|Readers Journal weblog/wEssays||home|
Innovative Financing and the Housing Bubble: leasing with an option to buy (Peter F., January 2, 2008)
The U.S. housing boom, subsequent housing bust, and concomitant housing debt collectibility problem, all originate from the same phenomenon. This epic socio-economic event was the acquisition of housing through lease with option to buy contracts.
Throughout the period of 2003 through 2007 a large number of Americans who "legally" purchased houses with 100% financing, "economically" rented those houses with an option to buy at the end of the lease. The lenders were the effective purchasers who granted the lessees options to purchase the property at a strike price of the loan balance. How did this work?
Let's say that several years ago a household with annual income of $50,000 and a decent credit history desired to purchase a residence. Assume further that these householders had little or no money for a down payment. What were the purchase choices available to them based on a standard underwriting practice of P&I not to exceed 28% of income? If they qualified for a VA loan, they could have purchased a house for $195,000. If they did not qualify for a VA loan, they could have purchased a house for $201,000 using PMI or FHA financing (down payment of $6,000). But they had further choices available. Such choices involved "innovative financing."
Using a 2/28 or 3/27 ARM with an initial interest rate of 3% they could have bought a house for $277,000. With a 4% interest-only loan, they could have afforded to spend $350,000 for a house. Finally, with a 2% pay, 4.5% option-pay ARM loan they could have bought a house for $700,000. Which house did this typical householder tend to buy: the $195,000 house, the $201,000 house, the $277,000 house, the $350,000 house, or the $700,000? I suspect that for such "purchasers" the median purchase price was somewhere between $275,000 and $350,000. After all a $300,000 house is so much nicer than a $200,000 house. Don't we deserve the nicer property? Hence the housing price bubble.
The innovative financing that allowed people to purchase properties they could not afford was in effect leasing with an option to buy. The lease period was the initial term of the loan. The option to buy occurred at the end of the lease period and the strike price was the loan balance at the end of the initial loan term. At the end of the initial term the house-occupant, the legal owner-mortgagor but the effective tenant, would have the following choices.
1. Exercise the purchase option. This would entail refinancing to a conventional, 30-year fixed rate loan, or making payments under the remaining life of the loan. The latter course would be the servicing of an amortizing, adjustable rate ARM loan.
2. Offset the purchase option. This would be the sale of the house for a net price greater than the remaining loan balance. The former legal owner, who walked away with a cash gain, would then obtain different housing, either purchased or rented.
3. Roll the transaction into a similar, new one. This would be the replacement of the existing innovative loan with a new, similar innovative loan.
4. Let the purchase option expire. This would be defaulting under the terms of the loan and letting the lender take title to the property through foreclosure. The former legal owner would then obtain different housing, in all likelihood rented.
Since 2005, house prices have fallen and are likely to continue to fall. Since 2005, median household incomes have not increased much and are likely not to rise significantly. How does this affect the house option-holder? Choice 1, the exercise of the purchase option is not feasible unless the option holder's income has risen significantly, or the option holder has obtained a financial windfall. Choice 2, the offset of the purchase option through sale, is also not feasible because the value of the house has fallen. Choice 3, rollover of the option, is also not feasible because the innovative financing is no longer available in the marketplace. For most of the tenant-option holders the only practicable course of action is to let the purchase option expire; i.e. default and foreclosure.
The big losers in this historic episode are the lenders. More correctly, the losers are the investors in the mortgage-backed securites into which the subject, innovative loans were placed. The fatal mistake of these "lenders" was that they looked only at the legal form of the transaction and ignored the economic substance. They evaluated the proposed transactions as debt investments. They should have evaluated the proposed transactions as purchases with the grant of an option. In effect, the lenders "bought" the houses, wrote purchase options (calls) with a term of from 2 to 5 years, and leased the houses to the option holders. The strike price of these options was the loan balance at the end of the initial term. Now that house prices have fallen these options are out-of-the-money, won't, or can't, be exercised and the debt-investors will be left holding the bag as owners through foreclosure. In essence, the debt investors become legally what they always were economically, the owners of the houses.
For more on a wide array of other topics, please visit the oftwominds.com weblog.
HTML, format and art copyright © 2007 Charles Hugh Smith, copyright to text and all other content in the above work is held by the author of the essay as of the publication date listed above. All rights reserved in all media.
The views of the contributor authors are their own, and do not reflect the views of Charles Hugh Smith. All errors and errors of omission in the above essay are the sole responsibility of the essay's author.
The writer(s) would be honored if you linked this Readers Journal essay to your site, or printed a copy for your own use.
|Readers Journal weblog/wEssays||home|