Tighten Up — Archie Bell and the Drells
We’re gonna tighten up
Let’s do the tighten up
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
A refresher from Fundamentals at a Market Bottom:
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.
That brings me to the final point of the day: The credit tightening cycle is not over. Lenders are still underwriting loans with DTI ratios that end up in default.
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.
{book}
Asking Price: $499,000
Income Requirement: $124,750
Downpayment Needed: $99,800
Monthly Equity Burn: $4,158
Purchase Price: $656,500
Purchase Date: 5/30/2006
Address: 54 Ardmore, Irvine, CA 92602
| Beds: | 3 |
| Baths: | 3 |
| Sq. Ft.: | 1,569 |
| $/Sq. Ft.: | $318 |
| Lot Size: | – |
| Property Type: | Condominium |
| Style: | Mediterranean |
| Year Built: | 2000 |
| Stories: | 2 |
| Floor: | 1 |
| Area: | West Irvine |
| County: | Orange |
| MLS#: | P669751 |
| Source: | SoCalMLS |
| Status: | Active |
| On Redfin: | 4 days |
Sheridan! This floor plan is rarely on the market. Large kitchen with
eat-in bar and desk. Seperate dining room, family room with fireplace,
half bath downstairs and indoor laundry room. Large patio with gas hook
up for a barbeque. Two car attached direct access garage.
Today’s featured property was purchased on 5/30/2006 for $656,500. The owners used a $525,200 first mortgage, a $131,300 second mortgage, and a $0 downpayment. If this house sells for its asking price, the total loss will be $187,440 after a 6% commission.
Let’s take a look at this property from a DTI perspective. Let’s assume this is a median property that should be affordable to a median income household. This is a small three-bedroom condo, so I think this is a fair assumption. Without toxic financing, a $656,000 loan would require a DTI of around 55%. Obviously, people cannot sustain ownership with such a large payment which is why it is being sold as a short sale right now.
What does the government think this owner should be able to afford? With a 38% DTI using conventional financing, the mortgage would be around $450,000, and with 20% down, that puts us at today’s $499,000 asking price. However, as experience is proving, people are still defaulting at DTIs of 38%, so this payment and price level is not sustainable either.
What does the FHA think this owner should be able to afford? With a 31% DTI and a 3.5% downpayment, the mortgage would be $372,643, and the downpayment would be $11,179. This property should be selling for $383,822 based on what an FHA buyer making the median income can afford. The median house price in Irvine should be around $400,000 based on incomes and reasonable, sustainable DTIs. The fact that the median is still near $600,000 should give you an indication of how far prices have yet to fall to reach a stable equilibrium.
{book}
Yeah, you do the tighten up
Yeah, now
I said, if you can do it now
It sure would be tough
Now look here, come on now
Now make it mellow
Let’s tighten it up now
Do the tighten up
Everybody can do it now
So get to it
We’re gonna tighten up
Let’s do the tighten up
You can do it now
So baby, get to it
Look to your left now
Look to your right
Everybody can do it
But don’t you get too tight
Come on and tighten up
Let’s tighten it up now
Let’s tighten it up now
Tighten it up
Do the tighten up
Come and tighten it up
Tighten it up now
Tighten Up — Archie Bell and the Drell
IR:
What an excellent read it is on the mighty important DTI ratios.
Thanks,
George8
Excellent post.
When those pretty curves go up and down there is huge wealth transfer. I think this has a long term impact on price to rent ratios of premium areas. Irvine is not SF or NYC, but you can see this effect in SF and NYC. (where rental parity will never exist baring a Mad Max scenario) For a local example you can see this effect on Balboa Island where you will never see rental parity again. My opinion might be unpopular on this blog, but I do not think you will see rental parity in premium areas of Irvine due to it’s comparative advantage to surrounding areas. I know down payments are very large in Irvine. Is this down payment trend the same for nice surrounding areas with lesser schools and a different target market?
Irvine is headed down from here, without question. This is excellent data on a macro level. The trend will be down for quite some time. Dissecting this data on a more micro level is dangerous. It’s the equivalent of saying all stocks should trade at the same P/E ratio. Even in a down market, future projections and time horizons have an impact on economic ratios when comparing apples to oranges.
Rental parity will not require the Mad Max scenario, although it will feel like it to those who have lost so much phantom equity. Time and continued lender tightening is all that is required.
Not all properties will bottom exactly at rental parity. Condos will fall below, median properties will match, and prime properties will retain a small premium. This is the nature of pricing in a normal market absent the effect of irrational exuberance.
Two major things have to occur for prices to remain high: banks need to continue to loan money at default-prone DTI levels, and buyers need to continue demanding it. The lenders are tightening their standards, and they will continue to do so. Our economy is suffering because of lender reluctance to make loans, and they are reluctant because previous loan standards caused them to lose so much money. Buyer psychology is always the last to change.
I agree with you on a more macro level.
Cash down paments impact price fundaments as they are added on top of loan DTI requirements….. but the caveat is that cash down payments are not necessarily seperate from DTI requirements and lending standards.
Keep in mind when I say “premium” it doesn’t mean prices are going up. The willingness for cash to flow into certain markets impacts how far asset prices will fall. The premium can go up while asset prices crash. Wealth disparity continues to be one of Americas greatest challenges, and I don’t see it changing any time soon. The knife catching data in Irvine is proof positive of this, we’ll see how long it can last.
The recent buyer pool has been dominated by buyers with large cash downpayments. There is a very limited supply of these people, but they are exactly what the lenders are looking for. Someone needs to step up and absorb the next 20% decline, and the lenders do not want to be the bagholders, so they find those few buyers with cash and give them the bag.
“so they find those few buyers with cash and give them the bag.”
I disagree. The banks are not finding these people. These people with large cash savings are lining up to pay the banks. The stupidity of bubble buyers is undeniable. The stupidity of people with piles of cash is another story.
“There is a very limited supply of these people”
This is why I read your blog, to find out if this is true. The massive wealth transfer that occured during the global bubble is an important side show to asset deflation. I would like to see an analysis that some how catpured the “limited supply of these people”.
I wish I knew of a way to quantify this number, but I do not. Asset price deflation has certainly reduced the aggregate wealth of society, and the savings rate decline during the bubble, so there wasn’t much sitting around in savings accounts that missed the asset price crash. Residential real estate markets have functioned for the last 60 years based on the availability of credit. The bubble was clearly inflated on credit. Perhaps there are enough buyers with 30% down to keep prices inflated indefinitely, but I doubt it.
Right now, inventories are relatively low because there are no discretionary sellers, and the influx of distressed sellers will not come until the ARM resets and recasts occur. As long as inventories are low and sales volumes are low, the few cash buyers can support the market. Do you think this situation can go on long enough for incomes and rents to catch up to current pricing? That will take years, and the market must absorb the must-sell inventory from the ARM problem before this occurs. Anything is possible, but it doesn’t seem very likely that buyers with large downpayments can absorb the coming must-sell inventory at current prices.
I believe that down payments in Irvine will continue to be higher than all areas of the OC with the exception of premium coastal areas. Beause of this I believe there will always be a premium for Irvine that exceeds any rental premium that might exist. Prices will continue to drop, the premium might end up being small. If prices drop too much there will be mass economic devestation (the Mad Max scenario). Few here are willing to recognize just how leveraged these assets were and how their jobs and the entire economy are connected to the value of these assets. This is an unfortunate fact. Those who keep their jobs close to asset bubble incomes will benefit greatly.
“If prices drop too much there will be mass economic devestation (the Mad Max scenario). Few here are willing to recognize just how leveraged these assets were and how their jobs and the entire economy are connected to the value of these assets.”
I think what you are describing as the Mad Max scenario is what I have been describing for quite some time. The closest parallel to what we are going through in 2009 would be 1992. What lies ahead will be similar to 1993-1996 except a bit worse. The deflation of a California housing bubble leaves many in the building industry either unemployed or underemployed, and it leaves everyone else in a state of indentured servitude to their houses. With the reduction in aggregate income, and with so much of the income of the states people going toward debt service, little is left over for discretionary spending. This is why the economy suffers. Reinflating the bubble or attempting to support prices will not help. Only time and people buying in at lower prices with lower DTIs will put the economy back on a stronger foundation.
The Mad Max scenario I am describing is more like the 1930s. I expect this to be more like 1990s Japan than 1990s Irvine… where mortgage interest rates go lower and stay low for a decade to deal with the ARM problem, a very slow bleeding of the asset bubble.
“Condos will fall below, median properties will match, and prime properties will retain a small premium.”
If you run the analysis on an aftertax basis, I’ll bet the numbers line up better across the different types of properties. People with mortgages just under $1 million are the ones with the highest portion of their income as a deduction for mortgage interest.
You always have to remember that ‘ole boogeyman, the AMT. If you have a million dollar mortgage, and the income to support it, then there’s very little chance the AMT isn’t chipping away at the “tax benefit” of home ownership.
This is just another extremely complicated calculation a prospective homeowner must make.
Yes, I came quite close to the AMT in recent years.
This reminds me of a collection of the things realtors don’t mention. The tax deduction gets lower over time, because there is less interest being paid. The tax brackets and rates move around. Congress is always playing with the tax code: you don’t know what your deduction will be in a few years. Congress could also completely get rid of the deduction.
I have 2 questions:
1. 31% DTI which the FHA has years of data showing it is the highest sustainable level. Then why is the current DTI allowed @ 41% for FHA?!
2. At what point does the median income of an area vs median price break down? for example, 90210 has the same “median income” as 92602. http://zipskinny.com/index.php?zip=92602 http://zipskinny.com/index.php?zip=90210
Obviously the breakdown for 90210 has 36% > 200k. But technically, the median is the same!
31% is the front-end DTI that covers payment, taxes and insurance. 41% is the back-end DTI covering total indebtedness including car payments, credit cards, etc.
The median income/median price relationship breaks down in areas like Beverly Hills where those in the top 50% make much, much more money than the bottom 50%, and the bottom 50% is relegated to rental housing. Irvine was designed with a many small condos in order to create a balance of ownership products. From 1995-1998 in Irvine, the aggregate DTI was less than 30%, and the median home price to median income relationship was at 4 times.
Nice Post.
Excelent post IR.
I have attempted to make this argument several times over the last three years. Bank policy takes months or years to change, but they will continue to tighten. No way around it.
Realtors have no shame and no credibility:
Realtor eyes O.C. housing bottom by summer
http://lansner.freedomblogging.com/2009/01/04/realtor-eyes-oc-housing-bottom-by-summer/10848/
I love the user comments at that link, especially this one:
Bogey Says:
January 4th, 2009 at 12:30 pm
“All of the ingredients for a market recovery are there”
http://www.urbandictionary.com/define.php?term=captain assclown
Wow, is this guy David Lereah’s reincarnation?
I believe there were enough people who were smart (and lucky) enough to sell near the top and are waiting with cash to get back in at a lower level. Once their remaining intoxication turns to a hangover then we’ll be closer to the bottom.
I remember in the mid-nineties when real estate was considered a bad investment is when we finally hit bottom. We’re not there yet.
It goes without saying, but I have to say it anyway, an absolutely amazing and educational post.
I am one of those people who would love to buy but see no property that would interest me. Here in Irvine you get so much less for your money–small lot on top of your neighbors. Most can’t even hold a pool. We are packed in like sardines. I really dislike this area and only reason here is we need the airport. But I think the city did a piss poor job of design. Large parks, large berms wasted so much space. Yet they water all this property while you get a 3k sq. foot yard. Apartments are everywhere. In my neighborhood you can’t even park your car in the driveway (doesn’t fit) and we all have recieved tickets from police. Insane build a drive way that does not fit a normal car. What great city planners here in Irvine–REALLY–great post IR—
“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.”
In your example above, 31% DTI using the median income results in a $2,353 monthly housing debt payment.
“Someone using a DTI of 31% is really spending almost 50% of their take-home pay on housing and related expenses.”
50% of take-home pay is a lot of money to spend on housing. If prices fall to valuations supported by fundamentals as cited in the charts above, that’s still a big expense for housing.
Regarding rental parity, does that mean someone making the median income should be paying almost $2400 for rent? I can’t speak for everyone, but I consider that to be entirely too much money to be paying in rent or any housing expense for that matter.
Don’t forget that on a macro level all these assumptions and predictions don’t factor in job losses or extended economic pain.
If 3 bedrooms crammed into under 1600 sq ft is what the median family in Irvine making nearly $100K/yr should expect to be able to afford, then that is very sad indeed.
This small condo should not be considered a “median” property. This was simply developer’s greed, during the bubble, maximize the number of properties per lot and maximize profits. When people realize this, they will flee to places where they can get more space and Irvine will crash down to earth and will be considered no better than Costa Mesa.
Alan, couldn’t agree more. I also have a hard time categorizing this place a a median property.
where’s the DTI data for 2007 and since? I would love to see it after the peek
In my generation, the colloquial way of talking about pushing the DTI was “house poor”– so much of your income going into showy housing, or to get into a good school district, that you had to take all kinds of lifestyle tucks — no travel, no eating out, discount-store clothes and furniture, old cars, doing all your own home repairs, etc. We felt sorry for people who had to do that. In places like SoCal, the housing bubble made “house poor” obsolete because you could compensate with HELOC money from your appreciating asset. Of course in my parent’s generation (the Depression Generation) everybody lived the no travel, no eating out, etc. life style just by instinct regardless of DTI, but I don’t think folks today are as ready for that. So it’s time to put the useful concept “house poor” back into popular usage.
The elimination of the problems of being house poor by HELOCs and refinancing is exactly what is keeping the market psychology from changing. People who believe they can have the big house, put 50% of their gross toward it, and not be house poor are the ones buying right now. People really believe those habits that have proven so disastrous to lenders are going to be enabled again soon.
People who bought because prices were going up became house poor out of ignorance to the market. People who are buying now that prices are going down are becoming house poor out of ignorance to the credit cycle. Both cases of buyer ignorance are sad, and they will have lasting financial impact on the lives of buyers.
I’ll never forget when in 05′ being transfered here I sat down and did the math–I make this much spend this much –2k a month for college (two kids in at the time) and I can live off of this much for a mortgage. And it sure was not 5k that could put me in the same house I just left.
The HOA, mello roos, homeowners tax was here 26k here in Irvine–What I left behind paying 5k for similar home in the Bay area mind you. Where HOA was $70 per month–no mello roos and taxes were almost 5k–for a somewhat new home. Irvine went tax insane!!!!!
No one would belive me when I said I looked at developments same kind of house and taxes were this high–HOA was over $100 even up to $400 in some areas in Irvine.
Everyone here needs to realize how over taxed you are compared to other places in CA. Along with how over priced these homes are.
In the Bay area at least I had a decent lot!!!
House Poor and the Money Pit. When the house was a burden and when sinking thousands of dollars in repairs and upgrades was largely money down the drain.
I’m noticing the workers are more helpful at Home Depot, now that they aren’t so crowded.
Did anyone read the article in the Orange County Register this weekend about Citi Bank giving a loan modification to the former owner of Quick Loan Funding – one of the companies who wrote billions of dollars of toxic loans? Daniel Sadek lived the high life and his company was a prime offender in this housing bust and yet he gets his loan modified. What a joke! If I read the story correctly, at least the loan modification didn’t seem to help him – the house is going to default anyway….
http://www.ocregister.com/articles/sadek-citi-loan-2270290-billion-quick
Dano
Debt to income ratio should never be over 40%, that is the breaking point when it comes to deciding whether someone can afford a mortgage or not, in my opinion.
Ryan Philipenko – Real Estate in Edmonton
Great Post IR!
*Great research and data as well
If I’m not mistaken, that’s a plan 2 without Cathedral ceiling. Plan 3 has the Cathedral ceiling and you could build a loft floor over it for an additional 340 sq ft ($15k-$20k cost).
I like the town-homes here but not the parking situation. For 3 bed homes they only give you 2 car garage without drive way, and limited street parking spaces. At night the streets are packed with cars and I had to park all the way by the pool.
How about the potential of the DTI changing because peoples’ incomes might finally go up now that we have a new administration? Thoughts on the other end of this equation?