The Self-Fulfilling Prophecy of Lender Fear

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Most people, particularly first time buyers, want 100% financing or as close as they can get. Actually, most first time buyers don't have a down payment and couldn't put a significant down payment (5% or more) if they had to. And since 5% of $400,000 is $20,000, and 10% is $40,000, that's a significant chunk of change. Especially when you think in terms of lifespan to save: a family that makes San Diego area median income ($69,700 per year when this was written) and manages to save a full 10% of their gross salary - $580 per month - takes almost three years to save a $20,000 down payment, and 69 months to save $40,000! Never mind closing costs, which can be anywhere from another $4000 on up, depending upon how many points you want to buy the rate down. Considering the psychology of the average American, these time estimates are hopelessly optimistic.

For at least ten years, 100% financing had been available, and the means to qualify for it had been routine. Since the vast majority of all buyers need a loan, this availability has been priced into the market. Indeed, it was one of the early factors that led to a run-up in prices in many areas. Nor is there anything wrong with 100% financing, per se. When you look at fully amortized fixed rate loans done on a full documentation basis, the levels of default and lender loss are not significantly higher than the most hidebound "traditional" loan standards.

It was only when the standards became so relaxed that this was too much to ask for that everybody got into trouble. There is a reason why less sustainable loan types - interest only, short term hybrid ARMs, and negative amortization loans had always required a much larger down payment - greater risk of default! Lenders, under pressure from the government under CRA and with an eye on selling the loans to Wall Street figured there was no down side to loosening loan standards until even "fog a mirror" was asking a little bit much. The assumption was that prices had gone up by double digit percentages several years in a row, so "of course" they were going to keep going up forever - and ignored anyone who tried to tell them otherwise.

Well, we all know by now how that one turned out. Unfortunately, everybody in positions of responsibility at various lenders (and the regulators as well) is now in full blown damage control mode - by which I mean playing CYA by slamming the barn door after all the horses have departed. For good measure, they're locking the doors to all the other buildings as well - even the ones that never held horses. Among these are full documentation 100% loans.

The best and cheapest way to get 100% financing was split the amount into two loans - a first for 80% of the value and a second for the remaining 20%. Unfortunately, as I have been reporting for some time now, second mortgage holders found out that they were the ones really holding the sack for all of this, and stopped approving anything over ninety percent of value. As I said then, this made things worse, especially for everyone trying to get out of unsustainable loans and those who lent to them. When someone buys with a loan they are going to need to refinance within a set period, and lenders suddenly pull all refinancing programs that could have refinanced them, that property is going to be a distress sale. People can sit in denial right up until the eviction notice, but that's what's going to happen. Multiply this millions of times over, and you have all of the problems that have plagued real estate since the bubble burst.

The second way to get 100% financing was with Private Mortgage Insurance. PMI rates had gotten very cheap when they were competing with another option for 100% financing. It was still more expensive than splitting the amount borrowed into two loans, but it was possible to get PMI even after second mortgage holders bailed out of the market. If the debt to income ratio was lower for A paper, it only made a marginal difference on qualification of approximately 10%. Even when PMI rates suddenly jumped, things were still manageable. The decline we had already had here in San Diego more than covered the additional cost.

But lenders have withdrawn all 100% financing programs except for the VA Loan.

So what happens when 100% financing suddenly isn't available? People who could have bought and were willing to buy suddenly cannot because they do not have the necessary cash. This constricts demand for housing, as there are fewer people able to qualify for the loans. Prices fall, when they would have been stable otherwise. Because of prices falling below what is owed, people are unable to refinance. Whether it's because they cannot refinance or there was just no way they could really afford the property in the first place, people who sell are unable to sell for enough to pay lenders in full, and those lenders, predictably enough, lose money they otherwise would not have. Poetic justice to a degree, but the lenders aren't the only ones paying. Just like when things were going crazy in the upwards direction, this is all a vicious cycle - except in the other direction

Furthermore, even if you are able to qualify, via one of the governmental or quasi-governmental programs, the added cost constricts what you can afford. If your family makes area median income ($69,700 in 2008), you can't afford a $300,000 property at 6%, even if you have no other debt. About $270,000 is the absolute limit.

Who are the big winners? Two sorts of folks, and for either one this is a real buying opportunity, the sort where if you buy now, you will be very happy in a few years. The first is people eligible for a VA loan. That's the only 100% financing program available right now, and since there is no PMI on VA loans, it can really make a difference as to what you can afford as well. Someone eligible for a VA loan making area median income can stretch nearly 20% further in terms of purchase price than someone without, and I don't know of any income limits on VA loans. Assuming the new limits come in, a family making $100,000 per year will qualify for $500,000 with no money down on a VA loan. When you can qualify and other people can't, that's negotiations leverage. The current owners can keep waiting and hoping for a prospective purchaser in the who makes $120,000 or more per year, but that's about two more standard deviations. Look up the normal probability distribution - at $100,000 per year you're already looking for about one family in 10,000 who might qualify, and most of those already have the property they want.

The other winners are people who have cash for a down payment. All this stuff about PMI doesn't constrict people who don't need PMI, or who at least have enough so that they don't need 100% financing. If you get up to 10% down payment, now you've got the possibility of a second mortgage, and once again, PMI goes away. So if you have a 10% down payment on a $400,000 property, not only are you only borrowing $360,000, but there's no PMI on that money, either. This saves you $480 per month on your first mortgage, $453 per month on PMI, and if it costs you about $293 for a second mortgage, you're still saving $640 per month, meaning you can qualify as if you were a purchaser who makes an extra $1420 or more per month - $17,000 per year!

Suppose you don't fall into one of these two categories? There are about four alternatives. First, you can accept purchasing a less expensive property, which is probably the smartest alternative for most folks. The best way to save for a down payment on the property you really want is to buy something less expensive now. People call this "settling" in a demeaning way as if there's something wrong with financial sanity - a sentiment I do not understand. Second, you can wait until you have saved the difference, fighting against leverage the whole time. Most folks never save enough to make the property more affordable. Third, you can find an owner with enough equity to carry back a large part of the transaction, a consideration for which they are going to demand a much higher price. For one thing, that money is their down payment for their next property. To say this is not a good way to get a bargain on your property purchase may be the understatement of the year. Finally, you can do completely without - in other words, stay a renter until the situation changes. Now every time I write one of these articles, I get some clueless watchers of immediate cash flow who have no understanding of leverage, real estate markets, or the fact that the crashing of the market is putting significant upwards pressure on rents, for two reasons. First, the people who have lost property have no choices except renting or homelessness for at least two years. Second, the leverage that was working in the landlord's favor these last ten years, encouraging them to keep rents relatively cheap, has disappeared with the housing bubble. Locally, I've seen the average rental price in the areas I work jump by $150 per month or so just in the last year, and this is just the leading edge of the adjustment. Paying attention to only the cash flow as it exists now is a way to make a bad decision - you need to look at the entire situation as it is going to be for the rest of your life.

Property values are going to come back. For one thing, I still expect 100% financing alternatives to become more available again. Since their absence had a negative effect on the markets, what's going to happen when they become available again? If you answered, "A one time shift back upwards in property values," give yourself a pat on the back. If you followed it with, "Which will have the further psychological effect of causing everyone who's been putting off purchasing to rush back into the market for fear of getting priced out again, putting further demand and causing another shift upwards in pricing," then you have some memory of how the general population chases last year's returns and the effects thereon. Fear and Greed, just like last time. Some people never learn. But if you buy before the great mass of humanity gets their fear and greed up, that will amount to a nice large chunk of change in your pocket, especially if you then want to move up. I expect San Diego to at least recover most of what we've lost very quickly once the average person gets it into their head that current price levels are unsustainably low, which they are.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on May 12, 2014 7:00 AM.

Games Lenders Play, Part I: Misleading Advertising to Get You to Call was the previous entry in this blog.

Lenders Holding Your Money Hostage is the next entry in this blog.

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