Asymmetrical Information

Winterspeak, welcome back and thanks for the thoughtful and thought provoking post.

One question, the linked article says that mortgage backed bonds have fallen 2.5% since September and attributes this fall to concerns about credit quality, but, given the falling market interest rates, wouldn't we have expected the value of mortgage backed bonds to fall without regard to credit concerns? I've always been leery of such instruments because I think they are subject to a triple whammy: As interest rates rise, the value of the bonds fall (in response to the rising rates), and the default risk increases. As interest rates fall, homeowners refinance at the lower rate (increasing the bond holders reinvestment risk). Other than that, what's not to love?

Thanks for the kind words, David

All of your questions are very good. Personally I cannot understand where the appetitie for this tranche of mortgage backed loans comes from -- the rates are not great and they are (as you say) exposed to a fierce triple-whammy. I certainly would not touch them.

Moreover, I am also stunned than anyone would take out (or buy) a neg-am loan. This is a mortgage where you actually don't cover all of your interest and make up that shortfall by cutting into your own equity. But a buddy in the business tells me that neg-am deals are really big right now.

If your equity is rising fast enough neg-am is okay.

My take on all of this is that the retail financial industry has morphed, though the change is probably temporary.

Historically low interest rates have made the return on real estate very high and the number of profitable projects large.

However, the financial industry doesnt't have the manpower to do due-dilegnece on all the new projects.

This opens an arbitrage opportunity which is being closed by specualtors. If you live near a new condo development the cost of seeing whether or not its a place you or your friends would like to live is fairly low.

You take out the loan and the bank only has to do due-dilegence on you, which is fairly easy thanks to Fair-Issac.

The problem is that as interest rates rise the arbitrage gap will close again and the speculator will be left holding the bag. This is probably one factor driving up foreclosures.

Word on the street is that market in California has already slowed enough to put a fair amount of speculators out of business.

Agreed on the negative-amortization loans. The first time I heard about these, I shivered at the thought. Everyone whose financial sense I trust has the same reaction, as far as I can see. I use it as a sort of litmus test.

Saying that these loans are fine "as long as your equity is rising fast enough" seems equivalent to saying that being chased by a bear is fine as long as you don't trip over something. True, I suppose, as far as it goes. . .

Of course, my wife and I put 25% down on our house, made extra principal payments on its 30-year fixed mortgage, and later refinanced into a 15-year fixed loan. So I'm clearly not a neg-am kind of guy.

I blame Dave Ramsey... I could have sworn I heard him tell some fellow to hand his house back to the bank in order to get out from under a crushing monthly mortgage bill....

But even more seriously: as the real estate market cools and rates rise and the "gimme" of refinancing (in which some amount of equity is taken out and overall monthly service falls) comes to a quiet end, wouldn't we expect all those who had been playing this game hit a wall?

Tying up a lot of money in your house isn't necessarily a great strategy especially if you live in a market where home prices have risen at a slower pace than on the coasts. It might be better to put those extra principle payments in equities.

I'm wondering if these instruments are more on secondary homes, which would indicate the owners may be more likely to allow a foreclosure. People sure would be more likely to use huge leveraging if they're intending to flip (or, I should say, hope to flip) or if it's just a vacation home that they can do without.

Friend of a friend is a real estate broker in Mclean VA, home of many $3 million houses. She sees the financials of her customers, says they are almost uniformly barely able to qualify under current lenient-low-interest-rate-exotic- financial-instruments standards. It's an anecdote, but it does suggest that if things change a lot of folks may go under.

I have heard about two people who are taking neg-am loans as a sort of insurance--they calculated what their normal payment would be on a thirty year, and are paying it, but view the ability to pay less than the interest as a sort of fallback if they have financial difficulties. But I doubt that most people taking these loans are thinking that way; I assume most of them are doing so because they can't meet normal payments. Very bad mojo.

But I doubt that most people taking these loans are thinking that way; I assume most of them are doing so because they can't meet normal payments. Very bad mojo.

But what difference does it really make? They'll lose the house if they can't make the payments regardless of equity and, if it comes to that, aren't they better off having their equity somewhere other than the house? That way they can hand over the keys and walk away. If they've got equity, they've got to try to preserve it by selling for a sufficient price.

It seems to me that the problem is taking out a mortgage loan of any type where the monthly committment is right on the margin of your ability to pay. What's even worse is taking out such a loan where the rate is variable. But if you do put yourself right on the edge, better not to have any equity tied up so you can walk away from the mess, no?

Slocum, Sure, until the bank sells the house at auction for much less than the loan balance and comes after their other assets and paychecks for the deficiency. I'd suspect it would be mostly paychecks; people who'd borrow on a neg-am mortgage are not the type of people who will resist the numerous temptations to blow their money.

I'd never heard of neg-am mortgages before. The concept is stunning: gross irresponsibility in borrowing matched up with gross irresponsibility in lending. I'm no fan of regulations restricting interest rates and loan terms, but it's becoming obvious that for bankruptcy law to be at all even-handed, it needs to recognize that some lenders deserve to lose their money...

My (mortgage broker) wife has only done a few neg-am loans and in all cases they've been for short-term situations--typically while they sell home #1 after moving into home #2. Think of them as bridge financing. Interest-only products are more popular than neg-am in our (central Calif.) market and, yes, variable rate loans are making a comeback after nearly disappearing.

"Given the deterioration in the quality of housing stock owners..."

I'll file this under Generalization, Gross and Unsubstantiated.

I suspect that the home loan market has forever changed to frequent refinancing as SOP. Folks keep their loans about as long as they keep their (leased) cars. FWIW defaults remain rather low here in northern Calif. Prices have leveled off and inventory is up, but I'm not aware of prices actually declining except at the very top end of the market.

It's worth noting there's a vast and unprecedented array of home loan products--a single lender's rate sheet can be a dozen pages of tiny type--and the loan officer's challenge is to match product to client. My understanding is that payment is usually the main concern, while a handful of folks will pay a boatload of points to get the very lowest rate (for bragging rights?).

If the stock market ever revs up, I'd expect quite a few investment homes to come onto the market, which could conceivably push prices downward. I also expect reduced housing starts to act as a safety valve against significant home price deflation, at least here.

Jane - my girlfriend was a mortgage broker, and she'd tell her clients only to use a neg-am loan if there was some sort of income stream which wouldn't be counted by the bank.

One house I looked at, which would be out of my comfort range had I lived in it alone, would have been easy for me to afford if I rented out a significant part of it. (Easy to afford meant fully-amortizing payment minus expected rental income would be smaller than my monthly rent in the apartment I was living in.) With a neg-am loan, I could qualify for it without having to deal with qualifying the rental income to the bank, and I'd have some cushion during vacancies.

On the other hand, my experience with the real-estate world has led me to believe that there are far more unethical operators there than in most other businesses, and I suspect that most neg-am loans are going to people who are not actually building up any equity.

On the other hand, if you owe the bank a thousand dollars, you have a problem. If you owe the bank a billion dollars, the bank has a problem. 2000 bad house loans in the Bay Area equals one billion dollars of "underperforming" debt. The banks will find a way to finesse the problem until valuations have risen to the point where the loans aren't so bad anymore. Unfortunately, that finesse may involve government action.

Oops - sorry Winterspeak - I'd forgotten that Jane isn't the only one who's interested in real-estate here.

Neg-Am is useful for limiting commited cash flow if used with discipline.

Consider for example investing in a rental property. Based on the comps in the area, you reasonably expect to be able to cover your carry for a normal 30 year mortgage, possibly with some positive cash flow. If the property goes unrented for a period, *you* have to cover the carry out of pocket. If you take a neg-am, you can significantly limit your mandatory cash flow during those unrented periods. It's a risk management mechanism.

Unfortunately, many folks are using neg-am not for risk management, but to reach beyond their means.

Here in OC, CA, virtually every single first-time buyer is using a neg-am loan -- and paying only the minimum. That's because there is simply no other way for them to afford prices that have tripled (you heard right) in five years.

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