Tuesday, September 14, 2010

Happy Anniversary

It seems inconceivable to me that tomorrow will mark two years since the collapse of Lehman Brothers.  I am sure that no one working in real estate or finance can forget October of 2008, when the world actually appeared to be turning in super slow motion.  Buyers who were ready to buy walked away from the transactions; homeowners who had home improvement loans approved decided not to go forward with their loans because they were afraid of what the markets were doing.

In some ways it seems like yesterday, and in others it could have been 10 years ago.  So much has happened since the fall of 2008--we have seen Fannie Mae and Freddie Mac go into conservatorship costing taxpayers billions of dollars and counting.  We have seen battles over health care and financial reform and huge changes to mortgage lending.

The collapse of Wall Street giants such as Lehman Brothers, Merrill Lynch and Bear Stearns is repeatedly blamed on "toxic assets"--bad investments in the mortgage markets.  "Toxic assets" sounds so sexy--so much better than "really stupid loans anybody with sense would know could not possibly work."  After all, Lehman Brothers owned Aurora Home Loans which was originating 100% investment property mortgages.  Through their program, a buyer could purchase single family residences as rental properties with no down payment.  Since statistically, borrowers who get into trouble will tend to allow their investment properties to go into foreclosure before they allow their primary residences to be foreclosed on, this type of loan carried an extremely high degree of risk.  For the real estate investor who had watched one too many infomercials, the ability to purchase up to 10 single family homes as rental properties was a huge temptation.  After all, most of them had been led to believe once they got these properties, the money would come rolling in and they could spend their days on a yacht somewhere in the South Pacific.  However, since  many of these investors were largely overextended, all they needed was a couple of months of vacancy in some of these houses to not be able to meet the mortgage obligations, and soon they were in default.  Multiply that problem by a lot of real estate investors, and soon the companies that owned these mortgages were bankrupt.

We have heard a lot over the last two to three years about responsible lending, and today we would decry these practices I just described as completely irresponsible.  And while I would like to point out that the loans themselves were irresponsible, not all of the borrowers were.  I had an investor who purchased 10 properties between 2004 and 2008.  At least one of those was purchased using 100% financing--others were purchased with 5% to 10% down.  When the market began to struggle, my borrower paid  cash toward the mortgages of the properties to make sure that he had some equity and refinanced his high interest rate, low down payment purchase mortgages into much lower interest rate loans that would allow him to cash flow.  Last fall, we took advantage of dropping rates to refinance 4 of the homes into better terms.  So not every borrower defaulted, although certainly many did. 

I wonder, though, if our practices today are truly more responsible, or just different.  Even though we have heard a lot about the importance of down payments in discouraging defaults,  the government is still providing 100% financing for primary residences through USDA and VA loans.  In fact, after a long hiatus, USDA funding became available again last week.  We are worried about homeowners going into foreclosure, but the average homeowner in foreclosure is now living free in their own home without making a payment for over 460 days.  Banks prefer to allow the homeowner to stay rather than to have the house vacant and open to vandalism, so they allow borrowers to stay in the house for over a year.  No one wants to see Americans foreclosed on, but does rewarding not making the house payment by allowing the homeowner to live there free encourage responsible behavior?  Does encouraging borrowers to ask their mortgage company for a 10% reduction in principle so that they can refinance into an FHA loan encourage responsible behavior on the part of the homeowner?  Does paying a mortgage for up to 2 years for a person who has lost his job and is drawing unemployment encourage the homeowner to sit in a house that he needs to sell rather than moving to a new area where he could get a job?

If we accept the premise that the "Great Recession" was caused by greed and irresponsibility on the part of banks and brokers who wanted make loans without consequences and borrowers who wanted to live in homes they could not afford or build real estate empires with no cash investment, then we should also recognize that rewarding irresponsibility and greed on an individual level is as great a mistake as rewarding it on a corporate level.  If handouts are a mistake on Wall Street, they are an equal mistake on Main Street.  As a society, we should not be "too big to fail," or "too small to fail."  We should be allowed to fail, period.  And from those failures, we should be allowed to learn. 

When Thomas Edison was accused of failing at 2000 attempts to invent the light bulb, he famously replied that he had never failed; he had only discovered 2000 ways not to make a light bulb.  And there was truth to that--the light bulbs in all of our homes and offices bear testimony to the fact that he learned enough from each of his mistakes to finally succeed.  But what if there had been some sort of "inventor bailout program" to protect Edison from his mistakes so that they were not so readily apparent?  What if his wrong turns and poor choices had been taxpayer subsidized?  Would he have been motivated to keep trying until he got it right?

Will the homeowner sitting in their home for 460 days without making a payment really learn to live within their means and consider the monthly payment and terms carefully when looking at housing options, or will they just have learned that it doesn't matter whether they can afford the house or not, because somebody is going to allow them to live in it anyway? Maybe the only thing that other home buyers will have learned is that it does not matter whether real estate values are up or down, because the government will come to their rescue and get their principle balance reduced.

As we near the two year anniversary of the failure of Lehman Brothers, Fannie Mae, Freddie Mac and other corporate titans, we should not just be looking back.  We should be looking forward at where our present actions are going to take us two years from now.

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