Barney, Say It Isn't So

Roger Schlesinger
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Posted: May 14, 2008 7:05 PM
Barney, Say It Isn't So

Barney Frank, the prominent Massachusetts congressman, is sponsoring a bill that he feels will help the recovery of the real estate industry. I, on the other hand, find it flawed in oh-so-many ways. The biggest giveaway is the last part of the bill that provides money to protect lenders from the lawsuits that will be coming from the first part of the bill. I do not even like the middle of the bill, but my hat is off to Barney Frank for at least trying something. The prevailing thought in this country is to simply let the system “work things out.” The trouble with this thinking is those who would “work things out” are also the ones that caused the problem. It is the old fox-guarding-the-henhouse situation.

Mr. Frank is looking for the Federal Government to buy loans from the lenders, making Uncle Sam the new home financier of the people in the United States. (As a small aside, I do not believe that if the government held the mortgage, it would make people more or less interested in paying it back. Those who will, will; those who won’t, won’t.) The plan starts to fall apart when it is noted that the government will only buy these loans if the lenders reduce the stated property value to 85% of its current appraised value.

Example:

House is worth $300,000; loan is currently $325,000.
85% of $300,000 is $255,000. The loss to the loan holder would be $70,000.

Would you like to be holding the loan, and wouldn’t you sue if they reduced the value of your note without your permission?

The theory behind Barney Frank’s idea is that the bank wouldn’t receive $255,000 if they had to foreclose on the borrower. Maybe, or maybe not. It depends on the property, the location, the condition of the property, the economic condition of the community, etc.

Fannie Mae has a better idea that isn’t destructive at all. They will refinance any loan that they hold at up to 120% of the value of the property, to conforming loan limits, as long as the borrower is not delinquent.

Example:

House is worth $300,000, loan is currently $325,000
120% of the value of the property is $360,000.
The loan can be refinanced to any loan that they offer.
Nobody takes a loss, no one sues!

Part of Frank’s new proposal stipulates educating borrowers about the loans they are considering to take to finance their house. I do not believe that the American public is that ignorant or naïve; therefore, some straight-talk on the complex and important subject of home finance can do some real good, coupled with some much-needed honesty and restraint from the mortgage industry.

There are only really two types of loans: fixed and variables. It would take about four minutes to explain a fixed rate, and one line can sum up variables:

If it seems too good to be true, it is! What is needed is the regulation of the advertising of the lenders. Therein lies the problem. The only real regulation is if you state an interest rate in the advertisement, you must indicate an APR. Less people in this country can tell you what APR stands for than can name the current Secretary of State. (Annual Percentage Rate. Condoleezza Rice.) For the most part, those who do know the term can’t calculate the figure.

Example:

I had to explain to a client’s CPA why the APR was lower than the start rate when the numbers confirmed it couldn’t be true. First, I had to figure it out, and it wasn’t easy!

The loan was a 3 year ARM, interest only, amortized over 30 years.
The first 36 months: the payment was $1600 a month.
The next 84 months: the payment was $1400 a month.
The last 240 months: the payment was $2200 a month.
The first 3 years: the rate was 6.5%, the APR 5.375%

Just looking at the figures, how could this be?

The answer is simple if you understand how the APR is calculated and how ARMs work. The interest rate after the fixed period is equal to the index (1 month LIBOR) and the margin (short for profit margin 2.25%) This added up to 4.875%. The loan was interest-only for 10 years, so the first 84 months of the variable portion of the loan must be projected at interest-only.

That gets us to the last 20 years of the loan, which is no longer interest-only. The loan must be totally paid back at the end of 30 years, so it must be amortized over 20 years, thus the higher payment but not necessarily a higher interest rate to catch up on the pay-down of principal. Most people, and some of them being in the mortgage industry, wouldn’t grasp this and shouldn’t need to learn this.

Stop the deceptive advertising and most of the problem would be gone. When the 1% option ARM was popular, I never heard anyone say or write that the 1% was the payment rate, not the interest rate. They would always say “1% interest” which technically was true for the first month in a 360 or 480 month loan. The next 359 months or 479 months were at a dramatically higher interest rate and thus because your 1% didn’t even cover the interest in almost every case you would experience negative amortization. That means your balance would be going up, not down. How did the lenders cover that problem? One line! “Your loan has the possibility of negative amortization!” They simply forgot to mention that the possibility was 100%. (If only I could get such odds in Vegas.)

The lenders weren’t through with enticing you to take this loan, and they’re still at it. You have four ways to pay your loan: the teaser rate that will put you into negative amortization because as I have said before it is less than the interest you owe for the month, interest-only, 15-year amortization, or 30-year amortization. Unfortunately the interest rate, determined by the index and the margin, makes the interest-only loan, the 15 year and the 30 year more expensive than just going into the market and taking one of those loans. By the way, do you realize that if you take an interest-only loan, which in reality is simply an option, you can pay that loan either interest-only, or as a 10-year, 15-year, 20-year, 22.5-year, 30-year, or any other amortization you choose? As long as you are paying at least the interest-only, you can add any amortization you want to the loan and pay it your way. Seems a whole lot better than the negative amortization option!

I could go on for much longer but I believe it would be redundant. Let common sense prevail and when you need to regulate, do the most good. Stripping home values with the stroke of a pen—bad. Improving understanding of mortgages—good. It is a simple concept, but not easy to grasp!