Friday, July 07, 2006

Bottom Feeders

So mortgage lingo is not my forte. I had a mortgage banker friend of mine explain these charts and acronyms to me once, but I forgot most of what he said (I also forgot if they applied to the entire housing market or not, so please correct me if somebody knows, otherwise I'm operating on the premise they do).

That being said, all you need to know is two things;

ARM's and Negative Amortization Loans.

We're all familiar with ARM's. Originally intended for people who KNEW they were only going to live in a place for 3-5 years, these loans were a great way for them to build up equity in a house and take advantage of lower, short term interest rates.

Of course, ARM's started getting abused when people who shouldn't have been loaned money bought houses they couldn't afford using ARM's.

They are paying for it now with WSJP and short term interest rates at 8%+.

But my favorite was something that I thought shouldn't have existed.

You know, there are things that just SHOULD NOT EXIST.

Like genetically engineered mosquitos that carry AIDS. That's a bad idea.

Or dance shoes with glass soles. That's a bad idea.

Or surgical gloves laced with Ebola. That's a bad idea.

Or music that is repetitive with no lyrical component, talent or creativity, ie-rap. That's a bad idea.

Now common sense would dictate to most industries that you would not develop a product that would harm the potential customer. But what if your a mortgage banker with few moral scrupples. Everybody with good credit already has a loan. People with marginal credit already have an ARM, leaving only folk with the crappiest of credit. How do you get them a loan and your precious 1% commish?

Enter in the negative amortization loan or the "reverse amortization loan."

Here's a loan where you are charged interest, but you are so unable to afford the house, you can't even pay the INTEREST on the loan. But that's OK, BECUASE THAT'S THE IDEA OF A NEGATIVE AMORTIZATION LOAN! You pay only PART of the interest and the remaining balance of interest is ADDED to your principal balance on the mortgage. Thus you never actually pay down your mortgage balance, it only GOES UP.

Sudden rap doesn't sound half bad.

What I'm failing to grasp is why would any bank or financial institution push such a product? The only way I can see it, is if they are predatory and fully intend on collateralizing the house when (inevitably) the poor schmoe that was stupid enough to get a reverse mortgage can no longer afford the PARTIAL interest payments.

Of course, that's just how it affects the few unfortunate souls that engage in this sort of financing.

Unfortunately there are not so "few" unfortunate souls as ARM's and, worse still, negative amortization loans are becoming more and more common. Common enough to the point they no doubt are having an affect on their entire housing market (namely a housing bubble). Thus when 25% of the loans hitting the market in 2005 are negative amortization loans and an additional 23% are interest only loans, this money that should not have been given to people floods the housing market, artificially driving up prices. Artifically I say, because once interest rates go up (which they are), these people will quickly leave the market as they cannot finance the loan, flooding the market with housing that frankly, nobody really needs, and prices will drop to normal levels.

The question is whether this decrease or even temporary halt in housing prices will destroy the "wealth effect" that has prompted American consumers to spend more than they make via the Home Equity Loan, and has been one of the engines of the economy's growth in the past 5 years.

I smell a minor recession coming on.

6 comments:

David_Z said...

Aaron, I introduced what I foresee as a huge problem here as a primer, and continued the explanation in part , I've got more rolling around in my head, but I think your suggestion about the NegAm mortgages is pretty accurate.

I've been sidetracked as of late, brainstorming for a terribly ambitious paper I'd like to start writing soon, and one idea that's rolling around in my head is that although banks, stereotypically "do not want to be in the real-estate business," when they finance loans with inflationary credit, their risk is basically nothing. Suddenly, it might appear to pay a bank to endorse such policies...

Not sure if that's what you're looking for, not sure if I'm right, like I said, it's an idea in progress.

Anonymous said...

I actually had a negative amortization loan, and it worked out great for me.
Back in 1995 my wife was expecting triplets, and we refinanced with a COFI loan (type of negative amortizaion). For us, we were looking at huge bills for medical, diaper, formula, and baby supplies. We stuck with the loan for 18 months, and then sold the house and moved. We also made 28% more on the house than what we paid for it, so we were not in danger of not being able to afford selling the house.

For us, it worked out as a loan against the future value of the house - which was exactly what we needed at the time.
Now I am in a 30 fixed load (5 3/8%) and would only ever reccomend a neg-amort loan for someone who knew what they were doing and needed to barrow against their existing capital in a house.

If one didn't have 25% or more of the house paid for the neg-amort would be the road to backruptcy.

Anonymous said...

Is Captain Capitalism trying to tell me that almost 50% (!) of all new home loans in 2005 were of the non-principle paying variety!?

I find that hard to believe, for no other reason than how scary that prospect is.

Captain Capitalism said...

That's how these charts were explained to me. And yes, even I find it hard to believe, but it wouldn't surprise me with the utter sh!t I'm analyzing in terms of commercial loans recently.

Anonymous said...

I am really shocked to hear the level of negative am mortgages, being in this industry myself. I question the accuracy of those charts, I will see if I can find some data on this subject.

Negative Ams are a GREAT product for the elderly who need to supplement their Social Security income. The theory is the bank lends them up 70% of the appraised value of their home in monthly installments, allowing them to live more comfortably. The gamble is they die before they tap all equity and then the Estate pays off the mortgage when they sell.
If these charts are accurate, then this can not be the case.
Either the WWII Generation is tapping into their equity now distorting the numbers OR:
The first wave of "Hippies" (a.k.a Baby Boomers) have retired and are tapping this source of income already because they have not saved a dime for retirement... Then we are looking trouble. But this problem will be small by comparison on what that generation is doing to our Social Security system...
Either way you slice it, the "Hippie" problem with social security and housing can be solved with immigration, LEGAL immigration that is... Not that immigration is going to be easy on us, but if we can import a wave of workers/taxpayers the system can continue on... thus solving the social security problem and Housing surplus! ...granted we will then have a set of entirely new problems on our hands...

Anonymous said...

neg am is great for invetment properties