Economic outlook.

by Maley, Frank

Business North Carolina • April, 2008 • housing prices

Foreclosures are on the rise in North Carolina--up 9.4% in 2007 and expected to increase as much as 20% this year. Government help for borrowers and lenders is OK, says one expert, but don't overdo it. After all, it's their own fault. Jacob Vigdor is associate professor of public-policy studies and economics at Duke University. He studied the subprime-mortgage market for the National Taxpayers Union, an Alexandria, Va.-based group that advocates limits on government taxing and spending.

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How did we get into this mess?

In the past 10 years or so, an upward trend in housing prices led people to make questionable decisions. If you live in a world where housing prices only go up, then you should be willing to borrow all the money you can to buy a house with no money down, because you know you'll build equity anyway.

What about lenders?

In a world where housing prices only go up, you should be willing to lend money to all sorts of people, because in a worst-case scenario if they don't pay you back, you confiscate the house and sell it for a profit. It's a world where almost any loan looks like a good one. A year or so ago, the housing market started to soften. If you live in a world where housing prices are going down, then all those loans you made to lousy borrowers look terrible because now you confiscate their house when they stop making payments and you have a hard time selling it. And if you do sell it, you're not going to recoup the full cost of the loan you made.

What role did hybrid adjustable-rate mortgages play?

A large one. With those loans, the interest rate is set at a low level for the first two years, then readjusts to a market rate and can readjust at points down the line. They allowed people with low incomes and low savings for down payments to get into expensive houses. But a lot of them got into trouble when their payments reset to a higher level. They were going to bail themselves out by refinancing the loan before the interest rate reset, which sounded like a great idea when housing prices were going up.

What market factors contributed?

We often talk about lenders as if one entity makes the loan, then holds it in a portfolio. That's not how the market works. A loan originator signs the paperwork, then sells the loan to someone who packages it for sale to the secondary market. The actual debt is held by bond holders. The originator has the incentive to write as many loans as possible and not worry about quality, because by the time these loans go sour, the originator is long gone.

So there's a ripple effect.

This problem affects anyone who owns bonds or trades in derivatives based on bond values. That includes a lot of Wall Street firms. A lot of these bonds were held by pension funds, institutional investors and big Wall Street banks.

How is North Carolina faring?

It's not as bad as other parts of the country where the economy is suffering, including parts of the Midwest where manufacturing employment has taken a hit in the past couple of years or places where there was a lot of speculative activity--waterfront properties in Florida, condominiums in Las Vegas, parts of California and the Northeast. A lot of people were buying homes to flip them.

What's the outlook here?

The market for high-end coastal developments or second homes in the mountains may soften over the next year or two. It's getting harder to finance very large loans. Your million-dollar beachfront house might be an $800,000 beachfront house a year from now.

What shouldn't government do?

This problem was created by bad decisions by lenders and borrowers. The wrong thing would be to try to absolve the parties responsible for this through a bailout. It puts taxpayers on the hook. It sends the wrong message: It's OK to make bad decisions because the government will take care of it.

What can government do?

Get borrowers and lenders to come together and negotiate better terms for the loans. The lender will take a hit, but it's the lesser of two evils. The alternative is that you force the borrower to stick to the original payment schedule, the borrower defaults, you get the house, you sell it at an incredible loss, and you're a whole lot worse off.

The state attorney general and banking commissioner recently pledged $300,000 for counseling to help people fight foreclosures. Is that a good idea?

Yes. It's not a whole lot of money. For the same price you might pay to bail out one or two people, you could counsel potentially hundreds of borrowers and get to a situation where they have the knowledge they need to go back to the table and negotiate with lenders.

Bank of America recently agreed to buy troubled mortgage lender Countrywide Financial. Good idea?

I wouldn't do it. They may think Countrywide has gotten past the darkest days. It all depends on the price.

It was $4 billion.

If I had $4 billion sitting around, it might be better under a mattress.