AIG is just one company involved in this financial turmoil that we have found ourselves in. The way to stabilize the financial markets and loosen up credit markets is to stabilize the value of the assets that are in turmoil. Those assets happen to be mortgage-backed securities. What asset is securitized by a conventional mortgage? A house: a tangible thing that has value in use and value in exchange. If plummeting home prices are the root of the problem, why are there not more funds dedicated to stabilizing home prices? Sliding prices are the reason why we have foreclosures rampant. Many people are walking away from their homes because the mortgage amount on their home, in some cases, may be two times what the house is actually worth. When they walk away, the lender forecloses on the collateralized asset and puts it on the market for sale for the current value or less. This phenomenon has built an unprecedented balloon in inventory that further depresses prices and causes more homeowners to walk away.
In order to stabilize home prices, we need to stimulate demand and discourage increase in supply. Decreasing inventory will involve staving off foreclosures. This can be achieved through facilitating loan modifications. Essentially, a loan modification allows a homeowner who wishes to stay in their home to recast their existing mortgage balance to reflect the current market value of their home. Although the bank loses money, it avoids a much worse outcome: foreclosure. The latter outcome can cost the bank tens of thousands of dollars in taxes, legal fees, and lost interest income. In fact, in normal market conditions, the loss absorbed by the bank for a foreclosure is between 30% and 40% of the principal value. After all is said and done, the bank still has to liquidate the house at the current depressed market value. Loan mod is proven to be the less expensive alternative. As an incentive for facilitating the loan mod, the Treasury guarantees the fulfillment of the mortgage.
Having these modified loans guaranteed by the faith of the US Treasury will provide the banks with more liquidity. In other words, a Treasury backed mortgage security is much easier to sell on the secondary market than one that is not. For instance, if a financial institution needs to liquidate a mortgage backed asset to satisfy a short-term liability, it will be able to. This, of course, is only effective at stemming foreclosure if the Federal government dedicates more than it already has. What has to be encouraged on the banking side is confidence, not writing blank checks.
One may object, “How will loan modifications work if real estate values keep dropping? In other words, if real estate values drop even more after a modification, won’t the homeowner still be tempted to walk away?” This is a valid objection. However, recent statistics suggest that we are near a bottom in real estate values nationwide. According to an article in Smart Money:
“In October 2005, near the peak of the boom, the median sales price for a U.S. home reached 7.3 times per capita income; by this May it had fallen to 5.7, in line with historical norms.” Smart Money 10/17/08
Assuming that we are near a bottom, we need to do what we can to avoid a devastating overcorrection.
Now that I have mentioned the supply side, I will discuss methods of stimulating demand. One resource that must be tapped in this regard is the first time homebuyer or the homebuyer who does not own a home. This class of buyers will better help sop up excess inventory than other homebuyer classifications. After all, people moving from one house to another cancel out the supply demand dynamic in this scenario. We must encourage new buyers to enter this market. Recently, FHA revised their minimum down payment from 2.25% up to 3.5% effective January 2009. Although a 1.25% increase does not seem like much to the average person, it could mean the difference between homeownership and years of continued renting for a first time homebuyer who is sufficient on income but light on cash. Furthermore, even SONYMA, one of the best programs for first time homebuyers in NY has bumped their interest rates from 6% up to 7% and have cut their closing cost assistance in half. Do these actions positively affect the demand side of our distressed real estate market?
First time homebuyers and the like are the lifeblood of a healthy real estate market. The first timer buys a house from a family that usually ends up upgrading to a more expensive home, so on and so forth. In other words, this class of consumer creates the tide that raises all ships. Additionally, the average homebuyer in this cascading chain ends up spending money on many products and services related to the move. If fact, statistics suggest between 17% and 20% of the equivalent home value is spent on these products and services. Do you think that this may help the overall economy too? We are in a CONSUMER LED RECESSION, aren’t we? If this is correct, why isn’t there more being done to reflect their importance to stabilizing real estate values? Yes, a $7500 tax incentive is helpful, but if we are to stimulate demand more effectively, we need to have a multifaceted approach. Instead of writing checks to money center banks so that they can afford to buy their competitors, maybe the Treasury should buy down interest rates for first time homebuyers and renters to encourage them to come into the marketplace.
Please let me know what you, the reader, thinks about this issue especially how it might pertain to real estate in Rochester, NY.
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