What Your Congressman Won’t Tell You
Next time you visit Washington D.C. ask a politician why the government wants to get involved in “fixing” the mortgage market mess. Their response would be something along the lines of “to help the average American who is in danger of losing their home.” In reality the primary reason is to help the banks. Lenders are sitting on billions of dollars of loans, many in danger of going into default, which they would like to sell. If they can't sell these loans and get cash, their balance sheets and profit statements go in the tank. Well, so what if the government helps the banks if that also helps homeowners as well? The problem is the government solution doesn’t require the banks to pass along any of benefits of their liquidity to their borrowers. On the contrary, I believe that the situation for borrowers will get even worse.
Here’s How It Works Banking 101
People deposit savings into banks to earn interest. Banks can do two things with the money: they can put it into their vaults and invest a small percentage of it in a few select very safe, low interest rate investments giving their shareholders meager profits; or they can loan almost all of it out at a much higher interest rate generating more profit. Banks decided long ago that the lending business is much more lucrative than the investing business. But what happens when the banks use up all of their cash and can’t get enough people to come and deposit more? That’s where the government started to “help” us back in the 60’s by establishing quasi-governmental agencies to buy loans from banks. Fannie Mae, the largest of these agencies, buys loans from banks which, in turn gives them more cash to lend earning them more profits.
Wall Street Gets Jealous
Since the 1970’s, but especially during the past ten years, Wall Street perfected a way to horn in on the action as banks were making enormous profits lending seemingly endless amounts of money to willing homebuyers. They called it “mortgage-backed securities or MBS’s.” Now investment houses were running around town buying loans and selling them to your father’s pension fund and to your rich old aunt Sarah promising them riches beyond their dreams, or at least, beyond their paltry 2% certificates of deposits. They set the bait on the hook and just reeled in the fish.
Bank Loans Then and Now
With the help of armies of Merrill Lynch salespeople selling MBS’s money flooded into banks as they generated and sold loan after loan after loan. Bank VP’s were just finishing their PowerPoint presentation showing last quarter’s record profits, when bank Presidents were demanding even more loans be made and even more profits be generated. The results were simple—adjust the guidelines for approving loans to allow ever more people to qualify. Like the car dealers on Saturday morning TV say, “Come on down! Bad credit? No problem! No job? No problem? You can drive off with the car of your dreams.”
1970’s Loan Guidelines: 20% minimum down payment; 6 months of savings in the bank after you put the money down; full documentation showing borrower’s income and debts; home loan payments can’t be more than 33% of borrower’s income.
Current (well, at least until a year ago): 0% down payment; interest only loans; stated income/stated asset loans (also called “liar’s loans); home loan payments up to 50% of borrower’s income.
Add money, combine with greed, stir for 10 years and the result can’t be good. One of the most widely sold and bought home loans were interest only loans whereby the borrower only paid back to the bank the interest owed. Since the borrower wasn’t paying back any portion of the amount of money they had actually borrowed, the monthly payments were much lower than a regular loan. There were two fundamental flaws for the borrower for these loans: first, most were only 5-year loans and at the end of the loan the borrower owed the same amount they had borrowed; and second, at the end of the 5-year period the loan interest rate would adjust to the rate at that time.
5-year interest only loans took off about 5-years ago and guess what? People who took out these loans 5 years ago have watched their home values drop and interest rates go up. A typical borrower could now have a monthly loan payment that is easily 50% more than it was when they qualified and took out the loan. Fast forward 5 years and the delinquency rate and foreclosure rate have skyrocketed. Coincidence? I don’t think so. At this point what had only been a potential problem for borrowers now had snowballed into an enormous problem for banks, for Congress, and even for the world economy. So let’s recap.
1. Banks were willing to lend money to practically anyone to make more profits
2. Borrowers were encouraged to lie about their qualifications on their applications, put no money down, and get a loan where they can barely afford the monthly payments
3. Interest rates go up
4. Home values decrease and, because borrowers didn’t put any money down, the amount of the loan is greater than the value of the property
A perfect storm and during an election year to boot.
The White Knights
Our elected officials would like to be re-elected and they would like us to believe that they can act to solve the mortgage crises. The influential bank lobbyists would like our elected officials to think that they need donations from the banking industry in order to get re-elected. So the lobbyists offer up a win-win solution: the government should raise the limit on the loan amount that Fannie Mae can buy thereby allowing banks to sell billions of dollars of loans that they have gathering dust and that have borrowers who are in danger of going into default, and voters can see that the government cares. The only problem is that this is a win-win for the government and for the banks, but a win-win-lose where the losers are the very ones that they are trying to help—the borrowers.
The End Result If Congress Increases Loan Limits
There is no assurance that the banks will turn around and start making new loans; or that they will be willing to reduce the current interest rate spread between conforming and jumbo loans; or, most importantly, that they will ease up at all on loan requirements (down payment, income/debt qualifying ratios, FICO scores, etc...). If they don’t do all three, then all of the people that have loans that they can’t afford now will still be stuck with loans that they can’t afford.
Wall Street basically stopped purchasing MBS’s in July 2007. Prior to that the interest rate on jumbo loans were only about 0.25% higher than conforming loans. Now the difference is 1%+ since banks are not be able to sell jumbo loans and have to keep them increasing their risk and decreasing their profit. If the government increases the conforming loan limits (currently $417,000), lenders will be able to sell them again because Fannie Mae will insure the new loan holder against any loss.
Loan underwriting guidelines will continue to get tighter: loan to values ratios will continue to go down as lenders want to see more home buyer equity; increasing requirements for the amount of money the borrower needs in reserves; and higher credit scores to qualify. The biggest Whammy is on interest only loans where lenders are no longer willing to qualifying borrowers on the interest only payment which is what they are getting, but now require them to qualify as if they are getting a fully amortized loan. If a borrower could afford a fully amortized loan, why would they even consider an interest only loan in the first place?
The facts are that over the last 5+ years most people qualified for loans with a 50% income ratio based on the interest only payment. If they were at 50% before, most likely they are at 55%+ now and no lender will touch them. Further exacerbating the problem bank underwriters consider California a "soft market" (decreasing home values) which made banks require an additional 5% to the down payment.
So what will happen when the government increases the conforming loan limit?
1. Many financial analysts believe that conforming loan rates will go UP, not DOWN because of the increased risk (the larger the loan, the greater the risk to the lender).
2. Lenders will charge a higher interest rate for loans above $417,000 based on the loan amount. For example:
Loans up to $417,000 no add-on
Loans from $417,000 to $500,000 conforming rate plus 0.25%
Loans from $501,000 to $600,000 conforming rate plus 0.50%
And so on.
3. Lenders will require a higher % for a down payment. For example:
Loans up to $417,000 20% down payment
Loans from $417,000 to $500,000 25% down payment
Loans from %501,000 to$600,000 30% down payment
And In ConclusionWe are being screwed by a combination of our government and the banking industry lobby using the mortgage industry debacle as a smoke screen to get public support of the program. The banks will get rid of all of the crappy loans that they made and Mr. and Mrs. Joe Borrower will still have the same problem of deciding every month whether they will buy food or pay their mortgage. So instead of the banks getting stuck with the defaults on these loans, the taxpayers will.