US mortgages built on shaky foundations

Even buyers with solid credit scores are finding it hard to secure home financing in the US.

You don't have to live in America long to figure out why it has landed in such a huge housing-induced economic quagmire. All you have to do is apply for a mortgage. For more than two years I had been following the course of the meltdown in the media. The early horror stories, flagged in a cover story in Business Week in September 2006, all seemed to involve adjustable rate mortgages, commonly referred to as "ARMs". These were initially set at a low "teaser" rate that the borrower could actually afford, but soon shot up to levels that made keeping up with payments impossible. Not a mistake a seasoned financial journalist such as myself would make, and, in any case, I am from Europe, where floating rate mortgages are the norm. But still, my heart went out to all those poor people who had been confused and caught out. Much better to apply for a 30-year fixed-rate mortgage. In contrast to almost every other country in the world, US banks are able to offer very cheap fixed-rate mortgages, and the reason is that they can then sell them to Freddie Mac, the Federal Home Loan Mortgage Corporation, and Fannie Mae, the Federal National Mortgage Association. Nobody really knew what these agencies were until they started announcing catastrophic losses: Freddie Mac just reported another US$10 billion (Dh36.7bn) loss in the first quarter. They are government-backed, set up decades ago to encourage more widespread home ownership. This has come at a cost: much of the $100,000 I paid in taxes last year has gone to bail them out. Still, it is worth it when you consider the beauty of being able to borrow $417,000 (the maximum amount for a Freddie Mac mortgage) at 5 per cent for 30 years. With great enthusiasm my husband and I gathered together all the paperwork, determined to take advantage of the cheap available credit. Other than our mortgage, we have almost no debts. I don't like buying things on a credit card, and despite having three children under three, would never allow us to live beyond our means. I am Dutch, and take great pride in my frugality. Our credit scores were pretty much perfect: one of my husband's came in above 800, the lowest at 747, which is still very good. The interest and principal we would need to pay each month came to about $2,300, according to the bank's good faith estimate, little more than 10 per cent of our combined income. Then came the appraisal of our house. We bought an old farmhouse in April 2007 for $1.2 million. It is less than 95km outside Manhattan, so my husband commutes to work every day. And yet, unbelievably, the $1.2m included 25 hectares of land. We are surrounded by trees and meadows, we constantly see deer and turkeys trotting outside our windows and the views are magnificent. The house needed a lot of work done to it, but the architect made sure that as we put in our insulation and high energy-efficient windows to meet building codes, we kept a lot of its old features: the bathroom in the basement, the old stone walls, the chestnut beams in the main living room, and the big old fireplace, which, according to the seller, dated from 1704. April 2007 was, of course, not a good time to buy a place, or spend a lot of money lovingly restoring it, and so we were prepared for the new appraisal to register a substantial loss. It did. In spite of all the work we did to it, our house is now supposedly worth only $825,000. Still, we are not intending to sell it, and even if we were we believe it would fetch a lot more than we paid. After all, in Greenwich Village, only an hour and 15 minutes away by car, $1.2m is still hardly enough to secure a broom cupboard. The $825,000 might reflect the value of a newly built house around here, in a sub-development with 20 other identical houses, but ours is an old stone farmhouse and unique. But I digress. What the appraisal certainly did not seem to herald was a problem in terms of the mortgage. We were still borrowing only about 50 per cent of what the property was worth. For Freddie Mac, in trouble because of loans to borrowers who put in zero equity and whose income was not enough to meet payments, surely our application was a golden opportunity to finally start making safe investments? We continued to hear nothing from the bank. My husband pestered them, I asked for updates. We were told there were no problems, they were just busy. We reminded them that the interest rate lock at 5 per cent, which we had paid more than $2,000 to purchase, was expiring at the end of June, and we needed to get a move on with all the paperwork. The application fee and appraisal fee together had already put us about $1,000 out of pocket. Finally, on June 9, I received a phone call from the bank. It could not lend us the money because they would not be able to sell the loan to Freddie Mac. The reason? Because our bathroom was in the basement. I was so flabbergasted that I immediately called the Freddie Mac press office. I asked if they had any objection to bathrooms in the basement. I was told there was no such rule. We asked our bank to inform Freddie Mac that their own press officer, Brad German, had told us there was nothing in the Freddie Mac rulebook stipulating bathroom location. In spite of our lobbying, our application remained rejected. Our bank explained that while there was no rule per se about the bathroom, it was a "grey area". (Actually our bathroom is blue, but I'm not going to nit-pick.) The bank proceeded to offer us other products, including various ARMs instead of the Freddie Mac deal. I have since looked into those more. The rate does not seem to move with central bank interest rates, as it would in the UK, but with other, much less transparent, variables. I thought it might still be OK to go ahead. But my husband, who works in finance, had the good sense to pester an amortisation schedule out of another local bank. It was only by looking at a piece of paper I had not even known existed, that I figured out that the payments on an ARM can really jump around all over the place: $3,000 a month here, $4,000 a month there. They do not just go up 0.25 percentage point when the Fed moves its rates up 0.25 percentage point. Or down when the Fed moves its rates down. Indeed, in the amortisation schedule we were looking at, they never seemed to go down at all. What I was looking at seemed less like an adjustable rate mortgage and more like a random rate mortgage: your monthly payment seemingly decided by potluck. In any case, it was not something a sensible, conservative borrower such as myself would willingly expose herself to. And that is the heart of the problem. Lending money should be a boring business. The system should encourage sensible loans to sensible, boring people. But in the US, that is impossible. To me, buying a house and applying for a mortgage has felt more like entering a potluck competition than a dull, long-term contractual agreement. Which is why in spite of the billions of dollars that have been thrown at the problem, I am sceptical about the chance that there will be a fundamental improvement in the US housing market any time soon. Or if there is, it will be followed by further catastrophes. Sophie Roell is a New York-based journalist. She has contributed to The Times, the Financial Times, The Wall Street Journal, the Boston Globe and The Banker. She has a Master's degree in East Asian Studies from Harvard University