The Dangerous “Teaser Freezer”

Problems, arising from the bursting of the housing bubble, continue to escalate. On Friday, the Wall Street Journal reported on a pending agreement between the Bush administration and lenders. The agreement would freeze interest rates to troubled borrowers for up to seven years at low, introductory, teaser rates.

My post Something for Nothing wrote of the resentment that such bailouts will create. At his outstanding blog, Mish Shedlock explains why the bailout will fail—those who have negative equity in their homes will have every incentive to fall behind on their loans in order to receive a bailout. Mish writes:

It will fail because it is in the best interest of those underwater on their loans to make it fail. People are going to understand they are way upside down on their home loans, and those people along with everyone who resents others being bailed out will have every reason in the world to walk away. So walk away they will.

Last week also saw Wall Street rallying on the possibility that Bernanke will cut interest rates by another half-percent. No doubt we will see continuing actions and proposals to bailout the financial sector—at the expense of the economy.

At the same time, there is little to indicate that the public has had enough of all of this. A dangerous belief has strengthened over the past decades—the belief that Fed is an omnipotent director who can navigate the economy away from harm. Doug Wakefield writes of crowd behavior:

Until we understand our human tendency is to extrapolate the past, and embrace stories that support our feelings of a current trend, we will fail to search beyond our feelings and passionately seek for signs of the END of a current trend.

In other words, until we are forced by circumstances to confront our beliefs, we usually don’t. This basic fact of human nature makes it almost a certainty that the current economic crisis will continue to escalate.

The fact that anyone can still have faith in the institutions that by their policies created the mess, is strong evidence for how hard it is for human beings to reflect on cherished beliefs.

Many independent financial writers and economists (myself included) predicted this housing crisis. Robert Prechter wrote in 2002:

What screams “bubble”—giant, historic bubble—in real estate today is the system-wide extension of massive amounts of credit to finance property purchases. As a result, a record percentage of Americans today are nominal “homeowners” via $7.6 trillion in mortgage debt.

Or, consider what Warren Brussee wrote in 2004:

Come 2008 the number of people giving up on making house payments will skyrocket. Since many of the recent mortgage loans were adjustable rate or had little or no collateral, banks will be forced to foreclose on the homes and sell them, causing a glut of homes on the market and a deflation of home values. In the 2000 market drop almost no banks went belly up because people had not bought stocks on leverage. This is not true in housing, where people and banks are leveraged. As the current inflated home values go down many people will have mortgages greater than the value of their homes, and they will happily give their homes back to the bank rather than fight their mortgage payments. Unless the federal government comes to their rescue, many banks will fail in this downturn. This is because banks also got too confident and optimized bottom line results with little consideration for the risks they were taking with marginal mortgage loans.

I could have included other prescient forecasts, but the point is this—our current crisis is not an unfortunate result of unpredictable events. Instead, it is a direct consequence of exceptionally poor policies. Many treat seriously proposals coming from the same institutions that implemented these poor policies—that in itself is a sign of how far away we are from the end of this crisis.

Consider this current sobering forecast. One financial writer was asked to use a baseball metaphor for how far we are into this economic crisis. He was asked: “Would you say we are in the seventh inning?” His response: “Hardly, they are just playing the national anthem.”

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9 Responses to The Dangerous “Teaser Freezer”

  1. E says:

    The public has not had enough of this because it generally is imprudent with its money, and is uneducated about “smart money” moves (ie an 18 year old who invests $2000/year for eight years is better off than a 26 year old who saves $2000/year until they are 65). If I left my financial decisions to the prevailing public sentiment of the day, I’d be so far in debt there’d be no end in sight. As it is, smart money survives these “institutional mistakes”, governmental gaffes, and corporate gimmicks. Smart money will find a way to survive (diversify their portfolios in European, Mid-East, etc investments).

  2. Frank v2 says:

    Although I feel a little sorry for the homeowners that have gotten in over their heads, I also have zero sympathy for them and especially the lenders. What ever happened to good common-sense fiscal responsibility? Why would you make risky loans to people that had a high propensity of faulting on the loan? And why would an individual accept a risky term? Quite simply: greed by both parties. Homeowners were jumping in on the boom hoping to flip a house and make a quick buck with the rise of the property values, and lenders were assuming that the property values would continue to rise so they made risky loans. Shame on all parties involved. Because what goes up must come down.

    So, for the rest of us that are fiscally responsible, why the heck should we use government funding to bail these folks out? We shouldn’t. We should let the cards fall where they will. House prices will fall, and interest rates may rise, but people that have been saving will benefit because they once again will be able to afford to buy a home. Supply and demand should prevail here. With lots of supply prices will drop.

    I am a naturalized US citizen originally from Canada and my wife and I have worked hard for the things that we own. When we bought our first house in Canada in the early 1980’s interest rates were at 16% and we thought we had died and gone to heaven when we were able to assume a loan at 10 ¾ on an existing property. Oh, and although you can amortize a mortgage over 25 years, the typical term that you can lock a mortgage in is for five years, unlike here in the US where we have the luxury of being able to lock in for the full 25 or 30 year term if we so desire. We bought a townhouse because we calculated that if interest rates rose to 18% we would still be able to afford it. If we had stretched ourselves we could have bought a free-standing house, but we did not want that noose around our neck. Also, we had banked my wife’s salary for a year before we purchased the property so that we had a significant down payment in order to assume the existing mortgage and not have to borrow anything else.

    Now in Canada the interest on a mortgage is not tax deductible, hence people work hard to pay off their mortgage, which is exactly what my wife and I did. Fast forwarding to 2003 when we moved from Rochester NY to house booming Baltimore we did the same thing. We raised as much cash as possible so that we could lock in our mortgage at a fixed interest rate. And because of the crazy prices, we did have to get a mortgage, but it was for about 40% of the selling price of the house. And we bought what we could afford, not what we wished we could afford.

    My father told me when I was very young: “If you can’t afford it, don’t buy it”. My wife and I have heeded this advice our entire working lives. We use credit cards strictly as a cash substitute and pay off the bill like clock work each month. When I have saved enough money, I buy what I want. Somehow our society has become one in which we want instant gratification and when the bill comes in and we can’t afford it, we get all teary eyed and ask for help. Shame on all of us. It is time that everyone takes responsibility for his or her own fiscal mistakes, and not rely on Uncle Sam to come to the rescue. Let’s let the marketplace do what it does naturally and make a correction. Yes the value of my property may fall. And yes some people will loose their houses that they could not afford in the first place. But those that can afford the new lower priced houses will win. C’est la vie.

  3. Frank and E.

    Thank you for your comments. Both of you point to “common-sense fiscal responsibility.”

    One measure of how early we are in this crisis is that expressions of such common sense are considered by some to be old-fashioned, not realistic or not compassionate.

    Until prudent common sense conduct becomes the norm, we can be sure that this crisis is still unfolding.

  4. Velvet says:

    And so the people who didn’t live beyond their means and who paid their bills on time get screwed in the long run as the government decides to jump into this to ward off a recession. Obviously, I don’t want to see people out of their houses, but, they shouldn’t be stupid enough to finance more than they can afford and more than the house is “worth,” worth being an arbitrary number because until someone wants to pay you what the house is “worth” then it’s not worth anything.

    A neighborhood business owner is about to lose her house in the suburbs and I asked her what the details were. She bought in 2002, well before the run up of the prices, and paid $285,000. Her loan? It’s for $385,000. Houses in her neighborhood are now just selling at $330,000, so they are stuck and are not going to be able to continue to make the $4000 a month payment they now owe. I asked her how the hell she got to that loan amount.

    She refinanced all her credit card debt and rolled it into her house because the lender told her she could and she thinks the lender should be responsible. Why don’t people understand that at the end of the day, THEY are adults and should be responsible for their own finances.

    People living beyond their means make me seriously ill.

  5. Velvet,

    Your example is an excellent one. It points out one group of individuals who will be potentially bailed-out–those who lived way beyond their means.

    There are individuals who buy cut coupons, shop in thrift stores etc. and now they will pay to bailout an individual who rang up $100,000 in credit card debt.

    This insanity is sadly only just beginning.

  6. outsider222 says:

    I can’t say I mourn the loss to any REALTORS.

    The question is –is our money safe in banks, and which banks?

  7. Outsider,

    Sadly, this crisis has only just begun. All of us will be affected and all of us need to pay due diligence to our affairs without assuming we are immune. There are rating services that report of on the solvency of individual banks. While I’m not in a position to recommend any service I can tell you this–all banks are not the same. See this recent blog post by Mish Shedlock on the potential for bank failures.

  8. rotus says:

    The “teaser freeze” is not intended to be a bailout of individual home buyers who fall behind on their mortgage payments, rather it is intended to be a freeze of interest rates on mortgages that were badly designed and improperly marketed. These loans had ridiculously low teaser rates and ridiculously high balloon rates. The lenders, real estate agents and mortgage brokers misrepresented the loans to unsophisticated home buyers and encouraged them to buy homes that they could not afford. Some then misrepresented the buyers’ incomes in order to put them into even larger loans.

    Now the economy of this nation, and the world, is in danger of recession because of these lending practices. Getting on one’s high horse about personal responsibility is not going to solve this crisis.

    The problem with the Bush plan is that it doesn’t go nearly far enough. Every predatory loan that is currently in effect should be frozen at a reasonable rate of interest. Those who can’t pay the going rate would still lose their homes. The lenders, unfortunately, will be the ones rescued from their own greed, but it is a price we must pay in order to soften the blow to the economy as a whole.

  9. E says:

    I talked to a good friend of mine who is an investment banker (who has no “dog in the hunt” save for his own holdings). Our opinions are that governmental action should not interfere with this area. It sets a bad precedent for further government action later (ie interference with commerce, especially contracts). Your mortgage is a contractual debt obligation. Having the government step in to re-write the terms of the contract is bad practice. i.e. “This bill of lading does not cover damages to lost parcel, we want to government to rewrite the contract and apportion the loss to carrier.” I mean, you can aver fraud in inducement, but come on. The terms were right there. You weren’t duped. Anyway, the scale of the mess this time is of such magnitude that if there is government inaction, the issue is whether the economy approaches a tipping point at which we’d all go down the shitter. Does it help the broader economy if the riskier fringes are saved? That said, if the Mortgage Lenders and institutional banks who were transacting in these collateralized debt instruments didn’t want to be landlords or real estate holding companies, they should have done their due diligence to see if every new mortgagee could afford their payments (it makes no sense for me to lend money to someone who can’t pay it back).

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