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No Skin in the Game: Congress & the Home Mortgage Debate

by on September 15, 2013 7:30 AM

Much has been written, proposed and even encoded into the law of the land as a result of real estate speculation, bubble bursting and its related fallout.

I was not a party to of any of this multi-year event, easily avoiding the problems through the application of sound financial practices.

Yet here we are again headed down the same road (like one definition of insanity: doing the same thing over again and expecting a different outcome) and the results are likely to once again be financially catastrophic to the players, both borrowers and lenders.

Now, however, the lender is the federal government and its shortfalls are covered by taxpayers. The mortgage market is bad, almost as bad as the student loan market, but that is fodder for another article.

The Dodd-Frank legislation has seriously complicated the business of borrowing and lending and has attempted to solve problems such as banks with no skin in the game, the concept of "too big to fail" and other supposed issues that led to the financial collapse of December 2007 through 2009 from which we are still trying to emerge.

Housing prices collapsed in that period as a result of the abolition of sound financial lending standards by the banks (encouraged and legislated by Congress through FHA and the Community Reinvestment Act as amended), the development of the shadow banking business, the guarantees of both Freddie Mac and Fannie Mae, and hopelessly naive ratings agencies. Add to that list the politicians who blindly believe that home ownership is appropriate for all Americans and many uninformed and financially incompetent borrowers chasing that dream and that provides enough blame to go all around to every party in this circus.

When the poor make bad financial decisions, the damage is generally limited to themselves and their immediate families. When Congress makes bad financial decisions, for whatever great and supposedly good intentions, the damage spreads far beyond Congress and impacts the entire country, and, in this case, the economies and governments around the world.

We generally expect the people who make the rules to do a better job managing the downside risk of their endeavors. Alas, such is often not the case. So it falls to you and me to avoid the problems heaped upon us by the well-intended leaders of the political and financial systems.

While Congress lamented that the banks had nothing to lose by playing the fast and loose lending game they encouraged (no "skin in the game" since the mortgages were packaged and sold to investors), their silence about the borrower's or homeowner's skin in the game was deafening.

Banks cannot force people to borrow money. Borrowers have a responsibility to understand the commitment they are undertaking and to follow the time tested financial principles of mortgage loans and home ownership.

First, have twenty percent to put down when buying a home. This is important for two reasons: first, it acts as a cushion should home prices decline, and second, if you've saved the required down payment (plus closing costs) it's likely you've also developed some good financial habits like saving money and spending less than you make.

For mortgage lending to work for the lender and the borrower, the twenty percent down rule serves as protection for all parties to the transaction. When Congress and the financial industry attempted to rewrite this financial principle by requiring smaller down payments (less skin in the game for the borrower), the die was cast for a collapse of the mortgage markets.

Now the bureaucrats are again pecking away at the twenty percent standard, which will lead to problems later. Maybe it is time to get the bureaucrats out of the banking business, and to let the foolish bankers fail and the foolish borrowers rent again.

Not everyone should be a homeowner. Despite efforts to encourage home ownership, our current rate is about 64%. This is similar to the rate in Canada, where the government does not encourage people to buy homes, they have no FHA, Fannie or Freddie, and mortgage interest is not tax deductible.

Aside from meeting mortgage payments, homeowners must also cover maintenance and repairs and buy insurance, all of which add up to much more than just the mortgage payment. Home ownership is never to be taken lightly because, for most people, their homes are a major financial commitment.

So my recommendation is to get politics out of home ownership and let bankers be bankers and let borrowers be borrowers. The market, if Bernanke and the Fed would stop manipulating interest rates, would sort the wheat from the chaff and the system would work successfully as it did for decades before politics got involved and someone coined the phrase "too big to fail".

Surely, the road to systemic collapse is paved with good intentions.



Dan Nestlerode was previously the Director of Research and Portfolio Management at Nestlerode & Loy Investment Advisors in State College. He retired in 2015 after 50 years in the investment business. A graduate of Penn State University, Nestlerode became an investment advisor in 1965. He can be reached at [email protected]
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