No Skin in the Game

by Lance Thompson

The wrangling over the financial bail-out will undoubtedly be settled in a very costly fashion. The question is, what lessons can be learned from this expensive instruction?

Years ago, under President Clinton, a Democrat-controlled Congress passed legislation that coerced banks to make home loans available to those with limited cash for down payments or compromised credit histories. Though some lenders protested, it all seemed so kind and generous–helping the underprivileged afford first homes.

The financial instruments that made such loans possible multiplied and diversified. There were loans with minimum down payments, loans with no down payments, loans with variable interest rates, loans with deferred interest, loans with balloon payments, loans that were approved on wildly inflated or falsified incomes, loans that allowed the borrower to decide how much his payment would be each month.

These all served to introduce to the market two vastly different but equally dangerous groups–unqualified buyers and speculators. Both contributed to the housing boom and the subsequent bust.

Unqualified buyers were relieved of the necessity of saving for a down payment, establishing a strong credit history, or even of having sufficient income to make regular payments. All these were unnecessary with the new categories of home loans. Hundreds of thousands of people who could never have afforded homes before now bought them at an ever-increasing rate.

A flood of new buyers raised demand, and the value of homes went up. When these new buyers bought the most affordable homes, the sellers of those homes were able to buy more expensive homes, and the increased value rose through every price range until there was a tremendous demand for real estate.

This brought the second group into play–speculators. As home values rose ever faster, the old paradigm of buying a house, living in it a while, making improvements, and later selling it for a profit seemed hopelessly archaic. It was now possible to buy a home today and sell it tomorrow and make a profit. This was called "flipping," and with the new loan instruments that required minimal down payments, and a steadily rising real estate market, it seemed foolproof.

But neither the unqualified buyers nor the speculators possessed that vital component of home ownership–an investment in the house itself. A homeowner invests a substantial amount of his or her own money in the purchase of a home. This is why banks, in the old days, demanded twenty percent as a down payment. They wanted to ensure that there was a commitment by the buyer.

But the zero-down loans that proliferated and enabled unqualified buyers and speculators to snap up houses like half-price computer games ensured just the opposite. New buyers invested little, risked nothing, and felt no commitment to the houses they were living in. As Ross Perot used to say, they "had no skin in the game."

The government allows homeowners to deduct interest on real estate loans because the government knows that home ownership represents an investment in and a commitment to a community. Homeowners represent stability–they get jobs in order to pay mortgages, they raise families, pay taxes, and take an interest in the neighborhood in which they live. The financial incentive for all this is their home, the biggest investment most people ever make. When hard times come, these homeowners work harder, save more, and spend less so that they can make their mortgage payments and keep their homes.

But unqualified buyers who had to put little of their own money into their houses, and speculators whose intent was merely to resell at a higher price as quickly as they could, had no such investment in their properties. They were not homeowners, and when the real estate bubble burst, they could just walk away.

Those who favored the loan programs for unqualified buyers called it a success, at least until the market crashed. They bragged about how so many disadvantaged people could buy homes for the first time. They believed that owning a house would create that commitment to community that most homeowners have.

A generation ago, the concept of self-esteem was misunderstood in much the same way. Social scientists and educators thought that children who misbehaved were suffering from a lack of self-esteem, and so endeavored to provide or confer self-esteem. They did this by banishing competitive sports and games, by inflating grades and dumbing down tests, by refusing to call any answer right or wrong for fear of damaging the self-esteem of those who answered.

But self-esteem cannot be conferred. Self esteem emanates from the effort and struggle to succeed, whether the result be victory or defeat. Self esteem comes from striving for a goal, whether it’s winning a basketball game, studying for a test, or working hard and saving for a home of one’s own.

Zero-down and other financially irresponsible loan packages were the same as those games in which everyone’s a winner. The result no longer matters because nothing is required to attain it. Self-esteem that derives from always winning is as empty and fragile as a real estate market that soars because anyone can buy a house. Both are illusory and doomed to fail.

Eventually, the politicians will hash out a compromise on the financial crisis we now face. But if we don’t learn the lesson that home ownership requires struggle, sacrifice and personal commitment, we shall find ourselves in exactly the same situation in the very near future, and again be forced to pay for a lesson we should have learned long ago.

http://www.lowdowncentral.com/feature-article/2008/9/29/no-skin-in-the-game.html
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