Professor Elam

Let’s back up and let me give you some basics to better understand what happened in the real estate market.  Traditionally a home was sold as follows.  The buyer would be required to put up a down payment toward the purchase, once upon a time this was about 20%. That cash payment did at least two things.  First it gave the home buyer a stake in the transaction. That amount of money was probably his or her largest financical commitment, something they would not likely walk away from. It was an amount such that they would probably do almost anything to preserve the investment and keep the house and not lose that down payment.  Second, it gave the lender some wiggle room.  For example, the buyer puts down $20,000 on a $100,000 home.  Now stop and think.  Suppose for whatever reason the region in which the home is built suffers economic setback, say  the Permian Basin which is a single idustry economy, oil, and the price of oil drops drastically. People lose jobs, many put homes up for sale, there are few to no buyers, home prices plummet.  Now suppose the home is worth $80,000 or even $70,000.  Is our buyer likely to sell the house and lose his down payment of $20,000, ie, the sale price would equal or barely equal the debt against it.  Not likely, more likely the kids get paper routes, the parents take second jobs, whatever, to keep from losing the house and their $20,000.

Now fast forward to 9/00.  After the attack the stock market plunges and America is uncertain about whether to even board an airplane. Clearly this would accomplish the attackers’ goals and really slow the economy.  The only blunt edged weapon available to the Fed Govt is to lower interest rates which it does.  While this does nothing to encourage one to board an airplane, it causes the home builders to go beserk.  Now here is something else about traditional home buying.  Basically your home payment should not be more than say 30% of your net take home cash paycheck. The reason is that the lender wants  the buyer to be able to make the payment and maintain a living standard, put food on the table for example. 

And so, if the mortgage rates are say 7%, and your take home pay is fixed at $2,000 per month, you qualify for a payment of say 2000 x .3 = $600.  Now  if the mortgage rate drops, that 600 bucks will qualify you for a more expensive home as the payment of $600 will make a payment on a  larger home if the rates drop. 

Example

$80,000 x 7% = $560

$160,000 x 3.5% = $560

So the magic of lowering interest rates means that the same payment buys twice the house. 
Wow, are the home builders and lenders thrilled.  Why, because the more house they build and sell the more they all make!  Whoppeeeee!  And so appraisers continue to appraise property higher and higher so the value of the homes goes up and up and wow are the property tax people at the cities thrilled, as property taxes based on appraised value are going up.

Everyone is clearly getting financially drunk so to speak at this party until, you guessed it, rates go the other way.  If our buyer got a variable rate mortgage, his rate could conceivably go back to 7% from 3.5%, ouch, now the payment has doubled.  And if the buyers cannot make the payments, everyone is under water.

But it was much much worse.  Giddy from the excitement of all this, lenders cast aside traditional conservative lending practices.  They talked old folks into re financing their homes on variable rates.  They talke apartment dwellers with no savings into zero down mortgages, that’s right no equity, te entire amount is financed. What is wrong with that concept?  Easy, the buyer has zip nada to lose. And so the buyer just leaves the keys on the lenders desk, suddenly there are entire neighborhoods with no equity and no one to buy.

But it was worse than that!  How you say?  Lenders went beyone that and made zero down interest only loans. Yep, the buyer is paying nothing on the principal, just interest.  These are nothing more than casino bets that housing prices will always go up or at least stay the same. 

Now, are you still with me, how do I cleverly tie all this up and relate it to accouting.  Glad you asked.

How then do we value the mortgage on the blanace sheet  of lenders with zero down no principal mortgages.  The mortgage value is there all right but the collateral is not, it is dropping as soon as the person moves out of t he house.  If there is no collateral is the mortgage worth what we say it is?  No it is not and that is when the mortgage company becomes the equivalent of Wiley Coyote who has run off the cliff to find nothing under him but air.  Wiley like the mortgage companies, drops to his doom. In the catoon of course, Wiley magically returns in the next segment, American Home Lenders and others of course do nt, they are history.

Now, the debts however are still arounnd. What to do, all debts must be paied, whether thru banktruptcy  or whatever. In bankruptcy, the mortgage company goes banktupt. The trustee takes the collateral the homes and puts them up for auction. Now we will find out what they are really worth.  But wait, do you really want to try to sell a house into a non existent market, ie, the air under Wiley?  No and this is why the Federal Govt FED bought $38 B  of worthless mortgages on Friday, to try to bolster the markets.

But in reality there is never enough money for a Hillary style bailout which she has already proposed.  The market will have to go where it needs to go to find equilibrium.

Did that help?