Tuesday, December 11, 2007

Blame Your Neighbor for Your Falling Home Value

A post yesterday on The Big Picture suggests the current mess was caused by cheap money and slack underwriting allowing millions of renters access to home ownership which they couldn't afford. In the same vein, this weekend's Wall Street Journal (12/8/07) has six letters to the editor all decrying "Mortgage Bailouts." Here are some excerpts:

"...To have those who were so irresponsible expect those of us who did the right thing to bail them out so they can stay in homes nicer than the one we live in and can afford makes me irate to say the least..."
"...People who have a basic inability to tell themselves that they can live in a less fancy, more affordable home also have a hard time living within their means, whether buying a pickup truck or dining out..."
"...Instead of morning prayer or the Pledge of Allegiance in school, I would like to suggest that school children read the story of the ant and the grasshopper every day so they don't grow up to be subprime borrowers..."
No doubt there were some irresponsible grasshopper subprime borrowers with uncontrollable urges to buy fancy houses and pickups. But, I think they're a small minority. Let's roll the clock back to 2000. Lenders required a 20% down payment, only 30% of income could be used to qualify for the mortgage payment, and interest rates were around 7%. Let's hypothesize three couples, Mr. and Mrs. Ant, Mr. and Mrs. Pickup, and Mr. and Mrs. Grasshopper. All three couples had household incomes of $80,000. The couples were looking at three identical houses side by side in a new subdivision. Here's the math:

The Ants and the Pickups buy on these terms. The Grasshoppers don't have $75,000 to put down and they rent the house instead of buying it.

Fast forward to 2005. The Grasshoppers have finally saved $75,000 and contact their landlord hoping to buy the house. They are shocked to learn the price of the house has almost doubled, to $711,111. The landlord refers them to his mortgage broker, who tells the Grasshoppers they can now get a loan that only requires 10% down and that will qualify them using 40% of their income and a 5% interest only teaser rate. Here's the math:
The Grasshoppers bought the house, and told their neighbors about the mortgage broker. The Pickups contacted the broker and were able to obtain a $339,385 home equity loan increasing their combined loan amount to $640,000 too (they used the money to pay medical bills incurred by Mrs. Pickup's elderly mother). The Ants were very pleased with the appreciation in value of their neighborhood and figured in another three years they would be able to retire.
Fast forward to 2008. The credit crunch that began in 2007 has caused underwriting standards to tighten, and the parameters are back to 20% down, and 30% of household income to qualify based on a 7% 30 year amortization rate. The Grashoppers have divorced, neither Grasshopper could make the payment on their own, and they couldn't find a buyer for the $640,000 loan amount so the servicer foreclosed and sold the house for $375,000 (the same math as 2000). The Pickups are still making their payments, but they have a $640,000 loan on a house worth $375,000 and if either of them lose their jobs, become seriously ill, or if they divorce they will almost certainly be foreclosed on too. The Ants can't retire early and spend their spare time writing bitter letters to the Wall Street Journal.
Cheap, aggressively underwritten leverage inflates asset prices. The mess today is not all about irresponsible, impulse-driven people buying fancy homes, it's mostly about people like you buying homes like yours at crazy prices inflated by liberal financing. Should we expect homeowners to anticipate how this would play out when rating agencies and securities buyers apparently didn't see it coming either?