NO TIME FOR OSTRICHES

It was a sad day Monday (9/29) when the U.S. House of Representatives failed to approve a fix for the liquidity crisis in the financial markets, spawned by the burst in the housing bubble. We can only hope our political “leaders” eventually see the light and find a path forward. Most of us don’t have a good handle – and after yesterday's vote, it's unclear if anyone does yet – of the nature and scope of the credit problem. So here’s a quick, understandable overview of the issue:

- First, the vast majority of people are not in trouble. About 3% of total households are behind on their mortgage payments (33% of households have no mortgage at all), and about 1% eventually go through foreclosure.

- Most homes are not mortgaged over their true value. Nationwide, homeowners have on average a 71% LTV mortgage on their property (2006).

- The foreclosure level of today is very similar to the foreclosure level in 1986 from a national perspective. But Minnesota did better that time around.

- A major difference today is about how financial firms packaged and sold mortgage securities to investors - often leveraging the value many times over (see more below).

- Fewer loans with no mortgage insurance. As consumers opted for loans that avoided PMI, it increased the lender's exposure.

Government asset reporting, as a result of the Enron fiasco (also referred to as Sarbanes-Oxley), requires a a company's balance sheet to show the true reflection of an asset's value. This means that the 65% loan-to-value (LTV) mortgage that a financial institution (or Fannie Mae/Freddie Mac) issued and now holds in their portfolio is reported as a “bad” investment because the value of the asset has dropped. As an example, say I take out a mortgage with 5% down and am issued a 95% LTV mortgage on a $200,000 home. This means the mortgage is $190,000, but it’s protected by an asset valued at $200,000. I make all of my payments on time for 3 years. However, in the last 3-years the home's value has dropped by 10% to $180,000. Now, the bank /financial institution/Fannie/Freddie must report the lower asset value on their books - which means they do not have enough asset value in the home to cover their loan. Multiply this scenario by hundreds of thousands of loans and you can see how massive this problem becomes.

Remember the leverage issue mentioned above? The financial institution now must report, and investors will see, that the assets protecting their securities are not sufficient protection to cover their investment. Keep in mind; I’m still paying my mortgage on time - as are the vast majority of people with a mortgage. Yet, if the LTV is upside down because the asset value has dropped, the lender is in trouble and in need of funds to shore-up his balance sheet for the investors who purchased the securities backed by those mortgages.

In the past, private mortgage insurance (PMI) was part of the protection against declining asset values. But because so many newer loans were issued without PMI, the lender's exposure to downside risk is much greater this time around.

“Liar loans" and other poor lending practices are a piece of the problem and demonstrate clearly how greed (at all levels - consumer, lender, appraisers and advisors) overwhelmed basic reasonableness. This also happened in the mid-1980's with the FHA/VA "fog a mirror" assumable mortgages. Credit tightening and ensuring that consumers have some skin-in-the-game will help eliminate this in the future.

But over the next two years, problem loans will primarily be the result of 2nd and 3rd mortgages, which are tied to the LIBOR index (the London Inter-Bank Offered Rate, which is the interest rate that banks charge each other for loans). Some of these mortgage are sub-prime, many are prime.

The LIBOR went up 50% last week and it’s the index used to determine the ARM interest rate. Many of these are held by middle-class folks who spent their home equity taking out 2nd & 3rd mortgages. The problem they face is LTV when they go to refinance out of the bad ARM product. For example: I have an 80% 1st mortgage and a 20% 2nd mortgage taken out in 2005 to buy a boat and pay off credit cards. The total of the 2 loans is $200,000 on January 1, 2005. I make all payments on time. In October, my 2nd mortgage - which is an ARM - has a payment increase of 25% because of the LIBOR index. I cannot afford the additional payment because of my job situation, health insurance, etc. so I go to the bank to refinance. Because the value of my property has fallen since I took out the mortgages, I can no longer borrow an amount equal to the 1st and 2nd mortgages on the house. You can see the hole that I’ve dug for myself - whether I used a sub-prime or "liar-loan" - as the asset value drops my options are significantly reduced and now I must make some very difficult choices.

It’s important to remember that for many years our homes were considered hard, ill-liquid assets. People rarely borrowed against their home, except for major repairs or emergencies, and the growth in their equity stake made upward movement possible. Over time, Wall Street’s financial geniuses invented derivative products and convinced people that homes should be a liquid asset that they individually leveraged in order to increase their standard of living. That strategy worked for a while, until people in mass began living far beyond their means. Often we find that the fundamental principals of the past are concrete solutions for the future.

(Portions of this article courtesy of the Minneapolis Association of Realtors.)