The latest regulatory body created by Congress and the Obama administration will fail to prevent future housing bubbles because they lack the understanding of what is required.
The scope and scale of the housing bubble is hard to comprehend. Lenders created four trillion dollars in excess debt, 12 million borrowers are delinquent on their mortgages, and 6 to 8 million loan owners are going to be forced to leave their family homes. And what was gained? There was no innovation or advancement, no long-lasting infrastructure that will enhance future economic growth, nothing we can point to as a silver lining -- unless you consider a sea of McMansions in the hinterlands a great societal investment. And don't forget the rampant consumerism from HELOC spending.
Never in the course of human events has so much been given to so many for doing so little. In my opinion, the housing bubble was a colossal waste.
During the great housing bubble and bust, journalists spent a fair amount of time searching for the perfect mortgage victim. This victim would be someone who played by the rules, took a conservative approach to his finances and simply wanted a decent place to live. He made his monthly payments on time, right up to the day that the bank informed him that his payments would balloon because of a fine-print technicality that no borrower could have understood. Just like that, the homeowner was facing foreclosure.
The stories of the housing bust tended to be more complicated. Many borrowers stretched to buy homes, figuring that they would be making more money soon enough or that housing prices would keep going up. In Southern California, one homeowner told me he was well aware that his monthly payments would eventually balloon. He thought everything would work out, though, because he assumed that ever-rising home values would allow him to refinance. Much of the country shared this belief.
This is also why education is not the answer. You can't educate the kool aid intoxicated. I know; I have tried for several years now, and by and large, I am preaching to the choir.
Banks, mortgage brokers and real-estate agents were only too happy to encourage these fantasies, of course. In many cases, their encouragement crossed the line into malfeasance. But the bubble grew as large as it did because this malfeasance fed on human frailty, naïveté and even irresponsibility.
I dig this guy calling out the corrupt players.
This summer, with the bubble long gone, Congress and the Obama administration enacted a sweeping new law meant to change the business of lending and borrowing money.
The bubble is not long gone.
The part of the law that will directly affect the most people will be the new Consumer Financial Protection Bureau, which has already been the subject of heated debate. And the central question facing the bureau will be how to distinguish between corporate malfeasance and consumer frailty.
It is not an easy task. For as long as there has been money, people have been doing stupid things with it. We borrow more than we can afford. We pay higher interest rates than we need to. We play the lottery. The new consumer bureau can prohibit some of the banks’ worst practices. But figuring out precisely where to draw the line will be much more nuanced than the past year’s black-and-white, left-and-right debate over whether an agency should exist at all.
Elizabeth Warren — the Harvard law professor who first proposed such an agency, in a 2007 article in the journal Democracy — has pointed out that the history of consumer financial protection is a history of “thou shalt not.” The government bans lenders from doing something, and the banks stop. Quickly, however, they come up with new ways to separate people from their money. Last year’s credit-card legislation, for example, cracked down on overdraft fees (the frequently steep charges for people who tried to withdraw more money on a debit card than they had in their account). Banks have responded by raising other fees.
The writer's view that the credit-card legislation was flawed because lenders raised their fees is short sighted. Lenders raised their fees because they could. They have a large number of borrowers treading water that could not avoid the fees if they tried. The fees that were banned should have been banned long ago. Just because legislation is difficult and the results are delayed doesn't mean the legislation is not the right solution to problems of bad lender behavior.
This is why the thou-shalt-not approach, Warren says, “means you’ll always be behind.” Or, as Richard Thaler, the University of Chicago behavioral economist, puts it, “Regulating what financial companies can and cannot charge for is a losing game, because they’ll always think of something else.”
Their agreement on this point is notable, because Warren has come to represent the muscularly progressive vision of the new bureau, while behavioral economists like Thaler (who is close to several Obama advisers) are seen as more technocratic. And there is no doubt that the bureau will need to make judgment calls that some regulators would make differently than others. But the basic vision for the bureau is not in dispute, at least not among the people who are likely to run it under Obama.
When the Republicans get back in, they will gut the bureau like they did with the EPA.
The overriding goal of the bureau will be to help people understand their financial choices. More often than not, it will allow banks to continue a given practice — but force them to explain, in clear terms, what it means for consumers. Earlier this summer, I refinanced my mortgage and was reminded yet again of how much modern finance depends on obfuscation. Nowhere in the pile of documents was there a simple explanation of the only information that mattered to me: how much the bank was charging in fees, how much the lawyer was charging, how much the government was charging and how much my monthly payment would fall. Instead, I was confronted with a blizzard of terms that I did not fully understand: origination, title services, release tracking and the like.
Done right, the new bureau can begin to change this. It can require banks to speak in the language of customers, not internal bureaucracy. Another part of last year’s credit-card legislation offered a preview. As of February, banks have had to give people the often-bracing calculation of how much it will cost them to pay off their balance if they make only the minimum monthly payment, as well as how many years it will take. To see if such steps are working — and to keep pace with Wall Street ingenuity — the new bureau will have a research budget allowing it to test whether consumers truly know what they’re signing up for.
I challenge anyone to find a way to explain the Option ARM in language plain enough for the financially illiterate to understand. In fact, I challenge anyone to explain it to experts in the industry in a way that they understand. There are some loan products that are simply too complex for mere mortals to comprehend. To me regulation would be much simpler if we banned all loan products where payments can increase. That is the only method of ensuring people understand the risks they are taking on because they won't be taking on much risk. Do you really think the average Joe understands interest-rate risk? Do you?
The ultimate goal is pushing banks to compete in ways that benefit consumers, rather than having them compete over which methods can most cleverly fool consumers. If people know the true costs of their mortgages, credit cards, debit cards and mutual funds, they are more likely to gravitate to those offering low costs and good benefits. This will have the added feature of reducing the enormous, historically abnormal profits that Wall Street has enjoyed in recent years. It is also the way a market is supposed to work.
Still, no matter how well we grasp the implications of fees and interest on our credit cards, we may still decide to use a card to buy a new television or kitchen we can’t really afford. The new consumer bureau will not try to stop us. And it almost certainly will not be enough to prevent another bubble, in some other realm, sometime in the future.
But that is probably not a realistic goal anyway. Prohibition, after all, has a decidedly mixed record. A better goal may simply be making sure we understand what we are doing and hoping that is enough to make us a little less frail.
Nonsense. We could regulate lending in a positive way. Education is not enough.
Educating Borrowers is doomed to fail
The first step in a borrower education program would require a consensus on what borrowers should be taught. Lenders will game the system to peddling unstable loan products as safe if borrowers can be taught how to use them. I saw a scholarly study from the bubble that said the Option ARM was a great loan program if borrowers could be educated. Obviously, that is crazy.
Lenders will also use the political system to create doubt as to what loan programs are safe and which are not. I recently wrote about Another Ignorant and Misguided Attack on the 30-Year Fixed-Rate Mortgage. This appears to be an attempt by some right-wing political operatives to create a smoke screen to obscure the real danger of adjustable rate mortgages.
Adjustable rate mortgages are a dangerous loan product, and any reasonable education effort should encourage people to use fixed-rate financing instead, particularly at the bottom of the interest rate cycle. No amount of education will stop the use of adjustable-rate mortgages, and those loans will almost certainly lead to more foreclosures when interest rates rise.
With poorly reasoned attacks on the 30-year fixed-rate mortgage floating around, it creates the impression there is some legitimate difference of opinion on the matter. There isn't. However, if lenders can create enough confusion and dissent, it will make the job of a government-sponsored education bureau impossible -- which is what lenders want. The Consumer Financial Protection Bureau will fail because it will get bogged down in the political process.
Further, the goal of education is unattainable: borrowers will not make good choices. Borrowers will borrow all they can no matter how much they are educated on the risks. Most ignore the risks or don't believe it will happen to them. Half of my masters curriculum was real estate finance, so recognized the risk and chose not to participate. However, there were plenty of Ivy League educated MBAs that didn't recognize the risk and got wiped out by the housing bubble. Education is not enough. We must have laws that limit lending.
The regulatory solution proposed herein is simple, yet far reaching. It comes in two parts, the first is to limit the amount lenders can loan to borrowers with a rather unique enforcement mechanism, and the second is to increase the penalties for borrowers who commit mortgage fraud. The following is not in legalese, but it contains the conceptual framework of potential legislation that could be enacted on the state and/or federal level. A detailed discussion of the text follows:
Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.
Any sums loaned in excess of these parameters do not need to be repaid by the borrower and no contractual provision is permitted that can be interpreted as limiting the borrower’s right to exercise this right, make the loan callable or otherwise abridge the mortgage agreement.
This last statement is the most critical. This is how the enforcement problem can be overcome. Regulators are pressured not to enforce laws when times are good, and decried for their lack of oversight when times are bad. If the oversight function becomes a potential civil matter policed by the borrowers themselves, the lenders know exactly what their risks and potential damages are. Any lender foolish enough to make a loan outside of the parameters would not need to fear the wrath of regulators, they would need to fear the civil lawsuits brought by borrowers eager to get out of their contractual obligations. If any borrower could obtain debt forgiveness by simply proving their lender exceeded these guidelines based on the loan documents, no lender would do this, and regulatory oversight would be practically unnecessary. One key to making this work is to prohibit lenders from introducing a “poison pill” to the loan documents that would make borrowers hesitant to bring suit, otherwise lenders would make their loan callable in the event of a legal challenge forcing the borrower to refinance or sell the property. Basically, if the borrower brought suit and won, they would see principal reduction equal to the deviation from the standards, if they brought suit and lost, they would have no penalty. Most of these cases would be decided by summary judgment based on a review of the loan documents thus minimizing court costs.
Another pillar to the system is the documentation of income as part of the loan document package–the “borrower’s documented income” from the proposed legislation. One of the most egregious practices of the Great Housing Bubble was the fabrication of income by borrowers that was facilitated and promoted by originating lenders. Stated-income loan programs were widespread, and they were the cause of much of the uncertainty in the secondary mortgage market during the initial stages of the credit crunch in the deflation of the bubble. Basically, investors had no idea if the borrowers to whom they had lent billions of dollars were capable of paying them back. Without proper documentation of income, investors lost all confidence in the secondary mortgage market. Stated-income loan programs were one of the first casualties of the credit crunch. These programs should be eliminated totally due to the inherent potential for fraud and the undermining of confidence in the secondary mortgage market stated-income loans create. If lenders can be sued based on the content of the loan documents, and if borrowers can be fined or go to jail for committing fraud or misrepresentation on loan documents, both parties have strong incentive to prepare these documents completely and correctly. Originating lenders will argue this adds to their costs and will result in higher application fees. The amount in question is very small, particularly relative to the dollar amount of the transaction. A small amount of additional expense here will provide huge benefits by assuring investors the borrowers to whom they are loaning money really have the income to pay them back. The benefit far outweighs the cost.
If such a law were passed, agency interpretation and court case precedents will end up defining adequacy in loan documentation. A single W2 does not establish a work history, but 2 years worth is probably excessive documentation. One of the most contentious areas will likely be documenting the income of the self-employed. In theory, the self employed must document their incomes to the US government either through Schedule C reports or corporate K-1s. The argument the self-employed have traditionally made is that these documents understate their income. Since many self employed take questionable tax deductions, there is probably some truth to the claim that tax records understate their income; however, why should the self-employed get to have both benefits? If the self-employed had to use their tax returns as loan documentation, they probably would not be quite so aggressive in taking deductions. A new business without a tax return or with only one year of taxable receipts probably is not stable enough to meet standards of income necessary to assume a long-term debt.
The poor quality of loan documentation during the bubble was a mistake of originating lenders; therefore, in this proposal much of the burden of paperwork and liability for mistakes falls on the lenders. During the deflation of the bubble, lenders paid an enormous price for some of their lax paperwork standards, but much of the problem was also due to borrowers misrepresenting themselves in the loan documents. There were instances where lenders encouraged this behavior, but in the majority of cases, the document fraud was perpetrated by the borrowers. The only recourse available to a lender is a civil suit as there are few criminal penalties associated with loan documentation and almost no enforcement. It can be very difficult and costly for lenders to pursue civil damages, and few lenders attempt it even when they have a strong case. To create a more balanced set of responsibilities, the borrowers must face criminal penalties for fraud and misrepresentation on loan documents. If borrowers know the lender can turn documents over to a prosecutor who will charge the borrower with a crime if they make false material statements, borrowers will be much less likely to commit these acts.
The parameters of the forming limitations on the debt-to-income ratio and combined-loan-to-value are essential to prevent bubbles in the housing market and to prevent the banking system from becoming imperiled in the future. People will commit large percentages of their income to house payments when prices are rising quickly; however, they do this out of fear of being “priced out” and greed to make a windfall from appreciation. These are the beliefs that inflate a bubble. Borrowers cannot sustain payments above the traditional parameters for debt service without either defaulting or causing a severe decline in discretionary spending. The former is bad for the banks, and the latter is bad for the entire economy. This must be prevented in the future. There are a number of reasons why high combined-loan-to-value lending is a bad idea: it promotes speculation by shifting the risk to the lender, it encourages predatory borrowing where borrowers “put” the property to a lender, it promotes a high default rate because borrowers are not personally invested in the property, it discourages saving as it becomes unnecessary, and it artificially inflates prices as it eliminates a barrier to market entry. This last reason is one of the arguments used to get rid of downpayment requirements. The consequences of this folly became readily apparent once prices started to fall.
The payment must be measured against “30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used.” One of the worst loan programs of the Great Housing Bubble was the 2/28 ARM sold to large numbers of subprime borrowers. These borrowers were often qualified only on their ability to make the initial payment, and these borrowers were generally not capable of making the fully amortized payment when the loan reset after 2 years. Regulations like this would prevent a recurrence of the foreclosure tsunami triggered by the use of this loan program. It is also important to ban negative amortization because it would allow the loan balance to grow beyond the parameters of qualification, and it invites property speculation. Perhaps borrowers would not be concerned because they would receive debt forgiveness of the expanding balance. Lenders should be wary of these loans after their dismal performance in the deflation of the bubble, but institutional memory is short, and these loan programs could make a comeback if they are not specifically outlawed. This provision is careful to allow interest-only loans. They are still a high-risk product, but an argument can be made that these loans have a place, and there is no need to completely ban them. They will not have a future as an affordability product capable of driving up prices if the borrower must still qualify for the fully amortized payment.
For the lending provisions to have real impact, they must apply to both purchases and to refinances, thus the clause, “Loans for the purchase or refinance of residential real estate.” If the rules only applied to purchases, there would be a tremendous volume in refinances to circumvent the regulations. The caps on debt-to-income ratios, mortgage terms and combined-loan-to-value only have meaning if they are universally applied. The combined-loan-to-value standard is based on the “appraised value of the property at the time of sale or refinance.” The new appraisal methods will have impact here. It is important that the records need only be accurate as of the time of the transaction. If a borrower experiences a decline in their income or if the property declines in value to where they no longer meet the loan standard, it does not mean they can go petition for debt relief.
The regulations would only need to apply to loans “secured by a mortgage and recorded in the public record.” People can still borrow money from any source they wished as long as the lender knows they will not have any claim on residential real estate. If a lender wanted to issue a loan secured by real estate outside of the outlined standards, the borrower would not have to pay back that money. If a borrower has non-recorded debts which create a total indebtedness requiring more than 36% of their gross income, they would not be eligible for a home equity loan even if they met the other qualifications. In such circumstances, it is better to limit borrowing than increase the probability of foreclosure.
Many states have non-recourse laws on their books. These laws serve to protect the borrower from predatory lending because the lender cannot go after other assets of the borrower in the event of default. In theory this should make lenders more conservative in their underwriting; however, the behavior of lenders in California, a non-recourse state, during the Great Housing Bubble was not conservative. These laws do serve to protect borrowers, and they should be enacted for purchase-money mortgages in all 50 states.
Since one of the goals of regulatory reform is to inhibit the behavior of irrational exuberance, the sales tactics of the National Association of Realtors should be examined and potentially come under the same restrictions as securities brokers through the Securities and Exchange Commission. After the stock market crash which helped precipitate the Great Depression, Congress created the Securities and Exchange Commission to regulate the sales activities of securities brokers. There are strict regulations in place governing the representations made concerning the future performance of investment opportunities. These protections were put in place to protect the general public from the false promises made by stockbrokers in the 1920s which many naïve investors believed. The same analogy holds true for Realtors. The National Association of Realtors has launched numerous advertising campaigns suggesting erroneously that residential real estate is a great investment and appreciation will make home buyers wealthy.
The result of these restrictions will be that all homeowners will have at least 10% equity in their properties unless they have borrowed from a government program like the FHA where the combined-loan-to-value can exceed the limits. This equity cushion would buffer lenders from predatory borrowing and a huge increase in foreclosures if prices were to decline. Home equity in the United States has been declining since the mid 1980s, and it actually declined while prices rose during the Great Housing Bubble due to the rampant equity extraction. The lack of an equity cushion exacerbated the foreclosure problem as many homeowners who owed more on their mortgage than the house was worth simply stopped making payments and allowed the house to fall into foreclosure.
If the new Consumer Financial Protection Bureau wanted to curb housing bubbles and restore stability to our banking system, they should implement the proposals I have outlined above. Will they do it? Not if the banking lobby has anything to say about it.
When you read about today's HELOC abuser, ask yourself if you think educating borrowers would have stopped this behavior. I don't think it any amount of government education programs would have made the slightest difference.
Long Term HELOC Abuse
It's obvious from looking through the property records that many borrowers supplemented their lifestyles with regular trips to the home ATM machine. The regularity and the size of these withdrawals is astonishing. It also explains much about why houses are so popular in California. If owning real estate gives you the opportunity to obtain hundreds of thousands of dollars for doing absolutely nothing, ownership will be highly desired; in fact, it becomes the primary reason people buy homes. Californian's live in their own personal ATM machines.
The owners of today's featured property paid $441,000 on 4/25/1991. I don't have their original mortgage information, but it is likely that they put 20% down ($88,200) and borrowed $352,800.
On 5/27/1997 they obtained a stand-alone second for $50,000.
On 12/7/1998 they refinanced their first mortgage for $387,500.
On 3/26/1999 they got a $47,500 stand-alone second.
On 12/28/2000 they refinanced with a $441,000 first mortgage and crossed the threshold of borrowing more than they paid.
On 3/31/2004 they refinanced with a $536,250 first mortgage.
On 10/5/2004 they obtained a $628,000 first mortgage.
On 11/30/2005 they refinanced with a $686,250 Option ARM with a 1.5% teaser rate.
On 5/3/2007 they obtained a second mortgage for $15,764.
On 7/3/2007, after witnessing the above patter of serial refinancing, World Savings Bank brilliantly loaned them $788,000 in an Option ARM.
Total property debt is $788,000 plus negative amortization and missed payments.
Total mortgage equity withdrawal is $435,200 including their down payment.
Total squatting time was minimal as the bank moved quickly to evict these squatters.
Foreclosure Record Recording Date: 05/11/2010 Document Type: Notice of Sale
Foreclosure Record Recording Date: 02/09/2010 Document Type: Notice of Default
The listing agent is Mike Dunn, and I have seen a prospectus for a fund he is forming to purchase and improve trustee sale flips. My guess is that he is also the flipper on this deal.
If you would like to learn how you can get involved with trustee sales like this one, please contact me at sales@idealhomebrokers.com.
Home Purchase Price … $711,100 Home Purchase Date .... 6/2/2010
Net Gain (Loss) .......... $83,200 Percent Change .......... 11.7% Annual Appreciation … 71.0%
Cost of Ownership ------------------------------------------------- $845,000 .......... Asking Price $169,000 .......... 20% Down Conventional 4.51% ............... Mortgage Interest Rate $676,000 .......... 30-Year Mortgage $165,337 .......... Income Requirement
$3,429 .......... Monthly Mortgage Payment
$732 .......... Property Tax $0 .......... Special Taxes and Levies (Mello Roos) $70 .......... Homeowners Insurance $80 .......... Homeowners Association Fees ============================================ $4,312 .......... Monthly Cash Outlays
-$818 .......... Tax Savings (% of Interest and Property Tax) -$889 .......... Equity Hidden in Payment $283 .......... Lost Income to Down Payment (net of taxes) $106 .......... Maintenance and Replacement Reserves ============================================ $2,993 .......... Monthly Cost of Ownership
Cash Acquisition Demands ------------------------------------------------------------------------------ $8,450 .......... Furnishing and Move In @1% $8,450 .......... Closing Costs @1% $6,760 ............ Interest Points @1% of Loan $169,000 .......... Down Payment ============================================ $192,660 .......... Total Cash Costs $45,800 ............ Emergency Cash Reserves ============================================ $238,460 .......... Total Savings Needed
Property Details for 35 NIGHTHAWK Irvine, CA 92604 ------------------------------------------------------------------------------ Beds: 4 Baths: 3 baths Home size: 2,600 sq ft ($325 / sq ft) Lot Size: 5,750 sq ft Year Built: 1977 Days on Market: 21 Listing Updated: 40386 MLS Number: S626030 Property Type: Single Family, Residential Community: Woodbridge Tract: Pl ------------------------------------------------------------------------------ According to the listing agent, this listing is a bank owned (foreclosed) property.
JUST REDUCED $5,000!!!***FANTASTIC OPPORTUNITY TO CHOOSE YOUR OWN UPGRADES FOR ONE WEEK ONLY BEFORE BUILDER STARTS REMODEL ON 7/30***This is a fixer but a beautiful blank canvas with an excellent location in the back of the development - high cathedral ceilings,guest suite downstairs,pool and spa size yard,two fireplaces,excellent interior location less than 75 yards to park,basketball,volleyball and less than 150 yards to beach club and community pool. Last two sales have been over $975,000. Very low tax rate and HOA dues.
I like Mike's idea to advertise the flip for sale prior to renovation. If a buyer emerges, they can get the property renovated to their taste by the flipper and the costs get rolled into the loan. He does need to lay off the CAPS LOCK, exclamation points, and asterisks though. I wonder if he thinks he can do $20,000 in cosmetic renovations and ask $130,000 more for the property ($975,000). If he can get that, buyers are not very bright.
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