Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Thursday, March 15, 2007

Reform the FHA?

You know, you have to love politics. A bunch of people over the last 7 years have gotten themselves in to a financial mess because they took mortgage loans that they had to have known they couldn’t afford at the time. And now that they are in distress, our presidential candidates Clinton and Dodd, want to told hearings to see what Congress can do to help. I don't have all the facts, but off the top of my head, I see 3 major problems with this.

1) Dodd and Clinton want to reform the FHA to give low-income people lower interest rates and to allow FHA to offer larger loans in more expensive areas. Define lower income? It is a curse to be middle class because you get no help, pay the bills for everyone else, and can’t afford to own your own home much less subsidize one for someone else.

2) The FHA is only one side of a large systemic problem. I don’t see how reforming the FHA will address the bigger problem. Banks had huge incentives to make irresponsible loans to begin with. Wall Street investors are driving banks and private lenders to make larger loans at higher risk. Wall Street then bundles and buys these loans, taking on the risk while making money off them. In addtion to this, the large loans granted by banks increase the money supply and help drive housing prices higher. It’s a vicious cycle.

3) Buying a home is a big deal and it isn’t done lightly. So if people didn’t know what they were getting into when they accepted their interest only loans, then they had to have been stupid or desperate. I don’t think that government should be too quick to float in and save them from themselves. I haven't tried buying a home, but I know that sweet deals that give you 6% for 2 years and then increase aren't really a smart way to go. That said, the government bails out businesses all the time. So why not individuals?

Some of our Citizens have recently bought homes. I would be curious about your thoughts on the matter.


Dr. Strangelove said...

As a Citizen currently in the throes of escrow, this post has special significance. The instability in the mortgage market has already cost me one loan offer, and we had to go with plan B.

Another problem with mortgage industry that adds to what USWest mentions is that, most lenders have been willing to rely on "stated income" without any documentation to back it up--amazing, but true! These "liar loans" have been so common that (although I cannot locate the study now) a study found that most loans were based on inflated income, often significant. It was even suggested to me a knowledgeable broker that I consider that route. (It's a way of life. Everybody's doing it...) The reason this practice makes sense is that, as USWest noted, banks make their money selling to Wall Street rather than collecting the interest payments directly. As USWest points out, Banks thus have every incentive to procure (and then unload) large mortgages without due diligence, and the traders on Wall Street have no way to know which loans were poor.

USWest says those who accept loans with unusual schemes (e.g. "interest-only" loans) without fully understanding them may be "stupid or desperate." While I can see what she means, I must say it was extremely tempting for me to do the same thing. There is a range of housing for which a modest increase in price yields a comparatively large increase in house quality... as a result, one gradually ratchets up one's expectations and willingness over time. And until this last year, since almost all astonishing growth in equity came from appreciation rather than paying down the mortgage, loans with favorable up-front terms were very attractive, especially for house-flippers. Just add this little bit more to your loan... it's wafer thin!

All good things come to an end, of course, and the housing market is suffering now--or as realtors like to say, "stabilizing." As with any bubble, there is always someone left holding the bag. It's not just the homebuyers--lenders are going down under the weight of near-record levels of foreclosure. While it is true that the market is, in the end, self-regulating, the process is highly unpleasant and--since it takes several years to go from boom to bust--the negative incentive simply isn't felt by executives under huge pressure to make profits THIS quarter. So in reality, government regulation is the only way to squelch irresponsible lending practices before they happen.

Unfortunately, the definition of "irresponsible" lending usually involves credit scores. And those scores are another racket altogether. Perhaps I'll rail against them in another post.

USWest said...

Dr. S makes good points. I am reminded of a little tale that RBR once told me about why Rockefeller didn’t loose much money in the depression. He had pulled most of it out by the time the market went bust. Why? He was getting stock tips from his shoe shine boy, a sign to him that "dumb money" was entering heavily into the market.

So when I hear about people house flipping (i.e. trading house like stock) or thinking they can get in for a penny and get out with a pound, I say run! It's no better than day traders in the boom.

This is no way meant to offend our Citizen buyers. I am sure they have examined their options carefully and thought out the consequences. And I do understand what Dr. S makes about creeping temptation. If you can afford $700K, why not $750K, right?

But beware . . .there are no get-rich quick schemes. The best tasting cooking is slow cooking and the best investments are those that mature over time.

Dr. Strangelove said...

"The best tasting cooking is slow cooking..." What a wonderful analogy! That should be a bumper sticker.

By the way, being fiscally conservative, we opted for a traditional 30-year, fixed mortgage. We ended up spending more than I had hoped--there will be a couple of lean years to come--but at least we resisted the temptation to dive in head-first with seductive mortgage packages. I hope in a few years we will still be content to have played it safer, rather than ending up regretting that we did not choose to gamble more and live more liberally.

Anonymous said...

It is a really unfortunate situation to be in, caught in a financial market where people are being irrational which forces you to act similarly. This seems to be the situation across the western world, especially in the USA, UK and Oz (the Axis of "Good"). In the UK and Oz though the markets appear to have rebounded again after a slump in 2005. In Australia in particular this is fuelled by the boom in resources that has driven Perth and Darwin property prices sky high.

I don't even know what the FHA is, but the reforms sound like a bad idea. Australia has had a first home-owners grant in place for years that has simply boosted house prices by the amount of the grant. In the end the change will come with the natural swing in the market.

Assuming the adage that I was told in school that economic markets last seven years, I am still curious as to what is the cause of this prolonged boom market. Low interest rates generally, but why have they been so low for so long, and are they likely to alter markedly soon?

The Spotted Handfish

Anonymous said...

Last night I went to see "Maxed Out," which is a documentary about consumer credit, bankruptcy, and mortgage lending. Even if you're not a lawyer with the soul of an accountant (like me), it's a pretty fascinating expose of a consumer finance gone horribly awry.

Several of the people profiled in the movie were the victims of mortgage scams. Some were clearly unsophisticated buyers, but many were middle-class types who were pushed into high-interest, high-pressure loans by unscrupulous lenders at the very last minute.

While I'm not sure if reforming the FHA will do much good, I think that the bankruptcy "reform" pushed through Congress is 2005 will be a real problem for a lot of middle-class people who used to be able to file Chapter 13 (reorganization). It's going to be a lot harder to keep the house under the current rules, and I doubt there's much interest in reforming the bankruptcy reforms.

-Seventh Sister

Raised By Republicans said...

I too am looking for a house now. After making an offer on a house that ultimately failed inspection I have a fairly good idea of what's going on now. Of course I'm in a small town in the Middle West so housing prices here are more reasonable than in California. The idea of $700,000 houses is thankfully alien to me now.

But even in his market, the banker was suprised when I told her how much I wanted to be pre-approved for. I actually named a figure that was lower than she was willing to go. Why? Because I'd worked out a budget at home and that's what I knew I could afford. Unfortunately, many people don't do that and like you guys have already pointed out, the bankers (and realtors) don't have any incentive to give sound advice.

What I'm worried about is the effect that a sudden wave of forclosures will have on the housing market for those of us who have been responsible but will be looking to resell the house in a few years (due to promotion or moving or other lifestyle changes). Will these irresponsible lenders and borrows cause a glut on the house market in a year or so that will last for several years?

Another possible consequence of this is that there will be enormous political pressure for debt relief programs - especially in states like New York or California where there are inflated housing markets and lots of forclosures. What will these debt relief reforms do to the incentives of banks to lend money to anyone?

USWest said...
This comment has been removed by the author.
USWest said...

All of this was easily predictable. I know because I predicted it 4 years ago and I am not an economist, housing market specialist, real-estate tycoon or the like. If I could have foreseen it, then everyone could have as well, and many others did.

The thing is, no one wants to think anything through to the end. We are in a perpetual present and no one things long term, as someone here pointed out. The time horizon is always the next quarter. Yet the outcome is predictable and preventable. That is what gets me.

Just to night on NPR, they were talking about tightened loan requirements and how some of these non-traditional deals will go away. The reporter said, "well that is too bad because these are the deals that allowed the middle class to own homes."

It spoke volumes. So now, owning a home is what the elite do. It isn't part anymore of the American dream for the middle class. And we have all accepted that without protest.

The Law Talking Guy said...

What has caused the run-up in housing prices? The best answer I can give is speculation. Nothing else works. Any chart of housing prices shows a significant change in annual % increases in value starting around 1998, and a sharp doubling of value around 2004-5. This just cannot last.

A few observations:
1. Population pressure is not causing increases in housing prices. If it were, we would see increases spike in areas of greatest population growth. Just not so. Modesto and Stockton have median housing prices of $350K and more. There are no pressures out there. The prices remain low where people are not speculating.
2. The median home price in Los Angeles is $500K, which works out to about $4000/month for most people. That is simply out of range of the overwhelming majority of potential buyers. There is no way the market can price the most of the housing stock above the majority of the purchasers. How can 50% of the housing be to only available to 5% of the people? Not for long, that's for sure. Who is buying these million dollar fixer-uppers? Not the middle class who used to live in them.
3. The housing boom started as the stock market became volatile around 1999-2000, and soared after the stock market became flat in 2003-2005. Money was going begging. When the stock market began to rebound in late 2006, money moved out of housing. This is not a very difficult correlation to observe.
4. Prediction: housing prices in overheated areas will probably not tumble by 40-50% or so. Unlike dot-com stocks, houses have real value. Instead, I predict the price of housing stock will drop by 10-20% and stay there for 5+years while inflation runs higher (it seems to be approaching 4-5% from the 2-3% of the late 1990s).
5. That is, of course, unless the bankruptcy rules and the subprime problems create a "run" on the housing market. This can happen if, as people discover they cannot afford their mortgages, they also discover that they cannot declare bankruptcy and hand the house to the bank, so the fire sale becomes the only alternative.

Dr. Strangelove said...

Here is an interesting graph about the housing market. It shows median house prices, both real and nominal over the past 20 years. I have not checked the data behind it, but the person has several spreadsheets containing all the data on the site, so I think he's done his homework.

Another site shows a graph for real housing prices and real rent prices from 1955-2005 (but it does not include data from the last 2 years). An associated issue paper concurs with LTG's point that the run-up in prices is not based on the fundamentals of the market.

A site with yet another set of graphs going back 40 years illustrates something hopeful for us homebuyers, however. Although the annual rate of increase in home prices is high now, the rates were similar in the late 70s, and the market it is almost never negative. However, these are median, nominal prices--ignoring inflationary affects in the late 70s. Still, worth looking at. Inflation hits different sectors differently, of course.

USwest said...

Yes, speculation is the only real explanation. And I will tell you that just south of Modesto in the small town of Turlock, whole new developments have gone up and houses that sold for $350K 4 years ago are now going for $550-$600K. Bay area residents flocked to the Central Valley in search of affordable homes and in so doing, drove the local prices up. However, these prices are now coming down as Bay Area Transits (BATS as they are seen only at night) are tired of driving 2 hours to and from work every day and are looking to get out.

Let's not forget the repercussions through out the local economy when people re-locate en masse. The process of everything go up and outpace the wages of the locals.

What I find interesting is that Congress is only interested in looking into the situation now that the market is re-equalizing. Guess they are concerned about their own property prices. That is a bubble for you. Greenspan just kept letting it build, just like they did with stock prices in the

USwest said...

I should add, upon reflection, that despite my cynicism, we do have a new party in power in Congress. And they will be more likely to investigate.