The Mortgage Crisis, Part 1: When too much of a good thing, isn’t.

An Analysis of the Mortgage Crisis from my colleague David Dworkin at Affiniti Network Strategies

If you've been waiting for the mortgage crisis to hit bottom, get yourself a couple of good books, because it's going to be a while, well into 2009 or 2010 at least. Count on it getting a lot worse before it gets better, and even that may be a rosy scenario if Congress passes bad legislation in an election-year panic.

Recent studies estimate over 1 million additional families will lose their homes over the next six years, due solely to subprime mortgages made between 2004-2006. And every time a home goes into foreclosure, the other homes on their block depreciate an average of $5000. To complete the viscous cycle, for every 1 percent reduction in home value, twice as many homes will fall into a negative equity position, where the mortgage is for more money than the house is worth and 70,000 of them will go into foreclosure. (source: First American CoreLogic, Inc. http://www.corelogic.com/)

Like all crises, everyone wants to know four things:

1. Who's to blame?
2. When is it going to end?
3. How did we get in this mess?
4. How do we get out of this mess?

In the next two entries in The Leading Edge, I'll try to answer three of these questions in plain English. I will not try to assign blame. It is human nature to identify responsibility when something bad happens. This reassures us somehow that justice has been done and we are safe from more bad things happening to us. A crisis of this scope requires lots of cooperation. While there are many truly innocent victims, there are many more who went into this with their eyes wide shut. Take your pick: lenders (including mortgage banks, commercial banks, S&L's and mortgage brokers), rating agencies, the Administration and Congress, GSE's, and consumers as well.

Homeownership is tremendously important and has broad community benefits, but only when it is done responsibly. The perception that everyone should be a homeowner runs into trouble when nearly everyone who should be a homeowner is one. By 2004, the national homeownership rate was over 69 percent. Interest rates were low and the entire economy benefited as the technology boom of the 1990's was replaced by the housing boom. No one had any interest in downshifting. Besides, housing had become a critical part of the overall national economy and a lot of the new home equity generated by rising home values was being spent to support it. Slowing down the housing market became synonymous with slowing down the nation.

To keep the mortgage market and housing machines running, mortgage underwriting (the rules that help ensure we buy homes we can afford), became a useful tool to expand historic growth even further. Loosen up on the rules, and more people can get on for the ride. The balloon metaphor is useful because the same air that fills up a balloon and makes it functional can also burst it. And that's exactly what happened with mortgage underwriting standards. Books will be written about the many "exotic" and "hybrid" mortgage products that contributed to this crisis, but the one product that has done the most harm is the "2-28".

A typical mortgage is a contract to repay a debt over 30 years. Most mortgages in the US are 30 year "fixed rate" mortgages. That means that you pay the same "fixed" interest rate every year, and your payment is the same every month. An adjustable rate mortgage, more common in the rest of the world, adjusts the mortgage interest payment to the market rate on an annual and sometimes monthly basis.

The difference comes down to who is taking the risk that interest rates will go up and down. In an adjustable mortgage, the consumer takes most of the interest rate risk because the mortgage payment changes with the market. When rates go down, the payment is less. When rates go up, the payment is more. With a fixed rate mortgage, the payment stays the same when rates go up, and they can refinance into a new mortgage when rates go down. An adjustable rate is better for banks, but only as long as most consumers are able to afford their mortgage when rates rise.

As a result of this risk imbalance between the two choices, the market usually makes adjustable rate mortgages cheaper than fixed-rate mortgages. From time to time, complicated factors reverse this trend, and the rates are pretty similar or even the reverse. But this time, lenders who made a lot of adjustable rate mortgages, which are more profitable for them, made some key changes to how the interest is calculated and how buyers were qualified.

Borrowers are qualified on their ability to make the first payment, not the 25^th payment. So lenders began offering mortgages with "teaser" or introductory rates that were a lot less than the interest rate that would be paid after the two year teaser period ended. In some cases, the teaser rate ended in a few months, but the payment stayed the same for two years while the shortfall (the difference between what the payment was and what the payment should be) was paid by the borrower in home equity - the small part of the home they actually owned. Teaser rates were sometimes less than 2% in a 6% market. Homeowners were qualified based on this rate, even though it would adjust after two years to a much higher rate.

That's why many lenders privately referred to these loans as lender crack. They knew these loans would kill them eventually, but they couldn't stop because they were addicted to the revenue and volume they generated. How much volume? Between 2003 and 2006, lenders originated 1.12 million loans with initial interest rates of less than 2 percent - $431 billion in credit. But these are just the worst of the worst. Nearly 60% of all adjustable rate mortgages originated in 2004-2006 will have payments reset more than 25% of their original amount. For a $300,000 mortgage with a 1% teaser rate, that means a payment increase from $965 per month to $1896 per month at the prevailing interest rate of 6.5%. (source: First American CoreLogic)

For low- and moderate-income consumers, this mortgage almost guarantees foreclosure. If you have plenty of cash, and have high yield investments, this kind of a mortgage may be a good deal. But for first time homebuyers, or those on limited or fixed incomes, it's financial Russian roulette with five rounds in the chamber. A low- or moderate-income homebuyer, who can't afford the increased interest rate now, is not going to be able to afford it in two years. When the biggest raise you've ever received was 10% and your mortgage payment goes up 50%, you're going to lose your home.

And that brings us to when this crisis is going to end. If you're an optimist, late 2009 is probably a good target. If you're a pessimist, tack on another year or two. Until then, if you see any light at the end of the tunnel step aside, because it's probably another train.

Foreclosures will continue to increase as more of the 2-28's reset. When resets peak in March of 2008, we will be approaching the beginning of the end. But remember, those homeowners will just be starting the process of getting behind on the payments. They won't loose their homes for another 6-12 months, depending on the state in which they live. That means that the real estate market in most states will be glutted in the spring of 2009. As that inventory is absorbed (or in the case of some urban neighborhoods, demolished), the market will finally bottom out. Personally, I don't know how much value my home will lose, but I am quite sure it won't appreciate another dollar until 2010.

Something We Can Do This Week

I decry the foolish strategies of the race hustlers and the apathy of our communities to engage each other and the challenges we face with real solutions. I believe we should be talking to each other to get off our collective cans and we should also be informing each other about opportunities for action. One of the challenges is getting and keeping capital in the black neighborhoods of America. We need sources of capital for revitalization efforts and we need to retain the capital we have, much of which is held in our home values and is being wiped out by the subprime crisis. Make no mistake, the subprime crisis is going to wipe out 20 years of black wealth creation. So what could you do this week that could help? I pass on the following action item regarding pending legislation in the Senate that would benefit black communities:

This is worth a moment of your time:

Sen. Jack Reed (D-RI) has introduced S. 2391, a bill to strengthen the affordable housing mission of Fannie Mae and Freddie Mac. It includes several provisions important to community development. In particular, it would provide substantial capitalization for community development financial institutions (CDFIs) and other nonprofits to leverage substantial private capital for housing and community development.

I. Contributions from Fannie and Freddie. Like the bill recently passed in the House, the Reed bill would require Fannie and Freddie to contribute an estimated $500-900 million annually. The Reed bill would split these funds as follows.

A. Affordable Housing Fund 65% would go into an Affordable Housing Fund. ($325-$585 million annually)

1. In the first year, states would use the funds to help address the current subprime mortgage crisis. These grants could be used to facilitate loan modification and refinance options for low- and moderate-income borrowers facing foreclosure. Some of the funding could also be used to help low- and moderate income homebuyers purchase properties that have been foreclosed upon to help stabilize neighborhoods.

2. After 2008, the funding would be distributed by formula grants to the states for the development, construction, and preservation of housing for very low- and extremely low-income families. This funding would complement other federal and state programs, such as the HOME Investment Partnerships and Low-Income Housing Tax Credit programs, to bring down costs enough to primarily target the income group most needing housing that is truly affordable to them, extremely low-income renters.

B. Capital Magnet Fund for CDFIs and nonprofits. ($87-$315 million)

The other 35% of this set-aside would be allocated for a Capital Magnet Fund managed by the CDFI Fund. This funding would go out through competitive grants to CDFIs and other nonprofits to leverage private capital for affordable housing development, construction and preservation for low-, very low-, and extremely low-income families. It could also be used for economic development activities or community service facilities, such as day care centers and health care clinics, that in conjunction with affordable housing activities implement a concerted strategy to stabilize or revitalize a low-income community or underserved rural area. This would be a major opportunity for CDFIs and other nonprofits to get capitalization to attract substantial private financing into distressed neighborhoods across America. This bill would do the following:


II. Fannie and Freddie’s Affordable Housing Goals. The bill would align their goals with current Community Reinvestment Act income targeting definitions, which should help the lower end of the conventional market become more liquid.

III. Duty to Serve. The bill would create a new statutory duty for Fannie Mae and Freddie Mac to serve “underserved markets” that lack adequate credit through conventional lending sources such as Affordable Housing Preservation; Subprime Borrowers; Community Development Financial Institutions; Rural Housing; and Manufactured Housing. Enforcement authorities are provided.

The bill is part of a broader package to strengthen the regulation of Fannie and Freddie. Timing in the Senate is unclear.

What YOU Could Do This Week:

Contact your Senator via a phone call, fax or email and tell them

• you support more capital for neighborhood redevelopment
  
• that you support Sen. Jack Reeds bill, S. 2391,
• you request that [your senator] support the bill
• and you would like a response to your letter,phone, fax regarding their support of the bill.

That is a concrete action step you can take this week that could help to put more capital in our communities nationwide. This is precisely the kind of stuff that the National Action Network and other race hustler networks do not do; targeted focused action aimed at concretely dealing with the challenges we face. While this stuff may seem boring and unexciting compared to meaningless made for TV marches, it is the everyday stuff of government, finance, politics and economics where the rubber meets the road. You won't see the race hustler network doing any action alerts on this.

Let me be clear. The federal government is not the answer to our problems. However, government has a legitimate role to play and we should always be prepared to engage the institution of government in our communities where it is prudent to do so. Contact your Senator and keep an eye open for activity on this bill.