Friday, March 16, 2007

Annals of Creative Financing: One of These Things is Not Like the Other

by Tom Bozzo

Dr. Black points us to Prof. Roubini who approvingly quotes a Washington Post article (also linked by Prof. DeLong, who makes an interesting point on when lenders should renegotiate vs. foreclose on defaulted loans) which indeed is a good primer on the types of loans that have been causing all the late fuss. Here's the Post's Stephen Pearlstein, along with some bracketing snark:
Here goes: Which of these products do you think makes sense?

(a) The "balloon mortgage," in which the borrower pays only interest for 10 years before a big lump-sum payment is due.

(b) The "liar loan," in which the borrower is asked merely to state his annual income, without presenting any documentation.

(c) The "option ARM" loan, in which the borrower can pay less than the agreed-upon interest and principal payment, simply by adding to the outstanding balance of the loan.

(d) The "piggyback loan," in which a combination of a first and second mortgage eliminates the need for any down payment.

(e) The "teaser loan," which qualifies a borrower for a loan based on an artificially low initial interest rate, even though he or she doesn't have sufficient income to make the monthly payments when the interest rate is reset in two years.

(f) The "stretch loan," in which the borrower has to commit more than 50 percent of gross income to make the monthly payments.

(g) All of the above.

If you answered (g), congratulations! Not only do you qualify for a job as a mortgage banker, but you may also have a future as a Wall Street investment banker and a bank regulator.

No, folks, I'm not making this up.

I would have to object to the inclusion of item (d), the borrow-most-of-the-down-payment loan, and to some extent (a), in the "would you believe it?" list. (*) My reaction is, in part, based on experience — we bought our first house with 5% down. (**) Apart from not having a traditional down payment in the bank, affordability of the old house ($160,000 — sigh) wasn't an issue.

We were, for sure, a bigger risk to the bank than someone who had an extra $24,000 lying around, but that risk was not uninsurable, and indeed we paid an insurance premium for a while. What sort of economist would object to such an arrangement as a matter of principle?

As for the piggyback loan, their role in this sort of arrangment is that the interest on the down payment loan (treated as a second mortgage) is deductible for U.S. income tax purposes, whereas the mortgage insurance premiums are not. Suitably chose, the higher interest rate on the second mortgage can make the lender just at least as well off as under the mortgage insurance regime (***), while being able to attract a few more buyers via the tax savings angle. In short, the piggyback loan product is a tax-favored equivalent to the economically unobjectionable mortgage insurance regime. Among the newer-fangled mortgages, this is the least worthy of tut-tutting.

Conceptually, there's nothing particularly magical about putting 20% down on a house; as a practical matter, it's darn hard for people such as first-time buyers without sizeable trust funds to scrape up that sort of cash. With even the lucky well-educated emerging from school, typically, with sizeable debt as a byproduct of cost-shifting, and with St. Alan — via Digby — suggesting that lower wage growth for the fortunate skilled (except, presumably, himself) would make the world a better place it doesn't look to be getting any easier.

I don't think there's any doubt that lenders went more than a little insane, some of the loan products cited by Pearlstein are barely distinguishable from fraud (b), and others even under better circumstances would slowly boil a good number of their takers alive (c, e, and f). Still, it shouldn't be forgotten that creative financing, up to a point, can be good for you, and some of the objections have more than a little whiff of elitism if not moralism.


(*) Balloon mortgages may make sense for someone with sterling credit who knows that they'll leave a house before the balloon payment comes due (e.g., because of work-related transfers).

(**) We took out an ARM at that, as in the spring of 2000 the likely direction of interest rates was as obvious as such things get. Through the magic of the bubble's run-up and the amortization of the 15-year fixed-rate mortgage that eventually superseded the ARM, the equity on that house became a slightly-more-than-20% down payment on the "new" house.

(***) Whether or not the lender actually buys the mortgage insurance with the money isn't the buyer's problem.

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Agree completely on (d), given that the second mortgage only covers the closing expenses. Having to come up with 20% is difficult enough before you get to the ca. $7,000 in costs associated with a first mortgage.

Less sanguine about (a); it's basically a rental agreement, since the "buyer" has no direct exposure to decline in the market value of the house.

I believe my refi is (b), but it is with the bank that currently holds the mortgage, and which knows our payment history and credit. Indeed, all of the "no doc" loans have ancillary information available (e.g., credit reports) that would allow a fairly good "sniff test"—and many of them have an above-market interest rate to reflect the greater risk.

"C" and "e" are simply malfeasance, and "f" is either that or usurious.
Note that, as of 2007, mortgage insurance is now tax-deductible, so it makes significantly less sense to structure a loan without 20% down as a piggyback. From a lender's perspective, it creates a significant issues with delinquencies and foreclosures since there is a second investor who can get in the way.

One common scenario that can come up these days is a first-mortgage holder who wants to permit a short sale (so they get more money back than if they foreclosed) who is stymied by a second-mortgage holder who has already been wiped out. These second-mortgage holders have no incentive to cooperate and, in the current environment, are often so busy dealing with the sheer volume of problems that they don't have time to cooperate even if they wanted to.
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