The slow rolling collapse of the housing industry in this country -- which the Center for Economic and Policy Research estimates could wipe out $6 trillion in housing wealth in 2008 -- has gotten me to thinking about the future. Why do we even have mortgages? What would the housing industry look like without them? Is there a better way? My conclusion is that we should eliminate mortgages altogether. This will cause housing prices to drop, which will make it possible for more people to buy homes instead of living in houses that are really owned by the mortgage holders.
The reason we have mortgages is that the $10 trillion industry supporting them is powerful and self-sustaining. It fuels an enormous housing construction and furniture industry. And there are those in government who think home "ownership" is a worthy social goal. Unfortunately, when people take on a mortgage and then move into a house, the people who live there don't have its title -- the mortgage holder does. Simply put, home ownership is an illusion for most people -- the mortgage holder owns the house until the mortgage is paid off. Instead of renting from a landlord, the "homeowner" is living in a house that's owned by a mortgage holder.
With the rise of securitization, that mortgage holder is no longer the company that originated the loan. It's an investor who holds a mortgage-backed security (MBS) that contains your mortgage and thousands of others. It's an oft-repeated illusion that this is "home ownership." But that illusion is critical for keeping the mortgage industry alive. Unfortunately, if Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) fail, it will be us citizens who will be on the hook for the $1 trillion needed to bail them out.
The concept of home ownership supports an industry that is now collapsing thanks to its shady business practices. In the last year, those practices have led to a 15% drop in the value of the average house, the implosion of the $1.3 trillion subprime mortgage business, $400 billion in bank write-downs related to MBS -- potentially rising to $1.6 trillion, and three million foreclosures which will force them out of the house that the mortgage holder owns.
To be fair, many citizens have "profited" from mortgages in the past. They "profited" if they started paying off their mortgage when housing prices were rising, paid off the mortgage when the price of the house was higher, and then sold the house at that higher price. But in calculating their "profit", these fortunate people should take into account the interest and fees that they paid the mortgage holder during the life of the mortgage.
As an example, consider a house purchased for $200,000 in 1980 with a 20% down payment and a 30 year 8% fixed rate mortgage. Let's assume that the price of the house appreciated to $350,000 in 2010 for a $150,000 increase. But to pay off the $160,000 mortgage, the borrower paid a total of $422,647 in principal and interest. (This is based on a monthly payment from Mortgage Calculator of $1,174.02 a month - multiplied by 360 payments over 30 years).
If you take those fees and interest into account, taking on a mortgage to "buy" a house does not look like such a good deal. It turns the $150,000 "profit" if the house is sold in year 30 into a $112,647 "loss" (due to the $262,647 you spent in interest and fees over and above the $160,000 you borrowed offsetting the $150,000 rise in the value of the house -- and this loss calculation excludes your $40,000 down payment). Mortgages are like casinos -- on average the house always wins.
When you take into account the huge profits to the mortgage industry, our cost to bail it out of its risky business practices, the write-offs by banks that hold MBSs, and the massive loss in housing wealth; I think it's reasonable to ask whether the costs of mortgages to society exceed their benefits.
If mortgages did not exist at all, we would not have these problems. So I think it's time to consider whether we can afford to let them exist in the future.
Update. A reader suggested that I should compare the decision to take on a mortgage with the one to rent. Of course, a family who did not take on a mortgage would need to live somewhere. If we assume that the family rented an apartment for $900 a month for those 30 years, it would have paid $324,000 in rent over that time. At the end, the family would have no equity in the apartment. With these assumptions it would make sense for the family to take on a mortgage since the $324,000 expense of renting would exceed the $112,647 "loss" -- even when adding in the $40,000 down payment.
Unfortunately for the millions who currently have negative equity in their homes -- these assumptions don't apply --they would have been better off renting.
Another way to look at it is to consider that the renter invested the $40,000 downpayment at 7% a year -- which is the long-term average annual return on common stocks. At the end of 30 years, that investment would climb to $304,490. Netting that against the $324,000 in rent would yield negative $19,510 -- far better than the $112,647 "loss" for the mortgage.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
7-13-2008 @ 10:23AM
Clint McIntosh said...
I agree with you. Buyers should at least have the option of a Simple Interest loan. The banks and lenders will still make money and it will improve the chances of people actually OWNING their homes.
7-13-2008 @ 2:33PM
william lindblad said...
Peter where do you get this nonsense? Notes of the type in question have been around since the times of Smith and Gresham and those two lads are the fathers of the entire economic system. There is nothing wrong with a mortgage note. Taken from French, it translates something like slow-death or to die slowly, which they do, one payment at a time. In order for an economy to operate someone has to make a profit - albeit, a reasonable profit. The last time that the U.S. had a similar default situation in housing was in the 1930's, but the cause was completely different and it cannot be compared with the present. The only real similarity between the two time frames was a "want it all now" mentality. In the roaring twenties the stock market was the vehicle and in the present and was turning the real estate market into one. The difference is that the market enjoys some regulation, while real estate does not. The recent boom was created by the infusion of cheap capital from all over the world and the bankers threw all caution to the wind to avoid being left out of the frenzy. I can understand the investment banks, the thrifts and I am sure there are many commercial banks holding bad paper on investment construction. We have yet to hear from that sector, but I doubt that the news will be good as luxury condo's are still being built and there exists a glut unsold. Fannie and Freddie are said to be in trouble and this raises questions. They are pseudo government private entities that have a degree of regulation. This is part of the FHA system and the only part that should have exposure to sub prime would be HUD. They are not supposed to be into sub prime banking across the board. Why are they there? How did this happen? The public is not that stupid and is going to want an answer. This is not going to be 15 Billion from the Treasury via Paulson, it will be more like a trillion dollar bill. The taxpayer is not going to be happy.
7-13-2008 @ 9:58PM
Sheldon L said...
Peter, while you and I can find numerous things to agree upon, I must beg to differ here. Almost all of your assumptions seem fallacious to me.
1) At a measly 5% appreciation over the 30 years from 1980 to 2010, the $200,000 house is worth over $828,000.
2) The entire interest payment is tax deductible through home mortgage deductions saving from 15% to 39% depending on your tax bracket.
3) You cannot live in a stock fund.
4) The home mortgage has traditionally provided the best investment the average person could ever make and provided the foundation for most retirements.
5) For most of the last 30 years you could get a home mortgage for far less than the 8% you discuss, it has been closer to 6.5%. If you believe that the long term yields in common stocks are 7% then for most of the time it would have been worth taking some home equity and investing it in an index fund.
I have not raised the issue of leverage which no doubt lately has been a tragedy for many, but a 25% down payment still gets you 3 to 1 leverage and that would be very conservative. There are plenty of things to consider whether one chooses to rent or own a home (if one has a choice) but the premises in this story leave me baffled.
7-14-2008 @ 6:32AM
al coholic said...
Maybe we should just consider eliminating equity loans. The mortgages of my day were issued and held by local bankers who used their own appraisers and were plain vanilla 20% down 20 year fixed rate mortgages. Risk of foreclosure was far lower because there were no morgage brokers to fudge the numbers with friendly appraisers and questionable financial information.
Isn't the real problem that people think of their house equity as a way to buy consumer goods instead of a nice one time windfall near retirement?
If people hadn't maxed out their houses with eloc's it seems to me that this whole crisis could have been a lot less severe. Of course the speculators in the go-go markets of Vegas, Florida, and SoCal would still be reeling, but they are only gamblers, not homeowners in the true sense.
7-14-2008 @ 9:08AM
Bud Woods said...
While there are doubtless many improvements that can be made to the current system [including eliminating interest-only loans and loans that do not sufficiently factor in future interest rate risks], dumping mortgages as a concept is a dubious notion: (1) There is a great difference in the care & maintenance given "owned" homes verus rental homes. (2) Despite the vastly more mobile population, many mortgages do get paid off. (3) Incentives for ownership [ala deductible mortgage interest] have proven to be good for the economy and the nation. (4) A mortgage holder enjoys more legal rights than does a renter. (5) A dream that can actually occur is a lot more powerful motivator than idle dreams. I recommend author review the movie "It's a Wonderful Life" to recapture a sense of the difference between owning and renting in Pottersville.
7-14-2008 @ 2:07PM
Chris K. said...
Mr. Cohan,
I am dumbfounded by your post.
For starters, you totally ignore the time value of money and the associated opportunity costs. So, yes, you will pay out a total of $422K in your example, but that is only $176K in Present Value terms (using your 7% opportunity cost as the discount rate). Additionally, the tax shelter available to individuals on mortgage interest paid would be over $78K, and have PV of about $40K over the life of the loan (assuming 30% marginal tax rate). Regarding rent, you can not assume that $900 rent payment today will be a $900 rent payment in 30 years. At a mere 2% inflation, your rent payment would be around $1,600 in 30 years, while your $1,174 mortgage payment will remain constant through the life of the loan and GOES TO ZERO thereafter. BTW, a very modest 2% annual appreciation would value the $200,000 home at $362K after 30 years. Of course, after a 7% commission, that is only $44K in PV dollars (again, discounted a 7%).
It wasn't the mortgage that gave many home investments a bad return, it was that the the buyer couldn't afford the payments or couldn't afford a depreciation in home value. If someone was making a payment they were comfortable with on a 30 year mortgage and can ride out this market, they are fine.
People would actually be better off if they viewed their home for what it really is, too: It is an EXPENSE, not an ASSET nor an investment. But, owning can be less negative than renting, and there is often a CHANCE of an upside. People just got complacent and began to expect the upside.
For me, the two factors that actually hurt the idea of home ownership are property taxes and maintenance, but you have to figure you are paying for these via higher rent, even if you chose not to own.
I am actually quite surprised that you would choose a traditional mortgage (20% down, fixed interest) to build your case upon. If the mortgage industry had stuck with those, we, as a country, would be in far better shape. The real problem came in the forms of variable rate mortgages (that would obviously only reset higher), interest-only mortgages, and, above all, giving mortgages to those who simply could not afford them. In other words, it was not the concept of the debt financing that brought the mortgage industry to its knees, it was the disconnect between risk and returns that did. This, of course, was exacerbated by the lack of accountability in the industry (something which you've harped on several times and that I agree with).
Maybe it was just too early in the morning and you hadn't had enough coffee yet, but if you can't blame that post on lack of caffeine, then ask one of your MBA students at Babson to spend 20 minutes showing you how to do a DCF in excel.
7-17-2008 @ 7:59PM
Edward Grano said...
Without the process of intermediation our economy and our way of life would entirely collapse. To eliminate mortgages would increase the cost of acquiring a home to the purchaser NOT reduce the cost. By allowing securitization of mortgages into CMO's (collateralized mortgage obligations) results in the ability of the lender to require a lower interest rate from the borrower.
When you borrow to finance your home, you are the seller of the loan and the lender is the buyer. A fixed mortgage contains an embedded call feature (call option) allowing you the borrower to call the loan or pay it off early. Hence if mortgage rates fall you can call the loan and/or refinance it at a lower rate, and if mortgage rates rise you can hold the loan until maturity. This creates a unique advantage to you the home owner.
Title is held by the home owner SUBJECT TO a lien, the mortgage. The bank does NOT hold title.
Analytical Finances Inc.
http://www.realestate-calc.com
7-17-2008 @ 8:01PM
Edward Grano said...
Without the process of intermediation our economy and our way of life
would entirely collapse. To eliminate mortgages would increase the
cost of acquiring a home to the purchaser NOT reduce the cost. By
allowing securitization of mortgages into CMO's (collateralized
mortgage obligations) results in the ability of the lender to require
a lower interest rate from the borrower.
When you borrow to finance your home, you are the seller of the loan
and the lender is the buyer. A fixed mortgage contains an embedded
call feature (call option) allowing you the borrower to call the loan
or pay it off early. Hence if mortgage rates fall you can call the
loan and/or refinance it at a lower rate, and if mortgage rates rise
you can hold the loan until maturity. This creates a unique
advantage to you the home owner.
Title is held by the home owner SUBJECT TO a lien, the mortgage. The
bank does NOT hold title.
Analytical Finances Inc.
http://www.realestate-calc.com