Fixing The Real Estate Mess - Proposing Some Small Changes That Would Make A Huge Difference Over Time

Yesterday, I published the first half of this article, describing the issues currently preventing a return to a more normal real estate market, and the facts that any proposed solution needs to be built upon. At a quick recap, the main facts to take into account are: magic solutions don't exist, people will continue to be people, The Mortgage Loan Market Controls the Real Estate Market. The main issues causing problems are: Overly paranoid underwriting, the overly restrictive requirements regarding income documentation that do not take into account societal changes since they were solidified in the 1930s, and a return of an old (and discriminatory) monster known as the 60% owner occupancy rule that is only going to get worse with time.

So, how would I fix this mess?

First off, I'd get rid of the 60% owner occupancy requirement for condominium loans. Other than scale, I can't see a difference between this requirement and Redlining, which has been illegal for decades. Furthermore, it's just helping the already rich get richer, to the detriment of those without large amounts of cash for a down payment. I described this issue at length in the first half of this article, so I don't want to make those who have already done so wade through it again, but if you haven't read the first part you probably should. This article will still be here when you're done. I've said many times I don't hate rich people and I want to be one of them, but they don't need the rules artificially rigged in their favor. Nor, unlike investments in employment producing enterprises, does this provide economic benefit to the economy. It's a purely parasitic transfer of wealth from those who don't have a large amount of cash to those who do.

Second, repeal or substantially amend the rules essentially prohibiting all but private money lenders from making more money when they make a riskier loan. I don't want to bring back loan sharks, not that they're kept out now. The current rules enacted in 2009 don't keep loan sharks out and they do keep out the enterprises with the ability to bring real competition back to the field. Allowing the regulated lenders with access to the capital markets to make these loans means that for consumers there is both more money available and a less costly alternative to loan sharks. More money legally able to make these loans means more supply for the same demand which means lowered interest rates, as well as meaning that people have the ability to choose whether getting the loan they can qualify for and get puts them into a better situation, instead of being locked out by law. In the early 1990s recession, such loans and the lenders who made them were at least one of the biggest drivers of recovery, perhaps even the biggest - but they're completely absent now because Congress and the Federal Reserve made them illegal in 2008. Allow mortgage securities investors to make more money if they assume a little more risk, and many of them will choose to do so. In fact, net returns on the secondary mortgage market are so low right now it's hard to imagine a scenario where the increased money they make does not more than pay for the increased risk, meaning pension funds and the like which are required to have so many percent of their money in mortgage securities can maybe start showing something more closely resembling a reasonable rate of return to those investing in them.

Third, we need something (or several somethings) that fills at least part of the niche that Stated Income loans used to fill. Yes, Stated Income was badly abused, but when it existed, there were people it was intended for and those who made responsible use of it for many years. The self-employed, those with large deductible expenses, those with gaps in employment or changes in career. When Stated Income loans went away, a large number of people who weren't having any difficulty making their payments suddenly found they were unable to refinance when their loan hit the end of the fixed rate period. People who were making the payments and had made ALL of their payments, had excellent credit, good reserves of money they could access if they had to, suddenly found their 5% interest rate shooting up to 9% or more but through no fault of their own were completely unable to refinance into something more affordable because the rules they originally qualified under were gone, made illegal at the stroke of a pen by the government. Many lost their homes solely for this reason.

I am NOT saying bring back Stated Income. I am saying we need alternative methods for documenting income that are generally acceptable, and acceptable in all loan niches from A paper down to what used to be called sub-prime. Methods of documenting and making acceptable to underwriters interrupted income. Change in Job Title or Career, providing you can show me a stream of income for at least four to six months at what you're doing now, should no longer be a reason to refuse a loan at all. I think the maximum you should be allowed is the stream documented in the current career, but income from all careers you may have had over some relevant period should be allowed up to that maximum. To illustrate what I'm saying, if six months ago you went from making a salary of $3500 per month as a clerk to $6000 per month as a nurse, you should get credit for ($6000x6months + $3500x18 months)/24 months = $4125 per month. If you did the reverse, you get credit for $3500 per month because the maximum is what you're making currently. Document the income, but be real about the economic changes that have happened since the traditional standards were adopted. Currently, if the sort of situation described in these examples applies, regulatory underwriting standards automatically reject the loan, and that's not in anyone's best interest. Current loan standards reject the loan even if someone went from being an employee making $6000 per month to being a contractor with a contract for $9000 per month for doing the same work, and that is nonsense on stilts.

Finally, I'd concentrate on the low end of the market - real first time buyers. I don't mean what the NAR considers to be "starter homes" of up to the conforming loan limit. I mean the people making $10 or $15 dollars per hour and the properties it would be appropriate for them to purchase as first time buyers. These people strongly tend not to have large down payments because they can't save them on such salaries. If a couple is both making $15 per hour, they're making about $4800 per month. If they've got car payments and maybe some debt, they can maybe afford a $200,000 loan at 6%, which may be higher than current rates but is low in terms of both historical rates and where we're most likely headed.

In most of the dense highly populated urban areas where the majority of the actual population lives, this means condominiums, or developments that may look like detached housing but are still legally condominiums. But condominiums or true single family detached housing, this price range is the real foundation of our housing market.

The real first time buyer market is damned weak for reasons that go back nearly 15 years now. In the Era of Make Believe Loans, the people in this market segment got leapfrogged by real estate agents and loan officers who realized they could make a larger commission by selling the people who should have been buying one of these properties a more attractive and therefore more expensive property. And now, with the 60% owner occupation rule for condominiums, the people who should be the market to buy these are locked out of the vast majority of condominium ownership because nobody will fund the loan they need to buy.

Let's take a slightly more in depth look at the situation of this couple who each make $15 per hour. With taxes and health care, if they can save $500 per month, they're doing better than 95%+ of their compatriots, and at $500 per month it takes them about seven years to save a traditional 20% down payment, assuming no financial setbacks at all. How many times you know has a car gone seven years without needing repairs? Why should their cars be any different?

What I'm trying to get at is that these people do not have enough for a traditional 20% down payment, and rules that require them to have that much are not based upon reality. Such rules will crash the market further, if implemented as currently proposed. This will result in further transfer of wealth from these people to the people who already have the cash for a down payment, who then are able to buy for a lowered price, and turn around and make a profit by renting to these people. Even a 10% down payment takes three and half years to save, while a 5% down payment takes just under two years, and none of these figures include the actual costs of buying the property nor any reserves so that a minor setback that occurs in the first couple years after purchase isn't an unrecoverable financial disaster. Think about that: Two years of scrimping and saving just to make a bare minimum 5% down payment, plus at least another year so they can pay the actual costs of buying, plus perhaps another year or more so they've still got something in the credit union in case the car needs fixing after they've bought the property. Minimum four years, more likely 5 or more, of focused disciplined saving just to have the money for a 5% down payment that the wealthy people in Congress and the lenders behind them are trying to outlaw as too small by a factor of 4. I have a great number of words for those who would mandate a 20% down payment rule for all loans, but I can't use any of them in a family friendly environment.

When I look at the loans which are out there and available to the general public right now, there is one loan program which the first time buyer with a 5% down payment can qualify for: The FHA Loan. The downsides, however, are many. The most significant is that the FHA loan is one of those government controlled loan programs out there that never did repeal the 60% owner occupied ratio requirement, and the FHA is now more firmly wedded to it than ever. Practically speaking, this means that once a condominium complex drops below 60% owner occupancy once, those wanting to buy there will never be able to get an FHA loan again. In point of fact, I don't know of any loan current loan programs requiring less than 25% down without a 60% owner occupancy requirement.

The FHA loan charges an insurance premium to borrowers to pay for the chance of default on the loan. Even if there is evidence somewhere showing that the 60% owner occupancy ratio significantly increases risk of default or loss, even if this requirement isn't illegal for precisely the same reason why Redlining is illegal, there is no reason on God's Green Earth why this insurance premium cannot be adjusted to pay for such increased risk, and if ever there has been a reason why we should make an entire insurance pool pay a slight increase in premiums, this is certainly that instance. The practical fact in favor of it is that paying to remove the 60% owner occupancy requirement prevents a crash in value of that development the first time it drops below 60% owner occupancy. Remember, The Mortgage Loan Market Controls the Real Estate Market. If the FHA won't lend on the complex, and every other lender requires 25% down payment in order to buy, people with less than 25% down payments can't buy there, which means the prices fall for that complex. When the value of a property falls, especially for reasons like that, likelihood of default skyrockets. There's a strong likelihood that removing the 60% owner occupancy requirement will lower the default rate over time, thereby lowering the risk and therefore the premiums necessary for that risk.

Even if such a step does not lower the default rate and therefore the risk over time, insurance pools are legally obligated to pay increased premiums in innumerable instances for purposes of social engineering. If you're not going to argue for the abolition of all of them, show me a more deserving candidate. You can't, because there isn't one. I'm a diehard libertarian and deficit hawk, and I'd vote for the US taxpayer financing this increased cost if there was no other way because the benefits to the treasury would far outweigh the cost. The FHA needs to abolish their 60% owner occupancy requirement immediately if they want to move people in urban areas onto at least the bottom rung of ownership. If they don't want to move people onto the bottom rung of ownership, then why do they exist?

(Note: At this update, the FHA is now using a 35% occupancy rate. While this is better than 60% for several reasons, everything I said about 60% still applies at 35%.)

Once people are flowing once more into the bottom rung of housing ownership, I think the market will pretty much sort itself out. It won't be immediate and it won't be perfect, but solutions alleged to have either of those properties rarely function anything like intended. Putting into effect small changes intended to push the markets back towards normal don't prevent someone from also finding some other solution I've overlooked, they won't hamper the implementation of additional ideas, and someone does try other solutions this cannot do anything but help push the market back towards normalcy. Those who currently own and live in bottom rung units will have equity increase as well as just flat out being able to sell, enabling them to in turn move to the next higher rung on the ladder if they so desire - and many of them desire, because they've been wanting to sell and move up for years but haven't been able to sell because the loan markets have been so screwed up, first in one direction (leapfrogging them) then the other (cutting them off from potential buyers).

As a general rule, It's really only first time buyers that have issues with saving a down payment. Once you're an owner, equity tends to increase over time. Not universally, and not evenly, but the vast majority of home owners are paying their balances down every month and when normal conditions apply, values do tend to increase for many reasons. The point is, if you buy a $100,000 condominium that increases in value to $130,000 over a period of several years while paying the balance down to $80,000, when you sell you'll walk away with $40,000 after expenses of selling - a perfectly acceptable down payment for much pricier properties. This is the "move up" or "property ladder" idea that, when the loan market isn't as screwed up as it has been, happens every day because of natural demographics. Normally, "move up" owners tend to have more of a down payment than they really need.

It takes some time, but the people in the rungs above that will see the benefits from this as well. It's straightforward macroeconomics. The "move up" or "property ladder" effect works on such a routine level that it's like water is for fish. Fish don't realize water is there, and most folks take the property ladder so much for granted that it is built into all of their assumptions about housing. The fact that it's so screwed up right now is itself one of the biggest things wrong with the housing market. Fix the property ladder, and you go a long way towards fixing the entire market, given time. It doesn't make everything magically better overnight, but as I told you at the beginning, there's no "magic wand that makes it all better right now" solution. There are, however, a few cheap and easy fixes that get things almost inexorably started in the right direction, especially if undertaken together.

Caveat Emptor

Original article here