Behind the Bailout, is it Really a Bad Loan, or a Lack of Confidence

Ever since the Enron mess, the government has required banks to give consumers reports that show a truer reflection of the current asset value on their books. This means when the value of a house drops, resulting change in the loan to value the loan will be considered a “bad loan.”  Even though the homeowner may be current on all payments, the loan is now reported, on paper, as a bad investment.

For example, let’s say newly married Tom and Mary take out a mortgage with 5% down. So they have a 95% loan to value mortgage on their $200,000 home. So the the house is purchased for $200,000, the mortgage is $190,000, they put $10,000 down. They have conscientiously made all payments on time for the last 3 years. However, in the last three years their home’s value has dropped by 10%, reducing its asset book value to $180,000. The bank (or FNMA/FHLMC) depending on who holds the loan) must now must report the lower asset value on their books.  This means they do not show enough value on the books to cover their loan in case of foreclosure. 

In reality, if Tom and Mary continue to pay, there’s no problem. Except, it looks bad on the books, and the confidence level of the mortgage holder may wane.

But the financial institution now files its required report, and the investors see that the assets protecting their (mortgage backed) securities are no longer enough to repay the loan in the event of foreclosure. Remember, Tom and Mary are paying their mortgage on time, each and every month- as are the vast majority of people with a mortgage. Yet, if the loan to value is short because the house value dropped, the lender believes it may be in trouble and in need of funds to shore-up his balance sheet for the investors who purchased the securities backed by these mortgages.  To some extent, it is a matter of confidence. Just as it is in the stock market.  If Tom and Mary make  payments, as most homeowners do, no problem. But what if they don’t. The mortgage holder’s confidence wanes. Will Tom and Mary continue to make their payments? 

However, it gets worse. When people have taken out second and third mortgages worth significantly more than the property is currently worth, they made bail.  This leaves the investor holding the bag, particularly because of the recent change in moving away from Private Mortgage Insurance.  For many years PMI protected the lenders against falling asset value, by double checking the likelihood of repayment, and writing insurance against default. But in order to save the money on PMI, many took out first and second mortgages simultaneously (known as piggybacks) in order to circumvent PMI payments.  The banks got a slightly higher yield on these loans, but much higher exposure because there is no PMI to fall back on.

There is no doubt that poor lending practices and greed are primary causes of this mess.  Consumers lied on unethical and illegal loan applications, lenders were negligent in checking loan applications, financial advisers told the public to take out second and third mortgages to pay for cars and boats, to pay down credit cards, etc., and regulators, they did nothing.  All of this has led to a tightening of credit that ought to help alleviate the problem in the future.  However, today, tightening credit is a disaster for the average consumer.  Because although most of us pay our bills on time, the system no longer trusts us to pay. The system doesn’t have the safety net of enough value in our houses, tightening credit. So legitimate, needed credit will be almost impossible to get.  The parents wanting to send their child to college will not be able to pay because they can’t get a loan.  The car that breaks down cannot be fixed because the owner can’t afford to fix it and can’t get a loan. The small business that has the cash flow problem and can’t get a loan, will be unable to make payroll, putting people out of jobs.

It’s not over. Our next round will be rise in rates for adjustable-rate home equity lines of credit (HELOC).  Because of the dropped value of homes, many of these loans are now subprime.  Many of these adjustable rate mortgages are set by the LIBOR. LIBOR went up 50% last week. A tightening of credit.  Now, when they go to refinance out of this expensive adjustable-rate product, they will be in trouble because there’s no longer enough equity in their house to cover it. We got ourselves into this one. In order to get new computers, new cars, new boats, and the latest television sets, we all borrowed unwisely.  Recognizing that we could write off the interest on that second mortgage, and recognizing that it had a lower interest rate than our credit cards, we bought, and bought, and bought. Those with 2^nd and 3^rd ARM’s are in trouble.  They will have to make some tough decisions.  Take a second job, sell the new boat, take Johnny out of that private school?  But as consumers, we knowingly put ourselves there.  In most cases, we have no one to blame but ourselves.  Somehow we believed that the value of our house would always go up, up, up and we could sell it tomorrow for much more than we paid for today.

This will be a difficult lesson for us all.  Our parents and grandparents worked hard to pay off the mortgage.  Remember the black and white movies where a grandma and grandpa danced as they tore up the mortgage?  Where mom and dad saved to buy a new couch or dining room set.  It’s a scene from the past.  Somewhere along the line we lost the vision to own things free and clear, and the desire to be mortgage free.  We saw our home only as an asset to be borrowed against for a new car or TV set.  But I believe we are smart people, and that we can learn from hard knock lessons.  Let’s hope the government steps up and bales us out from this disaster once again, there is no other way. Let’s hope we all learn from this. We must all pay our own way, as we go.