The Housing Bubble

Affordability Limits

Affordability is a measure of people’s ability to raise money to obtain real estate. It is often represented as an index that compares the cost to finance a median house price to the percentage of the general population with the income to support this house price. For instance, in Orange County, California, in 2006, only 2.4% of the population earned enough money to afford a median priced home. When affordability drops below 50%, there is a problem in housing; when it drops to 2.4% there is either a severe shortage of housing, or a housing price bubble. Most often, it is the latter.

Figure 23: Affordability / Demand

One way to envision affordability is through supply and demand diagrams like those found in introductory economics textbooks. Affordability is the demand curve. There are a small number of buyers who can afford very high prices, and many buyers who can afford very low prices. There is a limit to how high buyers can push prices. This limit is usually determined by lenders who provide the bulk of the money for real estate transactions. During the Great Housing Bubble, these limits were nearly eliminated. In terms of the demand curve, the loose credit standards and low interest rates shifted the demand curve dramatically to the right. Thus many more people were enabled to buy and they were able to do so at much higher prices. In bubble markets, once prices started to rise, they were bid up to levels where affordability was at record lows by historical measures. In a number of other markets, 2005 and 2006 were not the least affordable years in recent history. Markets not historically prone to bubble behavior might have a population which is decreasing (like Detroit,) steady (like Chicago,) or increasing rapidly (like Dallas). In fact, changes in population has very little to do with housing affordability in a particular city.

The expansion of credit took four forms: lower interest rates, lowering or eliminating qualification requirements, different amortization methods, and higher allowable debt-to-income ratios. Lower interest rates expand credit by allowing larger sums to be borrowed with the same payment amount. In 2000, the interest rate on a 30-year mortgage was 8.05%, and in 2003, it was 5.83%. This reduction in interest rates accounts for 20% to 50% of the increase in house prices experienced during the bubble. Subprime lending is an oft-cited example of lowering qualification requirements, but many loan programs included limited documentation that also allowed people with good credit to purchase multiple properties with little or no money down and no real ability to make the payments. Credit was also expanded by borrowers utilizing risky financing options including interest-only and negative amortization. Interest-only loans artificially “add” affordability to the market because it allows for larger sums of money to be borrowed with lower payments. The final component of credit expansion was a willingness of borrowers to take on larger debt-service payments as evidenced by increasing debt-to-income ratios. All of these factors also helped speculators. The acquisition and carrying costs of a speculative flip was greatly reduced. More people were eligible to speculate, and with rapidly rising prices, more people wanted to do so.

Table 7: Interest Rates and House Values

$ 244,900	National Median Home Price
$ 47,423	National Median Income
$ 3,952	National Monthly Median Income
28.0%	Debt-To-Income Ratio
$ 1,106.54	Monthly Payment
Interest Rate	Loan Amount	Value	Value Change
4.5%	$ 218,387	$ 272,984	145%
5.0%	$ 206,127	$ 257,659	137%
5.5%	$ 194,885	$ 243,606	129%
6.0%	$ 184,561	$ 230,701	122%
6.4%	$ 177,046	$ 221,307	117%
7.0%	$ 166,321	$ 207,901	110%
7.5%	$ 158,254	$ 197,818	105%
8.0%	$ 150,803	$ 188,503	100%
8.5%	$ 143,909	$ 179,886	95%
9.0%	$ 137,522	$ 171,903	91%
9.5%	$ 131,597	$ 164,496	87%
10.0%	$ 126,091	$ 157,613	84%
Note: The decline in interest rates from 8.05% to 5.83% explains about half of the national bubble.

Nationally, prices during the bubble rally increased by 45%. About half of this increase was due to lower interest rates. However, in the markets most prone to irrational exuberance, prices increased much more than the change in interest rates can explain. These markets also saw a large increase in the use of exotic financing and major increases in debt-to-income ratios utilized by many borrowers. For example, the median household income in Irvine in 2006 was $83,891. Applying a 28% DTI leaves a payment of $1,957. Interest rates at the time were about 6.5%; a payment of $1,957 on a fixed-rate 30-year mortgage at 6.5% would finance $309,691. Short-term adjustable rate mortgages carry lower interest rates than long-term fixed rate mortgages because the lenders have less interest rate risk exposure. The same $1,957 payment on a 5-year ARM at 5.5% would finance $427,081. The interest-only loan terms allows borrowers to increase their loans by 25% thus artificially increasing prices by 25%.

Table 8: Financing Terms and Conditions in Irvine, CA, 2006

$ 722,928	Irvine Median Home Price
$ 83,891	Irvine Median Income
$ 6,991	Monthly Median Income
6.5%	Interest Rate on 30-Year Fixed-Rate Mortgage
5.5%	Interest Rate on 5-Year ARM
3.8%	Payment Rate on Option ARM
Payment	DTI Ratio	30-Year Fixed	Interest Only	Negative Am.*
$ 1,678	24.0%	$ 265,449	$ 366,070	$ 529,838
$ 1,957	28.0%	$ 309,691	$ 427,081	$ 618,144
$ 2,237	32.0%	$ 353,932	$ 488,093	$ 706,451
$ 2,517	36.0%	$ 398,174	$ 549,105	$ 794,757
$ 2,796	40.0%	$ 442,415	$ 610,116	$ 883,063
$ 3,076	44.0%	$ 486,657	$ 671,128	$ 971,369
$ 3,356	48.0%	$ 530,899	$ 732,140	$ 1,059,676
$ 3,635	52.0%	$ 575,140	$ 793,151	$ 1,147,982
$ 3,915	56.0%	$ 619,382	$ 854,163	$ 1,236,288
$ 4,195	60.0%	$ 663,623	$ 915,175	$ 1,324,595
$ 4,474	64.0%	$ 707,865	$ 976,186	$ 1,412,901
* Negative Amortization loans (AKA Option ARM)

The most important single factor in the expansion of credit was the negative amortization loan, also known as the Option ARM. The payment rates on Option ARMs differ widely, but for the sake of this calculation, assume a 3.8% teaser rate (they were as low as 1 %). The $1,957 payment finances $309,691 with a Conventional mortgage, $427,081 with an Interest-Only mortgage, and a whopping $618,144 with Negative Amortization. Stop for a moment and ponder the math: the same payment now finances 100% more money. Is it any wonder the real estate in bubble markets like Irvine, California, were 100% overvalued at the top? People purchasing with Option ARMs were buying at the rental equivalent monthly cashflow–at least for a while. From a financing perspective, the market was not overvalued. People were paying exactly what they should have been paying. They were just doing it with loan terms which were going to destroy them–hence the terms “toxic financing” and “suicide loan.” This point cannot be overemphasized–Negative Amortization loans inflated the Great Housing Bubble. If this loan product had not been offered and aggressively pushed by lenders, the bubble would not have inflated to the degree that it did.

Figure 24: Market Rally Supply and Demand

The supply curve is the opposite of the demand curve: sellers will make very few units available at low prices, and sellers will make a great many available at higher prices. Wherever these two curves meet is where supply and demand are in balance and market transactions are taking place. In the initial stages of a market rally both transaction volumes and prices are increasing rapidly. In states with a cumbersome entitlement process like California or in the Northeastern part of the country, delays in bringing supply to the market exacerbates the initial price increase and ignites the speculative frenzy. During the Great Housing Bubble, an increase in demand was caused by a dramatic expansion of lending and credit. As a price rally matures sellers become reluctant to sell because the asset they own is appreciating rapidly, and they do not want to miss the opportunity to profit further. This limits the supply on the market. In terms of the supply and demand diagram, this shifts the supply curve to the left which pushes the balance between supply and demand to a higher price point. The demand curve shifts to the right from the increased liquidity of the lending environment and the supply curve shifts to the left because of seller reluctance; the intersection of these two lines moves prices markedly higher. However, once these two forces come into balance, their intersection is at a point of low transaction volume. There are fewer buyers who can afford the higher prices, so transaction volumes fall. [1]

The first sign of a troubled real estate market is a dramatic reduction in volume known as buyer exhaustion. There are simply not enough buyers able or willing to push prices any higher even at the lower transaction volumes. In a residential real estate market, this phenomenon is particularly pronounced at the entry level. The imbalance between supply and demand first becomes apparent at the bottom of the affordability scale with entry-level buyers because these buyers are not bringing the profits from a previous sale with them to the next property. Affordability is less of a problem for existing homeowners in the move-up market due to this equity transfer.

Figure 25: The Housing Market Pyramid

The real estate market can be visualized as a massive pyramid. There are very few multi-million dollar properties at the top of the pyramid, and a large number of relatively inexpensive entry-level properties forming the base. Like any structure, if the foundation is weakened, the structure may collapse. In the same way, housing markets collapse from the bottom up due to problems with affordability. The foundation of a residential real estate market is the entry-level buyer. Entry-level buyers are generally young people starting to form new households. When homeowners want to sell their house and move up to a nicer one, someone needs to buy their house. If you follow this chain of move-ups backward, eventually you come to an entry level buyer. If there are no entry level buyers pushing the sequence of move ups, the entire real estate market ceases to function. The entry level market was initially boosted the moment 100% financing became available because many more people were enabled to purchase; however, it was imperiled at the same time because of the change in savings incentives. This market was subsequently destroyed the moment 100% financing was eliminated because few entry-level buyers had a downpayment and very few people were in the process of saving to get one. In the past, people would rent and save money until they had the requisite downpayment to acquire a house. The barrier to home ownership was not the ability to make payments; it was having the necessary downpayment money. When downpayment requirements go up, the number of people capable of buying a house declines considerably, particularly for entry-level buyers who must save this money rather than transfer it from a previous sale. Since few potential entry-level buyers were saving money during the rally, sales volumes suffered dramatically in the wake of the bursting real estate bubble.

Figure 26: Affordability Limit

Affordability is the ultimate limit of any asset bubble. If prices are so high that no buyer can afford them, there are no transactions and thereby no market. The fear of many buyers in a financial mania is that prices will remain elevated to the absolute limit of affordability permanently. People who have this fear will put every available resource into getting a house before this happens. This becomes a self-fulfilling prophecy as prices get bid higher and higher by fearful buyers. If prices were to remain at the upper limit of affordability for a long period of time, the rate of price increase would slow dramatically until it only matched the rate of wage growth and inflation because prices could only rise if people had income gains they could use to bid prices up further. If the rate of house appreciation slows down to where it only matches inflation, it fails to have significant investment value. Money would generate much greater returns if invested in other asset classes. During the Great Housing Bubble, certain of the most inflated markets saw prices more than double their rental equivalent value. This significant additional monthly cost provides an economic return while prices are increasing rapidly, but once the rate of price increase slows, the additional “investment” is not providing sufficient returns to justify the use of capital. If price increases do not provide an investment return, many who bought in anticipation of that investment return will decide to sell the asset in order to put their money toward more productive uses. This selling slows the rate of appreciation even further. Also, if prices are not rising in excess of inflation, there is little financial incentive to buy because when affordability is very low, it is much less expensive to rent. If there is no financial incentive to pay more than the cost of rent, people stop buying. The additional selling pressure from those no longer obtaining a return on their investment combined with the diminished buying enthusiasm for the same reason plus the presence of a low-cost substitute (rental,) stops prices from rising and eventually causes a price decline. Once prices start declining, the incentives are even more negative, and prices fall back to levels where they are affordable again.

As prices begin to fall, lenders become more conservative. They do not loan large percentages of the value on a depreciating asset because they do not want to have the loan balance exceed the resale value of the house since the only assurance banks have for getting their money back is the collateral value. Prior to the Great Housing Bubble, lenders demanded 20% down payments to give them a cushion if values declined and they limited debt-to-income ratios to 28% to make sure the borrowers could afford to pay them back. When house values start declining, lenders require more cushion to protect their investments. The demand from lenders for larger downpayments to protect themselves reduces the number of buyers in the market because less people meet the more stringent requirement. Fewer buyers causes even lower prices and a downward spiral of tightening credit. This continues unabated until 20% down payments are the norm, and debt-to-income ratios fall back to their historically “safe” levels for banks (28%).

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[1] Praveen Kujal and Vernon L. Smith noted in The Endowment Effect (Kujal & Smith, The Endowment Effect, 1991) that even small changes in the bid/ask spread results in a large decline in transaction volume.