Quicken Loans encourages low-risk speculation in residential real estate
By offering private mortgages with only 1% down, Quicken Loans encourages speculators to gamble with other people’s money.
If most people were to go to Las Vegas and gamble with $1,000 of their own money, they would be cautious; if they lost, they would feel the pain of that loss, and the fear of the consequences would prevent them from taking crazy risks.
But instead imagine how their behavior would change if someone else gave them $990, and they only had to put up $10. Ostensibly the $990 would be a loan, but if the gambling borrower is unable to repay, they would simply walk away and default on the loan. Further, those without the capacity to repay would know this going in, so for them, it’s like a lottery ticket where they have everything to gain and very little to lose.
The same is true of low- or no-money down mortgages.
Mortgages as Option contracts
An option contract provides the contract holder the option to force the contract writer to either buy or sell a particular asset at a given price. A typical option contract has an expiration date, and if the contract holder does not exercise their contract rights by a given date, they lose their contractual right to do so.
An option giving the holder the right to buy is a “call” option, and the option giving the holder the right to sell is a “put” option. The writer of an options contract is typically paid a fee or a premium for taking on the risk that prices may move against their position and the contract holder may exercise their right. The holder of an options contract willingly pays this premium to limit their losses to the premium paid if the investment does not go as planned. Most options expire worthless.
Mortgages took on the characteristics of options contracts in the Great Housing Bubble. Speculators utilized 100% financing and Option ARMs with low teaser rates to minimize the acquisition and holding costs of a particular property. The small amount they were paying was the “call premium” they were providing the lender. If prices went up, the speculator got to keep all the gains from appreciation, and if prices went down, the speculator could simply walk away from the mortgage and only lose the cost of the payments made, particularly when this debt was a non-recourse, purchase-money mortgage — and by law all purchase money mortgages in California are non-recourse.
Of course, mortgages are not option contracts, and lenders did not view themselves as selling option premiums to profit from the premium payments; however, speculators certainly did view mortgages in this manner and treated them accordingly. If lenders ever return to 100% financing, they deserve the losses they will endure. I pray taxpayers like you and me aren’t called in to bail them out again.
Here are the details on the program that no one is talking about
Ben Lane, June 24, 2016
… Quicken Loans began offering an even better deal for borrowers late last year – a 1% down mortgage. …
First, Quicken’s 1% down mortgage program isn’t for everyone, as there are several stipulations and requirements, but a 1% down payment is still a 1% down payment.
… Bill Banfield, Quicken Loans’ vice president of capital markets, provides more details on how this program came about, how it works, and why it’s so important for Quicken.
According to Banfield, the 1% down loan program isn’t quite as shocking as it appears.
The program is actually part of a partnership between Quicken and Freddie Mac that was announced in October 2015. …
As it turns out, one of those loan options is a 1% down loan, but as Banfield notes, the loan is actually structured to be part of Freddie Mac’s Home Possible Advantage program, which the government-sponsored enterprise launched in December 2014, and requires a 3% down payment. …
“We require 1% from consumer and we give the consumer a 2% grant, so the client has 3% equity immediately,” Banfield told HousingWire.
I think he means to say the consumer is 3% to 5% underwater immediately. If the new owner were to turn around and sell immediately, they would pay a 6% commission and some closing costs, and they might have to discount the property, so the 3% equity touted by Mr. Banfield is basically bullshit.
But the 1% down program isn’t offered to everyone, Banfield said. There are several rules as to who is eligible.
First, Quicken’s 1% down loans are only available for purchase mortgages. No refinances are permitted.
Another method speculators and homeowners alike used was the “put” option refinance. Late in the bubble when prices were near their peak, many homeowners refinanced their properties and took out 100% of the equity in their homes. In the process, they were buying a “put” from the lender: if prices went down (which they did,) they already had the sales proceeds as if they had actually sold the property at the peak; if prices went up, they got to keep those profits as well.
The only price for this “put” option was the small increase in monthly payments they had to make on the large sum they refinanced. If fact, on a relative cost basis, the premium charged to these speculators and homeowners was a small fraction of the premiums similar options cost on stocks.
Second, the program can only be used on a single-family home or condo, not a second home, investment property or co-op.
I guess the invitation to speculation would be far to obvious in such instances….
Additionally, borrowers must have a FICO score of 680 or above, must earn less than the median income for their county, and must carry a debt-to-income ratio of 45% or less. …
According to Banfield, the terms of this loan are advantageous over a loan backed by the Federal Housing Administration, for example.“The truth of FHA is that its max loan-to-value ratio is 96.5%,” Banfield explains. “But most buyers roll in their upfront mortgage insurance premium of 1.75%, leaving them with 98.25% LTV.”
So with Fannie and Freddie offering borrowers the opportunity to put down only 3%, with no upfront mortgage insurance premium and no life-of-loan mortgage insurance premium like with the FHA, borrowers have more equity up front and more equity when they’re done with MI, Banfield said.
Given those stipulations, “You would not consider that a subprime loan,” Banfield said, when asked about the potential negative feedback to this program. “The market has changed so much since the crisis. Rules are so much different now. You really can’t roll out a program like this without thinking it through completely.” …
When the Option ARM was introduced, it was billed as the most sophisticated mortgage product ever developed. With it’s plethora of options and pick-a-pay flexibility, lenders believed they developed the ultimate product that customers would use intelligently. Or course, we all know how that turned out.
“We want to try to help people and do it in a smart way,” Banfield said. “For us, it was really a question of if you want to provide access to credit, how do you do it responsibly? How can you help people? If first-time buyers are struggling, are there smart ways to help them while still balancing access to credit?”
Actually, no, there is not. The way lenders provide access to credit is to evaluate the borrowers character, capacity, and capital. Do they have a strong FICO score? Do they have enough income to sustain the payments? Do they have enough skin in the game to stick it out when the going gets tough? This program intends to sacrifice capital while preserving character and capacity. Perhaps it will work — at least until house prices decline again, then their underwater borrowers with such a tiny personal investment will bail out just like they did 10 years ago.
“The question became, if you offer programs with 3%, why aren’t people taking advantage of that? Well, people are going to seek what is the best for them,” Banfield “And those programs were initially way too detailed on trying to find the right thing for the right buyer.”
When the 3% down mortgage was introduced, I quipped that the 3% down mortgage announcement more sizzle than meat. The private mortgage insurance made the loan cost more than a similar FHA loan with 3.5% down. And this was before the FHA cut their premium in half, making the 3% down loan way too costly by comparison.
Banfield said that the company has seen a good response from the 1% down program since its inception and expects the program to grow in the future.“We started offering this program six or seven months ago, and I think it’s worked out really well so far,” Banfield said. “This program is consistently grown and we think it’s going to continue to grow.”
Let’s hope not. This loan is an invitation to speculation, and if it proliferates and gets out of control, it will lead to waves of strategic default if prices endure a downdraft when mortgage rates rise.