Market Update – June 17th

Hi All,


It’s been a busy week.  I presented to the Pension Review Board on Monday and the Texas County Investment Officers on Wednesday in Corpus Christi.  I actually spent Tuesday through Thursday in Corpus because one of my children came with me.  It was three days of swimming, bumper boats, go-carts, miniature golf, the USS Lexington and the Texas State Aquarium.  It was loads of fun.  It confirmed two things: (1) one-on-one time is really special; and (2) I’m old.


I’ve been doing a lot of speaking recently and one of the things I’ve realized is that the “single issue” blogs are really helpful in putting my presentations together.  I say this all the time, but I hope to write more single-issue blogs.  Today, I’m doing it out of necessity – I just got home, I want to watch game seven (I’m hoping both teams lose) and I’m exhausted.


One quick basketball comment for those of you who have watched the series.  Ron Artest reminds me of myself when I was single and hanging out in bars.  He’s never seen a shot that he didn’t want to take and most shots are out of his range.  (The key difference is that every so often, Artest gets lucky.)


Today, I’m thinking about an important piece that was in the WSJ, “Rethinking Part of the American Dream.”  It was written by David Wessel.  He argues that our approach to home ownership has failed.  In addition, I read a couple of related articles by Daniel Indiviglio (a former Forbes writer and former banker who now writes for The Atlantic).   I’m going to touch upon several issues below, including:

1. shorter mortgages
2. prepayment penalties
3. mortgage interest deductibility
4. non-recourse loans

Wessel argues that the US has overemphasized the virtues of home ownership.  In addition, we’ve promoted thirty-year mortgages (and this has created the need for Fannie and Freddie to guarantee payments).  He’s also bothered by the fact that we have no prepayment penalties and this results in homeowners having an option to refinance.


Home ownership has been promoted as accomplishing several goals:

1. promoting social stability
2. providing a hedge against inflation
3. a way to save for retirement

Wessel argues that we have mistakenly measured the success of our “home ownership programs” by the home ownership rate.  In the 1940s, this was 40%.  In the 1960s, it was 60%.  In the 1990s, it reached 65% and by 2004 it reached 69.4%.  (Now, it’s back down to 67.2%.)  But, Wessel argues that a better way to judge the success of the home-financing system is to analyze whether the system can absorb shocks.  Of course, if that is our metric, our system is a complete failure.


Wessel advocates for shorter mortgages.  He explains that mortgages used to be 3 – 5 years.  I think that if we start talking about ten year mortgages, this has pros and cons.  It would force people to buy houses that are more within their price range and many people would end up better off financially (in effect, they would be forced to “save” more).  It may result in larger downpayments.  On the downside, we’d be mismatching the duration of the asset and the liability (an issue that has caused many problems throughout this crisis) and it could result in refinancing risk.


I disagree with Wessel’s complaint that we should have prepayment penalties on our mortgages.  The ability to refinance if rates go down is what lets me pull the trigger on a home purchase when rates are high.  Lenders know that I have this right and they (hopefully) price this into the rate I pay.  I’m more bothered by the fact that pre-payment penalties existed in approximately 70% of subprime mortgages and virtually no prime mortgages.  The only distinction is that it’s easier to put these penalties on the least educated members of society.  If the fear is refinancing when rates are low, prime borrowers are equally likely to do this.


In an older article, Indiviglio asks whether we should be promoting home ownership through the use of the interest rate deductibility of mortgages.  I might ask this differently: do we want to set up a system where the common man does leveraged buyouts?  Ultimately, that’s the system we’ve set up with homes.  You put a little money down, you use other people’s money, you refinance if rates go down and you walk away if the asset loses value.


My opinion is that while people always talk about interest deductibility, there’s another issue that is equally important in causing problems with home ownership.  They are the various laws that protect homebuyers – whether they are “non-recourse” laws in some states or laws in other states which make it easier for a lender to foreclose on property if the lender simply takes the property.


The bottom line is that we’ve set up our system so that homebuyers have an option.  As I’ve said a million times in class, an option is “the right, but not the obligation to do something.”  Is that a good system…where a homebuyer has the option to pay his loan, but not the obligation?


At the same time, I believe that a bankruptcy judge should have the right to restructure real estate debt.  (There’s a big difference between letting an experienced bankruptcy judge make a decision, as opposed to giving homebuyers the right to simply walk away.)  Maybe lenders would also make better decisions if they knew that a bankruptcy judge would examine not only a borrower’s ability to pay, but the appropriateness of the loan that a lender put them in.


I’ll end by saying that there are so many other issues to think about with the mortgage market.  We could argue about the role (and regulation) of mortgage brokers, the principal / agency issue caused by securitization of loans, whether we should allow homeowners to lower their taxes when we have a huge deficit, etc.   But, I can’t write about all of them right now.  The Lakers just won and I’m being forced to listen to hero worship of Kobe Bryant.  I need to go throw up.


One last thought about the game.  There’s one guy crying.  It’s Gasol.  It’s a sport.  You’re playing with men.  Go get some Kleenex out of your purse and get control of yourself.
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