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Following my studies in Business, Law, and Economics at McGill University (B.Com., LL.B., B.C.L.) and Johns Hopkins University (M.A. in International Economics), I began practicing law. I have worked as a Public Interest Attorney for 10 years, helping Seniors seek justice in a society where they... More
  • Introducing the Mortgage With No Possibility of Default  0 comments
    Nov 13, 2010 11:55 AM

    I came across a most interesting mortgage in my law office the other day - the result of a recent loan modification. The $500,000 loan was secured by a property worth $300,000. The loan was amortized over 40 years, but terminated after 26 years, with a $300,000 principal balloon repayment at year 26. There was a clause in the loan that stated that, should the borrower miss a payment or make a partial payment, the unpaid amount would be deferred, without penalty or finance charge, to the end of the 26 years. At the end of 26 years, a balloon payment of approximately $300,000 will be due. Also due at that time will be all the deferred missed payments from the life of the loan, the payments that had been missed prior to the commencement of the loan ($30,000), and $10,000 in fees. So basically, the borrower (age 75) has no reason to pay anything, ever again. And since he has no other assets and is retired, there is little chance the bank will be collecting anything close to what is, or will be, owed.

    Why would a bank create a loan with a 26 year term, during which no default is possible? I see two possible reasons why the lender (a TBTF bank) would conceive of such a thing:: A. Said TBTF lender will now be able to keep the loan on its books as a $500,000 asset (sorry, shareholders), and B. The loan is guaranteed by the government - so when the borrower dies, the lender will be paid in full by taxpayers (sorry, taxpayers).

    And why would a bank amortize a loan over 40 years if the term is actually 26 years? Because we don't do negative amortization residential loans in this country anymore. Neg ams are dangerous and irresponsible! On the other hand, if you amortize over 40 years but only have a 26 year loan... principal is being paid off! Well, not really... not if no payments have to be made. What we have here is the ultimate in 2010 neg am technology!

    When I tell this to my smart, educated friends, they tell me it's good for the economy! Otherwise there would be foreclosures. And the banks would be in trouble.

    To me, this sounds like madness. Do we really want to teach a generation of Americans to believe that anything is justifiable as long as it keeps asset prices artificially aloft? What we are really teaching Americans is that government can, and will, decide who financial winners and losers are. This time around, they have decided that owners and lenders and gamblers are the selected winners. If you fall into one of those categories, you can bend the rules with impunity. And if you are a lender, you get extra leeway - you can engage in mad creative accounting and shockingly creative lending - all backed up by... taxpayers (a.k.a. Fannie, Freddie, FHA, whatever junk the Fed buys, etc.).

    If our government was to begin to extricate itself from its massive intervention in our "free market", a few things would happen. First off, asset values would fall to market-determined levels. Some people, such as those who ignored market fundamentals and bought beyond their means, would lose their homes. Other people, such as people who had assessed risks correctly and had decided that purchasing during a mania was not a good idea, would have the opportunity to buy a home.

    Another thing that would happen is that market participants would be encouraged to actually do risk assessments based upon market fundamentals, before making an enormous leveraged investment, such as in a home. Buyers and sellers and borrowers and lenders would be able to research data like income distribution, long term macro-economic conditions, availability of credit, and the opportunity cost of tying up money, to reach rational financial decisions. Such assessments are almost impossible now, given our  government's frequent, capricious, and massive interventions.

    But our leaders have decided that the winners coming out of this crisis should be lenders and owners and gamblers. As such, they are making life very expensive for savers. And very expensive for renters. So that they can bail out and guarantee and subsidize and  incentivize behavior that is risky and irresponsible. They have decided to try to convince people that it is a better idea for them to rely on the government's commitment to prop up prices, rather than relying on, and honing, their own ability to assess risk and market conditions.

    The US government is taking on immense risk, on many levels, in attempting to overwhelm and distort market forces. It's not just that they are teaching individual market actors that there is no need, in this particular capitalist market, to assess risk. And it's not only that they are teaching our biggest banks that they have carte blanche when it comes to creative accounting and irresponsible lending. To top it all off, they are betting it all - care of QEI and QEII and debt beyond comprehension - on policies designed to blow yet another bubble.

    Let's just go over the government formula here:

    1. Teach Americans to ignore market fundamentals by propping up asset prices and failed companies.
    2. Inject massive amounts of economic steroids into the economy.
    3. Hope everyone was treated with sufficient moral hazard to start borrowing and buying and lending beyond their means again.
    4. Pray earnestly that the side effects from 1 and 2 can ultimately be contained.

    We had a golden opportunity to let markets dictate winners and losers. The results would have been very different - as in the honest and the entrepreneurial and the prudent and the  analytical would have come out ahead. Mortgages coming out of such a market clearing would now be written to be safer than prior to the crisis. Instead, government stepped in to determine who should be saved. The result is a population that has been taught to stop trying to assess risk, a failed banking system that knows that they will be bailed out whenever necessary, and fiscal and monetary steps that put the US currency and this country in a rather precarious position.

    The twisted mortgage on my desk is one tiny example of the bizarre consequences of massive government intervention. But when you choose to cure fraud with accounting tricks, and bailouts, and government backstops, you don't cure fraud at all. What you do obliterate is prudence, and risk assessment, and good judgment.

    Disclosure: No positions

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