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September 2, 1983
Year of Reckoning
This is the year of reckoning for many
creative financing deals that involve homes
purchased between 1980 and 1982. Many
recent homeowners will soon have to refinance part or all of the balance of their home
mortgages unless they can come upwith the
necessary cash. Estimatesof the magnitude
of the required refinancing vary, but the
amount is likely to be substantial because
short-term creative financing has been a
major alternative source of residential
mortgage funds in lieu of bank- or S&Loriginated mortgages.
As we shall use the term, creative financing
refers to some sort of seller-assisted financing at rates below prevailing mortgage
rates. Most such loans were to mature in live
years or less, and, because the monthly payments were frequently amortized over 30
years, involved substantial lump sum payments at maturity. Because of the latter
feature, foreclosures associated with
creative financing have risen recently.
However, with thedecline in mortgage rates
and the modest increases in incomes and
home values over the past year, most
creative financing deals now coming due
should not encounter serious refinancing
problems even though homeowners will
find the new monthly payments higher than
they had perhaps anticipated.
Affordability
Back in the halcyon days of the late 1970s,
creative financing was relatively uncommon. There was no need for it. The pace of
home sales was brisk, prices seemed on an
unending upward spiral and mortgage rates
were sufficiently low that initial payments
did not absorb an unmanageable proportion
. of homebuyers' current income.
The boom years for housing came to an end
rather abruptly, however. As the inflation
rate climbed towards the double-digit range,
financial markets began to revise their infla-
tion expectations upward, demanding
higher inflation premia on their long-term
investments, including mortgages. Moreover, on October 6,1979, the Federal
Reserve made a fundamental change in
policy that resulted in tightening the availability of credit. The effect of accelerating
inflation as well as the credittightening was
a nearly unprecedented rise in interest rates
(including mortgage rates) that wreaked
havoc in the housing market. Suddenly,
house prices that were attractive when
mortgage rates were 10 to 11 percent
seemed outrageously high with rates in the
17 to 18 percent range. Because potential
homebuyers simply did not have sufficient
current income to meet the larger mortgage
payments and because mortgage contracts
did not permit them to borrow against
(higher) expected future income, the high
rates precipitated a significant drop in the
demand for housing.
Enter creative financing
Faced with the prospect of having to offer
substantial price discounts in order to sell
their homes, homeowners and developers
frequently proposed creative financing
instead. Developers began to offer interest
rate "buydowns" whereby the developer
either obtained shorter-term financing at
market rates or compensated the mortgage
originatorfor giving first mortgages to buyers
at below-market rates for the lirst few years
of the mortgage.
Homeowners wishing to sell their homes
frequently agreed to provide prospective
buyers with subsidized short-term first or
second mortgages. Several state court decisions, the most notable of which was the
so-called Wellenkamp decision in California, encouraged tile use of seller-assisted
financing by declaring that existing first
mortgages origi nated by banks and statechartered savings and loan associations
could be transferred to the new homebuyer.
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Opinions expressed In l'his newsletter do nO'1
necess,1rilv reflect the views of the rnanagen1Pllt
of the Federal Reservt: Bank of Sar/Franc1sco,
or of the Board of
of the Federal
Reserve System.
liabilities of financial intermediaries (i.e., by
placing their deposits in intermediaries for
them to lend out as mortgage loans).
Since the older mortgage generally carried
lower rates than prevailing mortgage rates,
the prospective homebuyer frequently
assumed the existing first mortgage and
obtained a subsidized second mortgage
from the seller to make up the balance,
Why creative financing?
Why then did creative financing become
such a popular means of selling homes if, by
circumventing the financial intermediaries,
it introduced increased inefficiencies and
risk into housing finance? After all, homesellers could have offered price reductions
which would have given homebuyers the
same benefits while using conventional
financing.
Surveys conducted by the National Association of Realtors and the National Association of Homebuilders suggest that the
incidence of creative financing between
1980 and 1982 was indeed high, An estimated two-thirds of homebuilders offered
buydowns on new homes in 1981 and 1982
and an estimated 60 percent of the sales of
existing homes involved creative financing
during 1981 , In California, the incidence of
creative financing was even higher-the
California Association of Realtors estimates
that 77 percent and 74 percent of all sales
involved creative financing in 1981 and
1982, respectively,
That both homebuyers and sellers preferred
creative financing can be attributed, in some
measure, to their expectations of an imminent decline in mortgage rates and a return
to the upward trend in home prices and
incomes that had characterized the mid- to
late-1 970s. Given these expectations, the
risks of creative financing did not appear (ex
ante) to outweigh the benefits. The expected
decline in mortgage rates would enable the
homebuyers to refinance the purchase on
reasonably favorable terms, while the expected rise in housing prices would reduce
the risk of default for the homeseller.
, Such creative financing short-circuited the
normal process of financial intermediation
in the housing market, and reduced the
financial intermediaries' share of mortgage
originations, Theirsharefell from an average
of 70 percent of the value of homes sold in
the 1970s to SOpercent ofthe value of
homes sold between 1 980 and 1982,
These expectations alone do not explain
the popularity of creative financing, however. For the potential buyer, the lower
initial payments associated with creative
financing enabled him pr her to overcome
otherwise binding cash flow constraints.
Price discounts of equivalent market value,
by contrast, would have been amortized
over the 30-year I ife of the mortgage and
would not have reduced monthly payments
enough to overcome initial cash flow constraints. In essence, creative financing
permitted the buyer to borrow against higher
future income by moving all the benefits of a
price discount forward.
The effect of breaking down the intermediation process was to introduce economic
inefficiency and greater risk into the housing
market Unlike individual investors, financial intermediaries are able to realize
economies from specialization. For example, by specializing in lending and credit
evaluation, financial institutions can evaluate a potential borrower's creditworthiness
more cheaply or with fewer errors in judgment than can an individual lender. Moreover, financial institutions are able to reduce
the risk of default by diversifying their portfolios. Individuals who decide to invest
some oftheirequity in loans to homebuyers,
by contrast, may have to accept higher
levels of portfolio risk for a given rate of
return than they would by investing in the
Sellers also had reasons to prefer creative
financing to outright price discounts. In a
number of states, restrictions on traditional
lenders' ability to enforce due-on-sale
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clauses in mortgage contracts provided
existing homeowners with a valuable asset
-that of the low interest rate mortgage
which could be transferred to potential
homebuyers. The stream of lower payments
associated with a $50,000 mortgage with a
contractual interest rate of 10 percent when
prevailing rates were 18 percent, for example, was worth more than $20,000 (discounted at the prevailing mortgage rate
of 18 percent.)*
What happened?
Given the incentives to use creative
financing and the apparently widespread
expectation thatthe housing and housing
finance markets would soon improve, it is
no mystery that creative financing became
so popular. In hindsight, however, the
creative financing gamble seems far riskier
than many had anticipated. Interest rates,
particularly in real terms, have remained
high by historical standards. Households,
whose lump sum payments come due this
year will either have to struggle with the
higher-thancanticipated monthly payments
these rates imply (their incomes may have
risen slowly), sell in a still weak resale
market or try to renegotiate terms with the
seller-lender to avoid foreclosure.
Unfortunately, foreclosure has been forced
upon some homebuyers involved in creative
financing deals. In the first quarter of 1 983,
0.9 percent of all mortgage loans in California were in the process of foreclosure-up
from 0.2 percent in the first quarter of 1 980
-and 5.7 percent had payments past due
(compared to 4.7 percent past due in the first
quarter of 1980). Of course, it is difficultto
separate the impact of.creative financing
from that of a general economic and housing
downturn, but one recent study by the University of Southern California found that
foreclosures are running 10 to 20 percent
higher on creatively financed home purchasesthan on those conventionally
financed.
To realize the value of this asset, however,
the homeseller frequently had to offer the
buyer a second mortgage to make up the
difference between the down payment and
the purchase price less the face value of the
assumalJle existing mortgage. Although
seller-dlrried second mortgages entailed
default and liquidity risks already described,
such arrangements, even at subsidized rates,
were clearly in the seller's interest, given the
typical terms of these second mortgages. In
California, where the Wellenkamp decision
made conventional first mortgage loans
assumable, over half of all resales are estimated to have involved assumptions of first
mortgages supplemented by creative financing involving second and even other
"junior" mortgages.
A further reason that creative financing was
cheaper to offer than outright price discounts was that ,it permitted relatively
wealthier households to transfer tax benefits
to lesswealthy households. Because of the
income tax-deductibility of mortgage interest payments, households in high income
tax brackets cou Id borrow more cheaply
(after taxes) than could households in lower
tax brackets. Therefore, relatively wealthier
households could realize a gain by lending
some of their equity to potential homebuyers at below-market rates and, in turn,
borrowing a larger portion of the purchase
price of the homes they intended to buy.
Improved outlook
Creative financing represented a gamble on
the future by the homebuyer and a promotional tool using tax laws and assumable
mortgages by the seller. For a time, it did
not seem to payoff as foreclosures increased
because the housing industry, along with the
rest of the economy, suffered from the recession longer than expected. Now, with signs
of gathering strength in the housing industry
and the prospect that mortgage rates wi II
moderate over the next few years, homeowners whose unamortized debt is coming
due should be able to breathe easier.
Barbara Bennett Tom Klitgaard
*This example assumesthat a homeowner
was selling a home in 1981 that was purchased in 1978.
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