Thursday, July 19, 2007

Subprime, Spending and Lending Laws

In a news story, Bernanke: Subprime hit could top $100B, Bernanke says that if prices drop consumers could cut back spending as much a 9c for every dollar of lost wealth.

So, a half million dollar home declines to $400,000 and the person would cut spending by $9k. A $200,000 home to $160,000 and they would cut by $3.6k.

It looks like businesses of non-essential items are going to be in for a hit.

They also state they are working to strengthen lending regulations. I'm sure they will be marginal at best. Having worked in the banking industry during a period where people lost their homes and were left with further debt to pay back, over the years I have thought dearly about this topic, and I have previously on interest rates, Low Interest Rates - As Destructive as Usury.

I have been a private advocate of strong laws and regulations around lending as interest rates decline due to the crazy amounts that people can borrow based on income. It makes no sense mathematically to apply a fixed standard to borrowing rates that have increasingly leveraged effects on the amounts that people can borrow as rates decline.

Legislation that would protect the consumer would be lending laws that limit the amount a consumer can borrow based on a fixed evaluation of income, down payment, amortization period and interest rates.

I have a 4.4% interest rate mortgage.

Qualifying for a mortgage should not be based on current interest rates. The leverage of the potential increase in payments is utterly enormous when interest rates are down, and the amount of money people quality for at low interest rates is insane. I qualified for 53% more mortgage that I borrowed for interest rates at 4.4%. If they'd been 3%, well, then I'd have qualified for 76% more than I borrowed. Based on the payments I chose to make I'd have qualified for 85% more at 4.4% and 115% more at 3%.

Qualifying for a mortgage should be based on being able to afford the payments with 30% of your income with 25% down and 8% interest for a 25 year mortgage. I'd have actually only qualified for 10% more than what I borrowed with that criteria.

So, then comes the fudging factor on how to change that to change with difference in individual's financial situation. Zero down loans are actually fine, if you afford them with 30% of income at 10% interest. I would not have qualified for my mortgage with this criteria. The maximum I would have qualified for would have been 6% less than I borrowed.

And there's nothing wrong with having it go the other way, say 30% of income at 6% if you have 50% down. Under this criteria I would have qualified for about 30% more mortgage that I took based on the interest rate, but I would not have qualified for the mortgage because I did not have half down.

The actual length of the mortgage should be based on the criteria given. You have a repayment schedule based on a 25 year mortgage at 8%, but with current interest rates you will pay it off in x-years. This criteria would have me paying off my mortgage in 13-14 years. With nothing down my smaller loan qualifying amount with larger payment would be paid off in 12 years. If I had the half down the last example would have had me paying off the mortgage in 19 years.

Anyway, these are guidelines that I've come up with from thinking about the issue over the years. I think qualifying based on fixed criteria, such as 30% of income to cover 8% at 25 years, is how lending should be regulated, but how this fixed rate criteria is set should be open to debate.


twelvethoughts said...

This, along with your "Destructive as Usury" post, makes for some interesting reading. Here in the US I can't ever see there being a reasonable public debate similar to what you've posted. The anti-regulation crowd would have its usual knee-jerk reaction without even debating the merits of ideas such as yours, as sensible as they may be. I can see their argument which basically comes down to "If people want to be stupid, let them." Unfortunately, the counter-argument - that if we let a whole bunch of people do a whole bunch of stupid things, the ensuing economic fallout will affect us all - probably would not be heard.

The bit about the "leverage of the potential increase in payments is utterly enormous when interest rates are down" is such an important piece of financial knowledge that I don't recall seeing anyone post about in any Real Estate blogs. Some buyers are no doubt learning about leverage the hard way.

RE in the US has a long way to fall. I think enough widespread damage will occur that some lending legislation will be called for. Instead of a thoughtful debate with sensible proposals such as yours there will be a more predictable outcome. It will be superficial window-dressing at best, heavily vetted by RE and lending special interests, offer no real protection to the homebuyer (probably makes things worse for them actually), called the "American Home Buying Protection Act", and despite the congressmen crowing that "This is a great bill for the American people!", the stock prices for the lenders and RE companies will skyrocket when it's obvious it will be signed into law.

Deborah said...

I consider my write-up "Destructive as Usury" as one of the most important write-ups I've done in terms of what society as a whole is missing about how the low interest rate destroy ability to get ahead through paying off debt first, or the huge advantage that existed when homes were priced so people could afford them at 10% loan rates.

I think this also has to have a huge trickle down effect in suppressing spending within the economy as a whole as the number of people struggling with mortgages that their income never really gets ahead of.

If your disposable income remains tight, well, you aren't spending money and stimulating the economy much. I think the long term effect of so many people removed from participating in the economy because of being forever cash poor because of home ownership will be felt for years.

Jay Walker said...

Having myself worked in the finance industry, I can see the wisdom of this suggestion. However, there has to be, I think, some sort of bias towards current interest rates, even if exceptionally low. For instance, 8% would have been an unacceptably high barrier for most of the past decade.

Other than that, I think the idea is generally sound. Something that looks more towards historical averages or norms. But lets face it too Deb, these companies were incredibly stupid ... I mean, how dumb do you have to be to not figure out that the excess liquidity is eventually going to dry up, creating realty declines and subprime defaults in the aftermath ...

The Confused Capitalist

Deborah said...

Hi Jay,

Eight percent only became an unacceptably high barrier because of asset inflation due to a lower interest rate. Currently there is enormous asset inflation in some places due to lower interest rates.

This would correct the asset inflation problem as well. I suspect that in some places prices will decline and recent first time buyers will be ruined or hurt so much financially they will be very hard pressed to recover.

I first bought at a peak and I know it was an enormous set back and the set back buying at today's peak is even larger.