Tuesday, July 10, 2007

Mortgage and Credit

A couple of years ago a nephew of mine was selling subscriptions and I decided to purchase Barron's, the Wall Street Journal publication. This cross between a newspaper and a magazine (it is printed on newsprint but shaped like a large magazine) comes out weekly, every Saturday morning. I find that Barron's has some of the most interesting financial articles available.

Barron's posted an article called "Why a Housing Recovery is Far Off". In a simple graph they managed to capture the key essence of the housing boom - the "Real" mortgage rate.

The "real" mortgage rate subtracts the annual growth in housing prices from the interest rate. They note that in boom years the annual growth rate for housing values was as high as 10% while long term interest rates were as low as 6%, for a "real" mortgage rate of 10-6 = 4%. In this model, you were being "paid" to buy a home.

Note that this model probably understates the true "pay rate" for many borrowers. The 6% is pre-tax, and the mortgage interest provides a tax shield that probably reduces this to about 4.75% or so for most buyers. In addition, many borrowers (unwisely, as it turns out) picked ARM's or adjustable-rate-mortgages that had very low current rates with balloon payments in later years or rates that moved up as the prime rate increases.

Today, however, the equation is reversed. Home values are flat or down in many parts of the country, and long term interest rates are moving upwards. Barron's puts it succinctly:

"People don't like to borrow to pay for a depreciating asset"

At the same time, the Wall Street Journal had an excellent article on brokers, the individuals that were on the front lines of the mortgage explosion (and went down first when it all cratered). A July 5 article was titled "
Mortgage Mess Shines Light on Brokers' Role". In this instance the reporter's desire to "personalize" the story was a good tactic. The story focused on a broker in California who managed to work at a series of brokerages despite being fired and having multiple complaints filed against him. This broker was pretty much robbing people blind, signing them up for mortgages and misrepresenting his fees to the tune of many thousand dollars at a time. Due to the fact that brokers are "regulated" (to use the term very loosely) at the state level, only in the most egregious cases do they actually face discipline, and even those occasions can be avoided by crossing the state border.

This case was relatively "cut and dried" since the broker was misrepresenting his fees and services to clients; but many other less clear cut instances occurred when brokers steered borrowers into certain types of loans that may not have been suited to their circumstances. For instance, adjustable rate loans are inappropriate for people with fixed incomes or at risk of losing their income, and some borrowers may not have received the best rate available.

Why did banks use these brokers, instead of doing the loans in-house?

Mortgage brokers didn't set the standards for the many aggressive loans that are now going sour. But they provided the low-cost sales force that made it possible for lenders to quickly ramp up production without hiring employees... Unlike bank employees, brokers don't get medical benefits or need to be laid off when business is slow."

The other benefit, not mentioned in the article, is that the banks needed the brokers to limit liability. The brokers did all the "dirty work" of signing up borrowers to the subprime paper, much of which is going under, and all of which will cause howls of protests as repossessed homes hit neighborhoods around the country. You can go after your broker, but, good luck with that. Many of the brokers worked for fly-by-night companies that are long gone, or with little or no assets available to pay off would-be claimants.

An army of unsupervised, unregulated brokers hired by fly-by-night firms and microscopically low short term interest rates brewed a toxic mix that will take a long time to sort out. I wouldn't bet against Barron's when they say that a recovery is a long ways away.

1 comment:

Dan from Madison said...

I will be interested to see what, if any, political fallout there will be. Finger pointing hasn't started yet, but it is inevitable. When an industry f1cks up as bad as this one did, they are inviting the feds and state agencies to the party.