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Dumb Loans Damage Economy

February 29, 2016 Mickey Roth, For the Express-News : November 29, 2013
Dumb Loans Damage Economy

Recently, I received an email from a gentleman who identified himself as an economist. That email addressed my Express-News comment, which centered on how we can face up to the severe financial strains of our nation. I noted key parts of this situation:

Going to war in 2001 and leaving income taxes at or near the lowest-ever rates.

The war has become one of the longest in our history and has now cost over $2 trillion.

We've gone through a financial crisis centered on sub-prime mortgages, which we tried to insure with derivatives.

The “economist” told me that we don't need to raise taxes and that the mortgage situation can best be addressed by reinstating the Glass-Steagall Act, which placed limits on the securities activities of banks and the affiliations of those banks with securities firms, and the “Bucket Shop Law” of 2000, which had removed some regulation of derivatives trades between “sophisticated parties.”

Glass-Steagall was rescinded in 1998 and “Bucket Shop” is still in effect. This “economist” believes that such laws are the very best way to address our rampant creation of sub-prime mortgage loans. It is my strong belief that the stress of these sub-prime loans can and should be addressed in a much more fundamental way.

My 40 years in the investment business has taught me many lessons. One of the most important: You cannot make dumb loans.

That lesson, I have noted over these decades, is challenged by a widespread idea: Every American has the right to own his or her home! My view on this idea has always added a modification: You have the right to own a home if you can afford to do so.

This widespread idea (without my modification) has led to the creation of the adjustable rate mortgage (ARM).

The first time I saw ARMs was around 1981 when interest rates were sky high. Since banks then were paying double-digit rates for deposits, they could make mortgages only with rates around 15 percent, and almost no one could afford the payments required on such a high-rate loan.

So the banks replied by lowering the interest rates and, thus, the payments on those mortgages for the first two or three years. The hope was, that after that short period, interest rates would drop and the homeowner would be able to refinance at a lower rate.

As that dire situation passed, interest rates did indeed decline, and some folks in our banking industry perceived that ARMs could be used to address that idea of every American having the right to own a home.

This was a dire shift in the use of ARMs. The probability, in 1981, of a return to a normal range of mortgage interest rates was high.

The probability today of someone with little wealth and a low income being able to greatly increase their mortgage payment in two or three years is very low. This is simply a bad loan.

It is my firm belief that no lender should make a 30-year loan to a borrower who obviously can only afford to make artificially low payments only in the first two years.

After that, as those payments rise, the probability is extremely high that this borrower will default. And, for the lender to say, “That's OK because I can sell the loan!” is egregious.

We need to wake up.

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