Foreclosures, Sub-Prime Loans, And The Real Reason The US Housing Market Is In Free-Fall
It's happening. We're seeing the reports everywhere.
Official figures put the average house value in the US at the end of 2007 down 9% compared with the previous year.
There is a fundamental misunderstanding taking place here, and it seems to grip even the financial commentators.
For years now, the figure reported as the "value" of a house in the US has not been what we generally understand by that word - it has been something very different.
It used to be that the "value" of an item was the price at which it could be exchanged in a transparent market, between a motivated (but not desperate) seller and a motivated (but not desperate) buyer.
It used to be that when a house was "valued", the resulting figure was an expert's estimate of that actual market price.
But at some point in the past four or five decades, the entire juggernaut ran off those rails.
What is my evidence?
I kid you not.
Go and look at the real estate section of eBay.
You will find listings of homes, including their "valuations", and you will find the actual prices for which they changed hands at auction.
Now, you would have to think that an auction with a global reach would provide a reasonable indication of the price agreed between a motivated seller and a motivated buyer, wouldn't you?
I know there are issues with this direct comparison - the sale doesn't take place immediately, eBay Real Estate merely establishes an agreement that the sale WILL take place, for example, and there are requirements in terms of depositing funds to demonstrate good faith.
However, the fact that there are homes changing hands at these prices is still a fact.
So, go and check it out.
House "valued" at $97,000 sells for $38,000.
House "valued" at $38,000 sells for $9,000.
So, if the seller is willing to accept this price, and the buyer is there paying it, what on Earth does it mean to say that the house is "valued" at two or three times the selling price?
And here we come to the really nasty part of the equation.
These days, "value" doesn't reflect how much the house might make if it were sold.
"Value" refects how much you can borrow against the house.
Lenders aren't really concerned about anything other than whether they can get their money paid back.
When things were going well, house prices were rising, incomes were rising, people could handle the repayments, a new generation took the reins of management. This generation has lived their entire lives in the rising markets of the post-war boom. Their understanding of risk was distorted by a lifetime's experience of inflation (which reduces the value of debt over time) and permanently rising asset values.
Gradually, a bit at a time, the lending policies shifted.
"To help more people own their own homes ..."
And to help more people amass investment portfolios, of course.
Everyone was in on it - all the pigs were lined up at the trough. Low income earners who wanted to own a home they couldn't really afford, middle income earners who wanted a bigger home and the ability to pull out their equity to finance consumer purchases, high income earners looking for tax deductions and a property investment portfolio, politicians currying favor, and lenders looking for bigger profits by writing more loans at higher rates of interest.
If assets are rising, so the thinking goes, and inflation is working in their favor, then borrowers just need to hold on and make the payments for a while, and Nature will fix the problems.
Thus was born one of the most creative financing techniques yet - let's allow people to make SMALLER repayments for the first five years, and we will add the extra they should have been paying to the balance of their loan. After five years, the house will be worth more, so the bigger mortgage won't be a problem, and inflation will have raised their income, and they will be able to make the repayments at the higher rate.
And now we have reached the breaking point.
Five years have passed, and the expected growth in values and incomes hasn't heppened.
The borrowers can no longer make the repayments.
The creative financing techniques got just a little too creative.
And now, fifteen million Americans owe more than their houses are worth.
Structural Problems With The US Housing Market
I am in a unique position to comment on why the US housing market could so readily fall into this disastrous state.
As a financial educator, I have been teaching people about financial management and wealth creation in Australia.
Obviously, Australians have looked to overseas markets to expand their opportunities for wealth creation, as Australia is such a small country itself. Not is physical size, of course, being as large as the whole of continental USA, but in population.
Over ten years ago, I did a detailed study into the US housing market,because I was fascinated by the opportunities that existed there for buying houses well below their market value, due to foreclosures.
That simply doesn't happen in Australia, and watching how this is playing out, I have to say that the US government should seriously consider some major structural reforms to make the US market more like the Australian market.
1. Fiduciary Duty Of Mortgagee In Foreclosure
In the US, when a lender forecloses, they are only obligated to recover the unpaid balance of the mortgage.
So, for example, if there is a $100,000 house, with $50,000 owing on the mortgage, and the lender forecloses, they really don't care if they only get $50,000 for the house.
Bargain hunters haunt the foreclosure listings, looking to snap up these bargains.
So much so, that it actually makes a second market, where houses are trading for far less than their "official" valuation.
The existence of this "sub-value" market makes a mockery of the official "valuation" of houses, and creates the environment in which lenders can apparently disregard the actual prices at which homes are changing hands.
In Australia, lenders are legally obligated to obtain the market value for a property when they force its sale, and to give the resulting equity to the borrower, and they can be sued by the borrower if they sell it below market value.
2. Assuming Mortgages
In the US, you can sometimes just take over a mortgage from someone else when you "buy" their house.
To avoid foreclosure, many people take this path, which allows the "buyer" to basically walk into the house with no downpayment, and to gain a mortgage without ever having to satisfy the lender that they can afford the repayments.
3. Disregard For Equity
Because the equity in one's home (the difference between the value of the home and what is owed on it) can be destroyed with the stroke of a pen, US home owners simply do not think of it as real.
They don't struggle to save it, they don't think of their home as a place where they are putting savings, and they don't pay off their mortgages as quickly as possible, because if the house is ever sold in foreclosure, the only beneficiary of that strategy is the lender.
Australians are viciously, passionately protective of their equity. They know it is protected by the government, and for many people, particularly the self-employed, it is their only form of retirement savings. Paying off the family home "owning it free and clear", is the pinnacle of financial accomplishment for many Australians.
4. Tax Deductions For Home Mortgage Payments
I have to say, from the outside, this policy is sheer lunacy.
I realise that the political fallout makes it almost impossible to consider, but really - you are encouraging people to borrow every last penny of value they can against their home, and they can spend it on anything they like - consumer goods, holidays, parties, whatever. You are also encouraging people to buy bigger, more expensive homes.
In Australia, mortgage payments on the home you live in cannot be deducted. Owning your home is considered consumption, like buying food or paying rent.
However, if you borrow against your home to make an investment - shares, property, managed funds, etc, then you can deduct the interest payments, because that money is earning you an income.
It doesn't stop people borrowing their home equity and frittering it away, but it reduces the incentive.
5. Low-start Loans
We experimented with these in Australia about ten or fifteen years ago, and gues what? Lots of people ended up owing more than their house was worth.
They are just a bad idea, full stop, and they are no longer allowed here.
Taking these five factors, together with the expectation that prices would rise forever, the US housing market turned into a complete fictional universe.
The paper "valuations" for property in the US are now completely meaningless, and as long as mortgage and lien holders can foreclose without any responsibility to sell at anything like market value, there will always be a cancer eating away at the real value of houses.
A "valuation" on a house in the US is somewhere between hope and fiction, and it will remain so until the underlying structural problems in the US housing market are fixed by making significant changes to the financial laws and regulations.
I Am In The US Housing Market Now - What Do I Do?
For the house you live in - set your budget for housing at one third of your after-tax income, and adjust your house so that is all it costs you.
As an investor, you don't care about the "valuation" on your property if you never need to sell it. Your mantra should be "cashflow positive" - the rent pays the mortgage, repairs, and all other costs.
This information is for educational purposes only and does not constitute general or personal legal or financial advice - you should make your decisions after proper consultation with properly licensed legal and financial professionals.
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