'Prime Mortgages Look Terrible,' and here is why...

Thought: The big reason that the real estate market stinks in the United States right now came from the industry changing the way it defined what "affording" a house really meant.

The traditional definition, and the one I subscribe to, BTW, is that a buyer could "afford" a house if s/he had enough income to pay off the interest and principal of the mortgage by the time the mortgage was up, typically 30 years. That way, the buyer would own the home outright in 30 years.

The new definition, the one that the industry adopted over the past decade, was that a buyer could "afford" a house if s/he could obtain a mortgage loan that would allow the home sale to close and clear escrow. What happens after that moment doesn't matter. If the buyer could not or did not want to make the payments, s/he could refinance or sell the house for a profit -- who cares?

Well, the industry should have. And so should have Washington, consumers and buyers themselves. Because what the new definition missed was the possibility that home prices might at some point go down.

If that happened, what option did that new style of homebuyer have? They couldn't flip the house, because they would owe more than they could sell it for. They couldn't refinance, either, for the same reason.

They could continue making the payments, stick with the house and eat the loss, but what if the loan had an adjustable interest rate that went up? Or what if the loan offered a low introductory payment, one that covered only the accumulated interest or maybe not even that? What happens when the rate resets higher or the intro payment expires? What happens if the buyer of house with declining value can no longer make the payments?

Here's what happens: Foreclosure. And since millions of Americans "bought" houses using these types of loans, under this new definition of "affordability," those millions of Americans are going to lose those homes.

The new, looser definition of "affordability" encouraged lenders to write billions of dollars in mortgage loans that they would not have been able to justify under the traditional definition. That extra money inflated prices in the housing market, forcing new buyers to borrow more than they would have been able to afford traditionally in order to keep up. Lather. Rinse. Repeat.

Now, with lenders failing and the industry returning to the traditional definition of affordability, home prices must come down. They will come down to the level that would have been had the industry never changed that definition. They will come down to the level where they would have been had the bubble, and the resulting inflation in home prices, never happened.

In most markets, that means a return to prices last seen in the early 2000s, or even late 1990s. There is no other way. There are not enough high-income earners to support prices higher than that. And the market now has no tolerance for a lender that is giving out loans based on expectations of future housing price growth, instead of a borrower's ability to repay.

Robert Niles also can be found at http://www.themeparkinsider.com