This may have happened to you. You are out car shopping and you notice a car that is clearly out of your price range. The automobile salesman comes over and asks if you would like to take it for a test drive. “Oh no,” you say, “I really can’t afford it.” The salesman responds, “what harm is there in a test drive.” Off you go, and you find yourself smitten by the car.
When you return to the dealership, the salesman encourages you to come back to his office and see what can be worked out. He asks you what sort of monthly payment you were looking to make. You respond and then fill out some financial paperwork. You name your payment and, to your surprise, he tells you that you’re qualified to buy the car. How can that be? Against your better judgment, you’re about to agree to a seven-year car loan.
If you express your doubts, the salesman reminds you much pleasure you will get by driving that car and how affordable it really is. The reality, of course, is different. The transitory joy your ego receives by having your fancy, new car is quickly outweighed by your first scratch, then repairs, and years and years of payments. Down the road, you may find that you are still making payments on a car with 100,000 miles.
If you have ever engaged in this foolishness, you probably learned a lesson. You didn’t go crying that you were tricked—you didn’t insist that somebody should bail you out. Your ego may have blamed the salesman for your own irresponsibility, but you had enough common sense to know that your version of events would not be shared by most—most people would laugh at the idea of bailing you out because you were “tricked.”
When it comes to home buying, similar foolishness is no laughing matter. Countless “name your own payment” mortgages were made during the housing bubble. These loans are going into default in increasing numbers. These defaults will result in new downward pressure on housing prices—and it will result in new demands that the government do something about it.
These “name your own payment” housing loans worked in a very similar manner to the “name your own payment” automobile loans. The homebuyer goes house hunting for a house that he clearly cannot afford. The realtor and the mortgage loan broker, playing the role of the automobile salesman, encourage the home buyer to purchase a home that they cannot afford.
Unlike the automobile loan where the term of the loan is extended, in the case of these “name your own payment” house loans there was no extension of term. These loans worked instead on the principle of negative amortization. Each month the homebuyer paid none of the principle and only part of the interest that they would with a conventional loan. The result was that their loan balance was growing each month.
If the homebuyer expressed concern over these insane terms, they were told not to worry. They were comforted that all the experts were forecasting that housing prices would continue to grow at a clip of 20% to 30% a year—the increase in home value would more than offset the negative amortization.
Millions of Americans chose to believe that money could grow on trees. Others were simply motivated by the desire to shelter their family and they were caught up in the housing frenzy.
However, unlike the foolish automobile buyer, many homebuyers have the temerity to expect the rest of us to bailout them out. Worse yet, mortgage banks and hedge funds continue to expect that the Fed will destroy the rest of the economy to save their own skins. Politicians continue to bend over backwoods to promise, in the words of the Wall Street Journal, “to save the guilty and punish the innocent.”
Many of their proposals—besides costing prudent taxpayers incalculable sums of money—will actually exasperate the housing crisis. For example, there are proposals in Congress that will allow bankruptcy courts to modify, or even wipe out, a portion of mortgage debt.
Such proposals, while protecting the imprudent, will make it more difficult for new homebuyers to get loans. Lenders will respond to the increased risk they face in making home loans. How? They will dramatically increasing interest rates. At its worst, housing debt will be treated like credit card debt. How many home buyers will be able to afford homes at interest rates of 22%?
According to the Wall Street Journal, House Financial Services Chairman Barney Frank wants a homebuyer to be able to “recover all the principal and interest paid over the entire history of the loan—as long as he can convince the court that he didn’t have a reasonable ability to pay at the time the loan was originated.”
If you’re like me, you may have to read that last sentence or two or three times. You may be thinking that no reasonable person could propose such an idea. Why stop at homes? Under such reasoning, imprudent automobile buyers should be able to recover their debt too.
Any market is very difficult to forecast, and I make no claims to having a stellar track record. However, it is very likely that housing prices have only just begun to fall. Bailout attempts will result in a transfer of money from taxpayers to imprudent banks, hedge funds, and homebuyers. The consequences of these bailouts will be more than the money that is transferred—for many, their dream of home ownership will be shattered forever.
Giving Up Control 
Oh wow, do I love you! I miss your classes!!!
“If you have ever engaged in this foolishness, you probably learned a lesson. You didn’t go crying that you were tricked—you didn’t insist that somebody should bail you out.”
You are SO RIGHT! I’m so sick of these people crying about how they were tricked. Who doesn’t read paperwork and understand what they are signing when making the biggest purchase of their lives? Jesus!
Several things:
1) I’ve heard the “how much do you want to pay” statement when buying a car, a motorcycle and both of the homes I’ve owned. In no situation did I EVER come back with a number. Why? Well, I really want to pay zero, so why offer up anything above zero? The reality is that I want to know what the price is and I don’t want them to mess with me by backing into it, because at the end of the day it still matters what I’m paying when all is said and done. If I pay $40,000 over 10 years (in present value money) for a car worth $20,000, just to have the payment I want, then I’m a moron. I prefer to figure out the financing on my own. When I contracted for my last house, I had my own amortization schedule and determined I could do a 15 year conventional as opposed to a 30 year. But it was my choice, not some guy whose goal it is to put me into any sort of debt possible.
2) The idea of “prices rising” and equity that may come down the road is such a worthless argument and I’m not sure why people believe that. I don’t want to gamble today for something that may or may not happen tomorrow. Prices rising tomorrow is dependent on many factors, notwithstanding the individual financial situations of my potential buyers when I want to sell – that’s too tricky of a variable for me.
3) On that note, when I put a full price offer on my condo now, in Jan, 2005, the seller came back with “You need to escalate.” I said, “Escalate against who? Only an idiot would bid against herself.” They said I needed to “prove” I wanted it by offering another $10,000. Well, then he should have asked for another $10,000 in his asking price. That was unbelievable. But very symptomatic of this “I deserve so gimme gimme gimme” attitude that has everyone in trouble now.
And this, “many homebuyers have the temerity to expect the rest of us to bailout them out. Worse yet, mortgage banks and hedge funds continue to expect that the Fed will destroy the rest of the economy to save their own skins.” – You couldn’t be more right.
So many people have credit ruined, and while this should be some sort of satisfaction to those who make wise financial decisions and don’t buy “too much home” or sign away their life, it isn’t. Because somehow the ones who made the mistakes will get bailed out, and not learn their lesson. And if the government doesn’t bail them out, the rest of us suffer anyway, because we have to wait out the slump in the economy they have contributed to.
I pretty much agree with everything except I’d like more info about the source and background of Frank’s quote in the WSJ. if it comes from the WSJ’s editorial page, it is virtually guaranteed to be a Repbulican talking point, about as fair and balanced as Fox news. Other sources, please? Something direct from Frank himself?
Velvet,
As always your writing is compelling and thoughtful. Thank you!
Even more than having to “wait out the slump in the economy,” we run the risk of bailouts eroding the very foundations of our economy.
Erika,
Thanks. To be clear, the quote is the WSJ interpretation of the bill. I can understand that you would disagree with the WSJ but do you really think that they make things up? Here is coverage from CNN on Frank’s proposed bill: http://money.cnn.com/2007/10/22/real_estate/frank_bill.ap/index.htm
Should we expect anything less than a full bailout from the same government (executive and legislature) that cannot (1) live within its means, (2) disregards debts/deficits/etc, (3) doesn’t even apply Generally Accepted Accounting Principles to its finances, and (4) is generally ignorant of the oncoming financal train-wreck. There is an old fable of a great and wealthy country, that spent its way through history. One day, an imminent crisis caused its leaders to open up the treasury doors, to which there was a gasp since… the treasury was bare (and they had already borrowed to mint aureus, denarius, or sestertius). They could no longer form enough legions or raise the tributes to stop the sack of Rome.
Thanks for the link Dr Brownstein — no I don’t think WSJ would make things up but I have been reading it long enough to know their editorial page will spin any issue like the extra strength cycle of a whirpool to justify their neocon POV. Their straight reporting, by contrast, is word class, second to few if any other publications and I would never consider suggesting it was biased or incomplete.
It wasn’t a sarcastic or rhetorial question, although I guess it must have sounded like it.I know enough about what Frank is doing in housing – trying to tinker with Fannie and Freddie, setting up a low income housing fund (this I support) to believe he would promote this intiative as well. That quote, though, was so over the top — even for Frank — I wanted to get more context.
Elvis,
Thanks. Our government can only reflect our societal attitudes. Right now many want “something for nothing.”
Erika,
Thanks for your thoughtful comments. I didn’t think you were being sarcastic and I would agree with you about distinguishing WSJ reporting from their op-ed pages.
Both political parties have no shortage of demagogues and economic illiterates. Sadly we have just seen the beginning of proposals what will help further wreck the economy.
There is all the difference between low-income housing funds and proposals which change the rules after the game is played. The latter is infinitely more damaging to the fundamental principles upon which our economy functions.
Our economy is already wrecked. The who-who’s running this sinking ship right now are praying for a soft landing. Though society at large wants “something for nothing”, we should at least have captains at the helm who see this for what it is. The WSJ reporting, the policy debates, Franks, etc… the biggest indicator of this mess is the foreign exchange rates. Used to be when I travelled, I could afford to eat out. I travelled a few months ago and discovered that I was significantly less prosperous than I’d been led to believe. I mean, how can we compete and invest in the global economy when we’re poorer than the competition?
Elvis,
I agree with you and I fear for what we will all have to live through as a consequence.