Over the past two years, we have seen a pervasive and spreading economic turmoil that began with the Attack of the NINJAS—loans made in spite of No Income and No Job or Assets. It appears that the consequence of this turmoil has developed into a desire to hibernate. We are reacting to the NINJA attack like bears in winter—going into a protective cave of inaction. How did this all come about?
Federal encouragement of homeownership has a long history that goes back to at least World War II. In 1994, President Bill Clinton set a goal of achieving a homeownership rate of 67.5% by the year 2000. Then in 2002, President George W. Bush challenged the housing industry to create 5.5 million new minority homeowners by 2010. HUD was tasked with researching the major causes of racial and income gaps in homeownership to understand the barriers to minority participation. The conclusions of HUD’s Office of Policy Development and Research (PD&R) were hardly surprising. They reported that conditions affecting socioeconomic standing are not generally addressed in housing policy. Further, they determined that housing prices, discrimination, low wealth and income, a poor credit history, and not having required documentation can all deter minorities and immigrants from owning homes. The housing industry was subsequently encouraged to find solutions to these issues.
By 2004, homeownership rates had risen to an all time high of 69%. Minority ownership rates were still at only 51%, but they had grown faster than had rates for white Americans. In 2007, an issue of Cityscape (PD&Rs Journal) praised the strides made on mortgage rates and financing alternatives that had contributed to increasing minority homeownership. The response to national policy had been instrumental in narrowing the racial and income gaps in homeownership by offering greater flexibility in industry underwriting guidelines and affordable mortgage products. As late as this 2007 issue, well into the current downturn, the Journal was encouraging housing and finance industry groups to “pursue innovative ways of achieving even greater progress.”
Let’s discuss these ”innovative ways.” Creative loan options were created to enable first-time and low-income borrowers, who have limited wealth, to enter the market. Adjustable rate mortgages were not new, having been authorized as long ago as 1982 by the Garn-St.Germain Depository Institutions Act, which was intended to revitalize the housing industry and deregulate Savings and Loans. These institutions were finding that they could not attract funds from investors for locked-in long-term fixed-rate mortgages (30 year loans). The adjustable-rate mortgage was established so that the mortgage interest rate could be increased on a pre-determined schedule, providing the profitability needed to attract capital. The interest rate risk was in effect shifted from the investor to the borrower.
With the push to increase homeownership, ARM’s began to mutate into Option ARM’s and Hybrid ARM’s. These loans allowed borrowers to qualify at lower payments, and, in the process, they increased the pool of buyers. In some cases, the starting payments were below even the initial interest amount, creating negative amortization in which unpaid interest is added to principal balance. The peak volume of ARM’s and the sharply decreased underwriting standards occurred in late 2005 and 2006. As it became easier to qualify for loans and payments became (artificially) low, property values increased. Borrowers competed in bidding up property prices. As prices ballooned, speculators entered the market and “flipping” became a household word. Some homeowners became speculators, using their homes as ATM machines, pulling out equity and fueling the consumer/retail markets, or using equity to buy second homes or investment properties.
Decreased underwriting standards have been reflected in “no-doc” or “low-doc” loans, where the borrowers “stated” their income without verification. Those loans may have a place for the self-employed or those who cannot document their true income (we highlight the word “true”). However, during the housing frenzy these loans came to be called “liar loans,” as 3.2 million borrowers used them for home purchases. It is precisely these mutant loans that we call NINJA loans, as they were often associated with No Income and No Job or Assets. According to NAR, 70.5% of all sub-prime loans originated after 2005, and they constitute 40.5% of foreclosures.
One of the terms of these loans is that at the end of two years, or when an increasing loan principal exceeds 115% of the original loan amount, the loans will re-set to generally higher interest rates and often dramatically increased payment amounts, which for some owners has been far above their ability to pay. These alternative mortgages fueled the real estate boom, but the boom was dependent on the continuing escalation of property values. If instead, property values began to decline, a decline now compounded by negative amortization causing loan amounts to exceed equity, borrowers would find that their properties could not be refinanced or sold. Pre-payment penalties added to the problem. This is exactly what happened when the housing bubble burst.
So, where are we today? By 2005 these loans started resetting. Borrowers who had low “teaser” payments were faced with making fully indexed payments based on increased interest rates. At the top of the market, borrowers were able to sell or refinance their homes, but soon housing values were in decline. Many sellers then found that they owed more than the market value of their homes. They discovered that they could not refinance into fixed-rate products, and that lenders were not yet willing to consider loan modifications to lower the resetting interest rates. Adding to the complication, many loans had been bundled into Mortgage Backed Securities (MBS) and sold, so there was no “lender” to renegotiate with.
Foreclosures became a reality. At the beginning of 2007 (note that this is two years after the peak of ARM loans), foreclosures were 5.4% of resale activity. By the second quarter of 2008, that figure had increased to 40%. Even more alarming is the data released by the Federal Reserve Bank of New York, which indicates that the volume of resets will reach $80 billion in the second half of 2008—up from $55.5 billion in the first half of the year. If loans cannot be modified to assist borrowers, and home values are below loan amounts, we will see many more short sales, foreclosures, and deeply discounted REO’s.
For neighbors of properties in default, there is often a ripple effect, as they see their property values also lowered. Declining property values are even influencing decisions of some solvent property owners, borrowers who could make payments but choose to default on their loans and walk away from properties when they find that their loan balances exceed their home values. Some lenders refer to this as “jingle mail” where the borrower just sends the keys in an envelope with a good-bye note.
It is now apparent that the underlying causes of the housing bubble were low interest rates, lax underwriting standards, and the speculative fever that continued until the rapid increases in valuations become unsustainable. According to Robert Shiller in his book “Irrational Exuberance,” the end of the real estate boom was predictable when median prices reached six to nine times the median income. Over the past decade, the national average of housing values rose 88% (higher in California) according to Robert Brown, professor of economics at California State University.
The current downturn is having a broad effect on society. Some minority and first-time buyers are losing their homes, and even the often-meager assets they once held. But the effect is much broader. For example, many Boomers who relied on home equity as a retirement vehicle are seeing their wealth reduced. The credit crisis that has developed is making recovery difficult. Would-be buyers of distress properties are often unable to get loans, and job creation has been slowed as the credit shortage spreads to business entities. The full impact of the housing and credit crises is yet to be determined, but the effects on the generational and ethnic mix of Americans will clearly be substantial.