Friday, July 31, 2009

Creative Financing

One of the biggest factors that contributed to the housing boom and bust was the federal government's attempt to make housing "affordable" for everyone.

Members of Congress from both political parties have urged federal regulatory agencies to press banks and other lenders to lower mortgage loan requirements, and have passed legislation to that end and to subsidize or guarantee loans made under lowered standards. (p. 30)

Banks and other lending institutions have learned by experience that certain standards must be met by borrowers in order to protect themselves against the risks of default. Traditionally, one of these requirements has been a substantial down payment, usually in the neighborhood of 20 percent of the total cost of the home. This down payment protects the lender against loss if the borrower should default. It protects the lender in two ways: (1) It makes it less likely that the buyer will simply walk away from the home and the mortgage (since the buyer will lose a substantial investment in the home); and (2) the bank will have an easier time selling the house after foreclosure without losing money.

Say a home costs $100,000, and the bank requires 20 percent ($20,000) as a down payment. A buyer comes along and pays the $20,000 down and takes out a mortgage for the remaining $80,000. Very few buyers are going to simply walk away from the home and lose such a substantial investment (the down payment). But if it should happen, and the bank forecloses, it has an easier time unloading the house for $80,000 than for $100,000 (if no down payment had been made). The down payment insures the lender against the risks inherent in lending.

But Congress has passed various pieces of legislation to subsidize or guarantee loans made with lower down payment requirements. Banks and other lending institutions don't ordinarily make such loans on their own because it's too risky. But our illustrious Congress has come to the rescue by offering to assume the risk on behalf of lenders. They encourage "no-down payment mortgages" for the poor. And what happens if the poor can't keep up with their mortgage payments? Remember Congress guaranteed the loan. Lenders will get their money back from Congress. And where does Congress get its money? You guessed it, working stiff taxpayers like you and me.

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