Wednesday, June 08, 2005

Financial issues

This article is about interest-only loans, and I have a thought or two about it.
There is something disingenuous about calling these loans "risky"--they are, but only if you're in a certain position. For the first-time home buyer, they're a great way to get into the market--and if that buyer is looking to stay put in a good area for a while, it doesn't really matter if the so-called housing bubble bursts on him.
Assume FTHB Jack gets a loan of $100,000 more because he went the interest-only route. This gets him a single family house in a neighborhood he otherwise would not be able to afford, in which he is planning on staying for 20 or 30 years. The housing bubble bursts and his house is re-appraised downward. Big freaking deal. As long as Jack can make his mortgage payment, he's fine--he wanted to LIVE IN THE HOUSE.
Now let Investment Greg be the owner of 6 houses in California, none of which he lives in. The bubble bursts, and the houses are suddenly too expensive to sell at the price Greg was trying to flip them. Greg loses hundreds of thousands of dollars. Greg still owns 7 houses. Do we feel sorry for Greg making it hard for people like Jack to buy? No, we don't.
The people that bubbles affect the most are the people best equipped to deal with financial crises.


At 1:08 PM, Blogger J. Morgan Caler said...

The problem is that Jack is less equipped to handle general recession. If, for instance, the housing bubble bursts (something made possible by all the Jacks out there) and, in the resulting credit crunch, Jack looses his job (a likely scenario if Jack’s employer is similarly overextended, which is almost a given in areas where interest-only mortgages are common), then he is now the proud owner of nothing more than a lot of negative equity. If, however, Jack were to finance his home in a more traditional way (at the expense of an ideal location), then Jack could stand to benefit greatly from a housing bubble burst. It’s called gentrification. If Jack buys in a neighborhood that his fellow buyers shunned previous to their financial collapse, then Jack stands to profit considerably if there is an influx of those people into his less expensive neighborhood, thereby increasing his equity.

At 2:24 PM, Blogger RedHurt said...

Just because Greg's looking to make money off of the real estate market doesn't mean that he's trying to keep Jack out of a house. What if those houses Greg bought were in poor condition and he fixes them up so that people like Jack can and will want to live in them? Then the bubble bursts, and Greg loses money on his investment. Can we feel bad for Greg now?

Just because Greg's part of the upper/ownership class doesn't make him the bad guy, you stupid liberal tree-hugging communist-hugging snack-eating idiot you.

At 3:27 PM, Blogger CharlesPeirce said...

One, listing 7 homes as "primary residences," like many of the Gregs out there do, is illegal; and two, artificially bidding up prices, while not illegal, still makes you a jerk, as when the robber barons bought rifles during the civil war for $3 and then sold them for $25 back to the army, you conservative gun-toting Bible-thumping corn-fed bloviator.

At 3:31 PM, Blogger CharlesPeirce said...

j. morgan, you said that the bubble is "made possible by all the Jacks out there." That's like saying the stock market crash was caused by the people who weren't buying on margin, the people who had real cash in the market. Greg is intending to make money without doing anything--he simply WAITS and then resells the house, making money without doing anything. Jack, while benefiting from the interest only loan, is not going to flip his house--he's intending to get to paying off the principal as soon as he fiscally can. You can hardly say he's "the proud owner of a lot of negative equity"--if he has the deed to the house, he owns the house, whatever its value is. You own negative equity.

At 3:35 PM, Blogger CharlesPeirce said...

My point, which was bolded, was:

"The people that bubbles affect the most are the people best equipped to deal with financial crises (IE Greg)."

You wrote: "the problem is that Jack is less equipped to handle the general recession," as if you were contradicting me; yet, that Jack was less equipped to deal with it was implicit in the statement. Your point dovetails with mine.

At 10:24 AM, Blogger RedHurt said...

I don't think there's anything inherently jerky out of making the biggest profit you can selling a product. If that product is houses, guns, yard gnomes, whatever. Greg WANTS Jack in a house - one of his houses. As long as Greg provides Jack with everything he says he will, Greg's entitled to get as much out of Jack as he can. If Greg's charging too much, then Jack should go see someone else, and the competition will ensure that prices are kept reasonable. The only place this can go wrong is if Greg teams up with everyone else selling houses and they form a sort of monopolistic alliance, and that's where the government can get involevd and tell Greg to cut it out.

What's "bidding up prices" mean, literally, in reference to the real estate market? I don't know enough about how it works specifically.

At 10:54 AM, Blogger J. Morgan Caler said...

Charles: Our points don’t dovetail at all. My statement that Jack is less equipped to handle general recession was in regard to interest only mortgages not his overall financial position. So, to state clearly: if and only if Jack opts for an interest only mortgage is he less equipped to handle general recession. If, on the other hand, Jack opts for traditional borrowing, then he is well equipped to handle general recession (even though he isn’t a Greg). And as for your Great Depression analogy, it is exactly the opposite of what you suggested. Jack IS buying on margin big time, but he isn’t day trading. Nonetheless, he is only financially viable if the market rises sufficiently during his ownership of his particular stocks to cover his initial investment, the initial investment of the bank, and the interest accrued. That is a big gamble that (to continue the analogy) could result in Jack holding stocks for far longer than he could have otherwise, thus committing assets to something that is not his most profitable option just so that he doesn’t loose his shirt.

At 10:55 AM, Blogger J. Morgan Caler said...

redhurt: Your point about collusion being illegal was on the right track, but, in this case, isn’t true. Actually it is quite to the contrary with real estate. Real estate valuation and market (or selling) prices are two different things, but both are determined relative to other properties with similar specifications. In effect, the industry has to collude in order to determine pricing. Look, Realtors aren’t stupid. In an area where they know that buyers will regularly opt for an interest only mortgage, they list properties at well above their value. The result is that whole cities are being bought and sold at market prices well beyond the actual value of the property. This was my point about Jack causing the bubble to burst. By exercising this option, Jack adds fuel to the fire of artificial price inflation by 1) confirming for a Realtor that the market prices are legitimately inflated, and 2) not have actual assets to warrant his new purchase (thus putting him in the precarious situation of reliance on the market). And, in this case, because price isn’t tied to actual valuation, but backed by “hype” (as they would have said in the late 90s about tech stocks), as soon as someone gets wise and panics (and others follow), there is no actual determined value that brakes a price collapse.

At 11:06 AM, Blogger CharlesPeirce said...

I still fail to see how, assuming Jack keeps his job, a "price collapse" will hurt him if he intends on keeping his house. Mortgage rates go up and house values go down. So what? He still has his house. Assume he refinances out of his interest-only loan to a 30-year fixed, and has to take a huge hit on the rate because of the crisis--say he goes up to 10% from the 6% he had. He's still intent on staying in the house, so he just refinances again when interest rates go down.

And you're wrong about my analogy. Buying on margin was RE-investing money that you hadn't actually made yet, which is exactly what Greg is doing. Most Jacks (I don't have a figure) refinance their interest-only loans into normal loans as soon as they possibly can. Any "loss" that takes place can only raise their monthly mortgage or their interest rate! The Gregs CAN actually lose money.

At 11:14 AM, Blogger CharlesPeirce said...

Here's why what Jack is doing is NOT equivalent to buying stocks on margin. While his house can go down in value, it can never (theoretically) be devalued entirely, just as the fixtures of a bankrupt company whose stock is worthless are always worth something. Stock, and currency, can end up worthless; houses almost never do.

You also said: "Whole cities are being bought and sold at market prices well beyond the actual value of the property." Where are these "actual value" figures for properties, and how do I get them?

At 11:53 AM, Blogger J. Morgan Caler said...

1) Jack is hurt because the amount of equity he has built up in his property is effectively zero at the end of seven years, whereas it could have been substantially higher if he financed in a traditional way from the beginning. This affects his total assets negatively which limits his purchasing and lending power. This also means that if he decides to sell before the end of the mortgage for any reason, then he is going to recoup less value than he would have otherwise.
2) Jack is hurt by this scenario because, even through refinancing, he is going to end up paying more for his house than he could have otherwise because he would take less of a hit in transition from a traditional 30-year variable rate mortgage into a traditional 30-year fixed rate mortgage than from an interest only 30-year variable mortgage. Even if he refinances again, he is still refinancing more money than he could have otherwise, albeit at a lower rate.
3) Jack is hurt because he stands to make less profit (or probably not making any at all) in the event of a price collapse. Money not made is money lost. And by not making a profit on his property, Jack is tying up what money he does have in sustaining his property investment rather than investing elsewhere.
4) It is like buying on margin, because the only way Jack can make money on the deal is if, in the end, the property is worth more than what he paid, what the bank paid, and what interest accrued. The trick is, he can’t make that money until values rise again if there is a substantial price devaluation. That means the profit lies in something that doesn’t exist yet, namely market value, but that Jack is banking on will exist in the future. In that sense, all mortgages are buying on margin, the difference being that traditional mortgages build in equity from the beginning a) to hedge against the possibility that Jack never recoups his money, and b) to shorten the amount of time Jack has to hold his investment before he can make a profit.
5) You are right that buying real estate is different than buying currency or stocks, but if Jack looses tens of thousands of dollars, he isn’t going to care if there is still some residual value in his property left – he is still going to be out more money than he had to be.
6) Actual values are not based on what buyers are willing to pay right now but what investment has been made in the past, adjusted accordingly for general inflation, scarcity levels, etc. These are obviously better suited to older communities (I am sure there are good numbers on San Francisco) where longitudinal studies are possible. I am not sure where you get these figures, but I would check major economic journals.

At 12:14 PM, Blogger CharlesPeirce said...

You're treating Jack as if he were trying to make money on his house--IE, as if he were Greg. He's not. In 20 years his house will be worth more than what he paid for it. That's the bottom line.

At 11:05 AM, Blogger RedHurt said...

It seems to me that the only time an interest-only loan is "safe" is if the monthly mortgage payment is equivalent or cheaper than paying rent for an equal property. If the value of the property doesn't go up then Jack's interest-only payments gained him nothing more than time in the house, which is exactly what he'd get by renting.

I think interest-only loans are a good idea if 1.) you're not forced into them by ridiculously high prices, as J. Morgan says happens often, or 2.) you can wisely invest the money you would be putting into principle payments. It seems to me like the ideal way to go is to get an interest-only loan and then put the principal money into very stable parts of the market. If you can make enough in the investment to offset the interest that would be going down if you were paying against the principal, you can make quite a bit of money. This is the idea behind everything Lansing does.

But then again, that's talking about Jack as if he's more like Greg - interested in using the market to benefit himself financially rather than just buying a house and trying not to go bankrupt.

At 4:12 PM, Blogger CharlesPeirce said...

Quit gregging my jack.


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