CNC Mortgage Blog

In 1999 and 2000 it looked like housing prices were going to keep on going up. In Minnesota housing prices continued to increase through 2006. During these years it seemed like there were not enough houses for all the buyers. When a house came on the market there were multiple offers and frequently houses sold for more than the asking price.

No one ever thought of prices ever coming down. Mortgage lenders were sure that the assets that backed up their loans would appreciate forever so they moved aggressively to lend money. 100% financing was common, so was 103% financing and 106% financing. One bank even offered 125% financing. It was a bit deceptive, it really said 125% of the value of the property up to a maximum of $25,000. Anyway, it was aggressive lending.

Not only was 100% financing available, with seller paid closing costs people could really move into a property with $0 down, and since mortgages are paid in arrears they would even skip a month’s rent.

A lot of people who got zero down loans probably barely qualified for the payments, but under those underwriting standards they qualified. They frequently got a 2/28 ARM. That is an adjustable rate mortgage that is fixed for two years and then adjusts for 28 years. The initial “teaser” was affordable, but in month 25 the rate would adjust close to 5% over the initial rate and could adjust up from there. Most of the customers were not sophisticated enough to understand that this was a teaser rate, they never knew about the adjustment. Others were told that this was a “band-aid loan” that would improve their credit and after two years they would be able to refinance. Others were told that they only qualified for a 2/28, but that after two years they would be able to refinance to a fixed year mortgage. And imagine, in two years, the way property was appreciating, they could not only refinance and pay the new closing costs, they could even take out some of the equity that was growing in the property. With property values going up 10% per year, that was 20% at least that they would make. The borrowers weren’t told that the loans came with a two or three year prepayment penalty, equivalent to 2% of the original loan amount or six months of interest. Some borrowers got a 2/28 mortgage with a 3 year prepayment penalty, so they were almost forced to pay that initial rate adjustment. That meant really that a mortgage with an initial rate of 6% went up to 11% in month 25.

What were the investors told? This mortgage is now at a teaser rate that is close to the normal conventional rate, maybe a little lower. But in 25 months that rate is going to go up 5%. So a mortgage with a rate of 6% now will start paying 11% in month 25 for the next 28 years! The mortgage is backed up by bricks and mortar and not only is it an appreciating asset, surely the proud homeowners will make improvements to the house. So even if the borrowers default, your mortgage is backed up by a solid guarantee. Not only that, if they pay the loan off early, you will receive either 2% of the original loan amount or six months of interest along with your outstanding principal.

So investors in the US were given this sales pitch and bought it. When foreign investors heard about these wonderful mortgage backed securities, backed by houses in the United States, they also wanted to get into the business.

All it took was for houses to stop appreciating and borrowers whose income had remained flat and could not afford the adjusted payments to force the properties into foreclosure.

Just some simple, back of the napkin calculations. So a house that had a price of $194,000 was sold for $200,000 with the seller paying the closing costs. If the homeowner wanted to sell the house in two years they would still have to pay a realtor $12,000 (6%) in commissions. But the property did not appreciate, it probably went down and the owners were upside down, they couldn’t afford the payments on the house and they couldn’t sell the house.

And some investor in Manhattan, or Berlin or London was so happy because his mortgage loan would soon start to yield 11% in dollars.

So the homeowner and his family saw their dreams of homeownership disappear and the investor, who did not want to own real estate was now left with an empty house that would cost him around $50,000 at least to sell again.

Obviously those investors who got into the market highly leveraged have lost all their investment and owe money. But somebody still has some bricks, mortar and land out there so that they don’t have a total loss when they are able to sell the property again, even if it is for less than the loan amount.