Most of the consumers you talk with will not have a good handle – I am not sure anyone does yet – of the nature of the credit problem. In this short article, I hope to give you at least some quick, understandable talking points when discussing the issue. It is not 100% complete but should give most members an understandable overview of the issue. There is plenty written about the subject if people are interested in more detail.
- The vast majority of people are not in trouble. About 3% of total households are behind on mortgage payments (33% of households have no mortgage) and about 1% eventually go through foreclosure.
- Most homes are not mortgaged over their true value. The national number is that home owners have a 71% LTV mortgage on the property (2006).
- The foreclosure level of today is very similar to the foreclosure level in 1986 from a national perspective. MN did better that time around.
- A major difference today is about how financial firms packaged and sold mortgage securities to investors – often leveraging the value many times. (see more below)
- No mortgage insurance as consumers opted for loans that avoided PMI, thus increasing the lender’s exposure.
- Government asset reporting, as a result of Enron, requires a true reflection of the asset value on balance sheets. This means that the 65% LTV mortgage that a financial institution or Fannie/Freddie issued and now holds in their portfolio is reported as a bad investment because the value of the asset has dropped. As an example, Chris takes out a mortgage with 5% down and is issued a 95% LTV mortgage on a $200,000 home. This means the mortgage is $190,000, but it is protected by an asset valued at $200,000. Chris makes all of his payments on time for 3 years. However, in the last 3-years the home’s value has dropped by 10% to $180,000. The bank/financial institution/Fannie/Freddie now must report the lower asset value on their books – which means they do not have enough asset value in the home to cover their loan.
- Remember the leverage issue. The financial institution now must report and the investors will see that the assets protecting their securities are not sufficient protection to cover their investment. Keep in mid, Chris is paying his mortgage on time – as are the vast majority of people with a mortgage. Yet, if the LTV is upside down because the asset value dropped, the lender is in trouble and in need of funds to shore-up his balance sheet for the investors who purchased the securities backed by mortgages.
- Mortgage insurance was part of the protection against falling asset values in the past. Because so many newer loans were issued without PMI, the lender exposure is much greater this time around.
- Liar loans and other poor lending practices are a piece of the problem and demonstrate clearly how greed (at all levels – consumer, lender and advisors) overwhelmed reasonableness. This also happened in the mid-1980’s with FHA/VA “fog a mirror” assumable mortgages. Credit tightening and consumer “skin-in-the-game” will help eliminate this in the future.
- Problem loans in the next 2-years will be a result of 2nd/3rd mortgages which are tied to the LIBOR index. Some are subprime, many are Alt-A and prime.
- The LIBOR went up 50% last week and it is the index used to determine the ARM interest rate. Many of these are held by middle-class folks who spent their home equity taking out 2nd & 3rd mortgages. The problem they face is LTV when they go to refinance out of the bad ARM product. Example: Chris has an 80% 1st mortgage and a 20% 2nd mortgage he took out in 2005 to buy a boat and pay off credit cards. The total of the 2 loans is $200,000 on January 1, 2005. He makes all of his payments on time. In October, his 2nd mortgage – which is an ARM – has a payment increase of 25% because of the LIBOR index. He cannot afford the additional payment because of job situation, health insurance, etc. so he goes to the bank to refinance. Because the value of his property has fallen since he took out the mortgages, he can no longer borrow an amount equal to the 1st and 2nd mortgage he has on the house. You can see the hole that Chris has dug for himself – whether he used a subprime or “liar-loan” – as the asset value drops his options are significantly reduced and now must make some very difficult choices.
It is important to remember that for many years homes were considered a hard un-liquid asset. People rarely borrowed against their home, except for repairs or emergencies, and the equity growth made upward movement possible. Over time, financial geniuses invented tools and convinced people that homes should be a liquid asset that they individually leverage in order to increase their standard of living. That strategy worked for a while until people in mass began living beyond their means.
Often we find that the fundamental principals of the past are concrete solutions for the future.
Copyright: Minnesota Association of Realtors.