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Tim Kern, Talking Sense

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Location: Anderson, IN, United States

Friday, March 16, 2007

Mortgage Meltdown?

Nobody Would Do Such a Thing on Purpose!

The smart economics of writing second-tier mortgages

Copyright ©2007 by Tim Kern. All rights reserved.

While listening to one of many radio experts, on another of the Dow’s down days in March, the host asked an expert about the perceived raft of mortgage defaults, estimated at 5%, among so-called second-tier mortgage holders. The guest started to explain that, “Well, no one would do such a thing on purpose,” hinting that such action would be obvious economic suicide.

I wondered. After thinking about this for a while, I arrived at the economists’ answer: “It depends.”

If, as seems to be the case through some empirical telephone-calling, these “second-tier” buyers were moving into predominantly in lower-cost homes, the dollar values of the defaults are low, compared to the dollar values of the better-performing mortgages on the higher priced homes, and on the remaining 95% of the second-tier homes that are performing.

Why would any lender deliberately take over-market risk? Clearly, that’s the case, if lenders (and their investors) are worried. If the returns correlated to the risks, there would be no concern.

So, why take these risks? That depends. The first unknown is the price elasticity of homes, and that would require separate evaluations of higher-priced first homes and second homes (likelier to be purchased by safer borrowers), as well as mid-market homes (one would expect a mix, tending to safer borrowers), and entry-level homes (where one would suppose the most-risky borrowers would live).

What would have to happen, to make loaning relatively small amounts of money to somewhat-riskier groups attractive? Call it a loss-leader for the big mortgage houses. If setting oneself up to lose on 5% of small loans enabled one to collect on 95% of small loans, while pocketing closing costs up front and recovering the homes that, at the time of the loan, may have had 10% equity, then the risk may be worth the stimulation to that market alone.

Further, if easier money allowed purchases of entry-level homes by the marginal borrowers, it would encourage solider borrowers to move out of those homes and up a notch in their home market – equal numbers of bigger loans, with more equity, to better credit risks. With 95% of the entry loans’ performing and more mortgages (with bigger fees) being written on larger homes (backed by better-credit borrowers and higher equity in the homes), the seed money that the 5% are reneging on seems like small potatoes. It’s even smaller, when the higher-dollar, higher-credit-rating loans are considered, in the next step of up-market homes.

Could a case be made for seeding the housing market with a little easy money, money that is quickly recovered in fees, somewhat recovered in sales of repossessions, and totally covered by the performing 95%?

Could a case be made for those losses’ encouraging upmarket loan activity, with higher equity, higher closing costs, higher payments, and a higher ratio of larger, performing loans?

Well, then, it depends on who’s getting worried, and who’s getting flushed out of the market. Gee – is it easier to sell a lower-priced home, or a high-priced one? Is it easier to rent a lower-priced home or a high-priced one? If the debtor in the low-priced home defaults on the mortgage, the lender can repossess the home, pay off any existing equity, and rent the home. There should be plenty of prospective tenants – those people, former renters-turned-home-buyers, are looking to get out of their murderous mortgages and property taxes!

It’s not a gravy train for the lenders, but it’s a long way from disaster, even at this (the worst) level; and the losses there are dwarfed by the performing big-ticket loans that these seedlings made possible.

Oh – and speaking of those property taxes: because the home’s market price likely has fallen, the new owner of the home will likely face lower taxes than the one who defaulted, along with lower mortgage payments.