Right and Wrong ?

1/29/09

Meet Bob and Phil. Bob and Phil are both married with two kids and a dog. Bob earns $75K per year and Phil earns $50K per year. Bob saved $25K for a down payment while Phil saved $5K and in 2006 both took the plunge purchasing a new home. Both were educated professionals with good jobs, excellent credit scores and the desire to own their own home.

Bob decided to be prudent and he purchased a home for $250,000 putting 10% down. His monthly income of $6,250 allowed him to easily qualify for a home loan on a 30 year fixed rate program at a 6.5% interest rate and a total monthly payment of $1,850 including property taxes and insurance. This payment was only 30% of Bobs gross monthly income and he felt comfortable that this was something he could afford. The home Bob decided to purchase was not as large as he dreamed of nor was it on the golf course as he wished but he felt it was well within his budget and thus the purchase was the right decision.

Phil decided to purchase a much larger home located on the golf course for $600K. He put nothing down, using the $5K he had in savings to buy new big screen TVs and furniture for his new mansion. Phil did an interest only, “Pay-Option” adjustable rate mortgage with an interest rate that would change monthly but a minimum payment required of only $1,950 including his property taxes and insurance. This low payment was not in fact enough to cover even the monthly interest due and the difference was to be added to the loan balance each month meaning that as time went by the loan balance would actually increase. But Phil did not worry; he was having fun playing golf and besides he figured in a few years the home would surely be worth $1 million or more. The monthly payment represented 47% of Phil’s gross monthly income, but Phil felt he could still find a way to afford greens fees at the club.

Who made the right choice?

Three years later, times are hard. Both Bob and Phil have suffered pay cuts and they fear for their jobs. Property values have suffered, Bob’s home is now worth only $230,000 and Phil’s home is valued at only $525,000.

Phil’s mortgage has now reached the maximum allowed negative amortization of 115% of the original loan amount. His loan balance is $690,000 so he owes $165,000 more than the home is worth . His mortgage payment is resetting to $5,500 per month, which is significantly more than his total monthly income.

Never Fear! The Government is coming to the rescue!

The Federal Reserve has implemented a $500 Billion program to buy mortgage backed securities from Fannie Mae and Freddie Mac in order to push interest rates to historically low levels in support of the housing market. The FDIC and Treasury Dept. have devised clever programs aimed at modifying loans to prevent foreclosure.  These programs will surely help everyone, right?

Wrong.

Bob is eager to take advantage of the Fed subsidized mortgage rates through refinancing. He has never been late on a payment, his credit is still great and with his income he still easily qualifies. He gets a quote for a new mortgage rate at 4.75% that will lower his monthly payment by about $300 per month. But, his loan is declined. Changes in Fannie Mae underwriting guidelines have determined that his property is located in a “declining market” and thus the maximum loan to value allowed is reduced. This, coupled with the decline in his property value exclude him from benefiting in any way from any of the Government stimulus or bailout programs. Bob gets nothing, too bad for Bob.

Phil on the other hand quit making his mortgage payment 3 months ago. His credit is a disaster and he has gotten a foreclosure notice from his lender. But never fear… the Government is here! The FDIC and Treasury Department loan modification programs can make everything better for Phil. They can lower his loan balance to $350,000, give him a 40 year fixed rate term and an interest rate of 4% so his monthly payment is back down to $1,900. This is called “Foreclosure Mitigation”. Not only can Phil get a free $340K loan balance reduction but the IRS is so nice as to even forgive him any tax liability on this gain!

Did Bob make the right choice when he bought his home? He chose to be responsible and his reward is the Government restricts him from benefiting from Government aid programs.

What about Phil. Well, clearly Phil hit a home run when he made his purchasing decision! The Government is falling all over itself to throw money at Phil.

What is right and wrong? Should Bob stop making his payments so he can get a loan modification as well?

When the Government takes action that turns the fundamental social foundations of right and wrong upside down, that is not an acceptable economic stimulus effort.