Why the Banks Should Eat Upside-Down Mortgages
Economy; Posted on: 2012-03-07 16:19:33 [ Printer friendly / Instant flyer ]
by John Young
If you are like most people who purchased a home between 2002 and 2007, your home is mortgaged for more than you owe. The options offered by most lenders for modifying these loans are usually limited to nothing more than a reduction in interest rate. But if your circumstances are such that you need to move for work or family purposes, you are effectively stuck unless you simply walk away and let the home be foreclosed. Of course, if the home is foreclosed, the bank can only sell it for the market value, but they can nevertheless come after you, and even attach your pay, to make good the difference between what was owed and what they managed to get at foreclosure.
There is a prevailing school of thought that those who obtained such mortgages should suffer the consequences of their own bad decisions. Most certainly, there is something to be said for that point of view. Usually, it is the correct point of view. But allow me to offer a counterpoint in this instance.
Living in an apartment or rented home gives people very limited options for their own self-sufficiency and well-being. If you want to install a pull-up bar, set up a ham radio antenna, own a pet or even start a home business, your options are much more limited as a renter. Many landlords won't even let you plant a garden or use a backup generator in the event of power failure. Furthermore, rents overall have been nearly as high as, or even higher than, what the mortgage payments would be on a house. As an added incentive, last-earned-dollar tax rates are very high, and trading in one's rent payment for a mortgage payment turns one of the largest fixed expenses in someone's life housing into a sizable tax deduction that saves the average homeowner thousands of dollars in taxes annually. In addition, though as a renter you can't deduct the portion of your rent that is allocated to property taxes, when you buy a home, that is also deductible. In states with high property taxes, that also can equate to a thousand dollars or more saved in federal taxes.
For these reasons among others, it is only natural for people to wish to own a home rather than rent, particularly if they are in the 49% of wage earners who pay net income taxes, as opposed to the 51% of wage earners who don't pay net income tax.
Of course, from the mid 1990's up through 2007, the price of homes was skyrocketing. The reason why they were skyrocketing is also the reason why the banks should be eating the difference in upside down mortgages.
Why were home prices skyrocketing? Because the banks drove up the prices. Please allow me to explain.
The price of any commodity is controlled by supply and demand. When demand exceeds supply, the price goes up. When demand more closely matches supply or is less than the supply, the price goes down.
Banks have a some major incentives for driving up the price of housing. The first is that the when home prices rise, the security they have in existing mortgages that were issued at lower prices is improved because if the home owners default, the banks will more readily liquidate their costs at foreclosure auction. The second is that a higher price means more principal is lent: meaning that whatever interest rate is charged is being charged on a higher amount and thus the banks make more money. The third is that rising prices drive even more demand (at least at the beginning and in the midst of the rise) as people scramble to buy houses before the prices go up thereby ironically driving the prices even higher. So banks had a lot to gain $billions and $billions to gain by forcing up prices.
How did they force up prices? By artificially increasing demand.
Now, let's do some math. How many people, do you think, have an extra $200,000 or $300,000 lying around that they have saved up and they can use to buy a house outright? Not very many. How many people could scrape together $10,000? A lot more. How about $500? Most people who are working.
If mortgages were illegal, the price of homes would reflect a demand influenced strictly by people's immediate ability to pay. If most people could save up for a few years and afford $10,000, then that's what homes would cost.
But lets say mortgages are legal, and they require a 50% down payment. Now, that $10,000 home can be purchased by anyone with $5,000. But what is far more likely to happen is those with $10,000 will end up using that as a down payment on a home whose price has now risen to $20,000.
When mortgages require a 20% down payment, then the $10,000 serves to get you in the door to the exact same home that previously cost only $10,000, but now costs $50,000.
Banks and mortgage lenders played this game for years but ultimately got even more avaricious than would be expected, and started writing loans with no money down at all, with artificially low interest rates that would skyrocket in a couple of years to more than the borrower could afford, with interest-only loans and even, in some cases, with loans issued for more than the appraised value of the property where the borrower walked away with cash-in-hand.
Banks are not run by a bunch of four year old children who don't understand math or economics. Banks employ professional economists, economic forecasters, mathematicians and many experts who can tell them exactly what the results of this will be.
The results were easily predicted. The average nominal home price peaked at $250,000 in 2006. The monthly payment (including taxes) came to $1,811.38. The mortgage should never exceed 1/4th of your monthly after-tax income, meaning that an after-tax income of $7,250/month is required. That equates to an annual before-tax income of $124,200. To allow for savings, the ability to send kids to school and to afford major home repairs, it should be closer to $150,000.
Only 6% of American households have a combined income that great or greater.
This means that all of the artificial demand created by using creative mechanisms to allow someone earning $40,000/year to buy homes costing $250,000 would eventually collapse as chickens came home to roost through balloon mortgages, adjusted interest rates, when borrowers hit the slightest financial bump or gas and heating oil prices soared.
Meanwhile, however, lenders collected interest. Lots of interest. And mortgage originators collected hefty commissions. Real estate brokers collected impressive commissions as well.
Keep in mind, leading up to the real estate crash, the average home changed ownership every five years, and those five years are the highest interest-paying period of the loan. During the first five years of a $250,000 loan, the banks collected $100,000 just in interest, leaving the borrower still owing nearly the full amount originally borrowed! Such a deal! (If, that is, you are the banker.)
Imagine that the home that someone bought for $250,000 in an artificially-inflated housing market is now worth only $150,000. The bank has already collected the $100,000 difference between what was borrowed and what the home is worth. And all along the line lots of brokers made a killing. But the borrower who needs to sell the home in order to move closer to a job or an ailing loved one is stuck.
If he lets the house be foreclosed, the bank will only get what it is currently worth $150,000 for it. And it has already collected $100,000.
So the banks that created the artificially inflated housing mess should undertake proper appraisals of property and adjust upside-down mortgages by lowering the principle balances of the loans to the appraised value of the property. It is their fault anyway that the price was artificially high, they have long gained benefit, and even if they were to eat the difference they would be no worse off than if they had to foreclose on the home. The only purpose in forcing a foreclosure is to cause human misery something banks have been well-known for historically, but perhaps something that should be left on the scrap heap of history.
News Source: Email