Messy Incrementalism

Shortly after my wife and I were married, we set about building a house. My initial plan was to construct only the first floor and then move in with a plan to expand and finish the house over time as our family, and hopefully our resources, grew. That approach was vetoed by both my wife and the bank, the latter of which indicated they could not finance an incremental construction project. The house needed to be completely finished or the mortgage would not qualify for the secondary market. No secondary market, no loan.

To cushion that mandate, the bank was willing to loan me far more money to finish the house than I was comfortable borrowing. Incredibly, they were willing to do this even though I was a newly-married, 22-year-old with little credit history, no construction experience and only a homemade set of blueprints from which to do an appraisal. I took the leap and, in one year, my wife and I went from renting efficiency college apartments to having a mortgage on our own four bedroom, three bathroom home. This was 1996, before housing got really crazy.

After we moved in, my wife’s grandfather came to visit. Here was a man who not only lived through the Great Depression and both world wars, but had worked a solidly middle class job as a clerk for decades. When he walked in the front door and saw the vaulted ceiling his eyes were huge. He hugged my wife and shook my hand with both of his frail arms. “You guys have really made it,” he said.

I then realized that he thought we actually owned this house. He assumed that our college education and professional jobs put us in a position where we could afford such a huge place. It took people of his generation decades of hard work to have a house this grand, and here we were just a year out of school. From his perspective, we must be getting paid a fortune. We must have “made it”.

Of course, we hadn’t. We were doing what so many of our generation did: we used debt to obtain today what it took them years, even decades, to acquire.

When our grandparent’s generation built neighborhoods, they did it in a completely different way. The most important difference is that they built incrementally. It was not uncommon for a new family to start with a house that was little more than a small box, a couple of flexible rooms with maybe a loft. As the family’s resources grew, and as they added children, they would add on to the home. The old farm house I grew up in had at least four additions including a living room and bedroom, a second floor, a front porch and a rear entryway.

Building incrementally allowed a family to build their wealth without taking on lots of debt. They may not have had as high of a standard of living as we experience today, but they had fairly low risk of losing everything. If the family’s breadwinner lost their job, for example, they may have had a little debt, but it was a situation they could manage temporarily with savings and odd jobs. This is in sharp contrast to a society where both spouses must work to pay not only the mortgage but car payments and other debt. If one loses their job (or gets ill or there is a divorce), it can often spell financial disaster.

Another way traditional development patterns built financial resilience for families was by having commercial and residential cash flow under one roof. The quintessential building in pre-suburban America had a first floor business with a second floor residence. The young entrepreneur could mind the store at a very low cost by living above it, passively teaching the family business to the next generation in the process. When enough affluence was accrued, that business owner could move to a grander house and now the old home above the store became a rental property, another source of cash flow for the family. 

Unfortunately, our modern methods of financing, along with our land development regulations, has made all of this impossible where it isn’t outright illegal. Today there is a secondary market for home mortgages. When you get a mortgage from a local bank, it is going to be sold on the secondary market to someone who will package it with a bunch of other mortgages and then, much like shares of a stock, sell off securities to investors all over the world. They will get paid as you pay back your mortgage, an event that has a lot less risk – or so we thought – when you can pool them with other mortgages. The odds of someone defaulting has more volatility – and more consequence – than the odds of a percentage of a larger portfolio experiencing the same. 

All this means that your local bank no longer assumes the long term risk of loaning you money for a home; thousands of players across the country do. And that means that the home needs to fit the model, it needs to be like all those other homes, or it can’t be securitized. If you are like my wife and I and have the four bedroom, three bathroom house that meets the checklist and can be sold on the secondary market. If you have a little home with the essentials and plans to add on incrementally as resources allow, well…..you are not going to be eligible for the secondary market.

If you aren’t eligible for the secondary market, the only way to get a mortgage is through a local bank. They are going to have to assume the risk. And that means they are going to need a larger down payment and a shorter payment term, both obstacles for a buyer trying to getting into a home.

This also means that there is a smaller market for the home if it needs to be sold. A lot of people today who can qualify for secondary market financing could never get a much smaller loan from a local bank. They would lack the down payment or couldn’t pay the higher rate of interest. It is a self-reinforcing problem: finance locally and there is more risk, more risk means more difficulty in finding a buyer, more difficulty finding a buyer means more risk….

In an effort to make the mortgage market work “better” the federal government has established rules – underwriting criteria – for how all of this works. That home with the business downstairs and the living space upstairs, it doesn’t meet the federal mortgage criteria. Same with the incremental home. If you don’t meet the criteria, you aren’t likely to get a loan.

Now, one can argue that the ability to take on large amounts of debt increases our resiliency because, if a person does get in trouble and needs to sell their home, there are plenty of people who can access cheap credit and make that transaction happen. This is a Krugman/Bernanke line of logic that I just can’t ascribe to in good conscious. Maybe it is the DNA of my prudent ancestors, but I’ve never seen a situation where taking on more debt is a real solution to a debt problem. Go ahead and call me naïve as you are apt to do, all you Keynesians. Your macro theories are just so beautiful.

In the end, I don’t see us going back to a more localized financing model until the current financing system collapses. That may be a long while. Our ability to prop it up in 2008 – and to continue doing so – vastly exceeds anything I thought possible. Six years of zero interest rates, quantitative easing and all the market distortions that ensue have created a little bit of discontent – Tea Party and Occupy Wall Street – but nothing that has really challenged the status quo. As long as we have something we can do to keep it going, I suspect we will do it.

And there is some sense to that. I look at what my grandparent’s generation lived through – the hard work of starting with something small and building it slowly over time – and realize that it is really messy. Chaotic. Difficult. In many ways, the stress of having to make mortgage payments on an underwater home combined with the fear of being downsized, getting an unexpected huge medical bill or having gas prices spike pale in comparison.

Or not.