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Today's Commentary: 02.28.06
The American Dream: Dangerous Curves Ahead
American families fall into two categories: those that are buying a house or condo and those that are not. Driven by the "American Dream", the barometer of success for a family is a home, offering at least the appearance of stability and safety as well as a visible and tangible center for their memories.
Don't think for a minute that the haves are any better off than the have-nots. In far too many cases, the haves now numbering 70% of the population are not always able to afford the mortgages they currently own, jeopardizing all of the positive attributes a family home can offer.
Like many newly blended families, especially unions that come with children from a previous marriage, the Greenstreetıs are facing a few hard decisions they had not anticipated when they exchanged vows.
Cynthea Greenstreet desperately wants to become a homeowner. Recently married, she has just begun her search by assessing what she can bring to the table financially. Cynthea, a thirty something assistant food manager for a local grocery chain came to the marriage, her first, with a 401(k), savings and a stellar credit report. Her new husband brought a child, child support, no savings, no 401(k), and a credit score that was bound to impact any loan application negatively. They were sad to say, financial polar opposites.
Understanding their dilemma, Cynthea put another roadblock in her search for a home, a search that she hoped would land her among the ranks of the haves a mortgage she and her new family could afford.
The only question left to answer was how. She could take a one-time withdrawal from her 401(k) plan of $10,000 without paying any penalties but that sum is not even close to what she would need to get a traditional 20% down, 80% financed mortgage.
Cynthea wants a house but with a caveat: no fancy loan deals.
She refuses to believe that her dream is beyond her reach even after the stratospheric rise in home prices in the Portland, Oregon metro area where she has spent most of her life. Portland, like many other pockets around the country has seen housing prices soar. Aided and abetted by low interest rates and later by creative banking practices, the average price of homes in the area rose so dramatically that many including Cynthea have found the house of their dreams well out of reach.
According to Salvador Del Cid, a Portland broker, the average sales price of a house is Portland is now $297,700. "A year ago, the average sales price was $254,800." At those prices, the Greenstreets seemed defeated even before the hunt begins.
The search for a new home often begins with the question: "how much house can we afford?" Normally, and the last several years have been far from that, homebuyers begin the process by pre-qualifying, a step that dertermines how much money they can borrow, at what rate, and what kind of loans might best suit their profile.
Credit scores play a key role in determining not only how much money a potential borrower can get but at what interest rate. The Greenstreets have yet to get to this stage. They are worried that their combined creidt scores will impact the affordability of their loan.
Realizing this, lenders began creating ways to accommodate these types of situations. The conversation with potential buyers became: "What can we do to get you into a house?" without adding, "that you could not otherwise afford?"
And who wouldn't jump at the chance, risky or not. A recent study revealed that folks who owned homes had an asset base of $185,000 much in their home's equity while renters had barely amassed $4,000. You don't need too much in the way of financial savvy to see the ebenfits of owning a home with high risk financing
Banks were faced with a problem. They are in the business of lending money. The less than stable job environment and relatively low wage increases over the last five years have not given the lenders much to work with in terms of quality buyers. The lenders simply became more creative.
Traditional lending criteria usually involved 20% down with 80% of the house price financed. The so-called "sub-prime borrowers", the ones with less than stellar credit, less than the traditional down payment, and with little ability to afford a traditional loan needed a product outside the "traditional lending criteria".
Bankers simply created a new class of borrowing opportunities for these less qualified buyers. Unfortunately, that creativity is now coming home to roost.
Paul Krugman, noted Princeton economist and columnist for the New York Times has referred to cities like Portland as zoned zones. Within distinct boundary lines around the city, the limited number of properties available in cities like Portland with similar urban growth lines made housing prices increase more substantially than they did in sprawling suburban areas.
Gone was the old way of doing business. Here is an example of the kinds of loans the banking industry created to service the demand of customers like Cynthea:
Hybrid ARMs which are adjustable rate mortgages with introductory teaser rates that allow the borrower to pay a lesser rate initially often in the first three to five years.
IO mortgages are interest only loans in which the borrower pays only the interest while the principal remains the same and often require no repayment of the principal.
No Doc Loans or as they are sometimes referred to as "Stated Income" loans involve only the word of the borrower when proof of income is required.
Option ARMs are loans with smaller monthly payments with the difference owed being plowed back into the principal owed.
Piggyback mortgage, by far the most popular are loans in which the borrower borrows 100% of the money needed, 80% to the first mortgage at a higher than market interest rate paid by good quality borrowers and the remaining 20% borrowed on a line of credit with an adjustable rate tied to the prime rate plus.
These mortgages haven't just gone to those who were looking to purchase homes for the first time. Many of these types of loans were used for refinancing to tap the growing "paper" wealth in already occupied homes.
While Cynthea is worried about the long-term consequences of these types of loans, many of the people who have made financial arrangements like the ones listed above have a rude awakening awaiting them starting this year.
If you are a sub-prime borrower, you may be faced with some difficult times in the near future. A previously unknown phenomenon is about to take place. Known as equity resets, many sub-prime borrowers could be facing a jump in interest rates of 50% or more. Their once attractive "teaser rates" are about to expire.
In many of these loans, the reset will be based on the LIBOR, a six-month money market benchmark set by the London Interbank (current rates can be found at Bankrate). As of this writing, the rate is 4.93% and headed up. This means that many current mortgage holders could face a significant increase in their monthly mortgage payment.
If families have any equity left in their homes, the reset might mean that they can refinance their home with similar type adjustable rate mortgages. Unfortunately, those once low "teaser" rates are now 7.25% and also heading higher. Problem is, some of the borrowers may still be sub-prime and forced to get another loan on similar terms which they will need to refinance again in several years.
Risk layering will come back to haunt far too many area households. Families who used risk layering, a method of amortizing the principal for two years and paying only the interest will find that not only will they suddenly be obligated to pay the principal but the new higher interest rate as well.
Ameriquest recently settled a 49 state $325 million lawsuit involving sub-prime lending. Among the offenses cited in their settlement was the lack of disclosure involving refinance costs and availability. If you received a loan between January 1st, 1999 and December 31st, 2005, you may be entitled to a portion of the settlement. Household Finance Corporation paid similar fines totaling $484 million in 2002 for many of the same reasons. The failure to disclose what awaited many borrowers down the road was at the top of the list of complaints. That, and the cost of fixing those sub-prime loans became the genus of those laws suits. For many, the only option may be selling.
Even though new tighter standards are keeping many of these creative loans out of the hands of the higher credit risk customers, the problem facing many homeowners is what to do with their current loan. Many of the folks will find a less welcoming environment from years past. Lenders, at the strong request of regulators have begun to tighten the rules. Unfortunately, these new standards will not be as kind to sub-prime borrowers as they were just two years ago.
If housing prices remain the same, homeowners can convert their current loan to a fixed rate. Be prepared however to take a longer payback period, often as long as 40 years. This will not only affect some folks seeking new loans but also impact those looking to refinance loans. If these borrowers have remained sub-prime in the eyes of the lender, the loans they offer may force folks to accept terms of 9.25% or more. At least then, a homeowner could adjust their monthly budgets to meet what would be a much harder fixed monthly payment but at least it would fixed.
Cynthea remains optimistic. She hopes she can catch a break from lower interest rates. That possible break could come with the lowering of short term interest rates set by the Federal Reserve Bank. While these rates are not tied to home loans, when they rise, banks tend to follow their lead and do likewise. The new Fed chief, Ben Bernanke, has made it known that he is an inflation hawk. These so-called hawks keep prices in check by making money more expensive. Should Bernanke see the inflation rate stabilizing or the economy beginning to sputter, he could change directions and begin cutting those interest rates. Although that is not a good near term gamble.
Housing prices, at least in "zoned zones" like Portland are expected to continue to increase in the near future appreciating 5% per year. Hoping for cheaper money is all Cynthea can do.
Typically, overheated markets and Portland could definitely qualify as hotter than most, see an average price decline of 15% following their peaks. National City, a top ten mortgage originator recently conducted a survey and found that 38% of the housing market is currently at "extreme" levels. The trickle down effect of a significant drop in housing prices, while often temporary, would be felt nationwide.
Unfortunately, the best scenarios are not likely to take place in the near term. Even as many sage economist engage in thoughtful debate about the economic effects of a slowdown in housing, the facts remain clear. Inflation will remain stable with slight upticks - enough to keep the Fed tightening through the middle of the year, housing prices will drop in may hot spots but stay relatively constant in big cities, and pay will continue to stagnate.
Folks like Cynthea now recognize the value of good credit and savings. Refusing to tap her 401(k) she says she is at a point in her retirement savings where borrowing against her savings would be counterproductive, she is instead going to focus on her new husband's deplorable credit and poor savings habits.
If you are one of these sub-prime borrowers, don't wait to tighten your belt. Explore your possibilities now, discuss it with your family, and adjust your budgets to handle the financial tsunami that is on its way for many in homes that their owners, the haves, can no longer afford.
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