Stuck inside these four walls, sent inside forever, Never seeing no one nice again like you, Mama you, mama you. If I ever get out of here, Thought of giving it all away To a registered charity. All I need is a pint a day If I ever get out of here.
My passage with the Credit Siren
I want to share with you a personal experience today: my passage with the Credit Siren.
For those who remember their Greek mythology, the Sirens were singing seductresses who with their beautiful songs lured sailors to their deaths by crashing their boats on the rocks. The Siren Song has become a metaphor for pleasure or vice that leads people to their own destruction. On this blog, I write frequently about the Siren Song of HELOCs that caused so many homeowners to crash on the foreclosure rocks.
Any time someone writes about a behavior like that, there is the risk of the message sounding preachy or coming across as if the author is above falling victim to such things. I write about this issue in hopes that others will learn from it and recognize the folly for what it is. It isn't about morality, a statement of right and wrong; it is about wisdom, recognition of what is prudent and what is foolish. I am certainly not immune to the Siren Song about which I write.
I have not always been wise about how I have managed my own financial affairs. I don't know if I am even now. One thing I am proud of is the fact that I have no debt. I have been recently reminded about how difficult a discipline staying out of debt really is.
During December, I had too much activity in my savings account, and I began getting "excessive use" fees. Like many people, I was overspending. When I saw what was happening, I didn't want to get any more of these fees, so I quit using my checking account until the bank cycle for December had past. I used my credit card for almost 10 days.
I felt like I was spending free money.
I went out to eat with family, bought a few presents for my son, and generally had a great time. Neither my checking account nor my savings account changed. It was really cool. It brought up all the old feelings I used to have when I used (and sometimes abused) credit years ago.
When the first of January rolled around, and I was able to get access to my checking and savings accounts without further bank fees, I knew it was time to pay the piper for my 10 days of fiscal irresponsibility. When I paused to reflect on what I did and how I felt while doing it, I was quite astonished to see how easy it was for me to fall back into old habits. I guess it is like being an alcoholic or drug addict. Once you stop, you better not ever start again.
I won't be doing much in January. I spent all my discretionary income for January in December. I know where the rocks are, and I know how the Credit Sirens lead me there. Fortunately, I am at a stage in my life where I have the self-discipline not to listen to those Sirens and keep the family boat from crashing and sinking. Unfortunately, it means January is going to be quite boring...
While looking around YouTube, I came across this three part lecture series from former UCLA economist Christopher Thornberg now with Beacon Economics. He is one economist who correctly predicted the housing bubble. This series is excellent.
Real Estate Bubbles and California's Economic Growth, Part 1
Real Estate Bubbles and California's Economic Growth, Part 2
Real Estate Bubbles and California's Economic Growth, Part 3
If you like academic reviews of bubbles in general and the housing bubble in particular, here are two more videos for you:
I heard you found a wishing well In the city Console me in my darkest hour (in my darkest hour) And you throw me down
On Wednesday, we looked at the impact of cash buyers in Irvine's market and asked, Will Zealots and Foreigners Support the Market? Are those with large downpayments smarter than the fools who used 100% financing? Surely someone who put a large downpayment into a transaction must know something more about the market than a no-risk gambler using 100% financing. Well, perhaps not.
Many of the properties I have profiled have been speculators using 100% financing who bought at the peak. These people were not risking any of their own money, so they had little to lose other than their credit score. These people are the first to give up when prices go south because they have the least incentive to continue pouring their own money into the abyss of ongoing debt service.
The people who have their own money in the transaction are a bit more reluctant to give up because they know their money will be gone forever. We first started seeing people who had 5% or even 10% down a few months ago. Today is one of the first I have seen that has put 20% down on a mid to high range property and decided to sell.
Console me in my darkest hour Convince me that the truth is always grey
Personally, I think it is a bright move on this guy's part. He is getting out now before prices drop further and he either damages his credit or loses even more money. Very few in his circumstances would do the same. I admire his decision.
The closer people get to falling under water, the more they lapse into denial. Most of the market is simply hoping prices come back soon without any realistic chance of this occurring. Denial is paralyzing because it prevents you from taking action. The owner of today's featured property overcame his denial and is choosing to sell before it gets worse.
In a healthy real estate market, people only take on as much debt as they can afford, and they work to pay it off as quickly as possible. Debt is something to be retired not endlessly serviced.
If you look at the equity curve of real estate, you see that equity is built in 3 major ways:
Speculation.
Inflation.
Debt Retirement.
A truth that everyone is becoming painfully aware of is that speculative equity is not stable. Prices once detached from fundamentals will return to them at some point. The return to fundamentals is either accomplished through actual price declines or a period where prices increase at a rate less than inflation. It is usually the former. Speculative equity cannot be counted on, and it is only captured through careful analysis or blind luck. It is usually the latter.
Inflation equity is really not equity at all. If your house doubles in value in 20 years, but the value of the currency has cut in half, you really haven't gained anything. On paper you have a gain, but the money you get out has no more buying power than the money you put in, so you really haven't benefitted as much as you think you have. Inflation equity will preserve your wealth, but it will not add to it.
The real way to make money through long-term ownership of real estate is through obtaining financing equity. You get this by paying off your loan. This method of building wealth, the only one that really works, has been much maligned over the last decade as fantasies of easy money through boundless appreciation gripped the market.
Pay me or go to jail Pay me my money down
The last time we had a healthy, fairly valued market was from 1995-1999. During this period, people did not believe in endless appreciation because prices had been declining since 1991. Buyers realized the only way to make money in real estate was to borrow a small amount and pay it off or pay such a small amount that you could rent the place for positive cashflow. Once prices start going up, people see that they can profit from appreciation, and the slow, steady method of building wealth through retiring debt seems rather quaint and old fashioned.
Once prices start really going up, paying down mortgage debt is an unnecessary financial burden. Why bother paying an extra $500 a month toward your housing debt when the house is going up in value about $5,000 a month? Why not just use interest-only financing and spend that $500? Well, that is such a good idea, the next step is obvious: why not utilize a loan where you don't even pay the interest and free up that payment money for consumer spending. The Option ARM is born.
But why be satisfied with only falling behind $500 a month on your mortgage when house values are going up $5,000 a month? Why not borrow more? Why not go withdraw the equity in huge lump sums? After all, it is accumulating far faster than it can be spent. If you refinance or open HELOCs periodically, you can extract this free money as soon as it becomes available. Why not?
Do you see how speculative equity is a slow seducer? The foolish and irrational seems completely logical when you look at the changing circumstances.
When a Ponzi Scheme is built on debt, like it was during the Great Housing Bubble, each person in the chain must assume a larger debt than the person who came before them. Since nobody is paying down debt, and since most people are furiously adding to it, the amount of debt buyers needed to take on in order to pay off the debts of the seller becomes very large. There is a point where the debt becomes too large for people to service, and they default on their payments. Once banks stop getting paid back, they stop making loans: a credit crunch.
The challenge for lenders in the wake of a crashing Ponzi Scheme is to rediscover the debt-to-income levels people can support for residential real estate. Historically this number has been around 28%. The challenge for the market is to endure the crash back to pricing levels consistent with stable borrowing levels. We are in that process right now.
During the price decline, market psychology will also change. People will slowly recognize that the personal financing methods they believed were stable during the bubble (interest-only and negative amortization loans at high DTIs) are not stable and should not be used. As long as market participants believe in the fantasy of speculative equity, they will utilize whatever means of financing is available to them to acquire as much real estate as possible. It is the knife-catcher mentality. The slow grind of declining prices will pulverize this faulty thinking over time, but in the interim, people will continue to overpay for real estate to the degree that they can.
Eventually, it will become widely recognized that borrowing a small amount and paying down a mortgage is the only real method of accumulating wealth in real estate. Of course, when this happens, the market is at the bottom, and the whole cycle begins all over again...
Today's featured property is an example of how people get seduced by the free money of speculative appreciation. They were not bad HELOC abusers: a refinance here, a HELOC there, but over time this habit has more than doubled their mortgage obligations, and now they must sell their home before they fall underwater. Are you ready to assume their debts? Whoever buys this house is going to. They took out the free money and spent it, and now they need to find someone willing to pay off this debt before it becomes a short sale.
All their equity -- initial, speculative, and inflation -- was wiped out by their method of financing and mortgage management. Seventeen years of ownership, and they have nothing to show for it.
There were a significant number of all-cash transactions, particularly at the high end where you would expect to see them. When you take out the all-cash deals and look at the 85% of transactions where there was some form of financing, you see that the median downpayment was $150,000. This is 25% down. This is very high. This level of downpayment is unusual in a normal real estate market. Needless to say, it was much, much lower during the bubble rally. The reason is simple: how many people have that kind of cash saved up? Not very many.
We have another forum thread going on the phenomenon of cash buyers. No discussion of this topic would be complete without theories of how rich foreign buyers will save the housing market.
In yesterday's comments, a new poster named samuroo had recently sold his property. He made this observation:
"We priced aggressively and sold our property in 3 days with 10
written offers on the table. The offers were from a mix of people. We
had one investor (the only one to offer below asking) and the rest were
first timers, move-uppers, or someone buying for someone else (for
children or grandparents). Only one offer was 20% down, the rest
ranged from 40% to all cash. All offers were from asians (except one
Brazilian). The offer we accepted was a first time buyer with
substantial down.
The one thing that seemed consistent among all the offers as well as
those that came looking was that they believed the market was near
bottom and that Irvine is still the place to be."
I have no doubt that his observation is correct and accurate. So the question is will foreign money or the extremely kool aid intoxicated support the housing market?
Rich Toscano, from Piggington and Voice of San Diego, has made this observation:
"Investors from other countries are well known to be the very last
participants to arrive at the scene of a financial bubble. They are the
last to hear about all the riches to be made, the last to buy in, and
the last to realize that the party is over...
Far from being a positive fundamental, a sudden excess of foreign
participation in an asset market is indicative of ill-informed
speculative money at work. When the foreigners really start piling on,
it's always a good sign that the end of the bubble is nigh."
Foreign money can support prices for a while, but if market forces are working to drive prices lower, this buying support will be overwhelmed by the supply for sale.
So what about kool aid intoxicated zealots? Most people believe house prices will rebound quickly and that there are certain neighborhoods that are immune to the price decline. I have made fun of Turtle Ridge on many occasions for this attitude. If people believe prices cannot fall in a certain neighborhood, they are far more likely to buy there. If the neighborhood is small enough, and the number of buyers is large enough, it can become a self-fulfilling prophecy. In my opinion, the neighborhood most likely to see this phenomenon is Turtle Rock because there will be fewer toxic mortgages there. Turtle Ridge is toast. Is it possible for zealots to buy up all of Irvine?
In the short term, zealots and foreign money can support a housing market. As long as there are enough buyers willing to pay current prices to absorb the market inventory, prices will find an equilibrium. As some point the number of buyers with significant cash downpayments is depleted, and the inventory of houses for sale exceeds the number of available buyers at a particular price level. When this occurrs, prices fall.
Historically, high downpayment requirements has lead to lower prices because there are so few with downpayments, and there are so many houses that need to be sold. Is it possible that there will be enough buyers to support prices at valuations permanently detached from fundamentals? Well, anything is possible, but if history is any guide, then the answer is no. Cash buyers will continue to provide the liquidity for the low transaction volumes witnessed during price declines. They are the designated bagholders. When prices reach levels of affordability, transaction volumes will increase, prices will stabilize, and the market will be healthy again.
And these are the days When our work has come assunder And these are the days When we look for something other
Give it away give it away give it away now I cant tell iff Im a king pin or a pauper
In yesterday's rather lengthy post, I discussed Debt-To-Income Ratios: The Forgotten Variable. Today, I want to bring together parts of that post with other issues in the marketplace to paint an accurate picture of where we are. In the discussion on DTIs, I had the following table that shows how the median income household is financing median income properties.
$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 chart would suggest that people who are still borrowing 6 times their income are doing so by utilizing DTIs near 50% (which represents almost 80% of take home pay). The reality is slightly different. Lenders are telling me that most people buying today are using 5-year and 10-year interest-only mortgages to get the DTIs down to somewhat manageable levels. So how does that math work out?
A median income household earning $91,101 can put $2,885 toward housing payments and expenses if they utilize a 38% DTI. (I think this is insanely high, but the government seems to think this is manageable.) If 20% of the $2,885 needs to be set aside for taxes and insurance ($577 per month), then $2,308 can be put toward an interest-only mortgage payment at 5%. This will finance $553,920 which is a little over 6 times income. Add a downpayment to this, and median income households can "afford" a house price between $550,000 and $650,000. The numbers are a bit smaller with the higher jumbo interest rates, but the downpayment requirements are higher too. Plus, some lenders will still allow DTIs higher than 38%.
People using 38% DTIs, 10-year interest only mortgages and downpayments of 5% to 20% are sustaining the housing market.
Are you willing to do this? I'm not.
For this method of finance to sustain home ownership, mortgage interest rates will need to be at 5% in 10 years time and prices will have to be equal to or greater than they are today. If those two things do not happen, today's buyers will not be able to refinance, and they will be in the same circumstances as those facing foreclosure today. The only other thing they can hope for is that they will have a much higher income to afford the payments.
In the 10 years while these homedebtors are waiting to see if they can refinance, they will endure crushing housing costs that crowd out all other forms of consumption or savings. People buying today do not believe the harsh economic realities of making crushing mortgage payments is going to go on very long. Most believe that appreciation is right around the corner and with it, they will be able to get a HELOC and begin supplementing their missing income through mortgage equity withdrawal.
Do you think that is going to happen. I don't.
So there you have it: people buying today are doing the following:
Using 38% DTIs and interest only financing,
Betting the interest rates will still be at 5% when they need to refinance in 5 or 10 years,
Betting their house will appreciate between now and when they need to refinance,
Counting on rapid appreciation soon to provide free money they can tap with a HELOC,
Counting on banks giving them a HELOC after the banks just lost a trillion dollars doing the same.
Putting their faith in the Real Estate Gods to make it all happen.
It this does not work out as planned for today's buyers, they will be renting from their lender for 5 or 10 years, then they may be evicted when they fail to make the increased rental payments on the banks money that will come due after their loan resets. During their rental period, they will be paying 30% to 40% more than traditional renters will be paying for the same property.
Greedy little people in a sea of distress Keep your more to receive your less
So why are people doing this? Fear and greed. They are afraid that if they do not buy now, they will never get the chance again, and more importantly they want that free HELOC money they think is coming back soon. Fear might compel someone to buy, but only greed will compel them to pay that much.
In my opinion, if you took away the enticement of free money, prices would collapse almost immediately. We have documented on this blog the hundreds of thousands of dollars of free money borrowers got from their lenders. For those who sold at the peak, the money was totally free, and for those who didn't, they have to pay with damaged credit. Big deal. They all got to spend or keep the free money.
Californian's have learned this free money is there, and all they have to do is buy real estate to get it. The collective insanity of everyone believing and acting on this idea makes prices rise and makes the fantasy a reality. Right now, the only thing preventing this from happening is reluctance on the part of lenders to give away another trillion dollars in free money to people who will not pay them back. Personally, I don't think this reluctance from the lenders is going to change. Funny how losing a trillion dollars will make you a bit more cautious...
It seems like there are some properties people just don't want. I can
understand all the crappy little condos in The Lakes (Lakepines,
Pinewood, Streamview, etc.) but when you see newer, larger, more
desirable properties still in the system and still with declining
prices, you have to wonder what is going on. Today's featured property was first on the IHB as a 2003 rollback in August of 2007, right as the credit crunch hit. It has been almost a year and a half since this property was first featured, and it is still making its way through the system.
Do you see why the hangover from the Great Housing Bubble is going to last longer than most people realize? We will be dealing with properties like this one for the better part of a decade. We still have a number of resets in 2011. It isn't hard to imagine some of those still polluting the market in 2014. Plus we have all the knife catchers from 2007 and 2008 who used 5 year interest-only ARMs to clean up after.
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
