My fascination with the housing market started with a ho-hum comment made by some friends at dinner. The couple we dined with were surprised that my wife and I didn’t have a HELOC (home equity line of credit). After figuring out what a HELOC was (too embarrassed to ask), I was shocked they had mentioned it so matter of factly. I mean, very few people go around bragging about how much money they are borrowing on their credit cards. I had always thought of this couple as Middle America. The husband was a small-business owner and his wife a graphic designer. If they were using their HELOC like a credit card on steroids, what was the rest of America doing?
Around the same time I developed a friendship with a mortgage broker who owned his own business. When I brought up the conversation about the HELOC, he just chuckled and said, “You have no idea.” I didn’t. But the more I listened, the crazier the stories got. Flat out bad underwriting, fraudulent income documentation, and even the bringing back of the 125’s (which allow owners to take out up to 125% of the equity they have in the home) all appear to be almost standard operating procedure. The housing market is quickly becoming a dangerous game of “hot potato,” no one seems to care, unless they’re the ones left holding the hot potato - a mortgage about to default.
Here’s how it works. Let’s start with an everyday, run of the mill, marginal deal (Not eligible for Fannie / Freddie financing). In most cases, this starts off fairly innocently. A naïve homebuyer, (an unsophisticated borrower with little income and sketchy financial documentation) hears that a friend bought a house, and imagines that maybe he can do the same. The friend recommends his real estate agent and mortgage broker, and the deal gets rolling. Given the sheer number of subprime offers by lenders, the mortgage broker knows he can find a deal, but it will cost the borrowers in the long run. He also knows by now that the buyer isn’t savvy enough to fully understand the complexities of the deal, and that he probably lacks the resources to look anywhere else. So, he shakes hands and tells the buyer to go find a house in a certain price range, and he will take care of everything else. And the game of hot potato has begun.
Most of the time, the financing secured by the broker looks something like this:
· 6.25% fixed for two years, 30-year amortization
· At the end of two years, the mortgage changes to floating + 7%
· Prepayment penalty for the first two years = six months interest
2nd Mortgage: 11.75% fixed over 20 years.
The first-time homebuyer is the star player in this game, the one who gets the ball rolling. A multitude of emotions make it difficult for him to discern just how poor a deal really is. He hears the real estate agent telling him this property is going fast, and housing prices are only going up. He hears the mortgage broker telling him that money has never been easier to get. And his heart tells him a house is the ultimate status symbol in America, a sign to tell all of just how far he has come. The first-time home buyer might know that depending on his FICO score, he may be able to get a house for less out of pocket than it costs to rent an apartment (whose landlord collects the first month’s rent, the last month’s rent plus a security deposit). All of these factors may cause a first-time homebuyer to believe that if he just works a little harder and spends a little less, he can handle a mortgage payment, even one that seems high to today.
The mortgage broker keeps no inventory and has extraordinary margins. It takes little start up capital and education to enter the business, and a successful one can end up processing many more loans than a successful real estate agent. In short, the business of mortgage brokering is a good business.
Some mortgage brokers, mostly just the ethical ones, not only get financing for their clients, but also counsel them on the full ramifications and risks of the loan. Others don't want to risk the buyer backing out, and just get the loan, regardless of whether or not the buyer really understands, or more importantly, can really afford it. This group turns a blind eye when it comes to proper job documentation. They avoid important questions like “Have you thought about how much taxes and homeowners insurance are going to cost?” Or, from the above example of how the game is played “Do you understand that after two years, your mortgage payments will rise around 15%, even if short-term rates stay the same? Or, if short-term rates move to 2.5% (historically low), do you realized that your mortgage payments are going to jump to 30%?”
Most mortgage brokers typically earn about 1% per loan, but can make as much as 3% or more on some deals. This creates incentives to use “friendly” real estate appraisers.
The appraiser ascribes value to the house. His job is to ensure that a purchase and sale agreement makes sense, given the latest sales of similar homes in the area. Since no two houses are exactly alike, appraisers have a certain degree of latitude in their job. Appraisers generally don’t have to worry about conservatism or macro trends. Most appraisers are ethical and honest, but many make their money by catering to the mortgage broker, or they risk losing future business. Many mortgage brokers will not use an appraiser who doesn’t come in with the number they want.
Although it might be the mortgage broker who is glossing things over to get the buyer into a house, the lender is the one who approves it.
But what about lenders? Surely they must be the voice of reason in the chorus of confusion, right? Well, not always. They face fierce competition from other lenders. Rather than make prudent, sound lending decisions, they rely on automated underwriting, and are often influenced greatly by the threat of losing market share. Lenders also rely on the upward slope of the average housing price in America. Deals that go bad eventually find a buyer without too much damage done to principal. But this will not be the case should housing prices flatten or fall, or if the bear market in employment continues. Lenders are intent on growing, no matter what the costs, and most of them will.
Given the different roles of the players, this can look like a win-win kind of game; the buyer gets the house of his dreams, the mortgage broker gets a good commission, the appraiser gets paid, and the lender gets to use gain-on-sale-accounting to book a profit. Everyone is happy, everyone wins. Game over? Not quite.
You see, in the game of hot potato, there is always a loser. No matter how much fun was had, no matter how hard everyone played, (fair or not), at the end of the game, someone is left with the sting of a burning hot spud. And that fact, in this economy, changes everything.
Stay tuned for part II.