The Pin That Pops the Housing Bubble?

(I published this originally June 18, 2006. Anyone want to tell me I didn't hit this nail on the head?)

The housing bubble is not the primary focus of this website, but to pretend it does not exist is plainly wishful thinking. One of the ongoing phenomenon that have been driving the bubble is the "Stated Income"loan, where the lender does not verify that the prospective borrower actually makes enough money to qualify for the loan, only that they have a source of income that could generate enough income. If you're working the night shift at 7/11, they're not going to believe you make $90,000 per year, but if you're a in a profession where some folks do make $90,000, you may be able to qualify "stated income" regardless of whether you actually make it or not.

Lest I be unclear on this subject, despite being known as "liar's loans" because people use them to lie about their income in order to qualify, it is not what they are intended for. Nor is "stated income" intended to help shifty or incompetent loan officers shaft lazy borrowers by not bothering to document income. They are intended for those who really do make the money, but because of the way that the income tax laws work and the way that lenders qualify people for loans based upon income, do not appear to. Business owners and the self-employed and people on commission get to legitimately write off a lot of expenses that the hourly or salaried employees do not. For instance, I write off a large percentage of my vehicle miles, office expenses, etcetera. I'm paying for business related expenses with pretax dollars, where most folks generally do not get to take this deduction. Being self-employed, if I was silly enough to want the home office deduction it would be easy enough to justify. Not to mention asset depreciation. All of these don't have much effect upon the money I have to spend, but they do have an effect on my tax forms, where it looks like I make a lot less than I effectively do. So instead of using my tax forms to qualify for a loan, sometimes I need to do a stated income loan in order to qualify for the loan, because the tax forms show a lower number than people making comparable amounts who are salaried. This is what stated income is for.

On the other hand, I'm sure that most of the adults reading this have seen the potential for abuse. When I can just tell the lender how much I make and they agree not to verify it, a certain number of people are going to say they make more than they do, and indeed, both stated income and NINA loans are often informally known as "liar's loans". Furthermore, since if the person getting the loan does not qualify, there is no loan and the loan officer does not get paid, there's a certain amount of pressure on the loan officer to get the loan done even if the prospective borrower does not qualify. Let's say they don't qualify, but the loan officer wants to get paid. So the loan officer puts them in for a stated income loan, says the clients make more than they do, and voila! funded loan. Clients get the loan where they would not have qualified by documenting their income, loan officer gets paid, bank gets a loan, and if it was a purchase, real estate agents get paid for their transaction and the seller goes happily on their way because they got their money.

A few years ago this kind of practice was an occasional thing. Of late, however, it has become endemic. And although if the clients really do make the money there is nothing wrong with it, if they don't make the money to qualify but they get the loan they are still going to have to make the payments. This reflects the reason for the rise of the negative amortization loan, where the minimum payment does not cover the interest charges. Either one of these is something a good loan officer does with a trembling hand and a lot of care. I always make certain that these folks really can make the payment they're going to have to make, but the vast majority out there do no such thing.

Well, it looks like everyone is going to have to, because of IRS Form 4506. Form 4506 is an item the clients sign, usually at the end of the loan process, that gives the lender and anyone they may sell the loan to access to your tax returns. IRS form 4506-T is basically the same thing, except that it gives access to a transcript (the numbers) rather than an actual copy. Signing form 4506 is mandatory. No signature, no loan. It's that simple.

Now it take the IRS about sixty days to respond to this request, so this has zero effect upon funding your loan. If your loan isn't funded withing thirty days of you signing the loan application, there's something wrong with that loan unless something external to the loan is holding them back and you should go apply for a back up loan. But for later on, it can have an effect.

One of the ways it can have an effect is on the loan provider's subsequent business. Traditionally, as long as the borrower made the first three payments on time, a loan broker was off the hook as far as borrower default. Lenders who have recently become much more nervous about their loan portfolios have recently started to change this, whereby a broker who put through a stated income loan (or any loan, for that matter) which is not subsequently borne out by the evidence of form 4506 is liable for the loan for the loan's full duration. Since form 4506 is never borne out by any stated income loan, else the client should be getting the better rates for full documentation, this means that every time any broker puts through a stated income loan, they are liable for the consequences to the lender.

Well, it shouldn't take much of an imagination to figure out the effects this is having upon the loan market. With the shifting of the consequences to the broker, the brokers are having second thoughts about doing stated income loans. Make no mistake, stated income was way out of control over the last couple of years. I've always been religiously careful about them, but that made me a member of a tiny minority of loan officers. Most of the loan officers out there have no clue as to what is an appropriate stated income loan, which has to a large extent put the brakes on stated income here locally. I'm not certain what effect this is having upon loan officers at direct lending houses, and there are a certain percentage of broker loan officers that are too clueless to understand what this means to them so they are going to keep right on doing them until the lawsuits pile up, but it's really starting to put the brakes on stated income loans here locally.

Now stated income loans have been a large proportion of what drove home prices upwards. It was an easy way for loan officers and real estate agents to get people into loans, and therefore properties, that they really could not afford and did not qualify for. Both easier sales and bigger commissions, as people want the better house with the higher price and tend to reward the agent and loan officer who can get them in, regardless of whether they can really afford it or not. People who did not really qualify, but this gets them the loan, and therefore that beautiful McMansion they've got their heart set on, despite the fact that they cannot really afford it. It really is easy to sell people on too much house, and very few of them really understand the implications. I've sat people down, taken them through the math, and they still signed up with the agent who promised to get them into the McMansion because they wanted it so much.

Well, with the lenders getting aggressive about enforcing financial consequences, every loan officer with the brains to understand that heavy objects fall is suddenly taking a hard look at their business practices. Now it's not just a question of "Get paid or don't get paid," it's a matter of whether the money they get paid right now is enough to balance out the money they are going to have to pay later to buy the loan back, and the answer is largely coming back "No!" Furthermore, there could be actions taken against licenses by lenders and not just by clients. That brings a completely different trade-off into the picture, and a lot of loan officers aren't liking what it says.

Now because the prevalence and easy availability of "stated income" loans has been one of the things driving the increase in the price of housing, essentially killing the stated income loan is not going to have a beneficial effect as far as sellers are concerned. It decreases, by some amount, the potential market of people who can afford to buy your property. Where before, the bottom line with most agents and loan officers was that anyone who wanted the property could probably be qualified for the necessary loan and was therefore a legitimate potential buyer, that is now changed. Since anytime you constrict your market of potential buyers, the equilibrium price of the market is going to fall, expect this to have a further deflationary effect upon property values. Indeed, there are a lot of factors that are conspiring against highly appreciated property values right now, but this one small item could well be what starts housing prices more notably downwards. Because it attacks a way of doing business that was at the heart of the large run up in prices, this relatively small measure may be the pin that pops the housing bubble.

Caveat Emptor

Original here