Ability to pay seems like good bottom line for mortgage crisis

Just in the last four weeks, we have seen so much change in our economic landscape. And for those of us who own real estate, whether as our home or as investment, we find ourselves right in the thick of it.

Now we are told that the Emergency Economic Stabilization Act of 2008 will work to provide liquidity to troubled financial institutions and help restore equilibrium to real estate markets nationwide. I sure hope so.

One of the biggest problems I am having with the whole economic crisis is trying to understand just how much money $700 billion actually is. It’s hard get a handle on. In any case, a number of friends in the real estate business have been calling trying to figure out what caused this crisis and whether the rescue plan will fix it.

I certainly don’t pretend to have the answers to those questions, but I have observed three factors that may have contributed to the problems we are trying to solve today:

1. Changes at Fannie Mae. During the Great Depression, most home loans were made by the local bank and were five years in duration. It was expected that at the end of five years, you would go into the bank, pay the interest you owed, pay some toward the principal, and get a new five-year loan for the remainder.

As local banks failed, they were unable to reloan these mortgage balances, so homes and farms were foreclosed all over the country. Fannie Mae was created in 1938 to provide an aftermarket for a new breed of long-term mortgages of 20 and 30 years. So long as you made your payments, the loan could not be called due before maturity.

But in 1999, Fannie Mae was granted permission to enter into the risky “subprime” mortgage market, encouraging lenders to make home loans to groups that had been traditionally underserved. While the sentiment was laudable, the agency failed to couple its largesse with the education and follow-up needed to help first-time buyers understand their responsibilities.

In taking this step, Fannie Mae took on significantly greater risk than it had ever done in the past. But no one seemed to be concerned about the possibility of a downturn.

2. The Community Reinvestment Act. It was originally made law in 1977. Its original purpose of encouraging banks to make loans in areas that might have previously been “redlined,” or declared off-limits for lending, was a good idea.

But over the years, federal regulators have pushed hard for CRA compliance. Some people have questioned the safety of loans made to get CRA credit.

Whenever I have questioned bankers about the fundamental soundness of making mortgage loans in areas where the balances and payments just don’t seem to make any sense, they always talk about the importance of “serving the whole community” and “looking at the big picture.”

It’s no surprise to me that when government gets into the business of deciding who does and does not get a loan, there are mounting losses due to foreclosure.

3. Relaxed Underwriting Guidelines. Toward the end of the 1990s, Fannie Mae once again took steps to further expand the homeownership rate. This time the encouragement took the form of: relaxed qualification requirements in terms of income and expense ratios; the virtual elimination of a requirement for any significant down payment from the borrower; and the acceptance of nontraditional forms of credit as evidence of creditworthiness.

As an example, when I bought my first home in 1978, it was typical for lenders to expect the borrower to bring 20 percent of the purchase price to the closing table as a down payment. I had to prove that no more than 28 percent of my gross income would be needed for my monthly housing expense, and that my overall monthly debt load, including house payment, would not exceed 34 percent of gross income.

In addition, I had to show that I had established credit with several traditional credit sources such as auto lenders, credit card companies, banks or department stores. Amazingly, in recent years some borrowers have been able to obtain 103 percent financing with little credit beyond proof of on-time payment to the county water department or the power company.

These three factors must have had some part to play in the huge number of foreclosures we face today. I am aware that the causes of the overall crisis are many and complex. But I hope that one of the results of the Emergency Economic Stabilization Act of 2008 will be to encourage lenders to make loans only to those who can afford to make the payments on an ongoing basis.

John Adams is a broker and investor. For more real estate information or to make a comment, visit Money 99. Find previous articles by John Adams and more home buying advice on the ajchomefinder mortgage center.