‘Skin’ in the game is the key to successful housing recovery

Everybody is charting job growth and foreclosures. While many analysts say job creation is the primary driver of home sales, the hole that’s been dug by bad loans is too deep to be offset by a modest rise in future employment.

The reality is more foreclosures than ever are scheduled for 2010. What can be done about it?

A decade of cheap money and incredibly flexible loan programs offered by many lenders sparked overbuilding by developers, a flip-and-run mindset for speculators and unrealistic expectations for first-time homebuyers blinded by the low payments of a short-term loan.

According to Edward Pinto, a consultant to the mortgage-finance industry and former chief credit officer at Fannie Mae, the over-stimulus provided by Fannie, Freddie, FHA and the Community Reinvestment Act created the housing boom that went bust. The response to the bust has been to provide yet more stimuli which are serving to delay the market-clearing process, or allowing the traditional housing forces to return to the scene.

Just what are traditional housing forces? In a nutshell, it means skin in the game: Make certain that those who can truly qualify to buy a home are also able to produce a down payment and an income that will allow the repayment of the mortgage, taxes, insurance and monthly essentials.

“All we are doing is kicking the can down the street,” Pinto said. “The loan modification programs that were designed to help people stay in their homes have been abject failures.”

Basically, Pinto believes that the extra cash the government is tossing into the housing market is simply adding fuel to the fire by depressing prices while foreclosures continue to flood the market.

He and others would halt all housing stimulus funds and take the following steps to curtail foreclosures:

1. Separate those borrowers who are going to qualify at a lesser mortgage amount from those who will not qualify even at a lesser amount. For those who cannot qualify, lenders assist with rental subsidies for a period, in exchange for leaving the home in good condition. Lenders also accept deeds in lieu of foreclosure, where the borrower deeds the property back to the lender and avoids the foreclosure process.

2. Banks then chop down the loan amount and reduce mortgage principal amount to at least 90 percent loan-to-value. Affordable rates and terms are negotiated.

3. If the borrower accepts the reduced amount, he or she becomes personally responsible for the mortgage. The bank would have a “full recourse” loan, enabling it to seek the borrower’s other assets in the event of default. As of now, most foreclosures are non-judicial, meaning the borrower risks nothing but the equity in the house in the event of foreclosure.

The result: Qualified borrowers remain in homes; homes cost less; more genuine buyers surface because the “bottom” has been reached.

The lending craziness of the 1990s and 2000s was not present in any other decade. Sixty years ago, the average home price in the U.S. was about $5,000 and the average debt against it was about $2,500. In the early 1950s, the prevailing loan-to-value was 58 percent; many of the loans made between 2004 and 2006 had an LTV of 97 to 100 percent. Some lenders, blinded by the 10-year run-up in home appreciation, were making 125 percent loans.

In 1975, there were no adjustable-rate mortgages, 80-20 combo loans or equity lines of credit. The minimum down payment was 20 percent, unless a homebuyer wanted to pay for mortgage insurance which protects the lender if the borrower defaults. The only way a borrower could get a 3 percent down payment loan was through FHA. As a result, foreclosure rates were low.

It’s time to let the market correct itself. That means skin in the game for buyers.