Week of December 8, 2008
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We Must Put a Stop to Falling Home Values
Stephen L. Hodgkins

The following white paper was prepared for a meeting last month with NAHB Senior Officers and leaders of the Memphis Area Home Builders Association to discuss the housing crisis and efforts to address it through the Fix Housing First coalition.

The decline in single-family home values is the predominate reason for the current economic collapse. Falling values have decimated the single-family construction industry, which normally supplies roughly 16% of the gross national product of the United States.

At the height of the housing boom, developers and home builders were buying land, developing lots and building houses based on an economy fueled by subprime mortgages. They neither asked for nor were even aware of this giant social experiment conceived by our political leaders and the heads of mortgage giants Fannie Mae and Freddie Mac. As entrepreneurs and job creators, home builders were simply responding to perceived market conditions. Likewise, their banks and financial partners were making decisions based on historical market data.

After the subprime loans were pulled out of the marketplace, builders were left with large inventories of land, lots and houses and far fewer buyers who were able to qualify. The leveraged developers were forced to go to their banks and try to negotiate terms that would allow them to operate in an environment of reduced market demand. This put pressure on the local, regional and national banks who were engaged in asset-based lending. This was exacerbated by bank regulators’ insistence on these assets being marked to market, based on present value appraisals.

In addition to this loss in the value of the banks’ collateral, there has been a more subtle decline in the value of collateral in consumer loan departments. HELOCs — or home equity lines of credit — became a popular way for banks to make secured consumer loans, and it is easy to see what declining home values have done to this line of bank business. Bank bailouts are simply Band-Aids and will only delay the inevitable unless the decline of home values is curtailed.

Loss of value has also hugely affected the confidence of the American consumer, whose home equity typically represents the family’s largest financial asset. The deterioration of home values and resulting loss of net worth have made the consumer reluctant to commit to large purchases. It is not a reach to say that a turnaround in the automobile industry won’t be possible until home values stabilize.

The question, then, is how do we halt the decline in home values?

The first step is to recognize the primary elements affecting home values. Although it is commonly held that location, location, location is what determines value, there is nothing more important than financing, financing, financing. More than 98% of all real estate transactions involve some type of financing, and it is the loss of long-term financing that has caused the recent downturn in values. Bailing out commercial banks won’t help solve the problem of getting capital back into long-term mortgages, because banks by design rarely make commitments beyond 60 months.

This is the first economic downturn in the last 30 years in which long-term interest rates have not dropped significantly. In the usual cycle, sales slow and then rates drop, encouraging buyers back into the market to purchase homes with more affordable monthly payments. In this downturn, Treasury yields have fallen significantly while mortgage rates have not followed suit.

Older Americans who remember the 14% to 16% mortgage rates that were prevalent in the early 1980s may think today’s interest rates are good. Unfortunately, today’s rates are creating no sense of urgency among the young buyers who need to enter the home buying market. There is no doubt that lower mortgage rates would bring buyers back into the market.

Based on historical trends, long-term mortgage rates should be in the 4.5% to 5% range when compared to long-term Treasury bills. Because of investor reluctance to commit to mortgage-backed securities, rates have stayed higher. A reduction in mortgage rates to 4.5% would bring many qualified buyers back into the market. For example, payments on a 4.5%, $270,000 mortgage are $339, or 20%, lower than on the same loan at 6.5%. That’s the equivalent of a $60,000 reduction in the price of the home. Applying the general mortgage qualifying rule that housing costs should be around 25% of gross income, a purchaser could qualify for the 4.5%, $270,000 mortgage with $16,000 less annual income than at 6.5%.

The problem is: how do we get mortgage rates down and how do we get potential buyers qualified? The following is a list of recommendations to get buyers into houses that will also help those people who are saddled with punitive adjustable-rate mortgages stay in their homes:

  1. In addition to the interest rate, a major obstacle in achieving homeownership is the required downpayment. The present $7,500 tax credit could be used to fund the home buyer’s downpayment on FHA loans if it were restructured. The present credit does not help fund downpayments because the funds are not received by the buyer until their income tax refund is received. The credit must be made available to buyers at closing so it can be used to fund their downpayment and closing costs. The loan repayment aspect of the tax credit should also be eliminated so that it is a true tax credit. The credit should also be increased to $15,000 and set up on a graduating scale, going from $15,000 in January, to $12,500 in February, $10,000 in March and $7,500 in April through July.

    The timing of the credit and its diminishing value would create a sense of urgency to encourage buyers into the market quickly. The tax credit should also be available for all home purchases and should not be limited to first-time home buyers.

  2. Lenders should be encouraged to use a loan approval model that is based on common-sense underwriting by experienced bankers rather than a model that emphasizes credit scores. Credit scores can be manipulated and are not true indicators of a borrower’s creditworthiness. For example, a borrower who has medical bills is probably more creditworthy than a borrower who has excessive debt because of poor spending habits. Their credit scores might be the same, but common sense says otherwise. Common-sense underwriting should not be replaced with computer models that remove flexibility in approving loans.

  3. The quickest and most efficient way to get rates down to the 4%-5% range is to convince investors to invest in mortgage-backed securities. A way to do that is to offer mortgage-backed securities with tax-free income. These securities would be similar to Ginnie Mae securities, except that the income to the investor would have no federal tax consequences. These securities would fund FHA/VA loans in the 4% to 5% range. The mortgages generated from these securities should be limited to purchases and to borrowers who are in trouble because of high adjustable-rate mortgages. This would help control the cost of the program, encourage purchases and keep the mortgage system from getting bogged down with refinances.

  4. The use of tax-free mortgage-backed securities could be implemented quickly by requiring FHA insurance or a VA guaranty on the loans. This would make it imperative to set FHA loans at their statutory maximum amounts. An example of this need can be found here in Shelby County, Tenn., where the FHA loan limit is $271,000 compared to $417,000 in the Nashville area. The archaic formulas that dictate loan limits should be done away with and common-sense limits should be used. A higher loan maximum would help a larger segment of the market and generate more income for HUD.

In conclusion, the erosion in the value of single-family homes must be stopped for the economy to begin to recover. Decisive and dramatic action must be taken for this to happen. The above ideas are realistic and will work if they are implemented.

Steve Hodgkins is the president-elect of the Memphis Area Home Builders Association and the founder of Oaktree Homes, LLC.

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