How safe is creative home financing?
Boston — For most people, the decline in inflation and home prices recorded during October was good news. But not for everyone. In the last year or two, many home buyers and sellers have engaged in what has become known as ''creative financing'' to get around the problem of extraordinarily high mortgage interest rates. It has usually meant that the seller takes a second mortgage on his house, often with a large ''balloon payment'' of the balance at the end of, say, five years. The viability of the deals often hangs on continued inflation and rising home prices. If house prices stagnate or fall, some buyers may have trouble refinancing their balloon payments and sellers could be left holding the empty bag.
Donald L. Koch, research director of the Federal Reserve Bank of Atlanta, wonders whether second-mortgage home financing will be the REITs of today - but worse.
REITs (real estate investment trusts) boomed in the early 1970s. In 1969, only a few banks sponsored these tax-free trusts. They had about $1 billion in assets. By 1974, five years later, the REIT industry had grown to 208 trusts with assets over $21 billion.
Only two years later, many REITs were in deep trouble. One-third of their assets were represented by foreclosed property. Dividends to shareholders were less than one-fifth of what they had been in 1973. In fact, many REITs failed to pay dividends for a 48-month period.
The financial havoc was considerable. But if there is a similar shakedown in the housing area today, it would do much worse financial harm. There were many more people engaged in creative home financing than there were shareholders in crumbling REITs.
In an article in the latest issue of the Atlanta Fed's Economic Review, Mr. Koch and an associate, Delores W. Steinhauser, note three crucial similarities between the REITs of yesterday and creative home financing today:
1. Both involve an individual whose pay is derived from consummating a transaction, rather than from examining the creditworthiness of the borrow and his ability to pay the obligation from his current income.
Many REIT property managers made high-risk construction loans on apartments, motels, condominiums, shopping centers, and so on, since their salaries were based on the value of transactions they closed, not on the likelihood of the project's surviving hard times.
Similarly, the fees of real estate agents depend on their closing a deal - not on whether the buyer can pay off the loan.
2. Both are predicated on the notion that the asset's underlying value is likely to continue to rise, and that appreciation is critical to fulfilling the financial commitment.
Many REIT managers made loans on properties that were appraised far too high, or for which only a distress market existed once the economy declined.
Creative financing usually aims at avoiding a cut in the price of the house. And it often assumes that house inflation will continue and the mortgage market will offer easier terms in the future.
3. Both sacrifice scrutiny and critical credit analysis by the institution that is most fit and qualified to examine the risk of the underlying asset. Both assume that conventional measures of real estate financing are too archaic and conservative for current market conditions.
The National Association of Realtors estimates that over 50 percent of sales of existing homes nowadays employ some means of seller financing. With today's combination of high house prices and high interest rates, relatively few buyers qualify for adequate mortgage loans from financial institutions. The buyers either don't have enough of a down payment, or they can't afford the monthly payments on a 16 to 18 percent mortgage.
So real estate agents have been encouraging home sellers to offer buyers second mortgages with below-market interest rates. This is a disguised form of price cutting. Because the seller doesn't want to make a long-term commitment of his funds, the agent often arranges for a balloon payment of the remainder of the second mortgage after three to five years. The borrowers will be faced at the end of that time with the need to refinance their second mortgage.
In a transient society, buyers may expect to resell their homes at a profit before the balloon comes due. If prices are not up, they could be in financial difficulty. So too, then, could be the holders of second mortgages. They may be relying on the payments on that second mortgage to make their own payments on another house.
With the Fed successfully attempting to restrain inflation through tight money, some of the financial advantages of owning a house are now disappearing. For example, the two Fed authors note, from June 1980 through June 1981, the average mortgage rate on resale of existing homes was almost 15 percent. Over the same time span, the average sales price of existing homes rose only 10 percent. Homeowners were not getting free mortgage loans in real terms, as they did during much of the 1970s. Moreover, house prices are declining this fall - not just rising more slowly.
Another issue the authors raise is the question of the legal enforceability of a balloon payment. ''Sellers may find collecting balloon payments to be more difficult than they perceived at the time of sale,'' they write.
The two conclude: ''Sellers who take back second mortgages now are ecstatic about the sale of their homes plus the potential to earn a hefty return on the equity they must finance. But a depressed real estate market could spell serious trouble for the players involved in 'creative financing.' ''