Recession and The Housing Bubble

Originally Posted October 9, 2008

As I watched the debate Tuesday night, I listened as both candidates threw the blame for our current economic crisis on our mortgage debacle. The bubble of housing prices through the US has created negative equity, high foreclosures, which in turn are causing bank failures, etc… We’ve all heard it on the news for the past month, but I began wondering how much of this is really due to the housing? And actually, what has housing done for the US in the past 5 years.

A quick recap of the US economy over the past 4 years: (very quick indeed). In June 2007, the credit crisis began to become a reality. Since this time, the S&P 500 is off by more than 50%. We all know what has happened in the last two weeks, so I won’t rehash the current status.

I want to go back though to the years leading up to the credit crisis. You will recall that in June 2006, pundits started asking if we were in a recession. The answer was always no. However, if you look at the fundamentals of the US economy, there was reason for concern. Specifically, corporate spending was down, government spending (other than the war in Iraq) was down. Unemployment numbers were flat. The Fed had raised their target rate from 1% to 5% on fears of inflation. Gas was at $2.87 a gal (DOE numbers) and would hit $3.00 just two months later. But consumers were spending enough to keep the GDP growing.

I attended a conference in 2004 in which the speaker, a well respected national economist, said that every attendee should go home and refinance and take all the equity out of their home, adn keep doing it as often as the bank will allow. The idea was that no one was charging for re-fi’s, and that money had been cheap. Equity in our homes was the greatest method of increasing wealth ever seen. You could buy with no money down, and then in two months, take some cash out. And as Americans, many did… in droves… (By the way, this was not a get rich quick conference, this was a symposium for MBAs from all over the East Coast addressing “the new economy”.)

Fast forward to 2006 and we find that while nothing in the economy was really going right, the GDP continued to grow, albeit slowly… And what was the number one reason? Consumer spending. While corporate American cut off the spigot, and the Govt did too, Joe Six Pack kept spending like crazy. He bought cars financed through his house, he bought furniture, and the biggest TVs anyone had ever seen. Despite the lack of fundamentals in our economy, the consumer kept us going.

The only thing that allowed the consumer to keep spending was that their net worth was rising at rates never seen in the country. People felt rich. And that led to more spending. Conspicuous Consumption at its finest. God Bless the American savings rate.

We as consumers kept this economy going, and we have our mortgages to thank.

So this raises my question for the day. If we had not had the slack mortgage lending practices, and had we not promoted home ownership to the level that we did, when would this recession have started? 2004? Perhaps before?

The consumers won’t be spending money for the foreseeable future. It will now turn to the Govt to pump out the dollars (and the debt)… and pray we can pull it all together.

The Davis Plan

Originally Posted October 9, 2008

Seeing as we as taxpayers now have access to $700 Billion of federal money to play with in the mortgage market, I thought it would be irresponsible of me if I did not put forth a legitimate plan for what to do with this money. Yes it involves restructuring debt loads, but I think it does more to solidify the real estate market more than anything I have seen thus far from our friend Sec. Paulson.

This post began, as did the preceding post, as a reaction I had when listening to the debate on Tuesday. Sen McCain offered that as part of our helping the middle class, we should use the $700 billion to buy back the mortgages of sub-prime and Alt-A debt that are having difficulty paying back the debt. Once purchased, we would re-set the principal to the new value of the home, so that people are not underwater in equity.

In all fairness to both parties, Obama has said he wishes to do the same, although I did not hear him say it on Tuesday.
This is a horrible idea. A miserable idea of massive proportions.

Let’s dissect the value of this proposition and why it is being bantered about. The goal is that if we don’t have foreclosures, we won’t have diminishing property values. If we halt the fall in prices, it will restore confidence, and thus the world will be all good. Well, the other obvious thing is that people love getting something for nothing, and that’s just what this does. It rewards people who borrowed too much and are now unable to pay for it. Further, if we remove the burden of being underwater, what is to stop people from dropping the sales price of their house dramatically to get out from under the loan.

So, what is The Davis Plan?
Rather than adjusting the principal, adjust the interest. This has multiple purposes. If a borrower qualified for the teaser rate in the beginning, he (theoretically) should still be able to do so in most cases. So, the borrower should be able to make the monthly payments. Because he can make the payments, he won’t get foreclosed. However, because his mortgage is still underwater, he can’t sell. This is a GOOD thing. Because he can’t sell, he stays. This reduces inventory on the market. This produces a stable market. This provides for liquidity to those persons who can sell and wish to sell.

How does this really play out? Well, if a person bought a $400,000 home with 100% financing at 5.5% teaser, his original payment (assuming no negative amortization) would have been $2,271 + Taxes and Insurance. With interest rates resetting, that rate could be 8.5 or 9.5%. If we assume 8.5%, then the borrower is now paying $3,075 +T&I. Under the current plan touted on Tuesday night, the principal would be reduced to the market value. Let’s say it’s dropped 25% in Ohio, that borrower now owes $300,000 at 8.5% interest and the payment is all the way down to $2,306 + T&I. And the cost to the taxpayer is an instant $100,000. With no chance of ever seeing that money again.

Now, under The Davis Plan, the borrower returns to paying $2,271 (less than the proposed plan). The borrower stays in his home. He doesn’t sell because he can’t afford to; remember, he still owes $400,000 on a home that has dropped in value. But he still has his home which is really what he wanted anyway.

Now, I know what you are thinking: what if the borrower needs to move because of work or family. Well, I have that covered.
Remember how I said people like getting something for nothing. That doesn’t exist in The Davis Plan. People will have the option of putting their house into The Plan or not. If they choose not to, they can be foreclosed upon, face bankruptcy, and see what the court allows them. That’s fine. I don’t think most people will take that route. I think they’ll opt for The Plan.

Upon agreeing to this workdown of debt, the borrower agrees to one simple change in their mortgage. Just like government insured student debt, you won’t be able to bankrupt your way out of this one. It is with you to your death.

So, if in five years you need to sell your home and you only get $350,000 for it, you still have a $50,000 – 30 year note with the Government. You can take it to your next home. You can prepay it if you would like. It will be tax deductible to the same degree that any other mortgage is – provided that loophole remains.

We now have a method for helping out the middle class, keeping them in their homes, removing excess inventory from the market, stabilizing the housing market, restoring confidence to the markets, and all of this without giving away something for nothing.

How much would all this cost? I have no idea. But I don’t think anyone really knows if $700 billion is enough to do what little they want to do anyway.

Uncle Sam to the Rescue

Originally Published on August 12, 2008

On June 9, I wrote about a proposal that was floating through Congress to provide some real incentives to first time home buyers. I wasn’t a big fan of what I was reading at the time, but it appears that what congress has come up with is actually a pretty good idea for the economy and a really good idea for the borrower / buyer. Don’t be fooled by the name of Tax Credit. This is not really a tax credit. But it does provide some great incentives to any first time buyer.

While I hope to give you a good picture of the new Federal Housing Tax Credit of 2008, there is no substitute for reading the original source if you fall into the category of first time home buyer. Also, here are my thoughts from June.

The terms of this credit are very simple. If you have not owned a home during the past 36 months, and you make less than $75,000 for a single person or $150,000 for a married couple, you likely qualify for the new tax credit. Homes must be purchased between April 9, 2008 and July 1, 2009. The law was not passed until July 30, 2008, so there are some folks out there who did not buy with the intent of reaping this tax benefit but who will receive the credit retroactively. I have contacted each of my clients who fall into this category, not one of whom had heard of the credit before my call.

So a first time home buyer now buys their first primary residence (sorry, no investment property) and can claim on their 2008 taxes the credit. If the taxes due are not $7,500, a refund will be sent to the home owner, even if the refund is greater than the full tax liability before the credit.

For two years, nothing happens… but on April 15, 2010 the IRS wants some of their money back, just $500. For the next 15 years in fact, they will want $500. So, this really is nothing more than a 17 year, interest only loan of $7,500.

I like this a lot. It’s not a bail out, it is an incentive. And most importantly, one that the buyer will be paying back. If they sell the house, the full amount of the loan is due at closing — Provided the value has gone up enough to cover the note. So, if Joe Taxpayer buys a $400,000 home and sells it for $415,000 three years later, but pays $15,000 in commissions to a realtor, they don’t owe anything back to the IRS. So now, we are able to offer our first time buyers:
1) A short term incentive to buy now and stimulate the market.
2) The ability to buy when the buyers don’t have a huge amount of equity, in a market that is no longer friendly to 100% borrowers.
3) A safeguard against fears of a falling market.
4) A program that allows for a full $7,500 credit for any home over $75,000. Therefore, there is no incentive to buy bigger than you can afford just to get the credit.

What does this really mean in terms of dollar value to a borrower? Well, let’s assume that the buyer would need to borrow the $7,500 to make the purchase happen. ( I think assuming that it is a real stretch to believe that a buyer could find this $7,500 anywhere other than a credit card, but let’s not go there.) I am seeing 80% loans for homes still under 6.500%, but the second mortgages can be 8.500% up to 9.875% and higher based on final loan to value. Let’s pick the 8.500% for conservative sake. This loans tend to be 10 year, but we’ll stretch this assumption to make the first two years, payment free, and then 15 even payments.

Before the first payment would even be made in two years, the borrower would already have incurred $1,829 worth of interest. At year two and every year thereafter, the buyer would owe $979.92. That is a $479 difference every year, or a total of more than $7,150 should the home buyer stay in the home for the whole 15 years.

Even for people not NEEDING this money to close on the home, they should absolutely be taking advantage of the opportunity.

Transparency and the Mortgage Market

Originally Posted March 25, 2008

Today, John McCain called for more transparency in the mortgage market, claiming that such an act would keep us from a situation down the road. The stock market is regulated to death, and attempts to have the perfect market, and thus information is available to all, and valuations are market driven. Given this logic of McCain, the tech bubble never should have happened. So, why is transparency good, but it doesn’t actually work?

McCain, a supporter of Charles Keating in the early 1990’s, is now a member of the “more regulation” camp. In this transition, he has come to a decision that transparency would have averted the crisis of today. For the same reason that the tech bubble happened despite regulation, so this current credit crisis exists.

Greed. It’s that simple, although few of us would admit that we pick up this vice. We didn’t buy our houses to lose money, we bought them to make money. All we saw was prices in double digit inflation annually, and said “we need to be on this bandwagon”. We all knew that if we weren’t on the bandwagon, then we would never be able to afford a home down the road. So what if our debt ratio would not have been allowed in the 1980’s, this was 2005 and credit was easy to come by.

A note on debt: it became easier to come by because banks found a way to mitigate risk to the end level investor. Because of this, commercial interests were willing to buy the debt at better rates than Fannie or Freddie did, so out the window went the credit standards. But just like the tech bubble, all of this was above board. Everyone knew that we were no longer lending to 28/36 debt levels, but now closer to 36/42 and even higher. Everyone bought the debt because everyone knew the owners would just re-fi down the road. As long as everyone re-fi’ed in 3 years, everything went swimmingly.

Am I the only person that sees that this is a classic Pyramid Scam. It is always the last person in the game who loses. Well, those loses are now. Folks who bought in 2001 and saw their values double by 2006 can stand to lose 25% of the value and be fine. But those folks who stretched themselves to every financial limit and bought in 2005 are facing some really scary futures.

No matter how transparent the market could have been, it wouldn’t have stopped Mom and Pop from wanting abetter home, a better life, and a better investment vehicle. Leverage is what makes the world go round. It just seems that leverage can go to far, whether it is tranparent or not.

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