these condos, you either have to be a cash buyer, or buy using a 15-year note, which has a higher monthly payment.  As a result, sales are slackening, except for the least expensive "hotel" units (efficiencies) which are often selling for $75,000 or less, to cash buyers.  Deluxe units with asking prices of $375,000 are sitting unsold, as few people can afford to pay cash, or afford the monthly payment amortized over 15 years.

If the authority renewed the lease - and 30-year financing was again available - you would see sales go up and prices increase, as the pool of available buyers increased dramatically.

The law of supply-and-demand works in the financing arena, as financing increases the supply of buyers, increasing demand.  And as we saw in the last post, even a small change in demand can cause HUGE swings in prices.

And note that this huge swing in prices doesn't even address the interest issue.  When you buy "on time" not only are you tempted to pay more, in terms of purchase price, you also pay all that interest, over time, which further adds to the cost.

As a consumer, you have to look at the overall cost of a transaction - the effect on your net worth - and not just the monthly cost - the cash-flow.   Most people live a cash-flow lifestyle and have a zero net worth.  I know I did, at one time - and for a long time.  And while the cash-flow lifestyle fills your yard with shiny toys, it drains you of real wealth.

Borrowing money is something that is deadly serious and should be carefully thought out.   "E-Z financing" is the enemy of the consumer, as it encourages them to take on years of obligation on a moment's notice.  But moreover, it encourages them to take on bad deals and bad bargains - and pay too much for things in their life.