Back in the days of yore (when was that, exactly), if you wanted to buy a house, you saved up your nickels and dimes, and eventually you had that magical "20% down payment" socked away.
Lenders took this as an indication that you were at least partially responsible financially and extended you a loan, since it was less likely that you would default with so much skin in the game. If you went belly-up, between your down payment and what they could get auctioning off your crib, they'd break even and maybe make a little scratch in the process.
If you didn't have the 20% down, there was this thing called Primary Mortgage Insurance (PMI) that the lender required. It was not cheap. It might run you $150 per month on a $250K mortgage, but that was the upfront penalty for not being a saver. Also, PMI wasn't tax deductible like your mortgage interest, and that will be important later on in our discussion. So, for all these people running around with zero money down, or getting subprime mortgages, why didn't their PMI carrier step in when they couldn't make their payments and make the lenders whole? That would certainly have averted a large part of the current financial crisis.
As it turns out, there was a bit of gaming the system going on here, in which the lenders were complicit. Call it "piggyback" lending that was allowing people to buy more house than they had a down payment for, or a way to circumvent that evil 20% down / 80% financed model that seemed to work so well for, well, forever.
Here's how piggybacking worked - it was like getting two mortgages at once. Ta-da! The main mortgage covered the customary 80% figure that lenders normally like to see - made it seem like you've been a good boy or girl and saved well. The other mortgage was almost always a variable-rate deal for the difference between your actual down payment and the last 20%. If you had saved 10%, your variable-rate mortgage was the other 10%. If you saved 5%, your variable rate was for the remaining 15%.
I know, I know - you saw the term "variable rate" there and started to shake. With good reason.
Piggyback lending was fine and dandy when housing prices were on the upswing. Of course, everything was coming up roses then. With piggybacking, interest paid on both mortgages was tax deductible - it was mortgage interest, after all, not PMI. When the variable rate portion of the piggyback started getting costly as interest rate began to rise, no worries - borrowers could refinance the variable rate portion using the rising value of their home.
And then - POP. The mortgage bubble burst. As people began defaulting, home values began going south. Piggyback borrowers with declining home values could no longer refinance the variable rate mortgages, and since they had in many cases purchased more house than they could afford, their payments soared, and they began to default. Since no PMI was involved in the transaction, lenders had nowhere to go to recoup their investment, and with lower home values, they couldn't sell the houses for what the loan value was, and with little or no down payment, the lender was upside-down on the deal.
It's no surprise that the loans that are in the most trouble are the ones the skirted around mortgage insurance. And who owns those loans? The people who invested in mortgage securities. They're learning the hard way what's inside those bundled investments, and what they've done is essentially assumed the risk that would normally have fallen to the mortgage insurance companies. Except these investment groups aren't structured the same way as are insurers in the areas of loss reserves, credit risk, and so on.
So running an end-around to avoid PMI turns out to be a bad thing, so we stopped doing that, right? Well, I guess that depends on what your definition of "yes" is. Piggyback mortages were still being sold into this past spring, and so there are a lot of them still working their way through the investment pipeline. I don't think we've seen the last measure of pain from piggybacking yet.
Rather than going back to the old tried-and-true 80/20 model that was clear, transparent, and seemed to work pretty well, mortgage insurers used their lobbying influence to persuade Congress to allow borrowers to deduct their mortgage insurance payments. That law went into effect in January of 2007, so for all you folks who do the right thing and save your 20%, you're still getting screwed by the same group of people. The risk is now being assumed by PMI, and the home buyer can still buy more house than they can afford as long as they're willing to fork over large sums of tax deductible cash for PMI. From my perspective, this seems to be a recipe for future disaster instead of curing our current ills, but I'm sure everyone is hoping that home values will eventually bottom out and start to rise again, and at some point we'll be back on this crazy ride.
The law expires in 2010, so that tells me the mortgage insurance industry and lenders believe we will have staggered through this problem by then. What isn't yet clear is whether Congress, as part of the $700 billion financial bailout, will fund mortgage insurers, let people refinance using this new model, or better yet, place some sensible regulation around HOW a lender can structure a mortgage going forward.
My money is around the first option. I doubt sensible regulation will come out of this mess. But what do I know? I put 20% down on my new house two years ago, so I'm obviously old school and not one of the hip, groovy kids.
UPDATE: Very interesting poll numbers. Conservatives seem to want to portray that they are the standard bearers of traditional values and sane fiscal policy, yet more than 50% of seemingly progressive poll voters stated they had at least a 20% down payment. I wonder what the actual breakdown would be nation-wide? - K