I have been following very closely the media's coverage of the Sub-Prime meltdown. I am not denying that there is a melt down or that the mortgage industry is going through MUCH NEEDED change, I'm not even denying that the mortgage industry as a whole shoulders a lot of the blame. What I am trying to figure out is does the media have an agenda to help better protect their advertisers or are they just ignorant about what actually protects the consumer.
On the surface the media does seem to be writing stories to help protect the consumer, but a lot of what they are writing actually puts the consumer at more risk and protects the banks and wall street investors (aka ADVERTISERS). Do they have an agenda to protect their advertisers or do they just not understand risk and risk management?
In the Sunday, April 1st Kansas City Star there was an article by Steven Pearlstein titled "Be smart, first time buyers." He poked fun at the loose guidelines the mortgage community has been living under for the past few years by creating a quiz on loan types that have been offered and whether or not made sense.
Admittedly he was right on about several of the loan types (the liar loan, the option ARM, the teaser loan and the stretch loan) the problem I have is his contention that the piggy back loan that allows a buyer to purchase a home with no money is a bad loan.
He's not totally wrong. If you have someone that hasn't proven they can handle their bills, has to fudge their income, and has absolutely no money to fall back on then buying a home under any loan scenario is not a wise move, but he flatly says 100% financing is bad.
Bad for who? It's potentially bad for the banks making them because the buyer doesn't have any skin in the game, but it's not bad for the buyer. If the buyer has a big down payment the smart move from a risk management standpoint is to keep that money somewhere in a better more efficient investment vehicle.
Let me paint a scenario, a buyer just sold their house and walked with more than $40,000 from that sale and want to buy a $200,000 house- tradition and the media would tell you to put the $40,000 down on the house that's 20% so you avoid that bad old Private Mortgage Insurance- right? Well what they don't realize is this $40,000 is all the money the buyers have. They may have a couple thousand in savings and little to nothing in their retirement accounts. See that doesn't matter to the traditionalists and the media- you've got to put that 20% down if you have it because it's the safest and cheapest way to do it- right?
I say wrong. Let's say they closed on their $200,000 house got their $160,000 loan yesterday and today Mr. loses his job. See he was the primary breadwinner and they never would have qualified on his spouse's income. Their only savings is in the house in equity- how are they going to access that savings?
There are two options- refinance or sell. Refinance: hmm with the sub prime meltdown the easy money is gone so they can't get a loan because he doesn't have a job so they can't get it by refinancing. What about selling? What's the condition of the market? Can they sell it before the bank ends up foreclosing because they can't make their payments? Maybe, but at what cost? They discount the house to say $190,000 and still pays a 6% real estate commission. That's a $21,400 loss right off the top plus what ever interest has accrued in six months. That would have been close to $5,000 plus legal cost and their credit would be severely damaged. They lost between 65% and 70% of their life savings. The bank got their money though didn't they? That's the smart way to buy?
What if instead they did something crazy he financed 100% on the house and got one of those terrible interest only loans only this one was fixed for 7 years and had the interest only feature for 10 years? By doing this their after tax payment was only $100 higher per month, but they had $40,000 in a more liquid investment.
Now he loses his job the day after closing what's different? They aren't worried because they have $40,000 to access if he can't find a job right away. In the previous scenario they probably wouldn't have lasted 6 months before losing their house so what if he found a job in say 8 months which is about average for finding a new job. They could have easily made their payments that would have been about $7,000 or so in after tax payments.
So which way was better? The one where they had to sell their house, they lost more than $26,000 and their credit was all but ruined or the one where they got to keep the house were able to dip into their savings and kept their credit squeaky clean?
Which way was better risk management? Isn't that what we are all doing when we buy a home- managing our risk? That's what your parent's would tell you, your teachers, the bankers, the financial industry, everybody is telling you to manage your risk. The problem is the way they are telling you to manage risk only manages the bank's risk. How smart is that?
But, Kurt what about the extra $100 a month they would have to pay? Let's call that insurance. Pretty cheap since it would take 22 years for that $100 to equal the loss they would have suffered in the scenario put forth. Hey look it's not like we are going to bury that money in the back yard. If you put it into a conservative investment earning an after tax cost of say 6% in 5 years it is worth $53,954, in 10 years it's worth $72,775, in 15 years it's worth $98,163, in 20 years $132,408 in about 24 years you have enough to pay off the house in that account. (This is not an offer or recommendation of any particular investment it is a hypothetical situation to get you to think about things in a different way.)
Or if you couldn't swing that extra $100 per month all your $40,000 needs to earn to subsidize the payment is 3%. Kind of covers all the bases FOR THE CONSUMER doesn't it?
Really Mr. Pearlstein which way is safer for the consumer? The more equity you have in a house the safer the bank is in the situation and the more RISK the buyer is exposed to! When will these media types that are all worried about you the consumer wake up and realize they have been drinking the kool-aid that the banking and investment industry has been feeding them? I am sure that they aren't siding with their advertisers the ones that pay the bills the ones that pay their salaries?
Just something to think about when you are reading, watching or listening to the media.
Until next time,
Kurt
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