The Final Mortgage Innovation

Steve Heller
Mar 1, 2004

I've been following recent occurrences in the mortgage market with bemusement. When I got a mortgage, in the olden days of 1998, you actually had to put down 20% if you didn't want to have to buy "private mortgage insurance," which increased your monthly payment. Recently, of course, this old-fashioned requirement has been dropped, "to make homeownership available to more people."

Housing prices have been soaring for the last five years, so the monthly payment may not be affordable to many people even if they don't have to make a down payment. One "solution" to this problem has been around for a while: adjustable-rate mortgages. This reduces the monthly payment at the beginning, while exposing the buyer to the risk of tremendous increases in the payment amount after the initial low rate period is over.

But there are still people who can't afford houses anywhere near where they work, even with adjustable-rate mortgages to "help." So the next round of innovations was unleashed: interest-only mortgages. This reduces the initial monthly payment by about 20% compared to a thirty-year conventional loan. Of course, this "saving" might be considered somewhat expensive, since it means that you still owe as much money on the mortgage after five years as you did at the beginning, but after all the name of the game is "affordability," i.e., the lowest possible initial monthly payment.

However, even this was not enough to keep housing "affordable," given the absurd prices reached in many markets such as California and the Northwest. There, you can easily spend $500,000 to buy a modest home on a small lot 30 minutes from work. We know that everyone has to buy a house, to keep the housing bubble going, but how?

The next step was, according to someone I heard on CNBC a couple of weeks ago, to allow people to devote more than the "traditional" 28% of their income to housing. In fact, I was somewhat surprised to learn that "technology" made it possible for people to have mortgage payments upwards of 40% of their income. But who can argue with technology?

Even this, however, is not enough to guarantee the perpetuation of the bubble. The next stage in the insanity has already been implemented: the "pay option ARM." This loan (issued by Washington Mutual, possibly among others) starts out with a ninety-day introductory period at a very low interest rate, such as 1.75%. After that, the interest rate rises to an "ordinary" adjustable rate such as 5.25%. But here's the good part: the borrower continues paying as though the interest rate were still at the introductory level! The magic here can be explained by the seemingly technical term "negative amortization." What this means, in English, is that you owe more on the mortgage every month rather than less... but it does lower your payments temporarily.

But the fun comes to an end eventually, since the lending institution does not allow you to run up the mortgage amount indefinitely. When you get to 25% above your original loan amount, they require you to actually make a large enough payment to keep the interest from accumulating further. This could put a big crimp in your budget if you had already taken advantage of "technology" by spending 40% of your income on your mortgage payment, since the new payment would probably be about three times the original payment, or 120% of your income. But it does allow you to buy a much more expensive house that you can actually afford, so it has to be considered a success on that basis.
The final solution

I think the institutions offering these loans are pikers. They aren't seeing the big picture.

Here's my solution to the housing crisis: the no-pay mortgage. As with most great ideas, it is very simple. They simply lend you all the money to buy the house, with no foolishness like down payments or the like, allow the interest to accumulate until you sell the house, and then collect their money. What could be simpler?

Let's look at all the advantages of this plan:

1. Very low administrative costs after the initial loan is made. No one has to keep track of payments, amounts owed, or the like.

2. The loan can never become "nonperforming." Since no payments are due, they cannot possibly be late. Therefore, the lending institution does not have to worry about the soundness of the loan.

3. Removal of all concerns about the price of housing. No matter how much the house costs, you can always afford it. Thus, house prices will never go down.
I'm sure the building industry would love this idea, as it guarantees an infinite demand for housing. It will stimulate the economy by providing jobs in construction, and insure that everyone has a house to live in. And since it guarantees that real estate will never go down, the loans entail no risk to the lending institutions.

I guess I should make sure that the Nobel Prize committee has my telephone number...
When do they give out the awards for economics?

INSANE The final mortgage innovation, part 2

Steve Heller
Mar 8, 2004

In our first thrilling installment, I proposed a seemingly miraculous new kind of mortgage: the "no pay" mortgage. This allows the borrower to buy any house he likes, because he never has to pay anything; the lender simply collects the principal and all the accumulated interest at the end of the mortgage period by selling the house. This, of course, simplifies the administration and guarantees that there will never be a nonperforming loan due to nonpayment.

However, some spoilsports have pointed out that the lender is taking on a tiny bit of risk, namely, the risk that the house will not go up in price fast enough to allow the accumulated amount owed to be repaid when the house is sold. You'll be happy to learn that this really isn't a problem, so long as another innovative, forward-looking program is expanded from pilot status to a full-fledged federal program, and a few minor changes are made in its characteristics.

I'm referring to the "Syracuse plan," which allows homebuyers to insure against falling home prices in their neighborhood. Lest you think that I am making this up, it is described on this website (and the pages it refers to).

The basic idea is simplicity itself. You purchase what amounts to a "put option" against the average value of home prices in a particular ZIP code. If that average value goes down, you are paid the difference when you sell your house, even if you actually sell your house for more than the "covered amount." But what makes this really special is two features that one might not expect to find in such a program: first, you can buy the put option to cover more than the current price of the house, and second, you can finance the premium on the option. So what does this mean to us?

It suggests the possibility that you could buy a put option on the price of your house multiplied by whatever factor was necessary to cover all the interest on the "no pay" mortgage, and finance the price of the option itself. Thus, you would have absolutely no outlay of money, and the lenders would be certain of getting their money back at the end of the loan term.

To make this work, we would have to change the existing plan slightly, in addition to expanding it to a nationwide program. The only changes needed would be to allow the "covered amount" to be whatever was
necessary to pay off the mortgage at the end, and to guarantee payment of that amount, regardless of what happened to house prices in the meantime. Then the lenders could be absolutely certain to get their money back, no matter what happened in the interim period.

This also allows us to add another feature, suggested by an alert reader: a home equity line of credit. The buyer of the house would get a checkbook from which he could write checks whenever he needed money for anything. I guess we'd have to start out with some kind of limit, say 50% of the house price, just to satisfy those who believe in putting limits on creativity. Eventually, though, I'm sure the limits would be raised as much as needed to make the homeowner happy. After all, what if his SUV is more than a year old? You can't expect him to drive an old truck, can you?

As you can imagine, all of this would have phenomenal effects on the housing market. A million dollar house would be just as affordable as a $100,000 house, so no one would have to put up with anything less than their "dream home." In fact, a million dollar house would be MORE affordable, because you would get a bigger equity line of credit. The construction industry would be very happy too, as there would be no limit on the number or size of houses that people could buy.

This plan would be self-financing, too, because the unlimited demand for housing would guarantee that house prices would never go down, so the price protection program would never have to pay out anything. Thus, the premiums would represent pure profit to the government!

It has occurred to me that such an exciting plan needs a good acronym, so I've developed one: the "Inimitable Notional Security Advancing New Equity" mortgage plan, or INSANE for short.

Are there any problems with this INSANE plan? Well, maybe a few. But we'll leave those as an exercise for the reader, until next week's concluding installment.
In the meantime, please feel free to email me with your analyses.