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Thread: How Everyone Came To Have A Second Mortgage

  1. #1
    Vulture of The Western World Eric's Avatar
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    How Everyone Came To Have A Second Mortgage

    By Larry M. Elkin

    A quarter-century ago, only someone in desperate need of cash would take a second mortgage. Then Congress changed the tax rules, and today, millions of Americans have “home equity” lines.

    Banks are losing $30 billion a year on these products, and untold thousands of families stand to lose their homes to foreclosure. Is this another example of a law’s unexpected consequences? Nope. This outgrowth of the Tax Reform Act of 1986 was perfectly foreseeable, and in fact, foreseen. But, then as now, Congress tended to tune out warnings that it preferred not to hear.

    Prior to the tax reform, taxpayers could deduct nearly any sort of interest expense, including interest on credit card balances, automobile loans, and life insurance loans. After the tax reform, nearly all non-business interest expense was no longer deductible.

    But a few exceptions remained. The most important was (and is) that taxpayers still can deduct the interest on up to $1 million of mortgage debt incurred to buy or improve a principal residence or a vacation home. The real estate industry lobbied hard to keep this benefit in the law.

    The tax reform law also preserved a benefit for second mortgages. Taxpayers are permitted to deduct interest payments on up to $100,000 of debt, regardless of the purpose for which the debt is incurred, so long as they put their home up as collateral. The Internal Revenue Service explains: “Generally, home mortgage interest is any interest you pay on a loan secured by your home (main home or a second home). The loan may be a mortgage to buy your home, a second mortgage, a line of credit, or a home equity loan.” So, even if you plan to use the money for a big screen TV or a vacation, if you borrow against your home, you can take the deduction.

    In recent years, many home equity lines of credit have greatly exceeded the $100,000 cap. Interest on the excess debt is nondeductible. However, the government has no easy way to know the size of the loan on which the interest is being paid. Over more than two decades in the tax business, neither I nor any of my co-workers have ever been asked to demonstrate that the interest deductions claimed on a tax return are for a loan within the allowable limits. We follow the law anyway, but we can safely assume that many taxpayers do not, either out of ignorance or otherwise. In practice, therefore, taxpayers can end up taking deductions for interest expense on debt well above the limits.

    I was just getting into the tax business when the Tax Reform Act of 1986 passed. The rule on interest deductions made no sense to me, so I asked the experienced CPAs who were training me to explain it. It turned out the exception made no sense to them, either. Why would the government want to encourage an explosion of second mortgages, a term once used somewhat derisively? Wouldn’t the rule just prompt people to get into debt over their heads and then lose their homes? The answer was that it would, and it did.

    The popularity of home equity debt soared. By 2008, the value of outstanding home equity loans had risen to more than $1 trillion, from around $1 billion in the early 1980s. Banks did their part to promote the trend, rebranding second mortgages with the more positive terms “home equity loan” and “home equity line of credit.”

    “Calling it a ‘second mortgage,’ that’s like hocking your house. But call it ‘equity access,’ and it sounds more innocent,” Pei-Yuan Chia, a former vice chairman at Citicorp who oversaw the bank’s consumer business in the 1980s and 1990s, explained to The New York Times in 2008. High property values allowed borrowers to take on large amounts of debt, using their homes as collateral.

    Then the recession came, real estate values plunged, and many borrowers were suddenly unable or unwilling to make their payments. Because of the collapse of the housing market, the homes that lenders held as security had, in many cases, lost their value. Borrowers who were unable to pay off the loans by selling their homes frequently had no choice but to default, leaving banks with the often impossible task of collecting the outstanding debt. In 2009, lenders had to write off $11.1 billion in home equity loans and $19.9 billion in home equity lines of credit as uncollectible. Borrowers lost their homes and emerged with damaged credit histories.

    Congress claims to be shocked that such a thing could happen, and yet it was absolutely predictable. People did exactly what the tax code encouraged them to do. The system worked just how it was supposed to, but the tax code was encouraging people to behave in a way that, in the end, was bad for them and bad for the country.

    To Form 1040 jockeys like me, the only shocking thing is that it took so long for the house of cards to fall.

  2. #2
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    We have witnessed the greatest destruction of 'so called wealth'.

    Take a look at South Minneapolis. It's filled with 1,100 sq/ft homes. Many built around 1920 and 1945. Not particularly well designed, on small lots, terrible garages, accessible by an alley that is a horror in the winter.

    Most of these homes cost $3,000 to $5,000 to build. They did not appreciate that much until the 1970's. Then all of a sudden - between the economic boom and the two income earner (which meant you both literally had to work the rest of your waking hours doing laundry, cooking, shoping, etc, just to be prepared to go back to 'work')

    I remember clearly: we bought a home in 1975 for $35,000 - the home originally sold for $10,000 in 1960. Thus started the mindset of "your home will keep increasing in value - forever"

    How to keep the home increasing in price for forever? Well it was the advent of the 30 yr mortage. The bank earns a tremendous amount of intrest, and most likely you will move in 7 yrs. In essence you're renting the house - since you never really own the asset.

    Then when housing continued to rise - they invented the ARM and lowered to down payment amount to a few percent.

    To get even more intrest income banks convinced people to 'tap into' their phantom home equity. Why not put that money to work! Thus the 2nd mortgage.

    Then when they exhausted the ARM came balloon loans and intrest only for the first 'x' years mortgage.

    The last was the $0 down, intrest only loan (for the first two years). Since the prices of homes were rising so fast you could buy a $200,000 home, and have it 'appreciate' 10% a year, so after two years the asset value would be $220,000 - thus the owner had 10% equity!

    This is when the sh1t hit the fan.

    They ran out of ways to creatively finance a home, and keep the home values appreciating. There was a realization that there was not sufficient household income to keep paying more and more for a home.

    These loans were packaged and sold in blocks of 100. There were a ticking time bomb. As long as the payments were made, everything was OK. But when the balloon came do, or they owner had to pay the full PITI there was a default. This is when the bank realized they had purchased way overvalued assets. There was no equity in many of the loans. As a matter of fact - there was a loss.

    Near my home (in 2003), some of those crappy 1,100 sq/ft homes were selling for $225,000. Completely outdated, no closet space, bad floor plans (no floor plan), ill designed - compared to a modern condo or apartment. But yet the lemmings kept buying.

    We are now seeing the home pricing returning to somewhat what it was like pre 1960.

  3. #3
    Vulture of The Western World Eric's Avatar
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    Exactly.

    In our old neighborhood, which consisted of smallish (appx. 1,500 sq. ft.) single family homes that were shoddily built (on slabs, T111 siding, singe pane glass, hollow-core cheap doors, aluminum wiring, etc.) in the 1970s and which were originally "working class" homes - prices more than doubled in about six years, from the late 1990s to circa 2005 or so. Homes that sold for $160k in 1997 were selling for $420k by 2005. The shitty townhouses across the street - which were often literally Section 8/crack houses - that sold for $60k in 1996 where sometimes going for more than $200k by the time we left in early 2004.

    Now prices have collapsed back to around $250k for the houses and $150k for the townhouses... they still have some dropping down to do, I think.

    Our old house has already been foreclosed on twice since we left.

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