Monday, December 08, 2008

The Osman Plan, Continued

by Osman Parvez
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A discussion on the new mortgage plan (the Osman Plan) has emerged in the comments of an earlier post. It's interesting debate so I'm elevating it to a full post.

In the comments stream, Linton said that the new fixed rate plan unfairly benefits sellers and agents at the expense of buyers and tax payers. Here's my counter argument, based around a scenario of falling prices in a former bubble market, with the assumption that home prices will stabilize with a 4.5% mortgage rate and fall further with existing mortgage rates. I've also included a spreadsheet that can be downloaded HERE.

The Buy Side

Let's say a family purchased a home four years ago for $1,000,000. Because they bought in a bubble market, they saw their property climb 15% in the first year of ownership but the value has plunged since the bubble collapsed.

The home is now listed for sale. If the sale price was $977,500 (15% decline from peak), the buyer's monthly payment would be $4,705 with a new 4.5% fixed rate, 30 year mortgage and 5% down (excluding property taxes, insurance, etc).

Let's say that Linton get her (or his) wish. Our government fails to approve the proposed low rate plan. In this scenario, the market value of the house further plummets to $862,500 (25% from peak). This sounds great to buyers because they would save about $5,750 in down payment. Yet at a 6% mortgage rate (and with the same conditions as the previous example) their monthly payment would still be $207 more per month, adding up to about $75,000 over the life of the mortgage.

The Sell Side
For the seller's perspective, the world looks a little different. Four years ago, they put $50,000 down for this home at a purchase price of $1,000,000. They were happy when the property value rose 15% but they weren't planning to sell the house. This was just a paper gain. Now, their situation has changed. They still love the house and the community, but perhaps a job has been lost. They are motivated to sell, even though prices are falling.

In the first scenario (price drop of 15%), the sale price is $977,500. After paying their Realtor and mortgage, the seller will net about $20,000. They're glad to be out of the house but they've lost 60% of their original down payment.

In the second scenario (price drop of 25%), the sale price is $862,500. To sell the house at this price, the sellers will need to bring a whopping $88,000 to the closing table. Including their down payment, that's a 276% loss. Most sellers don't have that sort of liquidity, particularly if their other investments are taking a beating. They may be forced to let the house fall into foreclosure.

A few summary pros and cons.

Scenario 1

Pros:
Community is spared another foreclosure
Prices stabilize
Seller gets some equity back
Buyer saves $200/month (will likely spend it in the economy)
Other in neighborhood don't see massive erosion in values
If buyer can hold long term, will save nearly $75,000 over life of mortgage
Financial community sees new mortgage origination's with healthy equity, stable asset prices, and strong underwriting.

Cons:
Buyer pays $115,000 more, largely in the form of $5,750 down payment
Buyer pays slightly higher taxes and insurance

Scenario 2

Pros:
Buyer gets the house for $115,000 less, saving $5,750 down payment.

Cons:
Buyer pays an additional $207/month.
Community has another foreclosure
Family has bankruptcy/destroyed credit
Market undershoots (occurs in most bubble corrections)
Sellers are in bankruptcy/credit destroyed for many years

Overall, it looks like an approach that balances somewhere between these scenarios would work for all parties. For one thing, a community is spared the cancer of another foreclosure (abandoned homes, including break-ins, theft, drugs, and crime). Existing owners leave with some equity and their credit intact. The new buyer pays a lower monthly payment but pays out a little more equity.

It's worth noting that many buyers at the $1MM price bracket and above will use more sophisticated financing that conventional fixed rate mortgages. For instance, they might cross collateralize their property, take a loan from an investment account or from their business, or use interest only mortgages. If there is further interest, I might expand this discussion to include other forms of financing. For now a plain vanilla version seems appropriate.

p.s. Linton mentioned how agents benefit. In the second scenario, they make 11% less but that's still plenty to motivate them. What's critical is that they actually get the sale done and help create a stable market, rather than marketing listings for extended periods of time with several price reductions (the walk of shame). Don't forget, the income from the lender, agent, title company, attorneys, sign makers, will be redistributed in our global economy too.



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14 comments:

  1. Let the market fall. Allow prices to stabilize "naturally" - just as "naturally" as they skyrocketed. No tears from this corner for anyone who bought a house at or near the peak. Sometimes lessons are hard to learn. Artificial mortgage rates subsidized by Uncle Sam are as heinous to me as the cheap credit that allowed for the ridiculous valuations. It will be painful, but the market will find its own bottom regardless...

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  2. Osman - As you noted, the government can prop up valuations through subsidized loans. As a buyer, why do I want to purchase an asset at an inflated value? When the subsidized loans (4.5% or so) end, further correction will take place in the market. Buyers do not want to assume price risk created by government programs to prop up prices. Lower payments are great, but don't forget about the true value of the asset.

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  3. Again, Osman, you think it is win-win, when it isn't. Your plan and example redistributes both the seller's loss and the realtor's loss to the government (taxpayer) and the buyer and makes a false property market to boot.

    In your example, you did not address the taxpayer loss (to foot the bill for the 1.5% interest rate reduction on a $925k+ mortgage) nor the buyer's loss when he/she resells.
    Only 3 possible scenarios exist:
    1) The buyer holds the loan for 30 years, the government (taxpayer) loses 1.5% per year for 30 years!
    2) The buyer sells the house when or after the gov't interest rate subsidy to potential buyers expires (house prices must fall at expiry!) and takes the massive hit that the original seller avoided. i.e. the newest buyer's affordability falls when the subsidy is gone. In your example, $977,500 - $862,500 = $115,000!
    3) The buyer flips the house before the subsidy expires, and offloads scenario 1 and 2 above to the newest buyer and the cycle (musical chairs anyone?) repeats.

    Why should the losses be borne by the government and future home buyers that wisely stayed out of the property market when it got ridiculous?

    Without even addressing the losses by bringing government loan program inefficiencies into being; the following socialist and moral hazard risk are just too great to dismiss.
    An interest rate subsidy bailout is just a redistribution of wealth from those that made either greedy or naive mistakes to those that did not - socialism. A bailout also provokes those who foot this massive bill (as well as those who are bailed out!) to gamble next time instead of thinking twice in the midst of the next bubble - moral hazard.

    I am surprised you can't be persuaded by the truth i.e. Realtors and sellers gain at the expense of the taxpayer and buyers in your interest rate subsidy program. Per your example, let today's seller swallow a $22,500 loss on their original $1m purchase while you encourage us to buy an $862,500 house for $977,500! May a fool jump in.

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  4. Linton and anons,

    You have some good points but there seems to be a core misunderstanding.

    First, the government is deeply entrenched in the mortgage market and has been for a long time. As you probably know, mortgages are packaged, sliced into tranches, and resold (securitization). The largest players in the space essentially create the market and those players are (now) fully controlled by the government. The creation of mortgage backed securities is probably the most important factor in bringing rates to historic lows.

    The point is that government involvement is nothing new. Thus questions of what constitutes a "natural price" or a "false market" are not easily resolved and somewhat moot. Even if there were no secondary market for mortgages, the government would still be involved.

    Were the government to somehow exit the mortgage business, rates would certainly rise. The pendulum would swing in the other direction and housing would become increasingly unaffordable, despite falling nominal prices.

    Thus there is no "natural" market price exclusive of the capital markets. The government will continue to be involved, and once you accept that the next question is for what purpose. What are the goals? How will it achieve its aims? That's the area I'd like to focus our conversation.

    1. Is the new plan really a redistributed loss? I'm not convinced. Done right, I think it might put a floor under housing, not cause price appreciation. The losses being redistributed are entirely theoretical.

    2. If the government uses the GSEs and banks (which it now also controls) to create a new secondary market, I don't think the theoretical 1.5% loss over 30 years is material given the immediate benefit. Like all things, it's certainly a tradeoff but don't discount the benefit of price stability.

    3. The term: I think you've got valid points about potential abuse. I agree that the government should be careful that this program is not used to reinflate housing bubbles. I do believe that if designed intelligently, with levers to manage it well (i.e. phases out if price appreciation exceeds real inflation, etc)this plan is the best that has been proposed (so far). Given how lousy the other plans have been, perhaps that's not saying much.

    4. Finally, I'm not encouraging anybody to buy or sell anything. If you look back throughout the nearly four years of this blog's history, you will a pattern of cautious conservatism and pragmatic advice. If you find anywhere where I explicitly say that NOW is the time to buy or sell, please let me know.

    So what *is* my advice? First, gather opinions and think for yourself. Make sure the opinions you gather fairly represent a diversity of viewpoints (reducing confirmation bias). Second, make decisions for the long term. Buying a house with anything less than a 4 or 5 year holding period is risking financial catastrophe. Housing isn't a casino.

    p.s. Thanks for the comments.

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  5. Surely the taxpayers wouldn't be subsidizing $900k+ loans?! The blowback from such an ill-advised plan would be amusing to watch. More millionaires with hat in hand, begging Joe Sixpack for a handout.

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  6. Osman, it is time to pay the piper. Boulder real estate values will fall in 2009 and perhaps beyond as unemployment ramps up. I will grant that ANYTHING that happens in this economy is not "natural". However, fundamental laws of economics will prevail in the end, and the bubble created by cheap money and lax lending standards will deflate. Prices will realign with wages over the longer term because of this new (old) paradigm - pay what you can afford. I know you own a house in Boulder, and are obviously at risk in a sliding market in terms of your profession, but your "plans" calling for taxpayer risk and money to prop up artificially high prices will find few supporters (save those who own a house, perhaps, or bought in the last 8 years). And please spare me the no bubble in Boulder theory, the numbers don't support it - 20% gains in even 1 year of appreciation were certainly not supported by 20% wage increases.

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  7. Anon,
    At least we can agree that prices will come into a more natural equilibrium with income. In the former bubble markets, appreciation got way out of hand and, as I predicted (beginning in 2004), those are the same markets that have suffered the most.

    Will that happen here?

    The high end is certainly packed with inventory. Those homes have already started to come down and might fall a bit further. Meanwhile, the low end is still remarkably healthy. This might change if there are price drops at the mid range of the market. I guess we'll see.

    As for supporters of the new Treasury plan, you say there are few, save homeowners. Yet homeowners comprise an enormous percent of Americans. More than twice the number who rent, according to the latest Census release. I expect HUGE support for any legislation that addresses falling prices and foreclosures. Stay tuned...

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  8. Perhaps homeowners are in favor of this - that does not make it the right thing to do. There were 73 million (in peak bubblicious 2004) homeowners in the US. Seems everyone else lives somewhere - maybe renting?

    "Nothing can stop this process. It’s a necessary cure for the credit bubble that Greenspan puffed up." Credit Cycle Bust. Stop-gap it all you want with taxpayer money, it will not work. I, for one, am outraged that I will pay for the foolishness and conspicuous consumption of my fellow "citizens".

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  9. Anon suggested a well written opinion piece in the Journal by Harvey Golub, former Chairman and CEO of American Express.

    In Getting Out of the Credit Mess, Golub writes (emphasis mine):

    So, are the current credit easing actions likely to be helpful or not? In my judgment, measures to create liquidity are likely to be helpful. Financial institutions that lend money to credit-worthy people for reasonable purposes have experienced a substantial reduction in available funding from which they can make loans. Hence the programs to support the securitization markets are sensible because money used for this purpose will be lent and used for purchases. Programs that deliver a short-term reduction in mortgage rates will, at the margin, help absorb some of the available housing stock, reducing the time it will take for housing to reach market-clearing levels.

    However, measures intended to reduce foreclosures, per se, are likely to be ineffective at best and morally flawed at worst. When analysts say that people are being foreclosed because house values have declined they are missing the point. A large number of foreclosures are taking place because people can no longer refinance and take value out. They could not afford the houses to begin with and greed or stupidity -- not a falling real-estate market -- have caused their problems. On the other hand, measures to subsidize homeowners facing foreclosures because they have lost their jobs can be helpful.

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  10. I think the elephant in the room here is the fact that there are currently VERY FEW buyers who can or should qualify for loans to purchase houses at the prices they're currently going for. Lower interest rates? Great, but you've still basically got a tiny number of people who can put a decent DP down and have a decent credit score.

    Osman, you point out that investors (ie, non owner-occupants) could swoop in and purchase these places as rentals, but I don't see that as viable - even with low interest rates, rentals are *much* cheaper than any other option. It doesn't make much sense to buy a bottom of the barrel 3 bedroom house in Boulder for $400-500k, then try to compete with comparable rentals that go for $1500-2000 or so. As you move up the price food chain, things get even more out of whack (you can rent some really nice places for $3-5k, but you'd have to pay a cool mil to buy them).

    In other words, I don't think that the investors you're hoping for exist, unless they're interested in investing to lose money. Values are going to end up in line with rents and income again one way or another, it's just a question of minimizing the externalities/disruption along the way. I don't think artificially low interest rates is helpful in that regard.

    Changing bankruptcy law to allow forcing changes in mortgage terms could be useful, but I don't see much discussion of that anywhere.

    -Walt

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  11. Walt,

    When I was talking about investors soaking up excess inventory, I wasn't talking about Boulder specifically. I don't think we need to do anything to prop up the low end of Boulder's market. $375-500K, there's plenty of demand and inventory levels are very healthy. The opposite is true at $1MM+.

    Income investors also do not make up a large portion of buyers at $1MM+. At the high end, you'll find plenty of spec home builders, but people don't buy these generally to rent them out.

    Here in Boulder, there is excess supply on the high end (about 2 years of inventory). So I expect to see a soft market in 2009 (yes, with declining prices) for those luxury homes, somewhat less so if rates drop to 4.5%.

    As for willing and able buyers, I disagree. Anecdotally, we've got a very healthy number of potential buyers at the moment, all of whom well qualified. They are also hesitant because they're not sure where the economy is headed. Their collective price range is $200,000 to $1.3MM.

    Nationwide, there may be record numbers of people who leveraged themselves to their eyeballs but keep in mind that despite that, the fact is that the vast majority of Americans are not fiscally wreckless. Most pay their mortgage on time every month and nearly 40% own their home outright without any mortgage at all.

    By the way, I think you've got an interesting suggestion on bankruptcy laws being changed. Many would argue moral hazard, of course, but perhaps there is a way to structure it that doesn't reward stupidity.

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  12. Hi Osman -

    I probably should have been more clear about when I was talking about national level vs local level scenarios.

    Nationally, I don't think there are enough buyers with ready DPs at any interest rate right now. And things are likely to get worse before they get better.

    Locally, I'd guess that barring major changes in the employment situation, the market will stay "soft" but not collapse as Boulder folks (and folks moving here) do have a lot more ready cash than the average American. And nobody buys as an income investor in Boulder, at least not since the mid-90s.

    I think your point about moral hazard wrt/bankruptcy is a good one, but in many cases, I think it's a good idea to simply cram down the principal until people can afford their house. Sure, you can boot them and teach them a valuable lesson and such, but if you do too much of that kind of thing, you end up with essentially urban blight, which hurts the responsible property owners too. I'd personally prefer to bail out my neighbors and live with the unfairness of it all than see them all evicted. But that's just me.

    I guess my point really comes down to this - your idea only kinda softens the blow, and I don't see it having much effect on reducing the society-wide problems that the housing crash is causing. It's a no-win situation in some ways, but I don't know that pushing more public assets into promoting homeownership is the way to go - it is, after all, essentially a regressive tax on those folks who rent and generally can't afford to buy houses.

    There is nothing morally wrong with renting - the mortgage interest deduction, artificially low interest rates, DP assistance programs, etc, are all subsidies for ownership. But I don't see ownership of a house as a value in and of itself, at least not in most circumstances. The pro-ownership skew of public policy is, IMO, how this mess happened in the first place, and pushing it even further isn't the solution.

    Enjoyable discussion on this post, kudos for the interesting blog.

    -Walt

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  13. What is all this talk about 4.5% for $1MM home buyers? No way! Those rates will be for conforming loans through Fannie, Freddie and maybe FHA. Those were the details released from the Treasury.

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