A Realistic View of the Economy

March 28th, 2008

Yesterday, I read an article on CNN called From $70K to food bank.

It describes a woman who was laid off in February from a job paying $70,000 a year. “Weeks later”, with bills “piling up and in need of food for her family”, she went to a food bank.

The article proceeds to talk about the subprime lending situation at great length, which is largely irrelevant to this person’s situation.

Then we learn she applied for food stamps, but was denied. There’s a quote from this person about how frustrating that was, and general “tugging at the heartstrings” trying to make us feel sorry for this woman with two children whose mother moved in to help make the house payment. It seems to me that this is a correct decision; someone that can pay a $2500 mortgage each month ought to move into an apartment before trying to leech food or money from social service agencies.

And that’s where this story gets interesting.

She has an interest-only mortgage, and is managing to pay the $2500 bill each month.

If you’re not familiar with an interest-only mortgage, here’s how it works. The bank loans you money to buy your house — say, $200,000. This is a loan, and you have to pay interest on it each month, just like a regular mortgage. But with an interest-only mortgage, you never pay off the loan. You could be making monthly payments for 30 years and still owe $200,000. In general, the only ways to “pay off” this kind of loan is to sell your house, or get a conventional mortgage that pays off the interest-only loan.

Interest-only mortgages were largely banned after the Great Depression. Prior to that time, they were how mortgages normally worked. But there are several problems with them. One is that you have to pay on them forever, even after you retire. Another is that you can’t move unless you can sell your house for at least as much as the bank financed, even if you’ve lived there for 20 years. In times of declining housing prices and unemployment, that really stinks. People often default on the loans, and from a bank’s perspective, that really stinks, too.

Interest-only mortgages are usually used by banks financing construction (we had one for a few months when we renovated our farmhouse) or other short-term projects such as professional real-estate investors that buy old houses and fix them up to sell at a profit. Except for these things, in general, they should never be used for a primary house. It’s not in the interest of the bank or the homeowner.

But since you never pay off the principal, the monthly payments can be lower. It seems likely that this woman took a knowing gamble, buying a home more expensive than she could afford, and somehow found a bank willing to finance this. Problem is, both she and the bank took a knowing risk. If she ever ran into financial difficulties, she’d have to sell the house quick. But now the house is probably worth less than the value of the mortgage, so selling it won’t remove the loan — BUT it would let her pay off a large part of the principal, reducing her monthly payments and giving her some wiggle-room to buy food and pay off the rest of it.

It seems to me that she is unwilling to own up to the calculated risk she took, and wants society to help bail her out. Don’t get me wrong; I think we need to help people that run into hard times. We need to help make sure they still have the tools they need to find a job and a place to stay. But bailing out people that take huge financial risks shouldn’t be the job of society. Let’s help them land softly, but not be enablers keeping them in a home they never could — and still can’t — afford. Fortunately, I don’t think anyone in government (or running for president) is suggesting we should.

Not only that, but her bank shouldn’t have ever made that loan. Banks should be held accountable to not sell unwise products to people that rely on them for their primary residences.

Here’s another interesting point: in just a few weeks, she had burned through her entire savings.

This, unfortunately, is a quite typical situation for many Americans. My financial planner, and I think most experts, suggest that everyone ought to have 6 months of income in liquid non-retirement assets (savings accounts, investments, etc.) in case something like a layoff happens. Very few Americans have this.

And when it comes down to it, isn’t that part of the problem? The economy thrives on consumer spending. Or, put more starkly, overconsumption. If people start saving like they ought to, and stop feeling like they’re outcasts just for not keeping up with the Joneses and buying every last gadget or the biggest house, we’d all be in better shape — but the economy wouldn’t have grown as much.

The growth it would have seen, had we all been more responsible, would have been a lot more durable and recession-proof, I think.

Categories: Society

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  1. Adrian

    You say “suggest that everyone ought to have 6 months of income in liquid non-retirement assets in case something like a layoff happens”.

    That might be true in the USA where much seems to depend on people preparing themselves for such situations (and in reality people don’t save money but spend more money than they have). Other countries are aware that people don’t care enough for themselves and therefore force everyone to have e.g. an unemployment insurance, pension savings and a healthcare insurance.

    As an example, Germany handles unemployment benefits as follows: There’s a state insurance where each employer and employee has to pay some percentage of the wages, and if an employee gets unemployed he gets 60% or 67% of his last wages for some time (e.g. after being employed for two years he gets the money for one year) while searching for a new job.

    And that’s not good-will social security, everyone who gets money has paid for it.

    Reply

    John Goerzen Reply:

    That is a good point. In the US, we have some of that (unemployment insurance, for instance, but it tends to last not nearly as long as you mention). But things like health insurance generally don’t go along.

    Reply

  2. Mike

    No doubt this woman made bad decisions, and it sounds like she’ll end up paying for them.

    One thing about blaming borrowers vs banks: Most of the former have little experience whereas the latter have a lot of experience and should really know better or are simply being greedy. The most effective solution here will be to make it in their interest to act responsibly.

    Reply

    John Goerzen Reply:

    You’re quite right; I blame the bank, too. As I pointed out, this type of loan isn’t really in the best interest of either the borrower or the bank. I quite agree that the bank shouldn’t have even offered this type of loan.

    Reply

  3. jldugger

    Obviously the numbers sound strange to Kansan ears. A woman making 70 thousand unable out of cash and options after a month is bizarre to me. But whatever. Interest only mortgages are strange, and it was clear a year ago they were contributing to a bubble, when I heard that 40 percent of all new homes bought in Vegas were bought on interest only terms.

    Let me offer a different tack: What if she bought a home in order to give her children an education in a good public school? I don’t know the full dynamics of Californian schools, but I know what happens here: rich suburban neighborhoods raise funds for public schools, while rural and urban schools are rife with neglect. I’m not convinced that vouchers or other free market solutions will solve anything, but it might relieve some of the pressure for parents to live in the right neighborhood for their children’s future’s sake in homes they can’t afford.

    Reply

  4. Bill Steele

    This is not good on the part of the woman and also the bank. The bank should help the needy, but also should take care that the person is able to repay. The woman in the article had taken a bad decision, and will end up in paying.

    Reply

  5. Russ

    RE: germany unemployment

    Gah, I’d really rather not pay for the percentage of society that does not want to pay for the risks they take. I could have purchased a house double the size I have now, with a high risk loan, but then I wouldn’t be able to pay if I got laid off or if the rates changed.

    Meanwhile, we are talking about bailout for people who did exactly that?

    Same with unemployment insurance, and heck, for that matter, social security. I invest around 10% of my earnings, and I see another 10% go to social security. The 10% I invest will give me plenty to retire on 40 years down the road. The 10% or so that goes to social security will be chump change.

    Reply

  6. cliff

    You worried me for a while John. You started to sound like one of those stinking Republicans.

    Reply

    John Goerzen Reply:

    What can I say. Occasionally I slip up, I guess… :-)

    Reply

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