Interest Rate Roundup

Wednesday, February 18, 2009

An example of why principal reductions are inevitable in hard hit markets

I have talked an awful lot about principal balance reductions. But I decided today to put my time to use coming up with an illustration about why they're all but inevitable in hard-hit markets. I'm going to start in my own backyard, Palm Beach County, FL.

Let's say you bought a median priced home in the West Palm Beach market in December 2005, around the peak of the market. It would have cost you $408,200 at the time, according to Florida Association of Realtors figures available here). Let's be generous and assume you put 10% down, rather than finance with some 80/20 scheme. You would have had to cough up $40,820 and finance $367,380 -- leaving you with a mortgage with an initial LTV of 90%. Thirty-year fixed rates were around 6.3% at the time, so your payment (principal and interest only) would have been $2,273.98.

As of December 2008, just three years later, the median price of a West Palm Beach home is $246,000 (again, going from FAR data that's available here). That means your home would have lost $162,200 in value, or 39.7%. During that same three-year period, you would have only paid your mortgage principal down to $353,738.60 (about $13,600, or 3.7% of the original balance).

You would have $54,461.40 in equity, or a 13.3% equity position, assuming the original home did not lose or gain any value in the interim. Stated another way, your LTV would have declined to just under 87%, and the new Fannie/Freddie 105% LTV break would give you some relief.

But as I said earlier, prices haven't stayed the same. They've plunged almost 40%. That means you now have a mortgage with an LTV ratio of 143.8% (!) As you can see, even a more generous 105% LTV limit doesn't help you refi in a market like this one. And a $5,000 subsidy over five years doesn't do much to offset a $162,000 decline in value, much less incentivize you to stay put. This is why principal cramdowns/reductions are all but inevitable in hard hit markets -- Florida, California, and so on.

Oh and by the way, any guess how long it would take to get back to even (your original purchase price) on this hypothetical house -- assuming prices instantly turn around and rise 5% per year from the December 2008 level? Give up? More than 10 years. Your West Palm Beach house would finish 2018 at just under $401,000 and 2019 at around $420,700.

5 Comments:

  • Even cram downs will not make much of a difference. Those who get a cram down are already in the house so their refinance will do nothing for the inventory..in addition, due to the terms of the loan they are likely not going to be able to move-up down the road.

    Second, any divorce, job loss, move, or other traditional reason to sell still means a likely forclosure. Cram downs are only useful for those who plan to stay in the house.

    Third, there are millions (mostly condo owners) who were responsible and bought only what they could afford. Which means they are seriously underwater, unlikely to qualify for relief, and also probably ready to move up to a real home as their family or income has grown. Unfortunately the reason they bought a condo was simply to get on the ladder and use the appreciating in equity (yeah right) to put down later on the house they really wanted but couldn't afford. It appears they should have speculated, bought the house they really wanted in the first place, and then get a cram down to what they could afford.

    So now you have a condo owner with the same payment as the speculator but one has the house they always wanted, the other is stuck in the condo because they were responsible. These will begin to walk in droves as they see the injustice of it all.

    Finally, the economy will actually get worse as those who get cram downs are now paying a higher mortgage than ever because before they had a teaser rate, and then likely have been mortgage free for months. This will hit the economy initially hard in the consumer spending arena.

    All surprises will be to the downside.

    If they really wanted a "bottom in housing" they can only do it by sacrificing current asset holders. Bottoms don't occur with artifically low rates. What happens when rates rise? You are locked in but if you want to sell, the buyer has less buying power. If you want a bottom, RAISE rates to artificially high levels. All cash holders will be scooping up homes as those who have to borrow can't compete. Imagine saving up 200 grand to put down on a house and then finding you can get the whole house for that! If rates are high, they have no where to go but down. As rates drop future buyers are able to pay more. With house prices rediculously low then lending to someone to buy one is less risky. Private money would flood the market as buyers look to alternative lenders for lower priced money ("hey mom, instead of that 3% CD, how bout lending me the money to buy a house, I'll pay you 8%", which is lower than the prevailing 10%, or whatever)/

    Raising rates will work to bottom housing prices but it will kill current asset holders. Oh well. That's how markets work.

    Much pain ahead.

    Average Joe

    By Anonymous Anonymous, at February 18, 2009 at 6:30 PM  

  • Is there no more risks in life? Who should pay the difference? I get the sense you support the idea? The occupants should be precluded from ever gaining on that house until the cram down amount is paid back. Sorry but I am not uncomfortable watching people be wiped out. Why is the Federal government picking winners and losers. Let the markets sort it out.

    By Anonymous Anonymous, at February 18, 2009 at 7:21 PM  

  • Basically, the reason that principle cram downs are necessary is to give folks a reason/incentive to stick with their homes. Because Florida will not be helped by the recently released plan, people who are $100,000 or more underwater are going to walk in DROVES, further destroying property values. There is a real incentive to walk for certain people who need to relocate but will be unable to qualify for a short sale.

    By Anonymous Anonymous, at February 19, 2009 at 6:01 PM  

  • last poster is correct, we will walk in droves. we put 20% down a few years ago and are now at 150% ltv...we can walk, take the credit hit and purchase a new home and save hundreds of thousands...it's incredibly difficult to justify continuing to pay for something that's so far gone.

    By Anonymous Anonymous, at February 20, 2009 at 10:11 AM  

  • The term for walking away from a mortgage that is underwater is rational default.

    It only reflects capitalist market response. Good money should not chase after a bad asset. as with securitization, a foreclosure pushes the risk down the line. On such a scale, it impoverishes every neighbourhood, and causes a cyclical response in kind. More rational defaults.

    Good summary. Thanks.

    By Anonymous Anonymous, at February 23, 2009 at 6:06 PM  

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