November 2021 Archives

My aunt is going to move to a new condo and wants to sell her old one. I would like to buy her old condo as an investment and rent it out (as I am already a home-owner). This whole investment/rental buying is all new to me.
She has lived there about 5 years and the value has increased more than double. Obviously I would love to be able to keep her tax base. I am thinking about getting an interest only loan to help me get into this. Can I get a loan for 100% of value? My aunt will need the entire amount to purchase her new place. What suggestions do you have to make the loan process easier and pay the least amount in fees?

It is worth between 360,000 to 390,000 (we haven't yet got an appraisal, this is from comps in area). My wife and I currently have a house in (City) with a value of 650,000 and a mortgage of 400,000. We both work and have some extra income, maybe 400 a month that we could supplement against a renter. I think we could qualify for the loan, but then we would have to refinance our house to cover a down payment and closing costs. We don't have any savings to pull from. My wife hopes to retire in 2 years and I will in about 8 years.

Investment property is a different item from a personal residence, in several particulars. First off, even if it's residential, the loan is a riskier one to the lender. A loan on investment property is going to carry a surcharge of 1.5 to 2 discount points (one discount point is one percent of the final loan amount), over and above any other charges for the rate you choose. Most people in wanting a loan on investment property end up choosing a somewhat higher rate to keep the initial costs down a bit. When I originally wrote this and the general atmosphere was that 100% financing was widely available, I had to continually explain why it wasn't available to investment property. As far as I can tell, there was never any lender that would do a loan on investment property for more than 95 percent of the value, and most of them at this update want the investor to have minimum 20 percent down payment plus closing costs, while I still have a couple financing 95% programs and lots of 90% programs for people buying themselves a place to live.

The good news is that whereas you do not have savings to pay it, you do have a considerable amount of home equity. Depending upon your exact situation, either a "cash out" refinance or just taking out a HELOC (Home Equity Line Of Credit) might be in your best interest. It depends upon your current mortgage and your credit, and I cannot make a recommendation one way or another without looking at the market you're in for current comparables, running your credit, and seeing what can be done. If you've got good credit and income, and have had the good credit and income for some time, it's more likely to be in your best interest to simply take out the HELOC. HELOCs are comparatively low cost, and I have a couple that allow cash out to 80% of value even in this market. Depending upon market changes, If your credit or income has improved of late, it may be in your best interest to refinance, or if you've got an ARM that's about to adjust anyway. Assuming you're "A" paper, you may now be a conforming loan where you would not have been when you took it out.

Cash flow is also an issue with investment properties. If you don't have a tenant, you get zero credit for the rent at initial purchase from A paper. If you do have a potential tenant, with a signed lease for at least one year, the lender will give you a credit of seventy-five percent of the proposed rent towards your cost of owning the home (principal, interest, taxes and insurance). Some subprime lenders used to credit you with ninety percent, but their rates are typically higher in compensation. With the vacancy rate in urban California being about four percent, even ninety percent is a bit low, but the standards are what they are. I know many people who are making money hand over fist on rentals where the bank thinks they are paupers.

Now there is no such thing as an easy documentation investment property. There never was even in the Era of Make Believe Loans. Indeed, for any loan, for all real property you have to show the full breakdown for each property you own. You used to be able state your overall income in most cases (and indeed, most folks with investment property had to do stated income due to the cash flow computations being so restrictive.)

When I originally wrote this, prices in urban California had gotten so high that it was just about impossible to find a single family residence being purchased for rental purposes that "penciled out" with a positive cash flow. As I said in my article Cold Hard Numbers, this was one of the things that convinced me California real estate was overvalued. Well, now investment property often does "pencil out" with a positive cash flow, even by lender standards, even single family residences. Condos have become cash machines again.

But you need to be very certain that you do have that cash flow. When I originally wrote this, you'd have been looking at $360,000 purchase price with a first loan at about 6.75 percent on $288,000, which gives a payment of $1868. Additionally, there's going to be Homeowner's Association dues of probably about $200, and taxes (assuming no Mello Roos) are about $375 per month, or about $200 if you can keep your aunt's tax basis. That sums to $2443 or $2268 if you can keep her tax basis. Now ask yourself how much similar units are renting for? If it's less than $2050 (or $1875 if you can keep the tax basis), your $400 per month isn't going to make up the difference. You might have formerly considered a negative amortization loan in this circumstance, but be advised that you're eating up your investment every month, the real interest rate is actually higher than the 6.75 percent, and prices may go down and not recover for several years, leaving you holding the bag for a big loss. It's a risk some folks are willing to take, others are not. I was always a big non-fan of these loans, but was willing to do them for people in this situation after I explain all the pitfalls (Option ARM and Pick a Pay - Negative Amortization Loansand Negative Amortization Loans - More Unfortunate Details cover most of them). Usually people who have been informed of the pitfalls decide that these loans are not for them, which is one of the reasons why I have always questioned whether the risks have been adequately explained to the forty percent of all local purchases that were at one point being financed by these. At this update, they don't exist any more, but they could come back.

Indeed, given the fact that you're going to have to make payments on the Home Equity Line of Credit as well, I don't see how your $400 per month of extra cash flow is going to stretch to cover. If your credit is decent, I can get you into the property, but that's not exactly doing you a favor if you find it impossible to make the payments. I would advise against this particular property.

Caveat Emptor

Original here

I have been asked by more than one person how to measure desirability of real estate objectively. Fortunately, the Phoenicians did all the hard work for me three thousand years ago when they invented money. Precisely what that measurement unit is varies from country to country, but here in the United States that measurement unit is dollars.

A more desirable property will sell for a higher number of dollars. It's as simple as that.

Consider: The same property, moved to a more desirable neighborhood, will sell for more. This difference is nothing more or less than the premium for living in the more desirable neighborhood than the less desirable one.

A four bedroom property with X square feet will sell for more than a three bedroom property with the exact same number of square feet right next door. This difference is the premium for that fourth bedroom, so that one or two more people in that family now have a private place to retreat to - a private place they don't have to share.

A newer property will sell for a higher price than an older one, a well-maintained property for more than one with significant deferred maintenance, a well laid out property will sell for more than a poorly laid out one. I can go on and on, but the difference in all of these cases is precisely the desirability premium for the good thing as opposed to the not so good one. This difference is - you got it - measured in dollars. If it's worth more money to have the laundry area upstairs, the selling price between two otherwise equivalent properties will reflect that difference. If it's not, then the selling price won't be any different.

(In this case, you can figure the difference is a couple thousand bucks in the case of most two story properties around here.)

The obvious question that occurs to most people right about now is, "Do I get a package deal by holding out for a property with everything I like?" The answer is "not usually." Every desirability factor you add on pulls that much more interest to the property. Large lot? Downstairs bedroom? Great view? One of these or many other factors seen as desirable pulls in a decent amount of interest. Put two together, the interest level more than adds, because you're dealing with people who have to have both as well as those who would be happy with one or the other and the fact that the combined features attract the desire of everyone who can afford them - including those who can more than afford them. Have three or more common desirability factors like "gourmet kitchen" and now everybody who even has a chance at affording it is making a bid, especially in a hot market. This is how Flippers and Fixers make lots of money. A good agent with enough time and who knows how to negotiate can and will play them off against each other. They're going to get a hefty premium for that property, leaving the seller very happy indeed. The usual fight in my mind when I'm listing such a property and evaluating offers is "how much over appraised value is this person willing and able to pay?", because the appraisal can only go, at the very most, 25% higher than recent sales in the area. Especially given the conservative nature of appraisals done under the new HVCC appraisal standards, the offer I'm going to recommend my client accept probably be from the buyer with the most room on the loan to value ratio and a willingness to do without an appraisal contingency. Sure those people over there may have a higher offer, but with just enough cash for the down payment if the appraisal comes in are not going to be able to consummate it. Because the appraisal is not going to come in for the full purchase price in such circumstances - bet on it. You might be pleasantly surprised, but if you plan for it, you won't be scrambling to contact people who made other offers four weeks out when the buyer comes back and says "We can't qualify unless you cut the price." The buyer's ability to add to the down payment (or finance a larger loan if their loan to value ratio is still good enough) is what gets the transaction done in such instances.

How do you use this as a buyer? It's very simple actually - keep your "must have" list firmly in your mind; don't get distracted by beautiful presentation or bells and whistles you don't have to have. Such properties are ripe for bidding wars. If you must get involved in such a bidding war, keep your maximum purchase price in mind and don't offer a penny more. If you haven't got a maximum purchase price engraved upon your soul before you go looking at property, check yourself into an insane asylum immediately.

You can always make the property better once you own it. There won't be a bidding war then - except maybe between contractors who want the job (the low bid isn't necessarily the best there, anymore than the highest offer is necessarily to one to take for sellers). You own the property, and it's difficult to force you to sell against your will. Doesn't matter how much they like it, they can't have it unless you decide the offer is worth taking even though you weren't planning to move again. But if sellers have twenty, forty, eighty offers there has to be a reason to pick your offer - and the reason is that they figure they'll net the most cash out of it. Your offer really has to stand out. If sellers only have one offer, though, there's a lot more room for meaningful negotiation. If there are even two offers, you can expect to get played against the other offer, at least to some degree. I'll admit this has become a lot less common of late - but the good agents still do it, and we've gotten better at it.

Look for solid instead of beautiful. Look for improvable over perfect. Look for clear and reasonable upgrade paths rather than properties that are already highly upgraded. Your pocketbook will thank you. Yes, it's a bit of hassle to upgrade, but the dense, highly desirable areas like San Diego are headed for another period very soon like the one a few years ago, where it didn't matter what faults the property had, the buyers were glad to get into anything. Only unlike before, without unsustainable loans over-heating the market and setting things up for a crash when there's a subsequent reality check, the prices are going to stay that high this time. We're still going to have cycles, but the low point of this one is not something I would expect to ever see again (especially with the way the government has been sabotaging the economy). It took an awful lot of loans that were complete garbage to make this happen. The loan type that was the chief culprit has been essentially regulated out of existence, most of the companies that provided other garbage loans are gone as well, and Wall Street and the global capital markets have learned a lesson about real estate loans that it'll take them a generation to forget. It wasn't that long ago I heard with my own ears buyers express gratitude that they had an accepted purchase contract on crummy little places where their family would be shoehorned into a fraction of the room they needed to be comfortable. Those days are coming back, and they're going to get worse over time.

Things that you're willing to put up with that bother most other folks are good wedges for a deal. Popcorn ceilings, power lines, and too many others to enumerate. You may think popcorn looks tacky, but it's pretty easy to remove in most cases. Many utility companies are in the process of burying their lines. If you bought before and it happens while you own, that's a price boost. Don't take the listing agent's word - do your own research, especially if someone tells you, "That airport's going to close." (there's an Act of Congress that makes it extremely costly to close down most airports. The city or county has to pay the federal government back every dime in revenue they've ever gotten through that land, plus interest). But if the property's situation is likely to improve, or if it's something you can live with regardless of whether it improves, that may be the property for you. Let the other buyers fight to outbid each other over one "absolutely perfect!" property. While they're distracted fighting over that "absolutely perfect" property over there, bidding the price up to something unjustifiable, it's time to grab a real bargain somewhere else.

Caveat Emptor

Original article here

This is one of those things that trips up people to buy a house or refinance it: student loans.

First off, Form 1003, the Federal Uniform Residential Loan Application has the following relevant questions on page 4, among the "deadly thirteen"

a. Are there any outstanding judgments against you?

f. Are you presently delinquent or in default on any Federal debt or any other loan, mortgage, financial obligation, bond, or loan guarantee?

One of the things they don't generally tell people about student loans is that a default of a federally guaranteed student loan stays with you for life, or at least until it is paid off in full. Unlike most defaulted debts, which are a black mark on your credit for 7 to 10 years, this one never goes away. With interest and penalties, the amount owed can be much larger than it was, even at the default point. Bankruptcy doesn't cure this debt. It is basically there forever. So don't default on your student loans. A yes answer on any of these questions turns a slam-dunk loan into a very questionable one. In this case, you can kiss any possibility of actually getting a VA loan or FHA loan funded, and first time buyer programs, which are provided via federal funds, are off limits as well. This includes both the Mortgage Credit Certificate as well as all of the local first time buyer programs. Sometimes a conventional conforming or subprime lender will do a purchase money loan - but refinancing is right out unless you're going to pay the student loan debt as part of escrow. With the federal government now owning Fannie and Freddie, I would anticipate the conventional conforming becoming even more difficult in the future, leaving subprime lending as your only option. Truthfully, it's been quite a while since I had someone in this position, so it might already have happened.

But most folks pretty much figure that if they're in default on student loans, they're not going to get much help from the feds or anyone associated with the feds. They might try to get around it, but they're not really surprised or bitter when they can't.

The thing that jumps out and surprises people is student loans not currently in "payment" status. You're not making payments on them now, so you don't tell the loan officer about them, and he doesn't take them into account in determining your debt to income ratio. Since the loan officer doesn't know about the student loans, they don't take them into account, and they say you qualify for a loan amount that you're not going to qualify for. Actually, this is pretty common even without student loans, but with them, it's practically ubiquitous.

Whether the loan is in payment status or not, it's a known debt. You're going to have to start making payments on it at some point. Sure, you might have a much larger income then, but that's not something you, I, or anyone else can guarantee. So what you're going to be paying in the future, when the loan enters payment status, is something that needs to be taken into account. You need to be able to afford the loan payment as well as all of your other debts, which most pointedly includes student loans.

So it doesn't matter that you're still in school, or the loan is in deferral or forbearance. The real estate lender is going to want to see documentation from the student loan lender as to exactly what that payment is anticipated to be. You might as well ask for it ahead of time, so you have it ready when it's needed. You should want to take it into account in figuring what you're able to afford, as well.

The last of the most common questions has to do with student loan consolidation. Since student loan consolidation usually extends the repayment period as well as fixing the interest rate, consolidating student loans has the effect of boosting what you can afford a portion of the way back up to what you could afford without them. The catch is that consolidation has got to be complete to get this benefit, a process that takes about six weeks. It's not something to try when you're in escrow; it's something you need to have done ahead of time if you want it to make the difference in getting your loan approved.

Most folks want to stretch to the limit to get the most house they possibly can. In fact, quite a few ask if there's any way they can extend what they qualify for. The general answer to that is "Only if interest rates drop or you start making more money that we can document." But in order to know how much you can really afford, you have to know not only the income, but what you're already obligated to pay via student loans as well as other credit payments.

Caveat Emptor

Original article here

Got a search for that, and it occurred to me that it is a valid question. The answer is yes.

The degree varies. You can simply contact the bank to make yourself responsible for payment. They are usually happy to do this, although unlike revolving accounts you typically will not receive back credit on your credit score for the entire length of time the trade line has been open. Nonetheless, if the bank reports the mortgage as paid as part of your credit, it can help you increase your credit score, so long as the mortgage actually gets paid on time every month. One 30 day late is plenty to kill any advantage for most folks.

This is typically free. Hey, the bank has already funded the loan - the money is out there and they can't call it back, and another person has volunteered to be responsible for paying it back! This can be used as a way to start rebuilding credit after a bankruptcy or other financial disaster. A friend or family member qualifies for the loan, then adds the person looking to recover to the loan later.

If you want to go one better than that, you can actually modify the deed of trust to make yourself responsible for payment, although it really has no measurable benefit as opposed to simply agreeing to be responsible, and it costs money to notarize and record the modification.

It is entirely possible you'll encounter someone who is thinking only of the bonus they get for referring you to the loan department, or someone in the loan department who wants an easy commission. These folks will want you to go through a full refinance, and tell you that's the only way. To be 100% fair, many lenders don't go out of their way to tell their employees about this. Nevertheless, the lender loses nothing, as you're not taking anyone off, the people who qualified for the loan are still on it. You're only adding someone who, no matter how poor their credit and debt to income ratio may be, nonetheless is a legal adult and might have the money to make or assist in making the payment if something happens to all the other holders. Therefore, the lender can only gain in likelihood of the loan being repaid in full and on time, and that's what's important to them.

Unless you can get a better rate by doing so, I would advise against a full re-qualification for the mortgage just to add someone. It's a lot of hassle and expense for no particular gain. If you want to get me paid, I'm cool with that, but there are better ways to accomplish the gain to your credit at far less expense.

Note that removing someone from a mortgage is an entirely different matter. Before the lender agrees to let someone off the hook, they're going to want a full refinance - appraisal, title insurance, everything. If the people remaining on the loan can qualify on their own, then lender will let the other person (or people) off the hook through the mechanism of an entirely new loan contract. Otherwise, it's not going to happen.

Caveat Emptor

Original here

The negative amortization loan is a very popular loan with certain kinds of real estate agents and loan officers. It has two great virtues as far as they are concerned. First, it has a low payment, and despite the fact that people should never choose a loan - or a house - based upon payment, the fact is that most people do both, and the negative amortization loan enables both sorts to quote a very low payment considering how much money their client is borrowing. Furthermore, because it has this very low minimum payment, it enables these agents and loan officers to persuade people to buy properties that they cannot really afford. When someone says, "I'll buy it if the payment is less that $3000 per month," this brand of agent goes to a loan officer that they know will reach for a negative amortization loan, without explaining this loan's horrific gotcha, or actually, gotcha!s. Instead of someone ethical explaining that the real rate and the real payment are way above $3000, and this is only a temporary thing, they keep their mouth shut and pocket the commission.

This commission is, incidentally, far larger than they would otherwise make, and that's the second advantage to these loans from their point of view. When the pay for doing such a loan is between three and four percent of the loan amount, with most of them clustering around 3.75%, and they can make it appear like someone can afford a much larger loan, that commission check blows the one for the loan and the property that this customer can really afford out of the water. When they can make it appear like someone who really barely qualifies for a $400,000 loan can afford a $775,000 loan, and the commission on the $400,000 loan is at most two percent of the loan amount, that loan officer is making over twenty-nine thousand dollars, as opposed to between four and eight thousand for the sustainable loan, and that real estate agent (assuming a 3% commission per side) is making over twenty-three thousand dollars as a buyer's agent for hosing their client, as opposed to $12,000 for the property the client can really afford. Not to mention that if they were the listing agent as well, not only have they made $46,000 for both sides of the real estate transaction, but they have found a sucker that can be made to look as if they qualify for that property, making their listing client extremely happy - the more so because one of listing agents standard tricks is talking people into upping their offers based upon how little difference it makes on the payment. Ladies and gentlemen, if the property is only worth $X, it's only worth $X, and it doesn't matter a hill of beans that an extra $20,000 only makes a difference of $50 on the minimum payment for an Option ARM, as these loans are also called. Indeed, Option ARM (aka negative amortization) loan sales were behind a lot of the general run-up in prices of the bubble years. By making it appear as if someone could afford a loan amount larger than they really can, this sort of real estate agent and loan officer sowed at least part of the seeds by making people apparently able, and therefore willing, to pay the higher prices because the minimum payment they were quoted fit within their budget. When someone ethical is showing you the two bedroom condo you can really afford, fifteen years old with formica counters and linoleum tile floors, these clowns were showing the same people brand new 2800 square foot detached houses with five bedrooms, granite counters, and travertine or Italian marble floors. Talk about the easy sale! Someone who's not happy about what they can really afford now finds out there's a way they can apparently afford the house of their dreams! For a while, anyway. What happens later isn't so pretty.

So now that the Option ARM has finally been generally discredited by all the damage it has been doing to people, and has become well known, and deservedly so, by the moniker "Nightmare Mortgage," among others, this type of agent and loan officer are jumping for joy and shouting from the rooftops that a couple of professors have done apparently some work showing that "the Option ARM is the optimal mortgage." It was reported in BusinessWeek, which would have reason to celebrate if this defused the mortgage crisis, and therefore the credit and spending crunch that comes with it.

The problem is that the "Option ARM" these professors are talking about has very little in common with the Option ARMs, or more properly, negative amortization loans that are actually sold for residential mortgages. If you read their research, the loans they describe actually look a lot more like commercial lines of credit secured by real property. There really isn't much more in common between the two than the name.

The characteristics the professors describe in their ideal loan include first, it being the lowest actual rate available. This is not currently the case with option ARMs. In fact, since I've been in the business, it has NEVER been the case - or even close to being the case. The nominal rate can't be beat, but the nominal rate is not the actual interest rate you are being charged. Ever since the first time I was approached about one of these by a lender's representative, I have always had loans at lower rates of interest, with that rate fixed for a minimum of five years. Most recently, I've had thirty year fixed rate loans - the paranoid consumer's dream loan, which usually carries a higher interest rate than anything else - at lower real rates of interest than Option ARM. When you're considering the real cost of the loan, it's the interest you're paying that's important. The lender, or the investor behind them, isn't reporting the payment amount as income. They're reporting the cost of interest to the buyer as income, and that's what they're paying taxes on as well. But because people don't know any better than to select loans on the basis of payment, lenders can and do get away with charging higher rates of interest on these. The suckers pay a higher rate of interest than they could otherwise have gotten, and their balances are going up, which means they're effectively borrowing more money all the time, on which they then pay the inflated interest rate that is the real cost of this money. What more could you ask for, from the lenders and investors point of view?

There is a real actuarial risk associated with these loans, as well, which does increase the interest rate that the lenders need to charge. This is that because there is an increased risk that the borrower's balance will eventually reach beyond their ability to pay, a risk which is exacerbated by how these loans are generally marketed and sold, a larger number of borrowers will default than would be the case with other kinds of loans. So these loans aren't all fun and games from the lenders point of view, either - as said lenders have been finding out firsthand for the last several years as these loans go into default. This leads us to the second dissimilarity between these loans as they exist, and the loans said to be optimum by the professors research, and this one is a real problem from the lender's point of view.

You see, the professors' study assumes that the lender can simply foreclose as easily and as quickly as sending out an email. That's not the way it works. First of all, foreclosure takes time, and it costs serious money. The law is set up that way. To quote something I wrote on August 23rd, 2007:

It takes a minimum of just under 200 days for a foreclosure to happen in California, and we're one of the shorter period states. Notice of Default can't happen until the mortgage is a minimum of 120 days late. Once that happens, it cannot be followed by a Notice of Trustee's Sale in fewer than sixty days, and there must be a minimum of 17 days between Notice of Trustee's Sale and Trustee's Sale. Absolute minimum, 197 days, and it's usually more like 240 to 300, and it is very subject to delaying tactics. There are lawyers out there who will tell you if you're going to lose your home anyway, they can keep you in it for a year and a half to two years without you writing a check for a single dollar to the mortgage company. It's stupid and hurts most of their clients worse in the long run, but it also happens. Pay a lawyer $500, and not pay your $4000 per month mortgage. Some people see only the immediate cash consequences, and think it's a good deal.

So that loan is non-performing for a time that starts at just under nine months, and goes up from there. This costs the lenders some serious money - money which they expect to be actuarially compensated for, which is to say, everybody pays a higher rate so that the lender doesn't lose more money on defaults than they make on the higher rate. I checked available rates on loans the afternoon I originally wrote this, and for average credit scores on reasonable assumptions, the closest the Option ARM came to matching the equivalent thirty year fixed rate loan was 80 basis points (8/10ths of a percent), and that wasn't an apples to apples comparison, as the Option ARM had a three year "hard" prepayment penalty, while that thirty year fixed rate loan had none, as well as the Option ARM had the real rate bought down by a full percent by a lender forfeiting sixty percent of the usual commission for the loan to buy the real rate down. How often do you think that's going to happen? Sure, the *bleeping* Option ARM had a minimum payment of about $1011 on a $400,000 loan, as opposed to $2463 for the thirty year fixed rate loan fully amortized, but the real cost of money was $2350 per month, as opposed to $2083 for that thirty year fixed rate loan. The equivalent payment for the Option ARM was, that accomplishes the same thing $2463 does for the thirty year fixed (theoretically paying the loan off in thirty years, providing the underlying rate remains the same), was $2675. Not to mention that the thirty year fixed rate loan has the cost of money locked in for the life of the loan, where that *bleeping* Option ARM can go as high as 9.95%, and the prepayment penalty for that *bleeping* Option ARM starts out at $14,100, and is more likely to go higher than lower for the three years it's in effect. You can't just handwave away $14,100 that the majority of people who accept a prepayment penalty are going to end up paying, for one reason or another. Not in the real world.

Another characteristic of the Option ARM envisioned by the professors is a so-called "soft" prepayment penalty, where no penalty is due if the property is actually sold, rather than refinanced. That's not the case with the vast majority of real-world Option ARMs. With only one exception I'm aware of, they're all "hard" pre-payment penalties, and the one lender who offered the "soft" penalty has discovered it's not a popular alternative, because they had to charge a higher nominal rate in order to make it work. Since the minimum payment was higher, and it wasn't quite so easy to qualify people quite so far beyond their means, that particular lender had been contracting operations, even while the rest of the Option ARM world was going gangbusters. Indeed, their parent company sold that lender in early 2007, over a year before the meltdown got noticeable, because they just weren't getting any profit out of them, and at one point, they had been a very major subprime lender (They were extremely competitive on 2/28s and 3/27s and their forty year variants, as well as versus other subprime lenders on thirty year fixed rate loans). Until I checked their website, I was not certain whether they're even still in business. I haven't heard from my old wholesaler since over a year before I originally wrote this article.

The Option ARM envisioned by the professors lacks the "payment recast" bug present in all current Option ARMs. Indeed, under Option ARMs, it is difficult to avoid this issue, because they recast in five years no matter what. Payment recast is what usually wakes people up to what a raw deal they got and they suddenly see themselves on a road that can only end in default and foreclosure. Furthermore, the professors' assumptions as to the longevity of the loan were open ended - essentially infinite in theory, although no loan given to individuals can be open ended in fact because we're all going to die someday, and most of us are going to want to retire before that, at which point these loans would definitely not be paid down to a point where they're affordable on retirement income under anything like our current system.

One final crock to the whole Option ARM concept as envisioned by the professors seems to be that the borrower gets a reserve amount if ever they default. The obvious retort is "Not in the real world." That is contrary to every practice of lending as it currently exists. That is the very basis of the real estate financing contract - the lender gets every penny they are due, first, and the borrower/purchaser/owner gets everything that's left over. As the authors themselves note, this does create a moral hazard for the lenders. Furthermore, and I must admit I'm not certain I'm reading the relevant passage correctly, another characteristic of the "Option ARM" they propose is that the lender gets primary benefit of any gain in value, and at least under certain circumstances, takes primary risk for any loss. In case you were unaware, this would completely sabotage the benefits of leverage that are the main reason why real estate is a worthwhile investment. This would certainly make the communities that make their living off selling other sorts of investment happy. Lenders, and especially current owners, not so much. Furthermore, I'm pretty certain that if they think about the economic consequences of this, real estate agents and loan officers don't want this to happen, either.

Those aren't all of the differences or relevant caveats, by any means. I took quite a few notes that I didn't go through, but it was past bedtime, and by this point it should be obvious to anyone who took the trouble to read through the above that there really isn't a whole lot in common between the Option ARM as the contracts were written, and how it was marketed and sold, and the loan of the same name as envisioned by the professor's research, except that name. Any claim that said research rehabilitates the Option ARM aka Negative Amortization Loan aka Pick a Pay aka "1% loan" aka (several dozen words of profanity), is based upon nothing more than the similarity in labeling, as if claiming a Chevette was the same thing as a Corvette, because they're both Chevrolets. Someone reading the professors' research would not recognize anything like the loan they are promulgating in any Option ARM that ever was on the market, because those were not based upon any of the same principles.

The negative amortization loan was essentially regulated out of existence in early 2008. There were a very few legitimate uses for it so I was a tiny bit sorry to see it go. However, the vast overwhelming majority of them were sold in order to persuade people to buy a property or take cash out that they could not afford, and millions of people have had their finances utterly ruined for years if not for life. Given these fact, and that alleged professionals proved incapable of using them appropriately as a group, I cannot come up with any kind of reason that justifies reversing the decision to ban them. But that doesn't stop some people who miss the days of easy money by hosing the people who put money in their pockets.

Caveat Emptor

Postscript: Lest I be misunderstood, I had previously come to a lot of the same conclusions that the professors had, although I had never integrated it into a single article, here or anywhere else. A lot of what they conclude, while pretty much theoretical, has some significant real world applications. Indeed, I have said several times in the past that leverage works best when it's maximized, and when you pay as little as possible towards paying off the loan, although that one result has to be modified for real world considerations like mortality, morbidity, and various psychological factors, which the professors mention in passing but do not really address or answer. I think I have some real academic appreciation for the value of Professors Piskorski and Tchistyi's work, and what went into it, and the results they have achieved. I had to dust off some portions of my brain (and mathematical textbooks!) that I haven't used in almost twenty five years, which was a treat of a certain kind once I got into it. Nonetheless, the products that go by the same name in the current world of loans have nothing to do with what these two distinguished gentlemen are talking about. The loan product I'm aware of that comes the closest is, as I said, a line of credit on commercial real estate.

Original article here