A Legacy of Toxic Debt

Watching the news recently you might have thought aliens had landed in Idaho. Reporters, news anchors and commentators were shocked and awed by the August home price declines seen in many areas.

 

The source of this amazement was a calm and reasonable news release from the National Association of Realtors. NAR explained simply that the typical existing home was worth $225,000 in August — down 1.7 percent from a year earlier. This was the first month since April 1995 that median home prices were lower than the previous year.

 

Imagine that! Home prices not only go up, they can fall.

 

“For some time it’s been clear that the speculative real estate boom has been ending,” says James J. Saccacio, chief executive officer of RealtyTrac, the leading online marketplace for foreclosure properties. “When major builders offer six-figure discounts to unload new homes, you can be certain the marketplace is changing.”

 

Since the stock market crash of 2000 and the loss of $5 trillion, investors have been looking for alternative venues for their capital. Some of the choices have included overseas investments, commodities, bonds and real estate.

 

The case for real estate is fairly straight-forward: We have a growing population with a need to live indoors and a limited land supply in core metro areas. As well, real estate has value as both an investment and as a place to live, something stocks and bonds cannot duplicate.

 

But the same thinking that powered Wall Street before the crash — outright greed — also seeped into real estate. Buying property was seen by many as an inevitable source of profits and appreciation, reason enough to not only buy a house but to also invest in property.

 

As investor interest turned toward real estate, a slew of post-crash financing products became available. Interest-only and option ARMs allowed buyers to acquire properties with low monthly cash costs — payments that by design were insufficient to amortize loans in their first years.

 

New loan products combined with “stated income” mortgage applications permitted large numbers of buyers to readily qualify for financing with unexamined income projections and unverified employment claims, a ripe formula for error and abuse.

 

Since 2000, you could see people buying several investment condos at once, homes with 6,000 and 8,000 square feet of interior space and million-dollar townhouses in former slums. Why not? Real estate values, according to the accepted thinking of the time, always went up. If you were going to buy one investment condo, why not buy a bunch? You couldn’t lose, right?

 

To cement the logic of no-risk real estate investing, interest rates fell significantly after 2000. On January 14, 2000 — when the Dow reached a then-record 11,723 — interest rates for 30-year fixed-rate loans stood at 8.18 percent plus 1 point according to Freddie Mac. Rates fell to their lowest levels in five decades during June 2003 — just 5.21 percent plus .6 points. In effect, the cost of financing fell 36 percent in three years. The income which could finance a $200,000 loan in 2000 was now sufficient to underwrite mortgage financing worth $272,000 in 2003.

 

Even now that the market has plainly turned, most owners are largely unaffected. For instance, if you bought a typical home five years ago and sold at today’s $225,000 median price it’s hard to see how you’re losing. The typical home was priced at $123,200 in 2001.

 

“The problem we now have is a legacy of toxic debt,” says RealtyTrac’s Saccacio. “The loans with low initial costs that made so much speculation possible after 2000 must be repaid whether real estate values rise or fall.”

 

Interest-only and option ARMs typically have an initial five-year period when monthly costs can be well-below the amounts needed to reduce mortgage balances. This is fine so long as values rise and the properties can be sold or refinanced before higher monthly costs kick-in. For many borrowers, however, such opportunities are going or gone.

 

Consider the borrower who has a $300,000 option ARM with a 1.25 percent initial rate and a fully-indexed rate of 6.9 percent. The minimum cost will be $1,000 per month during the first five years. If a borrower only pays the minimum amount, then by month 61 the debt will rise to $323,193 because of negative amortization and the monthly payment will be at least $2,324 for principal and interest — taxes and insurance are extra.

 

Of course, if interest rates rise our borrower could face substantially higher monthly costs.

 

Borrowers who can afford $1,000 a month may be sunk at $2,300. Unlike conventional financing, new and toxic mortgage products increasingly assure that we will have owners who are forced to sell whether the market is up or down. The need to unload properties to relieve mortgage pressures will create more supply, additional seller concessions and more foreclosures.

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Peter G. Miller is the author of The Common-Sense Mortgage and is syndicated in more than 90 newspapers.

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