When we look at the so-called subprime mortgage crisis – if we look at it deeply enough – what we see suggests a difficult principle that we might call the “true cost” of debt.
Let’s say that the “true cost,” for lack of a better term, is today’s real price for borrowing money at a fixed rate, with no bells and whistles and shortcuts written into the loan. Thus, if the markets are pricing, say, the ten-year Treasury note at about 3.8% and demanding a 2% spread over that if fixed mortgages are to be acceptable to investors, then about 5.8% is the moment’s true cost of financing a home purchase.
Trouble is, we often reach the point where 2% over the 10-year note isn’t affordable for a great many buyers, so we – viewing their problem with compassion, and with a desire to make further origination fees – develop loan programs that, one way or another, fudge on the “true cost” principle. (We also have to deal with hikes to the 2% spread when investors shun fixed-rate mortgages.) The early VA and FHA loans, writing in the value of government guarantees, seemed to lower the “true cost” for borrowers. The early adjustable rate mortgages were first invented because there was no way borrowers could afford the true cost in the early 1980’s (when a fixed-rate loan bore an interest rate of about 18%).
We developed loans of temporary expedience, based on the reasonable idea that interest rates would come down some day. For example, I once had a loan whose effective rate (far from the true cost) was 13%. That was the interest rate my monthly payments were based on. But the true cost at the time, as I mentioned, was about 18% – so the unpaid interest (“negative amortization,” a term only its mommy could love) was folded back into the loan, which grew rather than being paid down.
There isn’t room here to trace the history of the many loan programs that we’ve developed with the specific intention of overriding the “true cost” principle somehow and allowing a borrower to afford a loan – at least temporarily – but readers will realize that this was indeed the way most subprime programs operated.
The conundrum that I see before us now is simple… and we may have to come back to it repeatedly as we follow what is and is not working in today’s loan market. Specifically: what do we have if a government program alters an existing loan to give a borrower, temporarily, a lower monthly payment but maintains the existing loan balance? Sounds like another evasion of true cost to me. So, in fact, does any other of the many ways the government is currently trying to make today’s loans (and therefore homes) even more affordable than they already are. A salient example – thankfully retired, at least temporarily – was the $7,500 tax break that you get today but have to repay over the coming fifteen years.
Clearly, the true cost represents the real value of a home today. Could it be that we continue to create the same old credit problems – excessive foreclosures, tentative and temporary home ownership, and currently, debilitating fears of entering a real estate transaction at all – with our manipulations of true cost? And could it be that the only genuine answer is for real estate values to come down to what may be considered their true value, given current conditions in the credit markets, rather than trying to lower the true cost from the financing end, a task that seems always to employ smoke and mirrors, eventuating in generally unforeseen future problems and crises? Or – who knows – perhaps we could invent a new standard home mortgage and let the 30-year fixed-rate fade. Hmmm.
by: Bill Fisher
