Housing: The Great Ponzi Scheme

A couple years after we bought our house in Upland, California, we decided to refinance. Before deciding, we compared loan rates from Countrywide and Ditech, which at the time had the best websites.

Eventually, I decided to go with Ditech, primarily because something about the Countrywide website left me feeling uncomfortable. It was just a general dislike, nothing specific.

Good thing I trusted my instincts, as you will discover in this New York Times expose of Countrywide. The nation’s largest lender used its sales force to manipulate borrowers into lower-quality, higher fee mortgages, according to the Times.

One of Countrywide’s strategies was to charge huge penalty fees when a buyer tried to refinance and get out of those ridiculous no-interest or low-interest loans, explains the Times. These are the loans where you pay down ZERO principle for the first few years. From the Times:

Consider an example provided by a former mortgage broker. Say that a borrower was persuaded to take on a $1 million adjustable-rate loan that required the person to pay only a tiny fraction of the real interest rate and no principal during the first …. If the loan carried a three-year prepayment penalty requiring the borrower to pay six months’ worth of interest at the much higher reset rate of 3 percentage points over the prevailing market rate, Countrywide would pay the broker a $30,000 commission.

When borrowers tried to reduce their mortgage debt, Countrywide cashed in: prepayment penalties generated significant revenue for the company — $268 million last year, up from $212 million in 2005. When borrowers had difficulty making payments, Countrywide cashed in again: late charges produced even more in 2006 — some $285 million.

The end result here is simple: If the homeowner overextends himself, he has to refinance his home. The lender gets a huge payout in the form of fees. Where does that money come from? The artificial increase in equity, of course.

The homeowner may now have lower payments in the new mortgage, but actually owe more overall, which perpetuates the scheme.

Countrywide also may have approved loans to people who simply couldn’t afford them, reports the Times. Here’s an example:

As recently as July 27, Countrywide’s product list showed that it would lend $500,000 to a borrower rated C-minus, the second-riskiest grade. As long as the loan represented no more than 70 percent of the underlying property’s value, Countrywide would lend to a borrower even if the person had a credit score as low as 500. (The top score is 850.)

The company would lend even if the borrower had been 90 days late on a current mortgage payment twice in the last 12 months, if the borrower had filed for personal bankruptcy protection, or if the borrower had faced foreclosure or default notices on his or her property.

Half a million to a person with a lousy credit rating? Um, something is going on here.

Countrywide is not the sole – just the biggest – operator in this arena. After all, plenty of other companies continue to advertise questionable  mortgages even as it is clear the United States is experiencing its worst housing market since the 1950s, reports two more New York Times stories.

Lenders spent nearly twice as much in the first 6 months of 2007 as in 2006 (see chart with story). Some of the ads are so questionable that Ohio and New York attorneys general are investigating.

Writes the Times:

Consumer advocates say many ads are at best misleading and at worst steer consumers into risky loans with promises of low introductory rates that do not make clear that they could pay significantly more in a few months or years.

“The advertising was a drumbeat to consumers, saying: ‘Don’t worry, you can qualify for a loan. We will approve it,’ ” said Patricia A. McCoy, a law professor at the University of Connecticut who has studied mortgage advertising. “It was push marketing to reach out to these people on the sidelines who have doubts about their ability to pay a mortgage and lure them in.”

Again, why do so many mortgage companies keep pursuing questionable customers?

The other story I mentioned foresees the first “official” drop in median home prices since such records were kept in 1950. The overall drop expected this year is up to 2 percent, but additional drops are expected to last into 2009. (Personally, I think home prices will continue to drop for about 6-10 years.)

The official national numbers, which don’t include mortgages over $417,000, greatly understate the issue. In fact, you would have to assume there was no housing recession in the early 1990s if you believed the federal numbers. Other indexes, such as the Case-Shilling, do a better job of revealing what is happening in the housing market.

The problem with these misleading numbers are comments like this: “For most people, this is not a disaster,” Nigel Gault, an economist with research firm Global Insight, tells the Times. “But it’s enough to cause them to pull back.”

Not a disaster? Read on:

In all, Global Insight expects a decline of 4 percent, or roughly 10 percent in inflation-adjusted terms, between the peak earlier this year and the projected low point in 2009. In California, prices are expected to decline 16 percent — or about 20 percent after taking inflation into account.

Let’s see, if you are in California and own a $500,000, that’s a $100,000 loss. While it may seem tolerable to an economist, what happens when responsible citizen John Smith needs to move from Los Angeles to Tucson for a new job? Will he sell his house for a big loss or will he just say put? What happens to a Baby Boomer who wants to sell his/her home to retire?

To make matters worse, I think predicting a 20 percent loss is highly optimistic. Take a look at this New York Times graphic of what’s happening in major cities around the nation. Clicking on Los Angeles, San Diego, Miami and Las Vegas reveal a much better picture of what is going on.

Compare Los Angeles in the 1990s to today. Certainly the downturn was more than 20 percent while price inflation today is much higher.

Some markets, such as in Las Vegas, home prices skyrocketed at even more obscene rates. Do you want to bet that this housing crash will be less or more intense?

If you look at how the mortgage industry is behaving – becoming ever more frantic for capital to fund loans and then push them on the American public – and couple that with the huge upswing in prices over the last few years, a simple fact is revealed: The American housing market has become nothing more than a gigantic Ponzi scheme.

Here’s the simple definition from Wikipedia: “A Ponzi scheme usually offers abnormally high short-term returns in order to entice new investors. The high returns that a Ponzi scheme advertises (and pays) require an ever-increasing flow of money from investors in order to keep the scheme going.”

What happens when such schemes run out of money to fund it? They are “doomed to collapse because there are little or no underlying earnings from the money received by the promoter.”

Economists will argue that there is a source of underlying earnings: You, the American public. That’s true if homes are affordable. When they’re not, homeowners run out of money and the scheme collapses. And that is what is happening today as we speak.

Comments

[The Mortgage Maker]

"Do you want to bet that this housing crash will be less or more intense?" I think it will be more intense. There is far more debt attached than in the past and the mad call for liquidity is only beginning. We have house in the Northeast selling for 20% below asking price. And a growing number of situations that are upside down.

[brettdl]

Yes, I tend to think this will be the most intense housing crash in our lifetimes.