Designer Mortgages
I recently received the King County official appraisal of my home's value; the value which will determine how much property taxes I will have to pay in 2006. The valuation of my property and improvements has risen, in one year, by almost 10%. Sure, the increased valuation is great news if I was interested in selling my home in the near future, but since I'm not moving, it only means I'll pay more taxes.

I don't mind paying taxes, I would just prefer to pay as little as possible. And so, as a faithful steward of my talents, I had been using the 2002 sale of my neighbor's house as a "real-world" example of home prices in my area. After my original neighbors were forced to relocate, their house languished on the market for about 1½ years and finally sold at auction after foreclosure; at a price below that of the original purchase price paid (and below what we paid for our smaller home). This helped me lower my property tax bill (and keep it unchanged) in each of the last two years.

Unfortunately, last year a house up the street (that is just slightly bigger than our own) sold for $650k. Thus, it will be impossible for me to use my former comparable (the house next door that sold for less than $500k) now that this new data point is pegging prices upward. Sigh.

I've long thought home prices are rising too fast in much too short a time, creating a "housing bubble" that eventually must burst. I've determined that the root cause of this is the proliferation of "Designer Mortgages" such as the piggyback and interest-only loans which came into vogue only a few years ago.

From the link to the Bruce Bartlett article above:

An important reason for the increasing loan-to-value ratio is the proliferation of what are called "piggyback" loans. Basically, a borrower takes out two mortgages simultaneously - a first mortgage and a second, piggyback mortgage on top. The first mortgage will be what is called "conforming," which means that it can easily be resold on the secondary market. The balance might be in the form of a home equity loan or credit line that is used to make the initial purchase, rather than taken out afterwards.

The effect of breaking the total mortgage into two parts like this is that it allows people to borrow more money with lower incomes than would be possible if they had a single "jumbo" loan, as would have been the case in the past. According to a recent report from PMI, a mortgage insurance company, in many hot housing markets 60 percent of home sales are financed with piggyback loans. The size of piggyback loans is also increasing rapidly, from $37,757 in 2001 to $51,617 in 2004.

Such loans are riskier than traditional loans because there is less equity backing the loan, making lenders more vulnerable to loss in the event of an economic downturn or falloff in home prices.

Further adding to the risk of default is the proliferation of interest-only loans. Historically, mortgage payments included a payment of principal that reduced the outstanding loan amount. In 2004, a third of new home sales were financed with mortgages having no payment of principal, according to LoanPerformance. As with piggyback loans, interest-only loans allow people to borrow more and buy more expensive housing, but with less of a margin to protect lenders from default.  (Emphasis mine.)

The high "loan-to-value" ratio basically has created a false demand for housing for what should otherwise be unaffordable to a typical borrower. As this false demand has gone up, so have home prices. But as Bartlett (and Alan Greenspan) have warned, it will likely not last.

Comments

Re: Designer Mortgages Only a 10% home value increase? Too bad. My home valuation went up 20%, and like you recent sales in my neighborhood (570k) prevent me from appealing my home valuation. :: Comment posted by Mark on Wed, 31 Aug 2005 07:24 [Respond to this comment]