Much of the analysis of the housing bubble has focused on the fundamental measures of price-to-income and price-to-rent. These are valid statistical measures of what the market should do, and they reflect the fundamental valuations to which prices ultimately return. However, debt-to-income ratios are very revealing of the buyer/borrower activity due to kool aid intoxication and irrational exuberance.
There was a significant price bubble in residential real estate in the late 1980s crashing in the early 1990s. This coastal bubble was concentrated in California and in some major metropolitan areas in other states, and it did not spread to housing markets nationwide. When comparing this previous bubble to the Great Housing Bubble, the macroeconomic circumstances were different: Prices and wages were lower in the last bubble, interest rates were higher, the economies were different, and other factors were also unique; however, the evaluation of personal circumstances each buyer goes through when contemplating a purchase is constant. The cumulative impact of the decisions of buyers is represented in the debt-to-income ratios – how much each household pays to borrow versus how much they make. Comparing the trends in debt-to-income ratios provides a great tool for elucidating the behavior of buyers.
Typically debt-to-income ratios track interest rates. As interest rates decline, it becomes less expensive to borrow money so borrowers have to put less of their income toward debt service. The inverse is also true. On a national level from 1997 to 2006 interest rates trended lower due to low inflation and a low federal funds rate. During this same period people were increasing the amount of money they were putting toward home mortgage debt service. If the cost of money is declining and the amount of money people are putting toward debt service is increasing, the total amount borrowed increases dramatically. Since most residential real estate is financed, this increased borrowing drove prices up and helped inflate the Great Housing Bubble.
Figure 21 - Debt-To-Income Ratio and Mortgage Interest Rates, 1997-2006
The figure below shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006. It is calculated based on historic interest rates, median home prices and median incomes. Lenders have traditionally limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels. During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards are prone to high default rates once prices stop increasing. In 1987, 1988 and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.
Figure 22 - Debt-To-Income Ratio, California 1986-2006
Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. The psychology of buyers reflected in debt-to-income ratio is the facilitator of price action. In market rallies people put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. People are not passively responding to market prices, they are actively choosing to bid prices higher out of greed and the desire to capture the appreciation their buying activity is creating. This will go on as long as there are sufficient buyers to push prices higher. The Great Housing Bubble proved that as long as credit is available there is no rational price level where people choose not to buy due to prices that are perceived to be expensive. No price is too high as long as they are ever increasing.
In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining. In fact, it is possible for house prices to decline so quickly that no mortgage program can reduce the cost of ownership to be less than renting. The only thing justifying a DTI greater than 50% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even beginning to decrease, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. In a bubble market when the market debt-to-income ratio falls below 30%, the bottom is near.
The graphs and charts are pretty, and they do illustrate what is happening in a macro sense in the market, but now it is time to look at the micro. The reason prices are still so high is not because of interest rates, high incomes or any fundamental measure of pricing. It is due to the debt-to-income ratios lenders are still permitting and kool aid intoxicated buyers are still willing to utilize to buy real estate.
Take a look at how even small changes in the debt-to-income ratio used by a borrower can make a huge difference in the amount financed and ultimately in the amount paid for real estate. At very low interest rates, every 3% of gross income put toward a housing payment adds 10% to the amount borrowed. Of course, the phenomenon also works in reverse. As DTIs fall due to both lender reluctance and borrower reluctance, the amounts financed decline precipitously.
$91,101
Irvine
Median Income
$ 7,592
Monthly Median Income
5.0%
Interest Rate
Payments, Taxes, Insurance
DTI Ratio
Max Loan *
$2,126
28.0%
$336,580
$2,353
31.0%
$372,643
$ 2,885
38.0%
$ 456,788
$3,644
48.0%
$576,995
$4,024
53.0%
$637,099
*
Max Loan based on 85% of payment going to debt service
The example above uses the most recent Irvine Median Household Income Data. From this it calculates the gross monthly income. Notice this is the gross amount, not the after-tax income. Someone making $91,101 per year would be taking home between $5,000 and $6,000 a month depending on the number of exemptions claimed and the amount of their tax write-offs. Note the effect this has on the take-home DTI ratio. Someone using a DTI of 31% is really spending almost 50% of their take-home pay on housing and related expenses. The maximum loan amount is calculated using a 30-year fixed-rate conventionally amortizing mortgage assuming 85% of the payment, taxes and insurance amount will be going toward the mortgage payment.
The FHA currently allows a 31% DTI for housing debt. Years of experience has shown that DTIs in excess of this amount have high default rates. This isn’t terribly surprising when you see how much a higher DTI starts to cut in to other lifestyle expenses. Prior to the Great Housing Bubble, lenders only allowed DTI’s of 28% for housing debt and a total back-end DTI of 36% which includes car payments, credit cards, and other debt-service payments. That is where standards are headed.
Let’s tighten it up now Do the tighten up Everybody can do it now So get to it
When the government embarked on its loan modification program in an attempt to save borrowers, they had to pick a payment DTI level to which loans would be modified. The higher this DTI level, the less banks would lose on the modifications because borrowers would be paying more money. Of course, the higher the DTI level selected, the higher borrower default rates were going to be. So what did the government do? Did they pick a DTI that has historically been proven to have borrower stability? Of course not. They chose the DTI that maximized lender and investor revenues and prayed that people would not default. Well, they have been redefaulting on loan modifications at rates exceeding 50%. What a surprise.
If the powers that be really want to stop redefaults and foreclosures, they need to modify loans using a 31% DTI which the FHA has years of data showing it is the highest sustainable level. Further, they need to hope that underwater homedebtors don’t walk away anyway. Even a 31% DTI is pretty onerous when there is little or no chance for appreciation and you are merely renting from the lender.
Lenders have gone back to their historic data to relearn underwriting all over again. They know they must underwrite loans at DTIs in excess of 40% in order to support current pricing, so they limit these loans to people with significant downpayments, large cash reserves, and high FICO scores. In other words, it is the smallest possible borrower pool. Because the potential borrower pool is so small, and because there is a foreclosure tsunami coming, prices will continue to fall.
Over time lenders will continue to lower their allowable DTIs because the default rates will continue to be very high. As long as there are high default rates, there will be more foreclosures, prices will continue to fall, and the lenders will continue to lose money. This downward spiral will cause allowable DTIs to shrink until 28% to 31% DTIs are the maximum borrowers will be able to find in the marketplace. Anyone who thinks this credit crunch in mortgage lending is a temporary phenomenon is sadly mistaken.
Also, as people begin to realize that rapid appreciation is not right around the corner, they will not be so anxious to take on massive debt loads. Realistically, the only way a homedebtor can manage their finances with a DTI in excess of 31% is to Ponzi Scheme borrow from HELOCs, credit cards, or other sources. This will result in a voluntary decline in DTIs as well. If you look at the chart at the top of the page, you can see this in action from 1990-1997. We will see it again in the statistics from 2006-2012.
The importance of allowable DTIs cannot be overstated. Look at the math and notice how much of pricing is being supported by the allowable DTI. The debt-to-income ratio is the hidden and often forgotten variable that enormously impacts market prices. When everyone is focused on interest rates at historic lows, they will miss the much more important changes in allowable DTIs.
I would like to remind everyone that we are having another IHB party on Wednesday, January 7, 2009, from 6:30-10:00 at JT Schmids at the District.
Last time was a great gathering, so we are doing it again. Here is your chance to meet many of the regulars of the IHB. Everyone is welcome, so please stop by.
Heart of stone—I tried to reach you Of the altar stone—I tried to warn you But you were not alone—you wouldn’t take the call You wear brimstone—I tried to warm you
Don’t say a prayer for me now, Save it ‘til the morning after
There will be some borrowers who will benefit from the ultra-low interest rates being engineered from the FED. Anyone who has not already refinanced into a 30-year fixed mortgage may have an opportunity to get out of their toxic mortgage. Of course, there are two problems: 1. Some people do not want the fixed rate mortgage, and 2. Very few people that do want it qualify for refinancing.
I remember having conversations with lenders in 2008 about the tightening loan terms. I was surprised by what they were telling me. Apparently, most people that were going in for refinancing were looking to refinance into another toxic mortgage with a low teaser rate. First, people with Option ARMs would ask for another one so they could stretch out their teaser rate period. Then, people who were getting out of Option ARMs (because they were no longer offered) were going with 1 year adjustables or whatever loan product gave them the smallest payment. People were not looking for stability, they were looking for the next bridge loan with the lowest possible payment. There is still a widespread perception among the borrowing public that serial refinancing from one teaser rate into another is a viable way to manage one’s mortgage obligations.
This dependency upon serial refinancing from one toxic loan to another is part of the reason people perceive today’s lending standards as being so restrictive even though by historic standards they are still quite loose (allowable DTIs are still at high-default levels, and they will tighten further). Everyone seems to be waiting for the return of toxic financing to re-inflate the housing bubble and allow them to continue serial refinancing their extreme indebtedness. I know I have said it a million times, but I will say it again: the loose financing of the bubble is not going to return.
Think about what the lenders just went through. Here at the IHB we have been documenting hundreds of thousands of dollars in lender losses on a daily basis. This is adding up to hundreds of billions if not trillions of dollars nationwide. This happened because the lenders were giving out too much money to people who could not pay them back. Does it seem likely they will do this again any time soon? Those people waiting for a HELOC dependant lifestyle to return might as well be awaiting the Rapture.
(Like all dreamers can’t find another way) You don’t have to dream it all, just live a day
The people who do not want fixed-rate financing must be flushed out of the system. As long as these short-term adjustable rate loan programs are being offered, the foreclosure crisis is just being extended. Nobody using this form of financing is in a stable loan program, and they will experience one of two possible outcomes: 1. They will eventually get a fixed-rate loan, or 2. They will end up in foreclosure. The longer they wait until they go fixed, the more likely they are to end up in foreclosure. The only thing preventing their foreclosure is an interest rate reset while rates are higher.
The second group of people, those who do not qualify for refinancing, is actually must larger and much more of a problem, despite the spin to the contrary. To illustrate why this is a problem, let’s examine a typical Irvine homedebtor to see the circumstances he is facing.
On January 1, 2008, I wrote a post titled Predictions for 2008. You can go back and review it to see how well I did.
As a recap, I would like to share with you a couple of charts from 2008 for Irvine and OC:
Click for larger image
Most of the macroeconomic conditions I made in 2008 are still operative, and several of the predictions I made which came true will likely repeat in 2009. These are:
2008 will see the worst single-year decline in the median house price ever recorded
One or more of our major financial institutions and one or more of our major homebuilders will fail
A severe local recession
I predict we will see many more angry homedebtor’s troll the blog
I do not believe 2009 will see median house prices decline as much as 2008, but I do believe they will drop significantly, particularly in high-end neighborhoods. The low-end neighborhoods are closer to the bottom than to the top, so 30%+ declines in these neighborhoods are not likely. The high end neighborhoods will experience big drops. Most did not drop 30% last year, so they have more room to drop. The unemployment rate is high, and the economy is in recession which will put pressures on home prices. The dreaded ARM problem is not going away, and these loans will start blowing up this year and on through 2011.
However, there is one bright spot for the housing market that will blunt the declines in 2009: ultra-low mortgage interest rates. We will see properties at rental parity in 2009. The low interest rates are going to reduce the cost of borrowing to the point that many properties will reach rental parity this year. This does not mean we will be at the bottom. These interest rates are artificially low due to the “quantitative easing” by the Federal Reserve. This policy may persist for some time, but it is not likely that sub 5% interest rates will be around for buyers 7-10 years from now when 2009 buyers go to sell their property. That creates the issue with Your Buyer’s Loan Terms.
With the low interest rates, and with the foreclosures resulting from this year’s loan resets being a year away, we are in a good position to see our first bear market rally. This summer, we might see two or three months of sustained appreciation. This will bring out all the bottom callers. Everyone will be cheering the Federal Reserve, and many will believe the worst is over for the housing market. This will cause some major emotional gyrations for desperate homedebtors. Those who had moved from denial to fear will likely move back to denial for a time.
Remember, the loans that reset this year will take a year or more to become foreclosures. The real problems caused by all the resets will not be apparent this summer. We will likely see a large number of short sale listings, but as we all know, these rarely consummate a transaction. It is only the presence of these short sales listings that will remind us of the impending disaster when the ARM reset problem becomes a tsunami of foreclosures. When these foreclosures start hitting the market in larger numbers, and the market rally is reversed, all of those who call the bottom this summer will act surprised. Ignorance is bliss.
Not to get too far ahead of ourselves, but 2009s bear rally will be wiped out by the first wave of foreclosures. I foresee 2010s bear rally being knocked back by continuing foreclosures and the much-anticipated rise in interest rates when the FED stops quantitative easing as the recession abates. The rally in 2011 will be tepid, but at least it will be for real. For 2012-2015, appreciation will be less than 5% each year as the overhang of foreclosures and a sputtering California economy keep prices in check until Californian’s lose their minds again and inflate another housing bubble.
In my opinion, these artificially low interest rates will simply guarantee that house prices overshoot fundamentals to the downside because the fundamentals in this instance are illusory. The low interest rates will prompt some people to buy, and this increased buying activity will stop prices from falling as much as they would have without the subsidized interest rates. However, very few people currently qualify for these loans. Loan terms are getting tighter all the time, and the buyer pool is very restricted. People talk about the conservative lending terms as if they are too tight. This is nonsense. We are still not at pre-bubble loan terms (20% down, 28% DTI, high FICO, etc.) and until we get there, loan terms will continue to tighten. The diminished buyer pool when combined with increased foreclosures creates an imbalance between supply and demand which will push prices lower.
Many people erroneously believe that low interest rates are going to save the housing market because the loan resets are not going to lead to foreclosures. As I outlined in the ARM problem, the payments are going to increase even if the interest rate remains the same due to the amortization recast. If you want a more detailed explanation from Mr. Mortgage, I suggest you read Pay Option ARMs - The Implosion Is Still Coming Despite Low Rates and Low Mortgage Rates to Spur New Wave of Defaults. The idea that low interest rates are going to save the housing market is another in our ongoing series of denial fixes being fed to a weary populace. It is all bull$hit.
Last year I predicted that we would see banks and homebuilders go under. We did see several banks including WAMU bite the dust. This trend will continue. All of our banks are basically insolvent. Only creative accounting practices and huge amounts of borrowing from the Federal Reserve is keeping them afloat. Even the huge infusion of money through the TARP program is not going to save them. There will be many more failures and consolidations in 2009.
One surprise from 2008 was the lack of bankruptcies and consolidations in the homebuilding industry. Ordinarily, during a recession, the weak companies go out of business or are absorbed by stronger ones. In my opinion, the reason we have not seen this yet in the homebuilding industry is because there are no strong ones, and there is no reason to consolidate or expand while housing starts and sales continue to decline. I think 2009 will be different. In the second half of 2009, the homebuilders will start to rebound. If past history is any guide, the recession will bottom when housing starts bottoms. This is when the industry will begin to consolidate.
I believe we will see massive consolidation in the homebuilding industry. During the 80s and 90s the homebuilding industry was dominated by small, private builders. Many of the small fry were wiped out during the recession of the 90s. During the 00s, we witnessed the rise of the national homebuilders as the dominant market force. I believe we will see consolidation into an industry dominated by a few big names with a few small privates picking up the scraps in various markets.
Last year I predicted a severe local recession. I did not have the courage to predict a severe national recession. Perhaps I should have…
I do not have a prediction about angry homedebtors. As the market shifts from denial into fear, there is a widespread acceptance of the reality of a housing bubble. Most trolling comes from people trying to maintain their denial (if you want to study this phenomenon, I suggest you read this forum thread). With acceptance comes less anger and trolling. However, I have recently launched an article marketing campaign that likely will catch the attention of realtors across the country. We may see a few of them stop by to explain to us why we don’t know what we are talking about. That should be amusing.
Today’s featured property was brought to my attention from a reader. It is a typical Irvine property struggling with a typical Irvine debt load. I predict we will see this house for sale as REO in a year.
I recommend the video above. It is a classic 2008 recap.
This year, 2008, was the year the world came to recognize that we have a huge economic problem caused by housing. As with all crises there was denial by everyone at every turn, and this denial is still going on. The latest nonsense meme is that low interest rates are going to solve the ARM problem: bull$hit it may even make it worse.
I received a sign that the general public is moving from denial to fear in Irvine. Some people I know that bought in late 2007 are selling their starter home because they see prices going down. Just a couple of months ago, they were determined to hang on to both properties as “investments.“ When even the most kool aid intoxicated start to see the fall in prices as an ongoing trend, and when these same people start to sell out of fear, the market is entering a new psychological stage.
Psychological Stages of Bubble Market
Today’s featured property is a 1/1 in Turtle Ridge that is showing significant distress. Apparently Turtle Ridge is not immune after all.
