Fun news on the mortgage front from Countrywide / Bank of America.
One of the clever new products they came up with in the flurry of bubble-building activities over the past few years was something called the "pay-option" loan. As the name might suggest, it was a loan that gave people the option of deciding how much to pay each month. Under normal circumstances, a debtor pays both interest and principle, but by choosing the "pay-option" you could send a check that covered only some of your interest.
For the banks involved, this was supposed to be a wonderful thing. So long as a debtor never makes a payment towards their principle, their payoff date never gets a single day closer. But interest is of course always accruing, so the longer a debtor strings to their loan, the more profit the bank will make! And if a borrower is foolish enough to pay only part of their interest each month, the size of the loan will actually increase over time, with interest compounded atop interest.
Now I'm no mortgage expert, but when I first saw these things I couldn't help but wonder what the banks were thinking. Yes, as described, these pay-option loans had the potential to become a huge profit center. But that assumes that people don't mind being upside-down (owing more than their house is worth) on their homes, because unless your house is appreciating in value more each year than your interest rate, that is precisely what will happen!
Of course, back then we were in the midst of a bubble, and everyone kept telling me I was crazy to worry about this. After all, housing values were increasing by double digit percentages year on year, and even if they stopped growing they would never, ever decline. It was as if someone had invented some new law of nature I had never heard of: Housing prices only go up, never down!
The thing is, I learned my lesson during the dot.com bubble. Back then, I bought into the idea that the rules of economics and human psychology had changed. The Internet was magic - it had changed everything! Until, of course, it hadn't, and stock prices came crashing back to earth. It was a hard lesson to learn - I lost my first and so far only million by age 28 - but learn it I did. And now, whenever someone tells me that prices always go up, or that this time things will be different because (fill in the blank with uninformed crazy nonsense), I can't help but laugh and shake my head.
So those housing prices they promised would never fall? We now know, of course, that they can and are falling. And yes, what happened next with those loans was entirely predictable:
Many of the option ARMs taken out in 2004 and 2005 are resetting at much higher payment schedules -- often to the astonishment of people who thought the low installments were fixed for at least five years. And because home prices have leveled off, borrowers can't count on rising equity to bail them out. What's more, steep penalties prevent them from refinancing. The most diligent home buyers asked enough questions to know that option ARMs can be fraught with risk. But others, caught up in real estate mania, ignored or failed to appreciate the risk.
There was plenty more going on behind the scenes they didn't know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan's interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they'll soon be confronted with the choice of coughing up higher payments or coughing up their home. The option ARM is "like the neutron bomb," says George McCarthy, a housing economist at New York's Ford Foundation. "It's going to kill all the people but leave the houses standing."
As of the end of December, Countrywide had nearly $29 billion in pay-option loans, with about $26 billion of the total having grown beyond their original loan amount, the company said in a filing late Friday with the Securities and Exchange Commission.
"Our borrowers' ability to defer portions of the interest accruing on their loans may expose us to increased credit risk," the company said. It added that its risk could be greater because the amount of deferred interest on pay-option loans was on the upswing.The company noted some 81 percent of the loans were made out to borrowers who provided little or no documentation on their income. As of the end of December, 71 percent of borrowers with pay-option loans were electing to make less than full interest payments.
Even though borrowers with such loans had the option to just make interest payments, many were increasingly missing payments, the company said.
Some 5.71 percent of the loans based on unpaid principal balance were at least 90 days late as of Dec. 31, up from 0.65 percent a year earlier.
Now let's be perfectly clear here: Walking away from a house that you are upside-down on is supremely rational behavior. Trying to dig your way out of that hole - a hole that your lender or mortgage broker helped you dig - makes absolutely no sense financially. Far better, far more rational, to simply walk away from the house, take the credit report hit, and find a new place to live. Voluntarily turning your home over to a bank is no fun, of course, but its the rational thing to do when you owe more on the loan than the home is worth.
And that's why I cannot help but laugh when I read stories about this. If there is one thing economists are supposed to be good at predicting, it is rational economic behavior. It is the premise of their entire discipline. And yet here are these banks and mortgage brokers acting all surprised when their customers decide to act rationally!
One last point before I let this go...
Whenever I write about this subject, I inevitably get emails from people bitterly complaining that it is somehow unfair to the lenders that debtors are allowed to walk away from their promises, contracts, and debts. Which is a fine complaint, so far as it goes. But what these people never mention is the banks. No one forced them to come up with these insanely risky loan schemes. No one required them to allow people to borrow ever- increasing amounts of money, month-on-month, without any income or employment checks whatsoever. That was a business decision made by these banks. So before you people write in to complain, answer me this: If you believe in the power of markets, what's wrong with allowing the markets to punish these banks for their foolish mistakes?
UPDATE: This post from Matt Y adds another interesting and important element to the discussion of home ownership:
One major attraction of investing one's savings in a home rather than in a broad index fund of stocks is that you can live in your house whereas the stocks are useless. But this introduces some rigidities into the economy which make it harder for workers to leave the places where nobody wants to hire them (Ohio, Michigan, etc.) and go to the places where people are looking for more workers (Arizona, Florida). For one thing, the transaction costs involved in selling your house are much greater than what's involved in leaving a rental property. Similarly with buying a new one. But what's more, the "living in your retirement fund" duality comes into play.
If you're considering leaving Michigan because it's economically depressed, you're not alone. As a consequence, your house probably isn't very valuable. If your stock investments tank, there's nothing you can do about it. But if your home investment tanks, you can still live there! Unless, that is, you try to move. If you'd been living in a rental and investing in the stock market, you could liquidate some of your investments to help finance the move to a more vibrant area where housing costs and employment prospects are better. But if you spent your savings on your house, then you're basically stuck.Now obviously homeownership has some real value, but when you consider factors like that it's not clear that we should be making it a policy priority to especially subsidize this one form of asset-building over all others. In particular, if you encourage people to live in their savings, the tendency is to acquire more house than they otherwise might (instead of a house plus some stock, you buy a bigger house) which compounds the economic rigidity issues and is bad for the environment to boot.
This is absolutely, precisely correct. Home ownership is not, as so many of my peers seem to think, the be all and end all of investing. If you are planning on staying in the same place for a long period of time, it most likely makes sense. But if you aren't willing to commit to living somewhere for at least the next 10+ years, and as Matt points out potentially much longer than that, home ownership does not necessarily make sense. What happens if you change jobs? Change careers? Change household status or size? With a house, your options are far more limited than with a rental lease. And given the huge down payments that were weren't are once again likely to be required before buying homes, they have an enormous upfront cost, too.
Ultimately, the primary value of a home, condo, or an apartment is that you can live in it, and that is true no matter if you rent or own. People often forget that. You aren't "throwing your money away" when you are renting. You are buying shelter, a place to put your stuff, and the freedom to move no-strings-attached when your 12 months are up.
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