By Peter G. Miller
It's gotten a lot harder to get a mortgage we're told, something routinely blamed on Wall Street Reform. If only we had less regulation, goes the cry, then lenders could surely make more home loans.
In fact, numbers from the Federal Reserve tell a different story. Residential real estate debt today is actually higher than in 2006 when home prices were soaring. Not only that, loan-to-value ratios have increased substantially, hardly evidence of a credit crunch.
The Federal Reserve says U.S. households had real estate worth $22.687 trillion in 2006, a number that fell to $16.370 trillion at the end of 2010 — a loss of $6.3 trillion during the past five years.
Meanwhile, what about mortgage lending? Surely if asset values have declined lenders must be lending less? That, after all, is the common wisdom repeated almost daily.
Guess what? The Federal Reserve says home mortgage financing has increased — from $9.865 trillion in 2006 to $10.070 trillion in the fourth quarter of 2010.
Loan-To-Value
A key measure used by lenders to determine if they'll make a mortgage is the loan-to-value ratio. Lenders would like the borrower to put down 20 percent of the purchase price, meaning they will extend mortgages with an 80 percent loan-to-value (LTV) ratio. For those without 20 percent down, they can put down less if they also have third-party backing, say private mortgage insurance or insurance through the FHA or VA.
In 2006 the national residential LTV — the ratio of debt to equity — was 43.48 percent. At the end of 2010 the national LTV increased to 61.51 percent.
So what do these numbers tell us?
1. Households now have more debt and less equity than at the height of the boom market. (RealtyTrac has a system where you can find the estimated equity for homes facing foreclosure based on local market prices.)
2. Lenders continue to make mortgages. That has to be the case otherwise outstanding real estate debt would decline as homeowners move.
3. With less equity the opportunity to have a cash-out refinancing has fallen substantially in many markets.
What About Lender Risk?
If the national LTV has increased from 43.48 percent to 61.51 percent then lender risk is objectively greater than it was during the height of the real estate boom.
Or is it?
By the numbers, yes, absolutely, lenders have more real estate risk. But that's not the whole story.
The reality is that lenders are now making better loans — and better loans mean less risk.
Since August 2010 when Wall Street Reform was passed, it's become virtually impossible to get a mortgage with a no-doc loan application. Today, everything is verified, meaning lenders have a better idea of borrower finances and the risk they represent.
No less important, you can't get an option ARM. Interest-only financing is rare. Even the mundane ARM is an endangered species — borrowers are going for fixed-rate loans and the certainty they represent.
“ARMs today are financing just 7 percent of new home-purchase loans,” said Frank Nothaft, Freddie Mac's vice president and chief economist. “In June 2004, ARMs hit a peak share of 40 percent of the home-purchase market but by early 2009 that share had fallen to just 3 percent.”
Nothaft said ARMs might represent 9 percent of the mortgage marketplace for 2011.
Interest Rates & Inflation
Despite higher levels of mortgage debt, interest rates remain near record lows. One reason for low rates is the simple matter of cash: The world is awash in dollars, and that cash has to go somewhere.
According to Bain & Company, private equity funds by themselves are holding cash worth $1.5 trillion. Separately, research from Howard Silverblatt with Standard & Poors estimates that U.S. companies have some $1.9 trillion in cash on hand.
Right now the mechanics of the marketplace — supply and demand — hold down rates but that's not a guarantee of low interest levels in the future. A major concern has to be the possibility of inflation.
With inflation cash money buys less. The bicycle that used to sell for $100 now costs $120. It's the same bicycle, what's changed is the buying power of money.
“As of January,” said the Wall Street Journal, “the average interest rate paid on relatively safe vehicles such as short-term savings accounts, time deposits and money-market funds stood at only 0.24%. That's one-tenth the level of late 2007 and the lowest on records dating back to 1959. Such depressed rates don't come close to compensating for inflation, which was running at an annualized rate of 5.6% in the three months ended February.” (See: Fed's Low Interest Rates Crack Retirees' Nest Eggs, April 4, 2011.)
With inflation, lenders want more interest to preserve the buying power of their dollars. Higher food prices, gas bills, commodity costs and government deficits all suggest that inflation looms.
Alternatively, the Federal Reserve has allowed banks to borrow at rates which approach zero percent.
The catch is that prices are being forced up in part by events beyond our borders, events which cannot be controlled by the Federal Reserve. People in developing nations want their share of the good life and now compete increasingly for such commodities as oil and grain. Instability in the Middle East and elsewhere also pushes prices higher.
“If inflation does begin to impact the marketplace then mortgage rates will inevitably rise,” said James J. Saccacio, chief executive officer of RealtyTrac. “If you have fixed-rate financing your monthly costs for principal and interest will remain the same because you've locked in the rate — essentially you have a hedge against inflation.
“For those with ARMs the story will be different: monthly costs will increase and borrowers will face higher costs. Worse, marginal ARM borrowers may face foreclosure if costs soar.”
As an example, a $150,000 mortgage at 5 percent costs $805 per month for principal and interest. Raise the rate to 9 percent — not the highest rate allowed with most ARM contracts — and the monthly cost increases to $1,207. Combine a higher monthly cost with unemployment or fewer hours and many households will be in trouble.
Foreclosures & Cash
The National Association of Realtors reports that 59 percent of all investment purchases in 2010 were for cash, and that foreclosure or trustee sales accounted for 17 percent of investment purchases.
These numbers suggest that a very large number of foreclosures are being bought mortgage-free, a situation with pros and cons.
The big pro with all-cash purchases is that there are no mortgage worries, no need to qualify with a lender and no loan costs at closing. Cash buyers may be able to obtain lower prices because they have the assured ability to close deals. No less important, if a property is vacant the carrying expenses are a minimal issue without monthly mortgage payments.
The con is that without a mortgage there's no interest write-off, a way to reduce borrowing costs.
A second negative goes like this: Maybe some investors who can pay all cash shouldn't. Maybe they should instead finance with a fixed-rate mortgage.
The reason to get a fixed-rate loan relates to inflation: If inflation hits then cash costs will rise throughout the economy. One likely increase, among others, will be rent. Another is the nominal price of housing. Selected properties in some markets which today are underwater may magically rise to the surface in cash terms should inflation return.
Cash investors with fixed-rate loans now have flexibility. They can pay off the financing — remember these are folks who can purchase outright with a check — or they can simply make their fixed monthly payments and watch as the buying power of the lender's principal erodes.
In effect, a fixed-rate loan can be seen as a guard against inflation — and as a reason to consider financing foreclosures rather than paying cash.
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