The Anatomy of a Credit Bubble

Financial markets represent the collective result of individual actions. To fully understand how our current housing bubble was inflated, one needs to understand how the actions of the individual market participants impacted house prices. In my last analysis post, Your Buyer’s Loan Terms, I discussed future interest rates and debt-to-income ratios and their impact on future housing prices. In that post, I made a blanket assumption that interest-only and negative amortization loans will simply not be available in the future. It is a debatable assumption. In this post, I want to show more clearly how these two loan types created this bubble and why I believe they will not be available in the future. In short, I will describe the anatomy of a credit bubble.

To illustrate how this loosening and tightening of credit creates housing market bubbles, I will examine the last two bubbles similarities and differences. I will demonstrate how the bubble from 1987 to 1990 was very similar to our current bubble from 2001 to 2004. The last two years of our bubble, 2005 and 2006, were uncharted territory created by "innovation" in the lending industry.

How People Buy

When people decide they want to buy a house, they figure out how much they can afford and then go find something they want in their price range. For most people, what they can "afford" depends almost entirely upon how much a lender is willing to loan them. In the past, lenders would apply debt-to-income ratios and other affordability criteria to determine how much they were willing to loan. Buyers were generally limited in how much they could borrow because lenders were wise enough not to loan borrowers so much that they might default.

Buyers / borrowers behave much like drug addicts — they will borrow all the money a lender will loan them whether it is good for them or not. Most are not wise to the differences between the various loan types, and they have limited understanding on the risks they are taking on. This financially irresponsible borrower behavior is particularly bad here in California due to Southern California’s Cultural Pathology. If you need a primer on the various loan types, start with Financially Conservative Home Financing or Your Buyer’s Loan Terms.

Comparing the Bubbles

The circumstances during each bubble was different. Prices and wages were lower in the last bubble, interest rates were higher, the economies were different, etc. What is the same is the evaluation of personal circumstances each buyer goes through when contemplating a purchase. The cumulative impact of these decisions in 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 seeing how this bubble compared to the last one.

DTI 1986-2006

The chart above 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. The last bubble is pretty obvious. In 1987, 1988 and 1989 people believed they would be "priced out forever," so they bought in a fear frenzy. Mostly people stretched with conventional mortgages, but interest-only was used, and helped propel the bubble to a high level of unaffordability. Basically, prices couldn't get pushed up any higher because lenders would not loan any more.

The Affordability Limit

When affordability limits are reached, prices must fall. This is caused by two related phenomenons:

  • People will stretch to buy an asset that is appreciating; when appreciation stops, so does the stretching to buy. During the bubble rally, rising prices justifies paying too much because you obtain a return on your investment. Once prices quit rising due to the affordability limit (lenders won't loan more money), there is no justification for the high prices, and people quit buying. The lack of buying causes volume to wither and inventories to spike; prices start coming down as sellers are forced to sell.
  • Banks will not loan large percentages of the value for a depreciating asset, nor will they allow borrowers to utilize high debt-to-income ratios. Banks don't like to lose money. Banks used to demand 20% down payments to give them a cushion if values dropped. Banks used to limit debt-to-income ratios to 28% to make sure the borrowers could afford to pay them back. The only assurance banks have for getting their money back is the value of the collateral (house). If house values start declining, banks want even more cushion to protect their investment. The era of 100% financing and 60% DTI is gone because houses stopped going up in value. As prices start to decline, down payment requirements will continue to rise and DTI will continue to fall which in turn reduces the number of available buyers which makes prices drop even further: a downward spiral.

What starts as buyers being unable and unwilling to buy turns into 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 of 28%. This is exactly what occurred from 1990-1997, and What is Past is Prologue.

Cheating on Affordability

Despite what the affordability charts show. People do not really make payments which are 62% of their gross pay. They cheat. They do this by utilizing risky financing options including interest-only and negative amortization.

Interest-only loans artificially "adds" affordability to the market because it allows for larger sums of money to be borrowed with lower payments. For example:

The median income in Irvine is $83,891. Applying a 28% DTI leaves a payment of $1,957. At current interest rates, a payment of $1,957 on a fixed-rate 30-year mortgage at 6.4% would finance $312,866. This same $1,957 payment on a 5-year ARM at 5.6% would finance $419,454. As you can see, the interest-only loan terms allows borrowers to increase their loans by 25% thus artificially increasing prices 25%.

2004's False Top

On the DTI chart, notice the similarities between the periods 1987-1989 and 2001-2003. Both were rising DTI's moving through the affordability zone pushing prices to the top of the range. If history had repeated itself, lenders would have become cautious in 2004 just as they did in 1990, and the market would have topped in 2004.

OC Inventory

As you can see from the chart of available inventory above, 2004 would have indeed been the top. Inventory exploded, time-on-the-market went way up, and it looked like the party was over. It should have been; however, the lending industry "innovated" and came up with the negative amortization loan.

Negative Amortization Loans

When lenders "innovate" trouble is brewing. Banking has been around over 500 years. Everything has been tried at least once. Innovation in banking is a matter of trying something which has probably failed dozens of times before and hoping for a different outcome (the definition of insanity if you didn't notice). It should not surprise anyone when the negative amortization experiment fails brilliantly.



From our example above, we can see how changing the terms from a conventional, fixed-rate mortgage with a 30 year term to an interest-only adjustable rate mortgage artificially increases home prices by 25%. Now look at what negative amortization does. In 2004, prices reached the limit imposed by interest-only. The only way to push prices higher would be to finance even larger sums with the same available payment. Option ARMs differ widely due to differences in their teaser rate, but for the sake of this calculation, I will assume a 3.75% teaser rate (I have seen them as low as 1%). The $1,957 payment finances $312,866 with a conventional mortgage, $419,454 with an interest-only mortgage, and a whopping $626,239 with negative amortization. In 2004, 2005 and 2006, people took out Option ARMs, bought the huge inventory spike from the summer of 2004, and sent prices into the stratosphere.

Map of Misery

32% of loan originations in Orange County in 2006 were negative amortization (Option ARM).

Stop for a moment and ponder the math: the same payment now finances 100% more money. Is it any wonder our real estate market was 100% overvalued at the top? People purchasing with Option ARMs are buying at the rental equivalent value. From a financing perspective, the market is not overvalued. People are paying exactly what they should be paying. They are just doing it with loan terms which are going to destroy them — hence the term "suicide loan."

Amortization Value Table


These exotic financing terms are going away for one simple reason: foreclosures. People simply cannot make the payments when interest rates rise. If you look at the foreclosure rates in the early 90's, you can see what happens when lenders get too loose with credit. Lenders overcooked the market then, and they got burned. You think they would have learned their lesson…

Feb 2007 NODs

(One note on the foreclosures: defense industry layoffs are often blamed for the problems with the housing market. These layoffs came after the housing market was already in trouble. It slowed the recovery, but it was not the cause.)

Lenders faced high foreclosure rates in the early 90's because they were too aggressive with their lending practices in the rally of the late 80's: it was their own doing. As you can see from the above chart, the ultra-aggressive lending practices of the early 00's are just now starting to show up in the foreclosures. Just as in the early 90's, this is being caused by the past sins of the lenders: karma on grand scale. If does not take an expert to extrapolate from the chart above to see that foreclosures are going to shatter the old records set in the 90's.

Price to Income Ratios

Just in case you still don't believe there was a credit bubble. Examine the chart below of historic price-to-income ratios.

Price-to-Income Ratio

Very high price to income ratios signify borrowing large sums with small payments just as illustrated in the previous financing example. Ratio's greater than 5 are considered very unaffordable and prone to high rates of default. The bubble of the early 90's did not exceed 6 partly because interest rates were higher and partly because they did not use negative amortization.

Elimination of Exotic Financing

I have speculated that exotic financing is going to disappear. To be more accurate, exotic financing is going to become so expensive for borrowers as to render it practically useless. These loans will always be available, but the interest rate spreads will grow and the qualification standards will tighten to make them not usable. For example, in the heyday of negative amortization loans, lenders would qualify borrowers based only on the teaser rate payment without regard to whether or not they could afford the payment at reset. For more sophisticated borrowers, lenders allowed stated income or "liar loans." Basically, a borrower would tell the lender how much they wanted to borrow, and the lender would fill out fraudulent paperwork showing the borrower was making enough money to afford the payment. This is amazingly irresponsible lending, but it was widespread. Now, lenders are requiring borrowers be able to actually afford the payments; of course, this makes many borrowers unable to obtain financing. That is credit tightening; that is how the downward spiral begins.



The next phase in the tightening of credit is an increase in interest rate spreads between prime loan terms and exotic loan terms. This is driven by the defaults and foreclosures. Mortgage rates for prime customers are very low because they rarely default. During the rally nobody was defaulting because prices were rising; people just sold if they got in trouble. This allowed banks to originates risky loans at very low interest rates because the loans didn't look risky. Now that the market has stopped rising, the underlying risk is starting to show with dramatically increasing default rates. The true risks of these loans will become apparent over the next few years.

Banks have to make enough money on their good loans to pay for the losses on their bad loans and still make a profit. As exotic loans start showing very high default rates, banks have to start charging higher interest rates to cover the losses. Higher interest rates make for lower amounts of borrowing.

Interest Rate Table

When banks realize the true risk associated with exotic financing terms, they may have to charge much more than they are charging for conventional loans. As you can see from the table above, if the interest rate is only 3% higher, the amount financed is 25% less. If the default rates are very high, no amount of interest rate spread can compensate the bank for the risk, and that loan program will be eliminated. This will be the fate of the negative amortization loan.

The 2006 vintage sub-prime negative amortization loans have already defaulted in record numbers. These loans are less than a year old. It is forecast that over 20% of these loans will default, and this is without a crashing housing market. If lenders have to make enough money on 4 loans to cover the loss on 1, interest rate spreads will be very high. If a negative amortization loan costs 13.75% rather than 3.75%, nobody will want it, and if lenders require borrowers to actually afford the 13.75% interest rate, nobody will qualify. Either way, negative amortization loans will die. The fate of stated income and interest-only loans may be no better.

When prices crash, defaults rates will increase for all borrower classes. Prime borrowers will not default at the high rates of sub-prime borrowers, but they will still default at rates higher than in the past; therefore, interest rates will rise for prime borrowers as well. The crash in house prices will cause all mortgage interest rates to rise.

What Happens Next?

Over the next several years, interest rates will rise to at least 8%, 20% down payments will become the norm, and debt-to-income ratios will fall back to their historically "safe" levels for banks of 28%. What will that do to prices?

Future Value Table

At some point in the future, the market will bottom near the values above. How it gets there will depend on the number of foreclosures. If there are a great many foreclosures, it will happen quickly, if there are fewer, it could take longer. Either way, the median prices shown above will occur, it is just a matter of when. I have constructed two different scenarios as to how and when: Predictions for the Irvine Housing Market and How Bad Could Bad Get?

The conditions for the above disaster are already in place. Right now, we are in the lull before the storm, but the storm is coming; there isn't much anybody can do about it.

53 thoughts on “The Anatomy of a Credit Bubble

  1. carl


    I’ve been lurking for a while… I guess I have a ghoulish fascination with this stuff. I would like to write and thank you for your well-thought-out and researched posts. This is obviously a labor of love for you, and the detail with which you write makes them serve as excellent educational material for intelligent (I hope!) but uninformed people like myself. Bravo!

    I’m hoping to move back to SoCal in a few years (my wife misses it) but after reading your posts I’m going to tread cautiously, and probably rent at first (unless the bottom has already fallen out).


  2. awgee

    In order for prices to revert to the mean, or median, don’t the prices have to fall below the mean for awhile?

    Also, during the last mania, there did exist interest only and neg-am loans. I think the difference which caused the larger use of exotic loans and the outrageous DTI levels is the introduction of MBSs and the CDOs and CDSs which supposedly mitigate the risk associated with non-convetional loans. It will be interesting to see if these new derivatves do indeed mitigate the risk, or if they are just hiding the risk and prolonging the agony. If the latter, prices could fall so far below the mean as to make the mean unrecognizable. Pass the popcorn.

  3. SoCalwatcher

    Another excellent, smart, rational and brutally clear analysis-IR!!! 🙂

    Wouldn’t you figure that banks, with their long history and plenty of money to hire the best staffs to figure this stuff out, whould have figured this stuff out?

    If they would hire people to make rational and smart assumptions and look forward to create and analyze scenarios such as this- we would be in a much better economic place right now.

    Too bad that will never happen when certain people in the right places are making too much money to care….

    God ble$$ America!!!

  4. IrvineRenter

    It isn’t just a matter of reverting to the mean, it is falling to buyer support. If prices drop below the point where aspiring homeowners will purchase to save on rent, cashflow investors will buy the units and rent them out. If these price levels are reached, a great deal of money will come in to the market and support prices. If there are a very large number of foreclosures, and they all hit the market at one time, you could easily see a huge downward spike while buyers sort through the inventory glut and pick over the bones.

  5. rkp

    IR – You made a mistake in the sentence below. A 5-year ARM doesn’t imply interest-only. As you know, the first 5 years are fixed at the 5.6% and after 5 years, the rate can go up.

    This same $1,957 payment on a 5-year ARM at 5.6% would finance $419,454. As you can see, the interest-only loan terms…

  6. IrvineRenter


    You are correct. However, many, if not most, ARMs issued over the last several years were interest-only. I should have been more careful in making that distinction.

  7. waitingtill08


    I hope people listen to you rather than taking the advice of NIR to look only at the monthly payment. You do an excellent job showing how such thinking has gotten us into this trouble.

  8. awgee

    In any asset market, it is possible for prices to fall below what may be a logical buyer support level; in this case, the rent equivalent. Prices are not always logical, and can fall below rent equivalent based on mass psychlology. Investors may wait to purchase if prices are dropping those investors are wary that prices will continue to drop. Even rents may drop. The prices of many homes “appreciated” far above their rent equivalent of even a 1% teaser rate, and they can fall below any other fixed rate rent equivalent. Fear and greed influence markets, just as logic and real econometrics.

  9. GeorgeO

    Excellent Post IrvineRenter!

    Let’s call the last 5 year what they were….AMAZING LEVELS OF GREED! Greed of home buyers. Greed of loan brokers. Greed of lenders. Everyone saw prices shooting up, and EVERYONE wanted a piece of the pie.

    Since home buyers can not change the lending rules, and brokers must follow lending guidelines, where does MOST of the blame fall? You guessed it….LENDERS! Lenders did everything they could possibly think of to keep origination volumes and PROFITS up. We don’t have to look to far to see what happened. Where is New Century now? Fremont? Peoples Choice? Ameriquest?

    In a rising home price market, lenders will do ANYTHING to keep lending.
    Does 100% LTV ever make sense? 60% DTI Ratio?

    To Lenders, the amount of money made during these “Boom” times is well worth any possible repercussions in the future. Most of these CEO’s will just close up shop, take the money, and re-open (under a new name) when the market is ripe for picking again.

    It’s gonna be a bumpy ride, so hold on tight!

  10. No_Such_Reality

    I suspect we’ll see substantial support before it gets anywhere near reversion to mean. The support will need to be exhausted before prices can continue down.

    My reasoning for this is the readouts from our friends down south on the REDC auction. It was apparently a circus with 1200 people competing for “a deal”. None of them got one.

    There are a substantial number of buyers out there waiting. Unfrotunately, I suspect every 5-10% down will suck in substantial support that will hold prices steady for several months before continuing down.

    If we removed all the wish pricing form the homes on the, did real comps accounting for kick backs and priced 5% below that, I’d wager we’d liquid the inventory back-log by August. I’m just guessing, but there are buyers out there and each sees each pull back as a different opportunity. It isn’t that people necessarily have all the money they need to do it, but there a enough, and enough waiting, to get the market rolling again.

    Spring Bull Trap ’07. It’ll repeat in ’08. Hopefully they’ll be exhausted at that point. But I’m not getting my hopes up. Watching San Diego isn’t giving me much hope.

  11. Purplehaze

    Irvine Renter,

    I have been reading your posts and I would tend to agree that your macro-economic prediction and technical analysis is sound. However the real question is what proportion of mortgages here in Irvine are ARMs or Negams? Your graph shows that overall the exotic financing used in Irvine is lower compared to rest of OC and CA. I have been going to open houses to understand this market better and I do sense a lot of fear among brokers. However they are still able to sell the houses to many a knife catcher. There are a lot of knife catchers and that is why the market is not really falling the way you would think. The question then is what will be the tipping factor in this market? Inventories go on rising, days on market goes on rising, but a lot of the people here in Irvine seem to have better resilience to holding out and are able to find a lot of knife catchers by dropping the price 8-10%. This 8-10% range is substantiated in the April sales numbers that you had posted on this website. Although I agree with your technical analysis, I strongly believe that due to the lower proportion of exotic lending instruments in Irvine over other areas and also due to the high demand for properties in Irvine – thanks to knife catchers, the response to this decline in the housing market is likely to be subdued and less dramatic than other areas in OC.


    Purple Haze

  12. mino2126

    IrvineRenter…..great posting and kudos on all the collateral to support your position. I was curious why did you leave out what effect a potential recession or the loss of jobs in Orange County might have on real estate prices, considering a majority of jobs in Orange County are directly or indirectly tied to real estate? Or was this just the icing on the cake?

  13. anon


    The banks didn’t care about irresponsible lending becasue they were selling the loans off…They knew the situation wasn’t sustainable but it didn’t matter to them. Upfront fees were the name of the game. Any put-backs they had to suffer on crummy loans down the line weren’t considered because raising the stock price TODAY so that the execs could sell their deep in the money options was all that mattered. Sad but true.

  14. WiseWithMoney

    did anyone watch NAR ad on TV yesterday.
    “historically low interst rate, favorable price, lots to choose from, …” were the main reasons to pursuade people to buy.”
    I think NAR doesn’t know much about history. If it did, it would conclude otherwise.
    It’s the worse time to buy.

  15. quietann

    Excellent analysis as usual!

    How would the numbers be different if you used the median income of *homeowners* (which is probably a bit higher)? My guess is that homes would seem marginally more affordable, but just barely. Even if the median homeowner income in Irvine is $150K, that still makes a huge percentage of houses selling for more than they could afford, even with a liberal DTI.

    I was around Irvine just as the last boom went bust, and it was *not* pretty. But this one is far, far worse.

  16. No_Such_Reality

    New homes are still being built. That means one of two things:

    1. Additional home buyers need to come from the “renter” pool to allow move up buyers.
    2. Additional home buyers need to move into the area.

    Even if you do what the NAR did, which was define affordability as the ability to purchase a home significantly below median, affordability is still horribly low.

  17. IrvineRenter

    Very true. Personally, I will start looking when rental equivalents are to my liking, but I many not buy if the market still looks to be heading south.

  18. IrvineRenter


    IMO, the buyers who are buying today’s bull trap are the last of the “priced out” kool-aid drinkers. These buyers still believe in continual double-digit appreciation, and they are celebrating their chance to get in on the action. When I wrote the post Appreciation is Dead, I was trying to reach this group and give them a wake up call.

    If you look at the volume numbers, sales are still dismal. There will be buyers in any market, but the number of knife-catchers is small in number and unlikely to provide any significant support. If there were large numbers of these people, the sales volume numbers would be higher. Plus, sales are being lost to tightening credit, and credit will tighten further.

    If you look back on previous bear markets, there were minor rallies along the way.

    IMO, the party will really get started when the foreclosures hit the market in large numbers. The foreclosures are piling up, and the banks haven’t started dumping them yet.

  19. IrvineRenter

    “The question then is what will be the tipping factor in this market?”

    Foreclosures will be the key. When these hit the market in large numbers, prices will drop.

    There are two pieces of data I really wish I had:
    1. The percentage of Option ARM’s and Stated-Income loans in Irvine.
    2. The percentage of mortgages with total LTV over 90% in Irvine.

    We know that 80% of Orange County loans in 2006 were either Option ARM or Interest-Only. We also know 32% of the total was Option ARM, so 48% were interest-only. Some of these were purchase money mortgages, but most were cash-out refinances. I suspect a great many in Irvine were cash-out refinances. The conspicuous consumption in Irvine is suggestive of living beyond ones income.

    Basically, the above two statistics — which I don’t have — would provide a better picture of the number of distressed mortgage holders in Irvine who will likely fall into foreclosure. I think we are going to find out it is worse than most suspect. Financial prudence was not the hallmark of the last 5 years.

  20. graphrix

    awgee – You are correct that option arms and I/O loans did exist in the late 80’s but not en masse like today. They certainly were not available to anyone with a pulse and the option arms were only found at S&Ls. MBS and CMBS did exist so did CDO’s and this was a small part of the S&L bust mostly the CMBS though. MBS and CDOs are good things but when investors forget or have no knowledge of the past and they get used to the low default rates is when it becomes a problem. That is when they become more aggressive on the DTI guidelines and qualifing rates. It is really sad but they are pretty much repeating history of the S&L debacle. Take a look at this report from the FDIC.
    Then go read the 10-Q’s of Novastar and Indymac. Try not to scream and rant like I do when I hear government bailout.

    The main difference in today’s run up is 100% financing which was almost unheard of back then. Also what isn’t mentioned that is ongoing today is S&Ls were not making enough money on the home loans in their portfolio so they would play with derivatives to hedge their losses. Sometimes those hedges lose too see Impac’s loss of $84mil this last quarter.

  21. ocbear

    I just visited Matt Padilla’s blog at the OC Register. His interview with Rod Thompson indicated they are still making hybrid option arms 6.875% fixed for 5 years but paying interest on 3.875%. I seems to me that anybody who just wants to forestall the inevitable will take out loans like this and we’ll wait another 5 years to see anything significant happen. I know that most people believed (because their mortgage broker told them) that they could come back and get another 1% teaser rate loan next year. The problem isn’t with new home buyers, its the serial refinancing that delays the day of judgement.

  22. IrvineRenter

    There will be people who do this. How would you like to be the owner who is $250,000 underwater with a loan reset coming that will double your payment? That is where those people will be in 5 years.

  23. graphrix

    The problems are both the serial refinancer and the new home buyer. The new home buyer is screwed because they bought with little or no down and promised by the sales agents that the next phases will go up. But the builder and the flippers have dropped prices below the comps needed to refi. The serial refinancer is screwed times two because the loan they were promised is gone and the values have gone down.

    The 1% 1 month option arm is still out there but it is a little more difficult to qualify for and recasts at 110% vs. 115%. The 5 year is just a hybrid of it and it somewhat guarantees that it will not recast until year five where as the one month will recast depending on the underlying rate much sooner.

  24. NickStone

    Irvine Renter:

    I think the price crash is actually about to heat up. For a while it appeared that the banks holding huge inventories of REO’s were either cooperating with eachother to prevent price slippage or engaged in a billion dollar game of chicken, seeing who was going to drop their prices first.

    It looks like at least some of the banks are finally flinching.

    Based on recent articles that I have been reading, the banks are bypassing using RE agents to sell off their REO stocks and are resorting to large scale auctions at large discounts to get rid of their stock. Last Saturday, one such auction was held in San Diego by Real Estate Disposition Corp., or Irvine California. Discounts ranged from 30 to 50% of 2005 appraisal values.

    According to the article, REDC “plans similar sales May 19 in Los Angeles and May 20 in Riverside, Calif.”

    Perhaps they are hoping that, by avoiding listing the properties on the MLS, and selling the properties in an auction environment, those properties won’t drive down the prices of housing in the market at large…. time will tell if these selling prices can be used as comps in later transactions.

    One way or the other, the fire sale has now begun in earnest.

    Source Link:

  25. graphrix

    NickStone – I always find your comments very well informed and I hope you keep posting more. Just wait until next weekend for the results of the same auction company in what they have in store for OC and LA.

    If you read through the 10-Q’s and K’s of lenders it seems they are in a scramble to unload the REO properties in a more effcient way. I have seen a few unload at 2004 prices already. It could get very interesting and I look forward to hear what you have to say.

  26. No_Such_Reality

    The more information I get on the auction, the happier I am with my initial negative view due to the volume of people showing up giving way to follow-on analysis.

    Bidding may have been fast and furious, but with an audience stuffed with shills that’s what you’d expect. If you look at the sales prices, still high IMHO, but compare that to the expense, hype and hassle they had to go through to get that price and the auction was likely a failure.

    Most of those properties were on MLS, but with wishing prices, I suspect the lenders learned that if they’d just put a liquidation price on they’d have sold it for more or about the same with much less expense.

    Overall this is really good for those on the side lines. The trial balloon of lenders didn’t float.

    Even with prices 30% down from the wishing prices, 10% of those that wanted to buy couldn’t. Granted, many of those homes had last valued prices that were easily 10-20% above reality. So much like previous cycles, I think the lenders again see that the market isn’t there and the people with the means to by their repos aren’t playing until it’s 30% or so down.

    That’s good.

  27. ProspectZone Mortgage

    I think no_such_reality has it right. There simply aren’t enough people in the area to warrant such astronomical prices anymore. People are choosing to move out and work for tech companies elsewhere … or to work remotely. The price crash is inevitable, but not really negative. It’s a natural reaction to the dot com bust, and will bring the finances of the bay area into something resembling reasonability.

  28. NickStone

    Just a follow up. The two auctions this weekend are being held by Real Estate Disposition Corporation (REDC). To find information on the auction, go to their website at: and click on the “HUGE 3 DAY Southern California Foreclosure Auction Event! “. There is a link for each location showing the properties, with full documentation. Pretty nice site actually.

    I called their hotline to see if I could go just to watch and they said “yes”. I would simply be attending as a guest.

    I will most probably be attending the Riverside auction this Sunday and I will report back on this blog to let you guys know what it was like and how many properties sold (and for how much).

    Since this housing crash is going to continue unbated for the next five years, I have zero interest in buying… but it should be a fun spectacle to watch! (they are offering financing with as low as 5% down payment – so it would appear that they haven’t figured out what chain of events led to the housing crash to make this auction possible in the first place.) I am particularly interested in which lender is the one offering the financing to the bidders… if I had to guess, I would say Countrywide, since they are the ones with most of the properties being bidded out.

    I will give a full report on Sunday night.

  29. Dave

    Irvine Renter,

    Great article. I believe that you have captured the essence of the credit bubble and resulting housing bubble. You, however, need a great deal more exposure.

    Why isn’t the “interest only and neg-am” theory of the housing bubble more widely accepted? It makes perfect sense to me.

    From the MSM we’ve been spoon fed erroneous information. They continue to spout fluffy info-tainment that has no real basis in fact.

    Assuming someone hasn’t already, I’m going to post links to this article in the OC register on Padilla’s and Lasner’s blogs.

    Keep up the good work. And fellow readers, spread the word. Post this article everywhere. Let’s try to start a real dialogue here.


  30. Mark

    I think being overly worried about your prospective home’s value decreasing, is substantially similar to being unrealistically optomistic about your prospective’s home’s value increasing

  31. IrvineRenter

    If your financing is with a conventional, fixed-rate mortgage, I would agree with you. However, if your financing is interest-only, or Option ARM and you must refinance in the next few years, a drop in housing values is a disaster.

  32. NickStone


    Dump the REO’s and you not only get Interest Only ARM resets, you get Option ARM recasts, which leads to more foreclosures and ultimately more REO’s. Each percentage of home value lost equates to 70, 000 new foreclosures….

    They are worried about home values going down for a very good reason.

  33. lendingmaestro

    Regardless of all the crap that is hitting the real estate fan one true fact remains. A home is only worth what someone is wiling to pay for it. Considering values are so high right now compared to incomes you can also add what a bank is willing to finance it at.

    There could be ZERO foreclosures, 28% affordability index, rapid job growth, no war, and low interest rates, but if more people think values will go down, then they will go down. Right now there is still a huge bloc of people, mainly realtwhores, who are pumping sunshine up the arse of the vast populus of uneducated America. The see-saw is typing and once it reaches critical mass its nothing but down down down

  34. Mark

    Any item is only “worth” what at least one other person is willing and able to pay. We’re seeing people unwilling to pay the current prices in Irvine, and we’re seeing their ability decreasing with lending standards tightening. So worth/value must come down, it’s just a quesiton of degree (how far how fast).

    If delinquencies spread from sub-prime to Alt-A and prime, and lenders tighten the front-end DTI down to 28%, virtually nobody in Irvine could purchase a home. But that’s a worst-case scenario that would require a local depression (major job losses).

  35. IrvineRenter

    “But that’s a worst-case scenario that would require a local depression (major job losses).”

    Not necessarily. It may just require a large number of mortgages with terms borrowers cannot meet, which is what we have. When lenders realize the depth and scope of their folly, they will retreat to what they know works — 28% DTI and 20% downpayments.

  36. No_Such_Reality

    If delinquencies spread from sub-prime to Alt-A and prime, and lenders tighten the front-end DTI down to 28%, virtually nobody in Irvine could purchase a home. But that’s a worst-case scenario that would require a local depression (major job losses).

    No it won’t. Alt-A has as many suicide loans as subprime. Time will do resets and Alt-A holders won’t be any better positioned to handle a 60-100% jump in their payment than subprime.

    When they start to have major defaults, the lenders will increase the down payment requirements since their own research is showing them that lack of significant downpayment is a bigger risk factor than credit rating.

    Frankly, requiring a down payment of even 10% will be much more devastating than restricting the DTI. If you’re going to run a 40% DTI or higher, I’m guessing you haven’t piled up a down-payment. More importantly, if you have to stick 10% or more of your money in the game, you’re not going to be comfortable hanging on to it with a 40% or higher DTI when you know you can’t flip the house for a profit at the drop of a hat and will need to make those payments for the next 60 months.

  37. Mark

    You may be confusing front-end DTI with back-end DTI. The front-end DTI is the housing cost and the back-end the total debt ratio including the housing cost. A high-earning ($125,000) couple renting in Irvine may not have saved 10% ($50,000+) but could afford a median-sized housing cost with a reasonable DTI, assuming they aren’t over-extended with other debt.

    We have data on the number of ARMs, and the percentage of ARMs is alarming, but I haven’t seen much data regarding these ARMs. i.e. Rates are still pretty stable and low, so if the discount period on most ARMs isn’t extreme, then the payment shock shouldn’t be extreme (>20%). So long as the back-end DTIs on these loans isn’t >50%, the payment shock should be manageable for most homeowners.

    I know there are a lot of assumptions in that statement. Again, it’s a question of degree.

  38. IrvineRenter

    I suspect the back-end DTIs will be pretty high for most borrowers. Most of them thought they would refinance out of the problem, so they didn’t concern themselves with the actual future cost.

    Also, even if the payment is manageable, how many of these people will continue to make a payment at or near 50% DTI on a depreciating asset on which they are underwater? If the “jingle mail” experience of the early 90’s is any indicator, many will simply walk away.

    The importance of this issue can’t be overstated. This single fact will do more to determine the number of foreclosures than any other. If these homedebtors hold on, prices will not drop a great deal.

  39. Mark

    I fear back-end DTIs for a majority of Irvine buyers and refinancers over the last two years are above 60%, if you use the fully-indexed rate as opposed to the discount period payment to measure the ratio.

    If lending standards continue to tighten, the Fed seems prepared to step in and prop the housing bubble by lowering rates. So that portion of potential homebuyers/refinancers take out of the market by tighter DTIs will be let back in by lower rates.

  40. IrvineRenter

    That is one possible scenario. Personally, I don’t think the FED will be able to impact mortgage interest rates much by lowering the FED funds rate. The spread between the two is artificially low right now due to the absence of foreclosures during the price rally. Once the impact of foreclosures gets priced back in to the mortgage interest rate risk premium, rates will rise even if the FED funds rate drops.

    Plus, I don’t think the FED has much room to lower rates. As the FED funds rate drops, our currency drops. This raises the cost of imports and causes inflation. This will prompt the FED to raise rates again. It is only the Chinese buying our currency and our bonds which has stopped this from occurring already. Of course, the Chinese have had an insatiable appetite for our “old maid” cards, so maybe they will keep buying so they have someone to export to.

  41. Mark

    You’re right. That’s a cycle of continuous tightening standards as more bad data hits. And normally I’d suggest that there are bottom-dweller lenders (free market actors at work) that will be aggresive and “hold the line” against the big banks/underwriters’ tightening, but most of them have exited the market in the last few months.

    These can be vicious cycles, can’t they? It’s seems like the best-case scenario at this point for the Irvine/OC market is a slowly depreciating (

  42. IrvineRenter

    That is the way I see it.

    Just as the loosening of standards increased prices and artificially concealed risk which beget even looser standards, the tightening cycle works the same way in reverse.

    Best case scenario is a 7 year slow decline like the early 90’s. I doubt that will occur. We will probably have a very large drop in 2008-2009 followed by a 4-5 year slow decline.

  43. Jerry

    I’ve always wondered the ‘true cost’ of credit for the lender. By this I mean does a lender make ‘more’ from a subprime loan than a low interest loan to a good credit borrower? And also, is it truly fair to someone with somewhat poor credit due to credit card mismanagement but one who pays on-time his mortgage payment? i.e. a person who ‘never’ missed a mortgage payment in 20 years but has a 600 score would only qualify for a sub prime rate and pay 50% higher interest over the term of the loan seems unfair. I’ve also wondered if people who pay 29% credit card interest truly warrant that rate compared to people who get 7% and often never carry a balance? Has anyone ever studied this? My guess is the Capital One’s and CitiCard people profit more from the poor credit folks even after factoring in defaults.

  44. awgee

    I don’t understand all this front end or back end DTI or whatever, but what I do understand is human nature and trends. I doubt if 1 out of 10 borrowers who used any type of Alt-A loan can afford any more than a 10% increase in their payment. They would not have gone to a no doc, or option ARM, or no down, or whatever, unless they had to, and that means they maxed themselves out. They don’t have another 10% per month. I posit that 10% of them can’t even make afford their payments as they presently exist before a reset.

  45. No_Such_Reality

    Jerry, it’s a two-fold thing.

    For banks, those with “poor credit” are much more lucrative. Yes they generate costs, but they also generate much greater revenues. NSF fees, account fees, higher rates, points etc.

    Those with good credit, and more importantly, capital, cost the bank money. However, the have money, which the bank then uses.

    Take cell phones for instance, high end customers are chased, but when the company looks at it, low end customers with borderline credit are actually more profitable. They cost less to acquire and generate periodic additional charges that are essentially pure profit like late fees that they have much less success getting removed from their account.

  46. Jerry

    I suppose no one wants ‘more’ regulation but if the poor credit people pay such a whoppingly higher rate (cost) the banks and credit card companies are effectively making it even more difficult for these people to pay off their debts. I have friends and relatives paying 12% mortgages and 32% credit cards. This is almost loan shark-like. And then the OD fees and their latest clever trick…….OD “loans” where they will permit(rather than decline) a debit purchase for a cup of coffee and sock the debit card user with a $35 OD fee. What a deal!My son overdrew his checking account by a few dollars but here’s another gimmick the bank got him on…….they took the highest amount check first instead of just bouncing it last and he had 5 OD’s instead of one. 5 X $35=$175 plus fees from merchants for their bounced check fees. Had the bank just OD’d his highest check his cost would have been only the $35 OD fee. I’ve researched these things and apparently the Fed allows this behavior. I’ve also heard the House Banking Sub-Committee is looking into these practices but I wonder if the banking lobby will subdue legislation?

  47. No_Such_Reality

    I won’t give your relatives much sympathy. They don’t have to take a loan out at 12%. Nor do they need to use a credit card at 32%.

    As for OD fees, they’re nasty, however, let’s put blame were blame is due, if your son didn’t write more checks than he had money, it wouldn’t be an issue.

    As for banks processing the big check and then bouncing the little checks, they typically process the checks in the order they’re submitted against the account. Not the order you write them, but the order whomever you give them to, puts them in the bank and their bank processes it against his bank.

    Your son needs to get his act together, as it is now, he’s signing his name to a piece paper saying it’s good today for a certain amount of dollars, and it isn’t worth the paper he’s writing it on.

  48. Steve Cohan

    Excellent article. Some of the assumptions are already underway. Some are not. I live in Phoenix and pull sales from MLS on an almost daily basis. Then I go to the county recorder’s Web site and examine the loans used to purchase the properties. Interest rates are HIGH. On adjustables they are in the 8s and 9s. I saw one that started at 11.999 with a cap of 19.999.

    The biggest surprise is that virtually every loan taken in the $500,000 to one million range is originated with 80/20 financing. People are still buying “no money down”. Did you ever watch that Dave Chapelle show? He says, “No money down? I got that!” I have yet to see a 30 year fixed. They are still using interest only and ARMs.

    The self-employed are still able to bull$hit their way into too much home by embellishing incomes and forging documents. There will have to be some major changes in the way self-employed people qualify for loans. I know of a self-employed couple where the husband is a truck driver. They make about $50,000 a year and are now $950,000 in debt on three homes. I noticed they formed a bs investment company and deeded all the properties to the company. Apparently they figure if everything gets foreclosed, they will still be able to keep the properties. Surprise!! I am also seeing a lot of listings where homeowner are refinancing with 80/20s, putting their homes on the market and moving out. Some banks are unknowingly buying homes.

  49. Steve Cohan

    Homes being purchased today are still financed by ARMs and interest only financing. The rates are higher. People are still purchasing with 80/20s. I believe today’s loans are even worse because the rates are so high. These loans will also end up in foreclosure. When lenders start requiring downpayments, prices will move down.

Comments are closed.