Mortgage Risk - Part 3 & 4

As you learned from early segments, there are two types of risk in this world: Real risk and perceived risk.  Of course, most people never separate the two. In fact, they can be surrounded by real risk but seem oblivious to it. When they perceive that the risk is real, they may go a little crazy.

What happened in the markets is that there was a big change in perceived risk. The risk of owning junk mortgages was thought to be minimal, and in fact, it really was when property values were rising at a rate of 10% or 20% per year.  Shaky borrowers who got into trouble could sell their homes and the loan would be paid off before the lender even knew it was in jeopardy. But with a slow down in the market, homeowners couldn’t bail out any more.

Note that this phenomenon is spotty – it’s not spread universally across the country. Remember when Speaker of the House Tip O’Neill said, “All politics is local.” Well, all real estate is local too.  In my area of Southern California, real estate sales are off 27% but prices are actually up 3.5% from a year ago. That’s not true in every city and town. Some areas are up more than 3.5% and others are off substantially. Outlying areas 50 or more miles away from downtown are suffering greatly and will suffer even more. Many of the residents there moved even though they were facing a commute of an hour or more.  With $3/gallon gasoline, they are stuck with higher commute costs.

If you think about it, the weakest borrowers, the ones who were likely to end up with junk loans, were most likely to buy in less desirable areas with lower values because that’s what they could afford. These areas are the ones that were most susceptible to being affected if things went wrong because they had the weakest homeowners.

The junk mortgage implosion is just a manifestation of a Perfect Storm, a collision of weak buyers, less desirable communities, and risky loans. Put them all together and they spell trouble with a capital “T.”  It is Trouble in the form of high numbers of foreclosure and falling property values that negatively impact the others in the neighborhood who may not be weak at all. But they will sure have a tough time selling their homes if they want to.

Then the reset problems started. Borrowers who got into inappropriate loans found that their mortgage payments were going to increase substantially. In many cases, the new payment was much more than they could afford.  That was what really triggered the current problem, including all the grand-standing by politicians in Washington D.C.

Finally, the screws started tightening on the mortgage lending community.  Without going into much detail here, the new rules that have been promulgated by the regulators result in a tightening of credit standards.  For marginal borrowers, it’s going to be harder to get loans, PERIOD. It will be harder to get 100% financing. It will be harder to get a mortgage if your credit is poor.  It will be harder to get a loan if you cannot document your real income.

So, we have millions of borrowers who find that they now cannot afford the home. Because of a weak market, they can’t sell the home. And because of the tightening at the lenders, they cannot refinance into an affordable loan.

For those reasons, there has been a substantial increase in the number of defaults, where people aren’t making payments and their lenders have started the foreclosure process. In some neighborhoods, homeowners are starting to see more of their neighbors lose their homes. The banks that now own these homes put them on the market at prices that are likely less than what those who are staying want to see.

Let’s consider the micro and macro aspects of this situation. At a micro level, it’s like two homeowners standing out in their front yards talking about financial affairs. One guy tells another, “My 401(k) took a hit this week.” “Why?” the other one asks. “”Because Joe, the guy down the street, might default on that sub-prime loan he has.”

“Wait a minute,” you might ask. “What does Joe’s loan and the likelihood that he MIGHT default on it have to so with my 401(k)?” And you’d be right if markets were rational, but they aren’t. Actually, if you multiply that by a million or two, you get the macro view of the current situation. The thought of a million foreclosures, whether they happen or not, is paralyzing. Worse, our entire industry operates on borrowed money just to sustain day-to-day operations. When that spigot is turned off, as is happening now, operations cease. 

It also affects the price of every loan type that looks risky.  For example, the price of Jumbo loans has leaped. They usually were from .25% to .375% more expensive than Conforming loans. Now it’s a 1.5% premium and the default rate on Jumbos is actually less than on Conforming loans. Go figure!

All these markets are intertwined. The current disruption in the credit market is, quite literally, a function is the contagion of fear. Risk and fear have always been inexorably intertwined and we have proof of that right in front of us.

In the final installment, we’ll talk more about risk to you as a borrower/homeowner and how best to avoid it.

Mortgage Risk – Part 4

Earlier I talked about the unfortunate reality that few people acknowledge risk until something bad happens.  The fact is that risk is all around us.  Sometimes it makes the papers.  Do you remember the Avian Flu crisis a few years ago? It did kill people who lived with infected chickens, but the scenarios that spread from that were so bad that people were afraid to fly on airplanes. Many people cancelled travel plans and those who got on the planes all wore masks, as if that would stop an airborne virus.

As it turns out, one well-regarded expert scientist has warned about a pandemic:

The world is teetering on the edge of a pandemic that could kill a large fraction of the human population.

As this story has developed, billions of dollars are being spent to develop a cure the H5N1 virus. Frankly, as serious as it is, no one seems to worry about it anymore. When was the last time you thought about it?

Here’s another one that is closer to home. 

Lucy Jones, a scientist with the U.S. Geological survey, said last week that the Coachella Valley area of Southern California – including Palm Springs, one of the fastest growing areas – is over 100 years overdue for a major earth quake:

…the shaking could last more than 100 seconds, kill thousands, destroy homes, collapse the I-10 and I-15 freeways, ignite petroleum pipelines and leave untold thousands homeless in potentially searing desert heat. The long-term effects could be akin to the economic collapse of New Orleans and the Gulf region following Hurricane Katrina.

Now how’s that for a risk scenario? Yet, my guess is that if you went down to Palm Springs anytime soon, you’d find that real estate activity was virtually unchanged from a week ago. Should we actually get such a quake, it will likely be far enough in the future that no one will remember Lucy’s warning.

So it goes with junk mortgages.  I sit in the epicenter of the junk mortgage meltdown with many of the industry’s (formerly) biggest players just a few miles away.  I could see that their business practices were encouraging the development of loan products that were potentially dangerous to borrowers.  I could see that the outrageous commissions paid to loan officers were encouraging unethical business practices.  I could see that the lack of regulation stimulated the growth of the junk mortgage industry.

Finally, I could see that millions of borrowers were being talked into getting irrational mortgages that would jeopardize them as individual homeowners. The chickens are finally coming home to roost, which is why it has been important to get a better understanding of the forces at work.

So assume that you want to buy a home today. What should you do to avoid risk? The first thing would be to find real estate and mortgage advisors who are going to give you honest advice. You can best find one of these by getting referrals from friends.

Second, get an education.  If this series on risk has stimulated you, you will be delighted by how much more there is to learn. Consider buying my highly praised book How to Save Thousands of Dollars on Your Home Mortgage.  The best part?  That education will help you make better decisions. Each good decision may save you thousands of dollars.

As to specific risk advice, there are some things you should do and things that you should not do. Number one: Don’t buy a home unless you can afford it with a sensible mortgage. You should not buy it if you can only appear to afford it because of some initial low payment loan. Buy a smaller home or buy a cheaper fixer-upper and get to work.

Next, avoid mortgage risk for as long as you are likely to own your home. The mortgage industry has loans that are fixed for six months, one year, two years, three years, five years, seven years, ten years, fifteen years, thirty years, and forty years. Pick a term that fits your situation.

Third, do not get a loan with a pre-payment penalty.  Most of the time, that’s something the loan representative sticks in there because he gets a higher commission. When you sign loan documents, make absolutely sure that you read the fine print and there’s no pre-payment penalty.

Fourth, these days there is no need to consider any type of Adjustable Rate loan. Especially avoid the so-called Option ARM.  These are sucker loans with very low payment rates and they spell real trouble.  These loans played a significant role in causing the current problems.

Wrap up

I hope that you have learned something from this little trip down Risk Street. Like most problems, the way it will finally turn out will likely be better than is currently anticipated by the markets.  The fact is that the world is NOT coming to an end.  In fact, even if there are a lot of foreclosures, they affect a very small percentage of the U.S. housing stock. The unemployment rate is low, job creation is at acceptable levels, and most homeowners are sitting in homes with good equity and a payment that is easily affordable.

That does not mean that these problems are going to get sorted out easily or quickly or that there won’t be some more casualties. There will be. In fact, I can see that the stock market traders are doing a good job of dismantling some fine companies that have mortgage exposure but not of the junk mortgage kind. The very good news is that we have a very resilient economy that has a way of blowing past problems, but it will take time. That will be the case here too.