Our nation is facing the greatest real estate crisis in recent history, and the fallout is impacting our entire economy. Today there is much debate around the government's $700 billion financial bail-out package and what steps should be taken to stop the bleeding and regain stability in our financial and real estate markets.
The plans on the table so far involve injecting banks with cash, buying up bad loans, and possibly suspending foreclosures. These strategies are what I call "quick fix' or band-aid solutions that have little chance of actually correcting the problem at its roots. Buying bad loans from banks puts the government in the position of having to dispose of a potentially endless supply of bad loans and real estate. A moratorium on foreclosures just defers the problem. A growing belief that mortgage loans are high risk will impede lending, allow real estate inventories to grow, and push real estate values down even further.
In this article, I propose a simple, yet powerful solution to this crisis which provides an opportunity to reverse the downward spiral and create a sustainable stability in our real estate markets. But first...
How We Got Here
Dozens of years ago, the only mortgage available to the American home buyer was a 15 or 30 year fixed-rate mortgage. If underwriting was done properly, the borrower knew what their monthly mortgage payment would be for the next 30 years. The simple formula that was used to decide how large of a loan a borrower could afford was based on a specific debt-to-income ratio. If this formula was applied properly, the borrower could not buy a property that would be beyond his or her financial means. From a lending perspective, the risk was isolated to personal disruptions in income such as illness, unemployment, death, etc.
The current problem is a consequence of creative lending practices designed to allow more people to buy high-end homes and tap into the equity of their existing homes for a way to live a lifestyle beyond their means. No one can argue against pursuing the "American Dream" of home ownership. But this dream now has become a nightmare because these creative mortgages, fueled by greed, have been abused by the entire system.
The formula for disaster was combining lenders, mortgage brokers, realtors and builders all motivated by profit with buyers who wanted an improved lifestyle, whether they could afford it or not. Although these motivations are not necessarily destructive on their own, when combined with risky mortgages that were issued based upon a general over-confidence in a rising real estate market and contrary to prior fundamentals in the industry, it was a recipe for disaster.
Option ARMS, 80/10/10 ARMS, Two Year Teaser Rates, HELOCS, Negative Amortization Loans and other products enabled people to qualify for mortgages that were as much as four times the amount they would have been allowed to borrow previously. The alleged safety net was the assumption that real estate would continue to increase in value allowing the borrower to refinance the loan before the unaffordable rate adjustment commenced. Mortgage brokers further complicated the issue by refinancing existing adjustable loans to new two year teaser rates (delaying the problem for an additional two years) and allowing borrowers to get cash back for general living purposes. As long as real estate values continued to increase, the music would never stop and there would be no mortgage crisis.
Now with borrowers in homes that they can't afford, foreclosures flood the markets, lending has stopped, the real estate market is loaded with inventory and prices are down. Qualified purchasers are reluctant to buy because credit is tight and no one is sure if the market has hit the bottom. Potential home buyers are holding back, waiting for a sign of a market turnaround, which only extends the downward cycle.
Before we see a market recovery, home values will have to hit the bottom and begin to stabilize and rise. Meanwhile, inventory needs to be slowed and consumed; delinquent borrowers should be saved when possible; and to avoid resentment for using taxpayer money to bailout irresponsible lenders and mortgagees, borrowers who are current on their mortgages need to be rewarded. A band aid approach will make the problem worse. We need a solution.
"The Simple Plan"
I call my plan "The Simple Plan." It creates a one-time 4.5% fixed rate 30 year mortgage loan insured by the United States government for every American citizen over the age of 18 using a 90% loan-to-value and strict underwriting guidelines relating to income and expenses.
Everyone must be underwritten and approved for this new loan. The time allowed to take advantage of this program would be 6 months for existing homeowners and 12 months for new buyers.
I. Existing Delinquent Borrowers
Under "The Simple Plan," lenders would give an exception to the 90% loan to value ratio and if borrowers can afford the full debt at the new rate, they get to place their past due amounts on the back of their new loan and remain in their home. If they still cannot afford the debt, the loan servicer would receive incentives to accept a short sale (possibly to the existing borrower). If the borrower is unwilling or unable to reach an agreement with the servicer, foreclosure would then be proper.
Loan Amount: $150,000
House Value: $120,000
At a 13% interest rate the monthly payment is $1,659.
At a 11% interest rate the monthly payment is $1,428.
At a 9% interest rate the monthly payment is $1,207.
At a 7% interest rate the monthly payment is $998.
At a 4.5% interest rate the monthly payment is $760.
Loan Amount: $200,000
House Value: $150,000
At a 13% interest rate the monthly payment is $2,212.
At a 11% interest rate the monthly payment is $1,905.
At a 9% interest rate the monthly payment is $1,609.
At a 7% interest rate the monthly payment is $1,331.
At a 4.5% interest rate the monthly payment is $1,013.
The examples above illustrate the projected payments at several percentage rates. In both examples, the loan amount is higher than the value of the home, as is often the case today. Borrowers will generally strive to modify a loan placing back payments and fees on the back end of the loan and giving the loan a fresh start.
For borrowers who don't qualify for the full debt but can make the payments on a smaller note, the servicer should be encouraged to modify the Unpaid Balance (UPB) to a number that the borrower can afford. If the servicer does not want to modify the UPB the home would foreclose and the servicer would bear the responsibility of reselling the home at a significantly decreased value. Such a scenario would permit many people to remain in their homes and expedite the inevitable demise of the loans that cannot be saved.
II. Existing Current Borrowers
Under "The Simple Plan," lenders would give non-delinquent homeowners the opportunity to opt out of ARMs and higher rate mortgages. Homeowners would have a chance to refinance their existing loans at the 4.5% fixed rate. The 90% loan to value requirement would be waived. The owners of the current loan can either modify the loan (100%) of the debt at 4.5% 30 year fixed rate loan or the borrower can get a new loan from another bank at 4.5% 30 year fixed and the old loans would be paid off at 75% of the 1st and 50% of the second. The added security of a stronger loan and collateral makes it easier for banks and investors to handle the fixed rate loans. Borrowers would also have the option to seek a new lender under these terms.
III. New Borrowers
Under "The Simple Plan," first time borrowers, as well as investors who buy rental properties and second homes would be motivated to get off of the sidelines and start buying homes now. When this happens, the inventory would decrease and the recovery would begin.
New borrowers would be underwritten with a 10% down payment, a current and accurate appraisal and appropriate debt to income ratios.
At first glance, it appears "The Simple Plan" would significantly reduce banks' monthly income. However, if home values continue to drop and lending fails to pick up, most of the current loans at higher interest rates will end up in default and the downward cycle will extend far into the foreseeable future. This plan will enable banks to do more volume and generate substantial income while re-establishing stability in the real estate market.
Under any other plan, the banks may get a higher interest rate for now, but the net results will be much worse and the recovery will take years.
"The Simple Plan" is relatively easy to execute and would stimulate the real estate and mortgage markets, revive communities, and provide a sustainable stability that would benefit everyone.
© 2008 All Rights Reserved By John C. Beggins
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