Housing: The leverage bulls return

By Felix Salmon
March 8, 2011
Linda Stern's latest paean to leverage and housing risk, it certainly seems that way.

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I know that memories are short on Wall Street. But are they short on Main Street too? Reading Linda Stern’s latest paean to leverage and housing risk, it certainly seems that way. Saving for a down payment is hard, she says. It can take time!

And that doesn’t seem to pay. If you think about the cost of paying rent for five or more years, you may be better off jumping into a home with a low down payment now. That’s true even if you have to spend more money on fees and mortgage insurance to get one of those low down payment loans.

Well, yes, let’s think about the cost of paying rent for five or more years. In fact, let’s plug all our numbers into a rent-vs-buy calculator and see where we’re at after five years. The problem with Linda’s formulation here is that it helps to reinforce the common fallacy that 100% of rent payments are “wasted,” in a way that mortgage payments are not. But that’s simply not true. In both cases you’re paying money every month for your shelter; in the rental case that money goes to the landlord, while in the ownership case it goes to the bank.

Some small part of your monthly payment may or may not end up helping you build equity in your home, if house prices move up rather than down and depending on how much of your payment goes towards principal. But remember that the alternative here is saving up for a down payment — which is essentially the same thing as building up equity in a future home. If you save up $250 per month for five years and then put down $15,000 as a down payment, then you immediately start off with $15,000 of equity in your home. By contrast, if you buy today with no money down and start making mortgage payments, there’s a good chance your equity will be much less than $15,000 in five years’ time.

But Linda’s on a roll here, and manages to come out with one of the most astonishing pieces of personal-finance advice I’ve seen since the crisis hit:

Even if you have the money for a bigger down payment, there can be good reasons to save your cash. Mortgage rates continue to skirt all-time lows: Why not put your money to work for yourself and borrow as much as you can reasonably afford, on a monthly basis, at today’s rates? You can put the money you’re not paying into a down payment to work elsewhere. If home values rise, you will have done your best to leverage a small down payment into bigger equity. If they fall, you’ll have less skin in the game, and that could put more pressure on your banker to improve your loan terms lest you walk away.

This, in a nutshell, is everything that was wrong with the housing market before the crash — everything that we want to avoid going forward. Can’t Linda look around at the current devastated state of many people who bought with little or no money down, and see the dangers here? Evidently not. Instead, she seems to think it’s a bright idea to borrow more money than you need, to the point at which you’re pushing the envelope of what you can reasonably afford. And then take the cash you’re not using for a down payment, and “put your money to work for yourself.”

I barely know where to start on this. Here’s one way of thinking about it: banks are not charities, and that they expect to make money from their loans. They have a cost of funds which is lower than the mortgage rate that you’re paying; the difference between the two rates is their profit. You, however, if you follow Linda’s advice, have a cost of funds which is your mortgage rate: if you wind up getting a lower return on your savings than you’re paying on your mortgage, you would have been better off just using the money for a down payment. Needless to say, if there was an easy way of getting a higher return on capital than the mortgage rate, the banks would have done it already, rather than lending you the money. And it’s pretty delusional, frankly, to think that you can invest better than say JP Morgan. Yes, there are tax benefits to having lots of mortgage-interest payments. But they’re not sufficient to make the difference here.

Here’s another way: let’s say you own your home outright. Would you take out a mortgage against 95% of your home’s present market value, and then invest that money in the market somehow, trying to “put it to work for yourself “? Of course not: you don’t have remotely that kind of risk appetite. Borrowing money against your house to invest in the market is, always, stupid. But that’s exactly what Linda’s proposing you do.

And here’s one more: shit happens. Sometimes, you end up needing money, in an emergency. If you’re already borrowing as much as you can reasonably afford, that’s a big problem. If you have a bit of fiscal breathing room, you’re much better off. If you end up in a situation where you’re in a position to put pressure on your banker to improve your loan terms lest you walk away, that’s not a good situation to be in. It means you’re broke. It’s something you want to avoid, whereas in Linda World it seems to be something to actively court.

Linda’s also convinced that house prices are going to rise: if you buy now rather than later, she writes, that means you’re buying “while housing prices are low.” That’s debatable — they still seem quite expensive, on some measures: the price-to-rent ratio, for instance, is still well above its historical average. And more generally, buying low doesn’t help you in the slightest if prices just continue to grind lower.

Linda’s conclusion is that “the less you put down, the better off you are.” Which is true so long as you keep on making all your mortgage payments without any problem, and nothing goes very wrong either with your personal economic situation or with the US economy as a whole. That’s the way that leverage works: it makes everything sunny, so long as things go right. And then it plunges you into misery when things go wrong.

The scariest part of Linda’s post, for me, is when she talks about how it’s a good idea to “do your best to leverage a small down payment into bigger equity.” It’s not the dollar amount of the equity she’s talking about here, it’s the leverage used to get there, and the higher the leverage the better off you are. Following that advice got us into our current mess. And taking it now is a recipe for disaster.

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