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.