Partners (Number 2, 2007)

Don't Bet the House

house graphic It was just a few years ago that we warned friends and families members: "Don't bet the house" and "Don't mortgage your future."

In recent years, however, these risks have become badges of honor as we've bet the house and mortgaged the future. And now we are beginning to see the consequences.

Home mortgage foreclosures are at record levels, and we're not yet sure that we can see the bottom of the market downturn. Homeowners today are more vulnerable to losing their homes than at any point in the last 80 years—when our grandparents and great grandparents learned not to "bet the house." As a society we have failed to heed those words of advice.

Housing market undergoing correction in home values
The Joint Center for Housing Studies (JCHS) at Harvard has recently released its annual survey of housing—The State of the Nation's Housing 2007—and the data are not encouraging. It paints a powerful picture not just of the current excess inventories of houses but of the reasons why homeownership is more precarious today than in decades. This brief 30-page report should be required reading for all homeowners and prospective homebuyers, for all mortgage brokers and mortgage bankers, and especially for governmental agencies and elected officials who have responsibility for housing America's families.

The JCHS Report confirms that we have done things in recent years to undercut the stability of the dream of safe and decent housing for all. The decade of the 90s and the first half of this decade witnessed tremendous annual appreciation in home values and simultaneous record high rates of homeownership. The housing market is now in a "correction" phase which is painful to many. Half of the metropolitan areas in the United States had a real dollar decline in median home prices between the fourth quarter of 2005 and the fourth quarter of 2006. The national homeownership rate declined in 2006, and mortgage delinquencies and foreclosures rose sharply. Even more troubling, however, are the shifts which have occurred in the fundamental conceptions of homeownership, putting at even greater risk the long-term consequences to the American dream. We have unfortunately forgotten the advice of our grandparents and great grandparents in five ways.

Uninformed choices putting American dream at risk
First, the terms of residential finance are so complex and variable that homeowners rarely know what they are doing. Precious few really understand a graduated payment adjustable rate mortgage with negative amortization. In 2006, almost 12 percent of all loan originations involved mortgages with deferred payments of principal and interest, pushing away only for a brief time the pending crisis.

Second, we've gone away from the classic fixed-rate mortgage which fixes the amount of the monthly payments for the entire life of the loan, and in which each payment involves a small but definite buildup of equity, of savings. Instead, we rejoice in the lowest possible monthly payments found in interest-only loans or teaser rates, blindly ignoring tomorrow. Though ARMs have been a significant part of the residential mortgage market for 25 years, the reliance on traditional ARMs has declined in the face of interest-only loans and payment option loans, which counted for almost one-third of all loan originations in 2006.

Third, we seek to borrow the largest possible amount for the biggest possible house, making the lowest down payment possible. With little or no down payment and little or no equity buildup, the only "cushion" that the homeowner has when tough times come lies in the hope for constantly increasing home values; but that is precisely what stops happening in tough times. The JCHS Report points out that 13 percent of recent homebuyers (in 2003 and 2004) already have "negative equity" in their homes as the mortgage debt exceeded the value of the home. With declining home values, higher interest rates coming into effect and deferred principal payments, the numbers carrying negative equity will likely increase in the next 24 months.

Fourth, we've taken the beauty and simplicity of ATM cash and applied it to our homes. Between 2002 and 2006, consumer debt increased by 21 percent, but overall mortgage debt increased by 62 percent. Whenever we desire or need cash we quickly and simply refinance (on terms we don't understand), leaving the cupboard bare for those tough times. Over 85 percent of all mortgage refinancings in 2006 involved cashing out equity, and the aggregate amount of home equity cashed out last year was $352 billion—more than 10 times the amount cashed out just six years earlier in 2000. When home prices stop rising this option quickly disappears.

Fifth and finally, we've let down our legal and social guards against the dangers of short- term gains which lead to long-term losses. We've completely abandoned all substantive legal constraints on residential mortgage borrowing in the name of freedom and instant satisfaction, leaving the foreclosed-upon family with little freedom and no satisfaction. For the past 30 years public policies have responded to market failures and market abuses in residential finance by increasing mandatory disclosures and by preempting state and local attempts to create substantive protections. If all borrowers had advanced degrees in real estate finance then disclosures might work to soften the problems. But that's not the way it is.

Low-income families less able to bear risk
Some can afford to take risks in balancing their incomes, their expenditures and their mortgage debt. It is those who have less who tend to get hurt more. The cost of housing has continued to rise while incomes have not, at least not for families in the lower half of the distribution of family income in the U.S. Half of all low-income families are spending more than 50 percent of their income on housing—the definition of severely cost-burdened, and this is at a time when federal assistance for affordable housing is not even keeping up with inflation in real dollar terms.

As a society we all bear responsibility. The lending industry needs to regain its sanity in loan underwriting criteria and in designing loan products. Our political leaders need to recover their courage in setting legal limits designed to protect a future for us all. As borrowers we need to reclaim the knowledge and understanding of the relationship between our income, the payments we might have to make and the reserves we have for those tough times.

For current and future homeowners there is still time to protect themselves even if the lending industry and political leaders close their eyes and point their fingers. Consumers can and must take advantage of intensive financial literacy and homebuyer education programs. Existing homeowners now confronting impossible mortgage obligations can and should seek help immediately. The recently created consumer foreclosure prevention program (1-888-995-HOPE) is a powerful first step, but it is only a first step. A second step is for everyone to read and then read again The State of the Nation's Housing 2007.

Don't bet the house. Don't mortgage your future.

These views are presented by Frank S. Alexander, professor of law at Emory University School of Law, an expert in Georgia real estate finance and foreclosure law.

The State of the Nation's Housing 2007 is available online at