At a time when the newspapers are full of stories about predatory lenders, irresponsible homeowners, and the terrible impact of foreclosures on the national economy, it is refreshing to read about a home builder that largely avoided the housing meltdown. The qualities of the company and its customers can serve as a case study demonstrating the positive outcomes that occur when all parties to a transaction attempt to operate with a sense of accountability and ethical standards.
Clayton Homes, a Berkshire Hathaway subsidiary, is the largest company in the manufactured home industry with 34% of the market in 2008. Manufactured housing has been in decline for several years since hitting a peak of nearly 373,000 units in 1998. Unit volume for the industry in 2008 was just short of 82,000 units. What makes the story of Clayton even more remarkable is the dismal state of ethical standards that prevailed in the manufactured housing sector in the late 1990s. Warren Buffett wrote at some length about Clayton and the housing crisis in his recently published annual letter to shareholders. Let’s examine some of the facts behind Clayton’s admirable track record.
Avoiding the Excesses of the late 1990s
In his letter, Buffett writes about how Clayton avoided the predatory lending excesses of the late 1990s and followed sensible practices throughout this period. Buffett’s comment that no purchaser of a securitized loan originated through Clayton ever lost any principal or interest seems almost too good to be true. This took place during a period of very significant losses on securitized manufactured loan portfolios.
Buffett reported that Clayton’s borrowers do not have unusually high credit scores; in fact, Clayton’s borrowers have below average FICO scores with many falling into the sub-prime category. However, despite the lower credit scores, Clayton borrowers had a delinquency rate of only 3.6% in 2008. This has risen from 2.9% in 2006, but is still very low considering the overall economic climate. Even more amazing is that foreclosure rates declined to 3% of originated loans in 2008 which is down from 3.8% in 2006 and 5.3% in 2004.
How Did Clayton Achieve This Record?
Buffett’s comments regarding how Clayton achieved this record seems very basic. Loan originators looked at borrower’s incomes and only provided loans that could be repaid based on the borrower’s actual income without counting on refinancing the home in the future or using “teaser” rates on adjustable rate mortgages that reset after a few years.
Buffett points out that Clayton borrowers are by no means immune from the current economic crisis, particularly because many of them have no savings and live “paycheck to paycheck”. Rising unemployment will surely result in delinquencies and foreclosures within this population. However, Buffett believes that the majority of foreclosures will result from borrowers being unable to make monthly payments rather than borrowers “walking away” from properties that are “underwater”, meaning that the loan balance is more than the property is worth.
The lessons learned from the current housing debacle and Clayton’s unusual experience seem almost too obvious: Homeowners should not rely on anything other than their regular incomes to make monthly payments. Monthly payments should be a reasonable percentage of take home pay. Homeowners should be required to come up with a reasonable down payment as a condition of purchase. Lenders should put in place incentive plans for originators that rely on the performance of a loan over time rather than large lump sum payouts that incent loan officers to provide mortgages regardless of a borrower’s ability to pay in the long run.
These common sense principles were abandoned by home builders, lenders, and borrowers during the past decade with disastrous results. Any proposed solution to the housing meltdown that does not focus on a return to fundamental principles of responsible lending and borrowing will fail to lead to a sustainable housing market in the future.