Piggy Bank -- Or House Of Cards?

As downpayments shrink sharply, highly leveraged homebuyers may be in for a fall

Multitalented Joaquin L. Thompson of Mableton, Ga., is a baker, a nurse for an insurance company, and now, a successful real estate investor. On Aug. 3, he made $14,500 by flipping a house he owned for only 53 days. A small Atlanta bank financed his entire purchase price. All Thompson put up was $1,200 in earnest money that went into escrow. Not bad: In less than two months, Thomson walked away with a 1,100% gain on the money he started with.

More and more homebuyers are discovering that in a bull market, acquiring assets with other people's money is the path to riches. They're borrowing a rising percentage of their purchase prices, contributing to the housing boom. The danger is that if prices begin to fall, people who have stretched to buy houses with 100% financing will be under water on their mortgages and at risk of default if they have to sell. "I always tell people, look at the worst scenario," says James R. Gillespie, chief executive of Coldwell Banker Real Estate Corp. (CD ). But many buyers ignore the warning.

How much leverage are buyers taking on these days? Surprisingly, the Mortgage Bankers Assn. doesn't keep track. The best numbers come from a soon-to-be-published study provided to BusinessWeek by SMR Research Corp. of Hackettstown, N.J. The debt-research firm collected data nationally on 2 million debt-financed purchases of owner-occupied homes from 2004 and more than 600,000 through roughly May of this year. It found that 95.1% or more of the purchase price was borrowed in 38% of all transactions so far this year. That was up from 34% of sales in all of 2004. In other words, over a third of buyers have little or no equity in their homes at the time of their purchase.

Blame the leveraging trend on the easy availability of so-called piggyback loans, says Stuart A. Feldstein, SMR's president and founder. In the past, many people made 20% downpayments to avoid paying private mortgage insurance, for which the annual premium can be half a percent of the loan amount. The insurance is required on loans of more than 80% of a home's value that are sold to Fannie Mae (FNM ) or Freddie Mac (FRE ). Now, instead of paying for the insurance, buyers often take out a first mortgage for 80% of the purchase price and a piggyback loan for anywhere from 10% to 20% more. SMR's forthcoming study reveals that 48% of home purchases this year, by dollar volume, involved piggyback loans, dramatically up from 20% in 2001.


How risky are such moves? Prime lenders give 100% financing only to people with very good credit scores, indicating they're highly likely to pay. But subprime lenders will offer leveraged financing to weaker borrowers in exchange for rates 4 percentage points or more above normal. Borrowers who go for these deals pay through the nose -- and because they have no equity, they may find themselves unable to sell if the going price falls below what they paid.

In case the market cools and there's a surge in defaults, those who stand to suffer the most are the overleveraged buyers themselves. If forced into foreclosure, they could have a harder time borrowing, buying insurance, and even getting a job, since many employers check applicants' credit histories. By contrast, lenders that sell the mortgages they originate into the secondary market don't bear default risk in most cases. Buyers of AAA-rated mortgage-backed securities are also safe because rating agencies like Standard & Poor's (MHP ) make sure there's plenty of cash flow for payment to holders, though buyers of lower-rated securities that have higher yields would take a hit.

For now, however, the credit keeps flowing. Joaquin Thompson is already onto his second deal. This time he's putting up even less of his own money -- $100.

By Peter Coy in New York

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