Thursday, January 17, 2008

Short Memories - Part 11

The step rate or negatively amortized adjustable rate mortgage, could have been a disaster back in the 80's. It wasn't, only because interest rate went down precipitously shortly after it's advent. Also, incomes were at the time recovering as well. Back then, the one element that wasn't present was that what we called "B" paper, or as it is now known, "sub-prime," did not allow borrowers to overextend themselves. Loan applications were plentiful. so plentiful that Seafirst Mortgage, where I worked, shut down new applications, due to office overload. With no further need, the market dropped the high risk loans, as well as the graduated payment ARM.

In years since then, 1987-88 for instance, the year I went broke in a new Mortgage Company that a partner and I started, interest rates went from around 8.5% in January 1987,to 10.75% in just two months. Over the years, the federal reserve manipulated the money supply and discount rates, so as to not over inflame the economy, nor let interest rates get too far out of hand. Some years, the industry went into a two or three year tailspin, then pulled back out. Nothing, however even close to 1980-81-82-83 has been experienced since.

Think about it. Those of us that were in middle management, or for that matter, upper management then, are retired. Portfolio managers that are now in their forties and carrying the heavy responsibility for risk management, were in middle school, and had no first hand memories of the "bad old days." When we don't remember, or experience bad times, we are prone to not expect them to happen. Most people feel that the world events that have happened since they reached majority, are the only events that carry any weight. Well, famine and pestilence haven't visited our part of the earth recently, but bad lending practices have.

In the last fifteen years or so,with a few short periods excepted, 15 and 30 year fixed rate mortgages have been very affordable. So affordable, that resuscitation of graduated payment ARM's wasn't necessary. Why then, you ask, did they? Competition caused it. Competition and greed. The market has been so hot, with in most cases, sub-six percent loan rates,that everyone that ever wanted a house and had reasonably good credit could buy one. Aha, but the key words here, are "reasonably good credit." The building boom in full stride, homes started climbing in value. over building caused lumber and other construction materials to become in short supply. Short supply means higher prices. Soon an average home was out of the grasp of most young borrowers, but wait! What if we offer graduated payment ARM's again.

It worked before, right? Suddenly, a $150,000 loan of 30 years went from a level term 6% with a payment of $900 per month, to $632 per month at 3%. The difference used in this example, allowed marginally qualified buyers to get much more home with what they could afford monthly. Or, they buyer could buy a lesser home with higher loan to value ratios. What the heck, if the borrower could make the payments in a year or so, the house will have gone up in value, so that we'll still be just fine. But what if incomes don't go up, and what if homes decrease in value, instead of increase indefinitely.

Sounds a little like 1986 when I, thinking the boom would last indefinitely, started a high risk business. Nothing, especially in the money markets, lasts forever. In my next installment, I will make predictions for the short term that will make Casandra look like a beginner. Stay tuned.

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