Let’s say you’re an American named Maria living in Southern California. The year is 2006. You make $45,000 and your husband David makes another $40,000. You have two children aged six and four and your two-bedroom apartment is getting too small. So you decide to consider buying a house. Eventually, you and your husband find a new home. Now, granted you know nothing about mortgage finance. But, your guy at New Century Financial hooks you up and with the help of a teaser-rate adjustable rate-mortgage you are able to afford the home. In the end, you shop around and get another bank you consider more reputable to match New Century’s terms. Sale Price $390,000. As you have no money down and roll up some fees into the mortgage, the final mortgage price is $390,000 with a second piggy back mortgage of $10,000 for a grand total of $400,000 of debt.
Fast forward to 2009. The economy is in tatters but you and your husband have your jobs. You’re doing alright. And, as it turns out, you have picked wisely by buying the smallest house on the block in a really up-and-coming neighborhood. The only problem is that house prices in your metro area are down 40%. Your house, while down less, is still down 20% and is only worth $320,000. This is a big worry because your mortgage was a 3-year ARM and the rate is about to go way up.
Enter the federal government’s “Making Home Affordable” plan. Just the other day HUD Secretary Shaun Donovan announced that mortgages owned or guaranteed by Freddie Mac (FRE) and Fannie Mae (FNM) can be refinanced up to – get this – 125% loan-to-value. That means, you can take out a refinance loan on your house now valued at $320,000 for up to $400,000. Bingo! That’s exactly what you need to keep your house. Do you do it?
Let’s take a look at some hypothetical home borrowers who currently owe $400,000 in various mortgages with difficult terms or high rates, and whose home is presently worth $320,000. They jump on the new FHFA Home Affordable Refinance Program and refinance into a single 30-year fixed-rate loan at a 5.75% interest rate with a 125% loan-to-value ratio…
With the home value appreciation tweaked to a slightly less rosy scenario, it takes 17 years before our couple can break even selling their house.
Nice, huh? Their comment on this is dead on:
If the goal of this new 125% loan-to-value program is to financially imprison people in their current homes for a decade or more, then it looks like it could be a rousing success. However, I’m not sure how many currently struggling home borrowers would really consider that to be much of a “help.”
I have a post from last year describing circumstances in Japan that are eerily similar. Take a look. It’s called “A cautionary tale: story from 1994 Japan.”
I have another angle too. You’ll notice I mentioned Maria is no financial wizard. She probably does not appreciate the intricacies of mortgage finance. Here are two points to consider.
- In the state of California, you can just walk away because first mortgages on primary residences are non-recourse. That means that the mortgage is only secured against the house you have bought.
- However, in the state of California, refinance mortgages are recourse loans. What does that mean? It means you are on the hook for that loan. You cannot just walk away. The bank can come after you and take your car and the stocks in your E-Trade account. They can garnish your wages. They can even take your clothes and the shirt off your back, literally. The only thing they can’t touch is your 401-K. But it’s down 40% anyway.
Why would you trade a non-recourse loan from which you can walk away for a recourse loan that guarantees you’ll end up as bad as some poor slob at Tappahannock? It doesn’t seem like an incredibly appealing choice, does it?
But, of course, this is a classic case of asymmetric information because you don’t know that you are getting a poor trade, but your bank and the government do. In fact, the bank makes more money this way because of incentives it receives for refinancing these loans – incentives, I might add that come straight from the taxpayer to the bank via the Federal Government (see my post “How refinancing helps the likes of Bank of America and Wells Fargo”).
So, to recap, you get shackled to a house with a recourse loan because you don’t know what the bank and government do. Meanwhile, your bank gets to forgo a writedown (remember, your loan was for the same amount as before). And the bank gets a refinance fee which is goosed by government incentives.
Is this predatory lending? Sure sounds like it to me.