Australia | Apr 01 2008
By Greg Peel
US house prices have now slumped on average some 10% from their peak, but in some areas of California and Florida in particular falls have been even more dramatic. It is now appreciated the US housing bubble was fuelled by the availability of cheap, and sometimes effectively free, credit, manifested as what we now know to be the infamous “subprime loan”.
It is also now appreciated that the bursting of the housing bubble has precipitated a complete collapse of US credit markets, affected by the flapping of subprime wings translating into a tsunami of fear and loathing in financial markets. As the wildfire of the initial subprime crisis has spread deeper and deeper into wider credit markets, the more house prices have fallen. The situation has snowballed, culminating in the effective bankruptcy for the fifth largest investment bank in the US, which in turn has prompted extraordinary measures from the Fed not seen since the Great Depression.
Yet despite the Fed’s ever more dramatic response, US mortgage rates have risen more than they have fallen. Americans have been faced with financing a loan at a higher interest rate over a house that is underwater on an equity basis. Last month it was revealed in the data that Americans now owe, on average, more on their houses than they own. Some experts have suggested that US house prices may ultimately fall some 50%.
Fortunately Australia has proven relatively immune to similar dire problems at the household level, given Australia is effectively devoid of the culprit of the subprime loan. However, the credit crisis originating in the US has not left Australia unscathed. While the RBA may have raised interest rates on inflation concerns, banks have raised lending rates even further due to their increased cost of funding – a factor directly related to the global tightening of credit markets.
The average house price in Australia has continued to rise, albeit at a more subdued pace. However, there are some areas of the country, particularly the “aspirant” areas of Australia’s two largest cities, in which house prices have begun to fall rather ominously. Overstretched mortgage holders have been forced to place their infamous “McMansions” on the market, and foreclosures are rising. The risk is that these falling prices then precipitate a wider reduction in house prices which sets off a snowball similar to that being experienced in the US.
The Australian economy is still in relatively good shape, and has its fortunes linked more closely in this century to the fate of China rather than the US. However, the rate of growth of household debt in Australia has not only kept pace with that of the US, it has exceeded it. Australians have never carried more debt as a percentage of GDP any time in history.
The bottom line is that one cannot dismiss the possibility Australia will indeed experience some sort of housing slump, leaving many a mortgage holder high and dry.
Recognising this threat, one mortgage lender has come up with an innovative solution that actually allows the mortgage holder to effectively benefit from a fall in the value of the mortgaged house. Ruse Capital has introduced the Declining Value Mortgage (DVM).
It is an unwritten law that the value of a house will always appreciate over time. While this may be true, there are still inevitable periods when house prices decline. A Ruse Capital DVM exploits such periods.
A DVM can be obtained for a period of ten years. It is assumed, for the purpose of the loan, that over that time the value of the house declines by 10% of the original value each year. In other words, a DVM assumes the value of a house tends to zero. Thus there is effectively no principal payment involved – this is an interest only loan. But whereas traditional interest only loans still leave the mortgage holder with the original loan to pay off at the end of the mortgage, a DVM has assumed there is no longer any principal left at the end of the mortgage.
The benefit thus lies in the fact that the mortgage holder will own the house outright at the end of ten years. While prices may decline, even dramatically, in that period, there is no house that will ever be worth zero. But having successfully managed the interest payments, a DVM holder will retain the equity value of the house at maturity.
“It is a revolutionary product,” said Ruse Capital spokesman Fred Herring, “and one that should prove very popular”.
So what’s the catch?
The catch is that the DVM holder cannot sell the house within the ten year period. If the DVM holder is forced to sell the house due to delinquency on the interest payments, the house will be foreclosed by Ruse Capital with no equity due to the DVM holder. Thus the DVM holder will walk away with nothing, having made some level of interest payment to date.
Nevertheless, the DVM holder is not required to pay a deposit. Indeed, Ruse Capital will lend 100% of the value plus costs. The DVM holder has no outgoings at risk aside from the interest payments. On the assumption the average Australian is happy to own a house for at least ten years, this caveat does not appear too restrictive.
But it still sounds too good to be true. And yes, there is one other small catch. The annual interest rate will rise proportionately to the diminishment of the ascribed equity value. But this is not quite as ominous as it seems.
Assuming a house value of $1m and a first year interest rate of 8%, at the beginning of Year Two the house value will be deemed to be $900,000 – fall of 10%. The interest rate will increase as a function of the 90% value now remaining in the house – that is 8% divided by 90% = 8.88%. That may seem like a steep one year increase, but don’t forget the RBA has increased rates by 0.75% since August, and banks have added up to another 0.3% of their own. And furthermore, the DVM holder has “collected ” $100,000 towards the ultimate value of the house, and is now paying interest only on $900,000.
At the beginning of Year Three the interest rate rises as a divisor of 80% of the original principal, that is 8.88% divided by 80% = 11.1% of $800,000. Again this looks like a lot, but by now the DVM holder is effectively up by $200,000 on the principal, offsetting the higher rate.
The interest continues to compound throughout the life of the mortgage based on the same equation, but with each incremental increase in interest rate over the diminishing value, the DVM holder picks up another $100,000 of equity. Assuming all payments are made over the ten year period, the DVM holder ultimately owns a house that is just as likely to be worth more than the original million at the time. And there is nothing left owing.
It is a win-win deal. Herring suggested a lot of thought was put into coming up with a mortgage package in today’s new world that provided a balance between advantage to the mortgage holder and, of course, some profit for Ruse Capital.
As the US begins what will surely be many years of litigation over the fraudulent issue of subprime loans, it’s good to see someone is trying to bring back traditional concepts in banking while maintaining a twenty-first century level of innovation.
(Special note from the editor: if you haven’t seen the value trap in this new product by now, you probably will once you start making calculations throughout the full ten year period. This story was published on the morning of April 1st and that probably explains all.)
