Notes from Jim Haughey

Jan 29 2007 1:02PM | Permalink | Email this | Comments (1) |
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By Jim Haughey

The sudden rise in the homeownership rate from 67% to 69% of households during the now unwinding housing boom was greeted as good news in all quarters. That was a "gross" view. Now that we are seeing evidence that the "net" gain in homeownership is much less than the "gross" we need to assess whether the social experiment to boost home ownership was worth the cost.

For the poor who became homeowners it was a dream come true. For the financially secure it was a promise of lower taxes. People who commit to a mortgage also commit to a better work ethic to meet their payments and protect their asset and will need less help from their neighbors.

Much of the increase in homeownership came from sub-prime mortgages in which previously unacceptable borrowers accepted mortgages rates two or three percentage points above the market rate but had their monthly payments lowered for up to several years with low teaser initial rates, payment skipping or interest only contracts. It was a win-win situation. Poor families got deeds (with a mortgage lien) for a home. Builders and their suppliers got more volume. Real estate and mortgage brokers got more commissions. And the financial market got a new high yield investment product when they packaged the sub-prime loans as collateral for mortgage backed securities.

For several years the new mortgage contracts appeared to be a painless way to get the clear social benefits of expanded home ownership. But the risk of a flood of loan defaults was only being deferred. Now it is here.

The Center for Responsible Lending estimates that 20% of the sub-prime loans issued in 2004-06 will be foreclosed, mostly in 2007-08 when monthly principal and interest payments rise as variable rates are reset from teaser to market level. The 20% estimate does not include financially strapped homeowners who manage to sell and avoid foreclosure. Typically, monthly payment will increase over 40% but will more than double for some new homeowners. More than $600 billion of sub-prime mortgages were issued last year, about one-third of all mortgages.

At most 75% of households moved into homeownership by creative mortgage financing will survive as homeowners. This is about two million new homeowners. If 20% of this group survive as homeowners because they improved their work ethic we have 200,000 more financially responsible households. But what was the cost? The cost was up to 500,000 foreclosures. Each of these households is at risk to become less financially responsible. They gave it a try but it did not work. Also the huge legal cost of the foreclosure process get passed on the financially responsible households in borrowing rates and fees.

Whether you think the social experiment was or was not a good idea, the netting out phase of the experiment is about to hit everyone in the housing market. A rising tide of foreclosure (and abandonments) will hit low cost neighborhoods in South and West where a large share of home sales in 2004-06 were financed with the new types of mortgages. Remember what entry level housing neighborhoods looked like in Denver and Houston in the 1980’s when the oil market collapsed. Entry level production builders are likely to see their sales decline even further from current depressed levels. But speculators will return to buy up sad looking houses and will call remodeling contractors.

This boom-bust in low cost housing should not have been a surprise to anyone. It was repeat of what happened in the late 1960s and early 1970s when the "great society" housing subsidies temporarily boosted homeownership and then collapsed from a similar surge in loan defaults.