No money down, revisited

by Russ Roberts on September 22, 2008

in Government Intervention

From Business Week, March 2002 (HT: Stephen Smith):

Fast-rising housing
prices, combined with a low-inflation economy, means that homes are
steadily getting more expensive compared with other goods and services
that households can buy. Moreover, gains in home prices are
outstripping wage gains. That creates a gold-rush mentality in which
potential homebuyers rush to grab a house as quickly as possible, even
if they overpay.


And mortgage lenders are willing to oblige, even in the case of buyers
who might not have qualified before. The average downpayment has
dropped to only 5% to 10% over the past decade rather than the 10% to
20% it was in the past, according to Doug Perry, a first vice-president
at mortgage lender Countrywide Home Loans Inc. Under the right
conditions, Countrywide is even willing to lend homebuyers 103% of the
value of their new home to cover their closing costs, too.


In part, the aggressive tactics of mortgage lenders have been made
possible by the automated underwriting systems developed in recent
years by the Federal National Mortgage Association (Fannie Mae) and the
Federal Home Loan Mortgage Corporation (Freddie Mac). These two
government-created companies buy 70% of new mortgages in the U.S. and
repackage them as mortgage-backed securities, which they then sell to
investors.


The new underwriting systems being used by Fannie Mae and Freddie Mac,
which are analogous to the credit-scoring systems used by banks, allow
for higher loan-to-income ratios than in the past to encourage home
buying. That’s good for borrowers, but the relaxed ratios could pose
serious problems in the future. For one, there is already evidence that
defaults are rising, particularly at the low end of the market, where
there is a concentration of homeowners who might not have owned houses
without the mortgage boom. The Federal Housing Administration (FHA),
which makes low-income loans, saw mortgage delinquencies and
foreclosures jump to 0.71% of its portfolio in the middle of last year.
"That number has been hanging around 0.59% for years," says Wharton’s
Wachter, who used to work at the Office of Housing & Urban
Development (HUD), which collects these statistics. That may not sound
like much of a jump, but it amounts to about a $600 million increase in
delinquencies.


   For Fannie Mae (FNM
) and Freddie Mac (FRE
), which only began expanding into subprime mortgages two years ago,
deteriorating credit quality may be a new and unpleasant experience.
Since they control such a big chunk of the market, if their portfolios
are perceived to be more vulnerable to credit issues, that could boost
mortgage rates across the country.

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{ 3 comments }

Steven Walser September 22, 2008 at 1:44 am

The bigger issue is what to do now?
I propose the following:

Rather than give the 700B to the stricken firms we require Wall Street and the banks who need help to issue equity in their company in exchange. All these shares would then be put into a trust for the benefit of the American people directly by then issuing shares in the trust to each person as they retire. Could be in lieu of a portion of their SS benefits or additional to these benefits.

This avoids the problem of the government owning a big portion of the financial markets of the US and also satisfies those who want private accounts in SS.

If we put a hard bargainer in our corner we should be able to drive a pretty good deal given the current need of the financial wizards that got us into this mess. A large dilution of their ownership would be truly just. Who knows, those of us who don't really expect to see SS solvent when we retire, might be pleasantly surprised.
Perhaps we kill three birds with one stone: 1.End this financial panic, if we are lucky.
2. Get the ball rolling on privatization of SS and
3. Help plug the gap in SS.

Given the outsized profits of this industry, this bailout might even end up just being a huge purchase at the bottom of the market of normally very profitable industry.

Will September 22, 2008 at 5:09 am

Steven, I'd love to see SS privitizatin, but I think that's a loonng way politically. Especially if this crisis weakens public faith in the market. Obama is already using this to attack McCain for wanting to privitize SS.

Intriguingly, an op-ed in the Washington Times today cites a Rasmussen poll that the majority of Americans oppose more bailouts, and independent voters are more worried the government will do too much than too little. In any case…

"allow for higher loan-to-income ratios than in the past to encourage home buying. That's good for borrowers, but the relaxed ratios could pose serious problems in the future."

You don't say…

Dano September 22, 2008 at 10:07 pm

I confess, I bought my home with no money down. Actually that is not quite true since I did pay the closing costs but it was a 100% loan to value mortgage. One of my MBA students asked if that was because I was following Modigliani and Miller's Proposition II (if interest is a tax shield, the value of a firm is maximized at 100% debt). I told him no, I did it because when home prices in my area were rising at 1% or less per year – which unfortunately they were (the values have risen here the last couple of years) – it was better to keep my money invested elsewhere. Though of course the higher interest tax shield has benefited me.

I was also asked why I would do that when I had to pay private mortgage insurance. My immediate answer was a shrug. I didn't want to explain that PMI was just the premium on a put option I purchased. Or that all PMI did was raise my effective interest rate and I was still willing to pay that rate. Plus, the present value of the monthly PMI payments for nine years (the approximate time before the mortgage dips below 80% of the purchase price) is approximately the same as 5% down on the mortgage.

Given those conditions wouldn't it have been irrational to put any money down on the home?

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