No-Money-Down Mortgages Can Destroy Affluent

By Feb 5, 2013, 3:50 PM Author's Blog  

Here comes another lame idea in finance, made especially for affluent investors with little sense.  Banks are offering no-money-down mortgages secured by portions of an investor’s portfolio.  Maybe this is a sign of how desperate high-end homebuilders have become to move new inventory.  It’s definitely a sign that parties to mortgages are once again throwing common sense out the window.

Limiting the stock portion of the mortgage’s collateral to 50% means little in the event of a stock market decline.  Let’s say a flash crash hits the market and the investor’s stock portfolio takes a 5% hit.  Now the stock collateral is (0.95 x 50) is at 47.5% of the loan’s original balance.  The servicing financial institution can presumably see the investor’s portfolio if it’s been pledged as collateral, and is most likely custodied with the servicer if it’s a TBTF bank.  If less than 2.5% of the loan’s principal has been amortized with principal payments up to that point, the homeowner will face the equivalent of a margin call to put in cash that will restore the value of the collateral.  The danger here is that affluent investor pledged securities because they didn’t have the cash or were unwilling to sell securities to raise cash.  Forcing a margin call would be the equivalent of an unpayable balloon payment and probably put the home into foreclosure.

Collateralizing 80% of the mortgage’s value with bonds is likewise no sure thing.  High inflation could reduce the real value of that fixed-income collateral faster than it reduces the real value of the loan’s balance.  It’s an unpredictable relationship because this country has gone so long without serious inflation.

Securing a mortgage with liquid securities rather than cold cash is a dangerous “innovation” in an extremely unstable macroeconomic environment.  I’ve blogged before about the risks of an equity market crash and  hyperinflation in the U.S.  A sudden reversal of fortune for the economy would jeopardize a mortgage whose down payment is secured with anything other than a large cash payment at the beginning.  Some affluent people will go for this anyway.  I’ll quietly await their distressed asset sales.

Nota bene:  This is not any kind of advice to either use such a mortgage or avoid one.  I’m sketching out a possible scenario and I risk nothing by watching to see what happens with these instruments.

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