Systemic Risk in the Housing Market

I’m sitting looking out the window like damn

Tryna fix this situation that’s at hand

You still running through my mind

when I’m knowing that you shouldn’t be,

Me all on yo mind

and I’m knowing that it couldn’t be

Cause you ain’t call

and I ain’t even appalled

I still got allot of pain

I ain’t dealt wit it all

To get you outta my system.

You know what you do to me (do to me)

You don’t even understand (damn)

You know what you do to me (do to me)

It’s so hard to get you outta my system.

Outta My System — Bow Wow



Today’s post is part II in an analysis series. Part I was yesterday’s post: Structured Finance 101. If you do not fully understand structured finance, this post may be difficult to follow. I will answer any questions you might have in the comments section.


Systemic Risk in the Housing Market

Credit rating and analysis of collateralized debt obligations and all structured finance products are part of the smooth function of the secondary market for mortgage loans. A credit rating agency is a company that analyzes issuers of debt and debt-like securities and gives them an overall credit rating which measures the issuer’s ability to satisfy its debt obligations. There are more than 100 major rating agencies around the world, and three of the largest and most-important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.

Credit ratings are widely used by investors because they provide a convenient tool for comparing the credit risk among various investment alternatives. The analysis of risk is crucial in determining the interest rate a syndicator will need to offer to attract sufficient investment capital, or from the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this critical, third-party analysis both sides of the transaction can rely upon for unbiased, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.

Unfortunately for many investors in collateralized debt obligations during The Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were subsequently downgraded. In defense of the agencies, they were providing an analysis of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any analysis and widely ignored by investors who are counting on the rating to be a market forecasting tool rather than the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.

Risk Synergy

One of the major failings of the credit markets in The Great Housing Bubble was the failure to take a holistic view and evaluate the systemic risks involved. A typical credit analysis reviews various risk parameters and attempts to rate the impact of each. The implicit assumption is that the total risk is equal to the sum of the parts; however this is not necessarily the case. Synergy is when the whole is greater than the sum of its parts, and there is a strong synergy in default risk in collateralized debt obligations that became apparent during The Great Housing Bubble. The credit rating agencies failed to identify this risk synergy until after the fact.

The risk of default in a tranche of a collateralized debt obligation is directly related to the default risk in the underlying mortgage notes. There are six general areas of credit default risk that may be evaluated independently, but their interactions are often synergistic in nature: creditworthiness risk, high combined-loan-to-value default risk, high debt-to-income ratio risk, fraud and misrepresentation risk, investment perception risk, and market valuation risk. Of these general areas of risk market valuation is most responsible for creating synergistic effects and amplifying default rates. Since many of the more “innovative” loan programs entered the market during a time of rising prices, there was no history of performance of these securities in other market conditions making it very difficult to assess the impact a down market would have on default rates. As it turns out, exotic loan programs do not perform very well in any conditions other than a raging bull market.

Creditworthiness Risk

Every mortgage loan that is originated contains an evaluation of the creditworthiness of the borrower who is responsible for making timely mortgage note payments. The most common evaluation tool is the FICO score. Prime borrowers have the highest FICO scores, they are considered the lowest default risk, and they receive the lowest interest rates as a result. Subprime borrowers have the lowest FICO scores, they are considered the highest default risk, and they receive the highest interest rates. This is the best documented and most carefully evaluated risk parameter. Before many of the loan programs were introduced during the Great Housing Bubble, FICO scores strongly correlated with default rates. This correspondence broke down in the price decline when the bubble popped because the other risk factors proved to have a greater influence.

High CLTV Defaults

The combined-loan-to-value (CLTV) is the total debt of all mortgage obligations as a percentage of the appraised value of a particular property. A high CLTV generally corresponds to a low downpayment, but as resale values fell in the market crash, the CLTV rose for many borrowers as a consequence of falling prices. Although all borrowers with high CLTV loan balances show high default rates, it is important to distinguish between those borrowers who had a high CLTV because of a low downpayment and those who had a high CLTV because of falling values. Even though downpayments are a sunk cost and irrelevant to the market value of a house, it does have a strong psychological impact on the behavior of homeowners. People who put little or no money of their own money into the purchase of real estate exhibit greater default rates because they are not losing much of their money. Most people really do not care if the lender loses money, particularly if they will not have to repay the lender for the loss. When a borrower has less of their money in a transaction they are less likely to sacrifice to stay current on their mortgage note obligations, and they are more likely to default if resale values decline, particularly if their payments are greater than the cost of a comparable rental.

Fraud and Misrepresentation Risk

Most purchasers of collateralized debt obligations did not realize there was a huge amount of fraud and misrepresentation in the underlying loans they were purchasing. High CLTV financing, particularly the widely offered 100% financing, became the ideal tool for fraud. A fraudulent transaction required a “straw buyer” willing to sacrifice their credit for a fee, an appraiser willing to inflate the houses value, and a realtor and a mortgage broker either willing to go along with the transaction for cash or too ignorant to see the truth. In the transaction, the straw buyer purchased a house for greater than its true market value, and the excess payment was used to pay off the corrupted parties. Fraud was much easier to commit with 100% financing because the bank loaned the full amount of an inflated appraisal. It is much harder to commit fraud when the bank only loans 80% of a property’s value. Most often the seller was in on the scam and was using the transaction to get out of a bad deal, but sometimes sellers were also innocent victims. The straw buyer had no intention of repaying the loan from the start, and the property quickly went into foreclosure.

A more common problem was misrepresentation of income. Stated-income loans, also known as “liar loans,” were very common during the bubble rally. People would simply make up a number that qualified them for a loan and state it on their mortgage application. One of the assumptions purchasers of CDOs made was that the originators of the underlying loans made sure the borrowers really made enough money to pay back the loan. Often times the extent of the loan originators due diligence was examining the borrower’s signature on the loan application and hoping they were telling the truth. This was a very serious problem for valuing an interest in a CDO because there was no way to accurately determine the viability of the income stream when the income of those responsible for paying the underlying mortgage notes was in doubt.

High DTI Defaults

The debt-to-income ratio is the total amount of payments compared to gross income expressed as a percentage. A lender evaluates the DTI of the mortgage loan as well as the total DTI of all borrower indebtedness when making a determination of creditworthiness. Historically, a borrower could not have a mortgage DTI in excess of 28% and a total DTI greater than 36% to qualify for a loan because debt burdens in excess of these figures proved to have high default rates. Despite the proven history of default of high DTIs, lenders widely ignored these guidelines in The Great Housing Bubble in the quest for more customers. During the rally, few of these people defaulted because they were offered even more debt through home equity lines of credit from which they could make mortgage payments, and the few who did get into financial problems simply sold their house to pay off the mortgage. During the rally, people were keen to take on mortgage debt because interest rates were low, and it was a necessary tool for obtaining real estate and its commensurate appreciation benefits. It did not matter if 50% of more of a borrower’s gross income was going toward debt service if the property itself was providing the additional income necessary to sustain the borrower’s lifestyle. Of course, this only works when prices are increasing rapidly. Once prices stopped rising, the property could no longer provide additional income, and the borrower had to make the crushing payments out of their work income. Without the benefits of appreciation, borrowers quickly found the burden of a high debt-to-income ratio overwhelming, and many borrowers defaulted because they payments were too much to handle – just as past history said they would be.

Investment Perception Risk

One of the biggest fallacies pushed on the general public was the notion that residential real estate was a great investment. This idea caused people to view houses as an investment and treat them accordingly. When the participants in a housing market perceive houses as an investment, they will more easily default on the loan than if they viewed the house solely as a family home. People develop emotional attachments to their family homes, and they will sacrifice much in order to keep it. People behave in a more businesslike manner when they view a house as an investment, and they are willing to give up the house if the investment does not perform as planned. Many people when faced with the reality that house prices were not going to go up and payments were going to continue to cause losses decided to stop making payments and let their investment go into foreclosure. Financially, it was the correct decision given the alternative of continuing to make payments on a losing investment. When the “Great American Dream” of home ownership was tainted by investment motives, it became a nightmare for all concerned.

Market Valuation Risk

The biggest risk faced by buyers of collateralized debt obligations is the default risk of the underlying mortgage when the collateral for the mortgage (the house) is overvalued in markets characterized by low affordability. The greatest risk of default is based on changes in the resale value of homes. All other default risk factors are masked when prices are increasing, and they are amplified when prices decline. Valuation risk is the ultimate synergistic factor.

There are three methods of appraising the resale value of residential real estate: the sales comparison approach, the cost approach, and the income approach. The sales comparison approach uses recent sales of similar properties in the market because comparable sales reflect the behavior of typical buyers in the marketplace. The cost approach determines market value by calculating the replacement cost of an identical structure plus the cost of the land or lot upon which the house would sit. The income approach determines market value by analyzing market rents of comparable properties and applies the gross rent multiplier of expected rents. Most lenders give the greatest weight to the comparable sales approach when establishing market value before applying any loan-to-value limitations to the loan amount. The income approach is generally only considered for non-owner occupied homes. The three-test approach to appraising market value as used during the Great Real Estate Bubble is fraught with risk and seriously flawed.

The comparative sales approach reinforces delusive behavior and irrational exuberance of a financial mania. If everyone is overpaying for real estate, the comparative sales approach simply enables greater fools to continue overpaying for real estate. Since market prices for houses which serve as loan collateral fall to fundamental valuations based on income after the financial mania runs its course, mortgages originated based on the comparative sales approach have a great deal of market risk not reflected in the pricing of collateralized debt obligations based on the underlying mortgage loans.

The cost approach has an even greater level of market risk. The cost of a structure may represent a relatively small percentage of the market value of real estate in high-value markets. In some of the most overvalued markets during the bubble, the replacement cost of the structure may have been $250,000 while the value of the underling land was $450,000; however, since the market value of land is a residual calculation based on the market value of the property, the value of the land cannot be determined independently of the house situated on it. Either the comparative sales approach or the income approach must first be applied to establish the market value of the property before any calculation of the market value of the land can be determined. In short, since the cost approach is dependent upon another valuation method, it is not useful as an independent method of property valuation. Also, since the valuation of land is extremely sensitive to small changes in the valuation of the property, the cost approach is misleading with respect to the valuation of residential real estate.

The only reliable method for the valuation of residential real estate is the income approach, and it is the only approach that is widely ignored by the lending community. It has been demonstrated in previous residential market bubbles in California and in major metropolitan areas in other states that once a price decline begins, prices fall to fundamental valuations based on income and rent. The reason for this is once the speculative investment incentive is removed from the market, buyers do not support prices until there is a new reason for them to buy: they save money versus renting. Comparative rents are the fundamental valuation of residential real estate. Mortgage default risk is low only when market prices are in line with comparative rents or when market prices are increasing. Default risk is low when prices are in line with rents because a property can be converted from owner-occupied to a rental unit and the payment can still be covered. Default risk is low when prices are rising because a borrower experiencing financial difficulty can always sell the property to repay the loan. Unfortunately, once market prices increase beyond the level of comparative rents, they will go through a period of decline back to comparative rent levels; therefore, if lenders continue to use the comparative sales approach, they will enjoy a temporary period of low market risk while prices increase and another painful period of losses when prices decrease. As was demonstrated in the aftermath of The Great Housing Bubble, these periods of lender losses can imperil the entire banking and financial system. The only way to prevent the pain of loss is to recognize the end-game risks when prices are increasing and choose not to participate in that lending environment. Many lenders did not participate in the crazy lending of The Great Housing Bubble, and they were not damaged in the aftermath; however, the hunger for mortgage loans from the CDO market compelled many lenders to join in or get buried by their competitors. The only real market-based solution to the problem of originating bad loans must come from the CDO market.

The CDO Market Solution

The solution to preventing future bubbles in the residential real estate market lies in the market for collateralized debt obligations. The government sponsored entities created the secondary mortgage market in the 1970s, and the CDO market is the extension of this market bringing large amounts of investment capital to residential real estate. During the Great Housing Bubble the CDO market did not properly evaluate the risk of default on the underlying mortgage notes they pooled. If the CDO market evaluates mortgage default risk based on the income approach rather than the comparative sales approach, the performance of CDOs will be greatly improved, and investor confidence will return to the market. It is only after the risks are properly evaluated that capital will return to this market. If the CDO market evaluates risk based on the income approach, the lenders that originate loans hoping to sell them to CDOs will be forced to do the same. If lenders originate loans based on the income approach, the irrational exuberance that creates financial bubbles will not be enabled. People would still be free to overpay for houses with their own money, but the scope and scale of financial bubbles will be limited to the funds of buyers, and the banking system will not be imperiled by the foolishness of the market masses when prices fall to fundamental valuations based on rent and income.



51 thoughts on “Systemic Risk in the Housing Market

  1. IrvineRenter

    I am going to be away from the computer most of the day, so I am apologizing in advance for not participating in the comments today. I will answer questions as soon as I can.

  2. stated

    If I didn’t know better (apologies if you have already answered this), I would say that you are planning on assembling these articles into a book.

  3. IrvineRenter

    Fannie, Freddie Agree to New Appraisal Standards

    This is nice, but it doesn’t address the underlying problem of appraisers using an incorrect method of valuation.

    WASHINGTON (Reuters) – The two largest sources of U.S. mortgage financing agreed on Monday to sponsor a new home appraisal watchdog to prevent inflated home values.

    Fannie Mae and Freddie Mac will uphold a new code of conduct meant to keep mortgage lenders at arm’s length from home appraisers and will also spend $24 million to jump-start the new oversight body in a deal to prevent lawsuits from New York Attorney General Andrew Cuomo.

    Starting January 1, 2009, the government-sponsored enterprises will buy home loans only from lenders that endorse an appraiser code of conduct that Cuomo said he hopes will become an industry standard.

    “This is one of the greatest, most dramatic reforms of the housing industry in the last 20 years,” Cuomo said at a press event in New York announcing the deal. “We believe as a group that this will be a significant and dramatically positive reform.”

    Since Wall Street gladly bought and bundled home loans for investors during the housing boom, lenders may have felt more comfortable inflating loan amounts. Cuomo filed subpoenas against Fannie Mae and Freddie Mac to determine whether the companies stood by as that happened.

    The new code will prohibit mortgage brokers from selecting a home appraiser, while lenders may not use in-house assessors for initial reports on the value of homes. In another provision of the settlement, Fannie Mae and Freddie Mac will each provide $12 million over the next five years to help establish an appraisal oversight body.

    The companies’ federal regulator, the Office of Federal Housing Enterprise Oversight, will host the new watchdog group, which will maintain a consumer hotline and promote appraiser independence.

    The new standards will help break long-standing business practices under which lenders often had close ties to home appraisers, said David Berenbaum, an executive with the National Community Reinvestment Coalition.

    “Many lenders have had business interests in appraisers,” he said. “Unless you have independent appraisers, you are losing consumer protections.”

    Sheila Bair, chair of the Federal Deposit Insurance Corp., said the public was served by honest appraisals and that the mortgage industry would have time to comment on the proposal before it was implemented.

    “The integrity of the appraisal process is fundamentally necessary to the effective functioning of the primary and secondary mortgage markets,” Bair said in a statement.

    In a joint letter to Cuomo, several appraisal trade groups wrote that they would use the comment period to “provide input to you on the development and completion of your plan.”

    But one regulator expressed disappointment that the accord with Fannie Mae and Freddie Mac did not have broader input.

    “We are concerned that the closed-door fashion in which (the deal) was reached could result in negative unintended consequences,” the Office of Thrift Supervision said in a statement. “The proposal should be discussed among the bank regulatory agencies and go out for public comment before being adopted.”

  4. kris

    Great post, IR. I love this blog! To be honest, interesting times like these make me glad I stuck it out to get my Finance MBA. I will say, though, that I find the general public’s lack of knowledge in the subject to be frightening. IMO, that’s the major reason these cycles can happen in the first place. Though it is easier to change CDO valuation standards than to educate the public. Anyway, keep it up!

    (quietly saving a down payment)

  5. BD

    Well written IR. The thing that still suprises me is the extent to which the banks and financial industry propelled the mania instead of restraining it with fundamental evaluation of home values. As you say in your post people should be free to ‘overpay for a home with their own money’ but, never be allowed to overpay with someone elses money. I’m in healthcare and it reminds me of what people really think of healthcare – and that is they want the absolute best healthcare someone elses money can buy! Nobody cares what things cost if they don’t pay for it… Yet another example of how prices get perverted when basic market forces are removed from the equation.

  6. George8

    In practice and politically correct, it is one step in the right direction.

    Jumping to the ultimate income based appraisal method is likely too remote from reality of today’s market and political environment.

    Personally, I’d like to see resolution as to the treatment and sometimes penalty on the fraud and crime committed during the great real estate bubble, such as falsify documents and lying on the applications, etc.

    After all, no rules is better than rules that are not enforced.

  7. Exit

    The banks and financial industry had management and employees whose bonuses were predicated on higher loan volume – that’s why they enabled the mania.

    Excellent analysis IR.

  8. zaleriana

    Basing appraisals strictly on rental value will have an unrealistic flattening effect on larger homes–nationwide (i.e., California may well be different), there is only so much demand for 4000+ sq. foot rental homes. Indeed, in many cases, a rent-based approach might not even reach the replacement cost of the structure, never mind assigning some value to the underlying land.

    Income-based valuation is fine for a market with ready comparisons–condos v. apartments fit the bill. But what do you do in Peoria, IL, where most renters are in apartments and most buyers are in SFRs? Do you base rental values for SFRs on the (mainly) old, run-down rental stock of SFRs? Or the handful of newer/updated SFR rentals? Or an adjusted RSF based on apartments?

  9. buster

    This is perfect because it provides a concise and incredibly well-reasoned analysis. This (and Part I – Structured Finance) should be mandatory reading for anyone thinking of buying. There should be a Q&A Section in the escrow process making sure every potential buyer scores a 95 or better before escrow closes!

    I can see it now, “I’m sorry Mr. GF, we can’t close this escrow because you’re an idiot. Read these four pages again and take the test over. And in the essay portion, ‘but I saw a TV ad from the Realtards saying “It’s A Great Time To Buy” is not an acceptable answer.'”

  10. kis

    I can see how the income method represents the floor to which house prices might descend. Its how you would value any investment, by the cash flows it produces. However it fails in valuing the intangibles – the value of being able to customize your house with luxury items, the value of living in a nice neighborhood or having a nice view, the value of not having to move your kids to a new school every few years, etc. As others have mentioned, the rental market is neither transparent or liquid in nicer areas with large SFRs. And those homes that are rentals tend to be dated and/or run-down – hardly good comparables.

  11. Walter

    Very good post. Well written and sane view of the situation. I worked at New Century and saw first hand the greed. While many of the people were clueless to the risk and impending doom, they were very talented and clever people that will find a way to make a buck.

    This is way it will happen again. People will find a crack in the system and use it to make a buck. On the bright side these market bubbles create opportunities for the patient buyer. I have a lump of cash and a good job and I am hoping a great buying opportunity is soon approaching.

  12. lendingmaestro

    I agree that there was waaaay to much fraud involved in the appraisal process; however, I don’t believe in totally eliminating sales price approach.

    A home has an intrinsic value (cost to completely construct) and a market value. The market value is whatever someone is willing to pay for it. Since this is inherent in the price of sold homes, I can’t imagine removing the sales approach to appraising a home.

  13. skek

    I think the answer — and this is already done with super jumbo mortgages — is the lenders will hedge their risk by requiring more down payment and lower LTV ratios. If a lender requires 25% down, they can afford to be a little off on an income based valuation of a 4000 sq ft house.

  14. MalibuRenter

    What? You don’t include refinancing or credit availability risk?

    If houses were priced fairly compared to rents, and then credit availability contracted severely, defaults would go up. People who needed to sell because of divorce, for example, would find themselves having a harder time finding buyers. One income of the person staying in the house frequently wouldn’t be enough.

  15. lendingmaestro

    No. An appraiser has no business incorporating rates or credit availability when valuing a home. Now a lender can choose to view the collateral however it sees fit. An appraiser’s job should be simple and non-influenced.

  16. MalibuRenter

    Do you think there should be a homeowner’s license or permit? Like a driver’s license?

    Perhaps people should get a lower interest rate if they were able to score well on some sort of test regarding homeownership and/or financing?

  17. Surfing in Newport

    You don’t have to eliminate it. The amount you are allowed to borrow against stocks is not based on the income produced by the stock. However, you are also not allowed a 100% LTV on a stock even though the loan is a recourse type of loan. I think the typical margin requirement is 50%.

    So, what you could do is set a margin requirement based on income and market value. Require different margins for the two different valuations. For example, 90% LTV for valuation based on income and 70% for valuation based on comparable sales. You can get a loan up to the larger of the two limits.

  18. kis

    The problem with the sales approach is that home prices were artificially inflated due to a excess in purchase money supply. If home purchase money is ‘cheap’ (1.5% teasers, no money down, no credit check, etc), then demand/prices goes sky high – along with income/price ratios.

    Interesting, since that money was very specific – people couldn’t borrow money at these terms for rents – rents have growed only at the pace of broader inflation and incomes – so GRMs grew. Though remodel costs in our area also went up to $250-300 per sqft, due to cheap equity lines.

    The larger question is how ‘cheap’ will home purchase money be over the long term, or even 1-2 years from now? Do we see a return to 20% down, income/credit verification, 30% DTI, and 30-year fixed around 7-9%? If so, whatever is affordable at those terms for average area incomes would seem to be the expected target for home values. I bet that number is probably around the historical 3-4 times income and/or 150-200 GRM metrics. Or perhaps we see some new exotic loan structure (but with better risk controls) that makes 5-6 times or 250 GRM stable.

  19. vicstah

    IR’s gone hip hop today! Strings of Elvis last year, and now Bow Wow… Eclectic music taste!


  20. Purplehaze

    I believe the market will self correct over a period of time through the process of new lending guidelines coming through the chain of stricter CDO risk appraisal standards. As IR said the CDO origination end of the process cycle has to drive the toughening up. Once the standards tighten at the top, then logically standards would have to tighten at lower rungs under increased scruitiny and concern about the associated risk.

    IR, great article, it took me a while to read it through. But in my opinion this was the most coherent 2 parts I have read on this blog to date. The simplicity and yet the intricacies of the process cycle have been aptly described by you in this write up.
    Thank you!

  21. tenmagnet

    Yeah, I was also surprised by IR’s musical range today, going with Bow Wow.
    “Shortie Like Mine” is also a great jam.
    I’ve added it to the “convert a female friend” part of my toolbox.
    Song was also featured in a recent episode of Lipstick Jungle.

  22. skek

    “The Case for Foreclosures.”’s “Everday Economics” series features an article today that seems consistent with many of themes we see here on IHB. The article is by Steven Landsburg, but if I recall correctly, isn’t writer Daniel Gross one of the national journalists who has cited IHB in the past? The influence of this blog seems to be growing.


    Key quotes:

    After a foreclosure, one family moves out, and another moves in. We see the sad faces of the people moving out, but we don’t as often see the happy faces of the new homeowners moving in.


    If you get to live in a nice home for a few years and then lose it to foreclosure, you are not worse off than someone who never got to live in a nice home in the first place.


    There’s at least one more reason to regret Secretary Paulson’s eagerness to forestall foreclosures: If banks can’t enforce contracts (or even if they “voluntarily” forgo the enforcement of contracts under pressure from the Treasury Department), they will undoubtedly be more reluctant to make loans in the future.

  23. Lucy

    Surely not true in Irvine, kis. there are plenty of large beautiful houses for rent (I am living in one of them). We are not talking about Pennsylvania here, but Irvine – where beautiful empty homes are in ample supply. The intangibles you are talking about are emotional constraints and, of course, should be noted. However, it has been my experience with Irvine houses that they are so similar (some are practically identical) that unless you are extremely particular with your layout or feng shui, you will always find a comparable home. Irvine models kinda remind me of old Soviet planning where evrything had to be if not identical, then quite uniform.

  24. zaleriana

    Yes, but. IR is moving beyond just Irvine with this analysis. If the analysis is going to be of the overall market (I’m unaware of an Irvine-only RMBS issuance), then it has to make sense for the overall market. You just don’t have enough comparable rentals in a “nicer” area of SFRs everywhere.

  25. Priced_Out_IT_Guy

    A government test for home ownership? LOL

    If its anything like the drivers’ tests, you could get it in 100 different languages and cheat off the guy next to you…and you’d have to stand in line for three hours just to take it.

  26. Priced_Out_IT_Guy

    I almost forgot. How are the music videos going to fit into the book? E-book time…

  27. mark

    Agreed, but this can be more art than science in a rapidly changing environment (increasing or decreasing).

  28. djd

    Not to mention the useless questions like “What is the most common reason people do <name of dangerous behavior>?” How does this help? If people think that the reason justifies the behavior, won’t this just expose more people to the most popular justification and thus probably increase the prevalence of the dangerous behavior?

  29. CapitalismWorks

    “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” J. Paul Getty

  30. IrvineRenter

    You might see some flattening of prices because loans would be capped by the income, but people who want bigger, fancier homes can always use their own money to get it. The whole idea behind using comparative rents is to limit the exposure of banks.

    In areas where there are limited rental comps, the government’s equivalent rent numbers can be a guide. The basically do what you are describing and attempt to find a relationship between various home types. They survey 2 bedroom units and they provide a multiplier for 1, 3 and 4 bedroom units. It is not a direct comparable, but it is a reasonable estimate.

  31. IrvineRenter

    “The market value is whatever someone is willing to pay for it. Since this is inherent in the price of sold homes, I can’t imagine removing the sales approach to appraising a home.”

    This is also the mechanism for inflating a bubble based on irrational exuberance. The only way to eliminate the “greater fool” problem from market valuations is to stop accepting appraisals based on the foolish behavior of buyers. Let people do it with their own money if they want, but when you start doing it with the bank’s money, you end up where we are today.

  32. IrvineRenter

    “Or perhaps we see some new exotic loan structure (but with better risk controls) that makes 5-6 times or 250 GRM stable.”

    This is certainly what the inventors of the Option ARM and other loan programs attempted to do. So far, they have failed miserably.

  33. Rocker

    That’s good!,

    A blog to book deal is a good incentive for bloggers, and as a reader, that’s an incentive to keep coming back for independent, unbiased thinking.

  34. Irvinexpat

    Getting accurate monthly rental info for sfr’s is toughest information for an appraiser to get their hands on.
    The MLS offers lease info, but in my experience, it only represents about 5% of the market (maybe a 15% in Irvine). Most transactions are completed privately and some with property management.
    Residential appraisal is quite different from commercial appraisal when it comes to data sources regarding rental info. I’m sure most of you know that residential appraisers rely on a public record system to verify a closed sale and then cross reference it with the mls and a physical inspection of the comparable to confirm accuracy of all data. Appraisers worth their salt will call agents to further investigate a comparable transaction when the info looks shady. This method has weight as it can be proven, quickly and efficiently on a daily basis. It can also hold up in court.
    This is the valuation process for residential homes. Is it the best way??? Probably not. But using rents to value homes is nearly impossible because their is no official rental data source. The mls info cannot be considered accurate. The agent types in whatever he/she wants in the closed lease price box. We all know they lie their asses off, I’m sure some pump up that price to attract more listings.
    Also, an appraiser cannot rely on what Ned down the street told Joe homeowner he is getting for his condo per month. Appraisers are responsible for every letter and figure in their reports:
    “Your Honor, His neighbor said he was getting $3,500 per month, Why would he lie to Joe???”

    Residential property management is a dead end. This is what a conversation sounds like between an appraiser calling for rental info from a property management company…1st attempt:”Hi, this is Bill from Acme appraisal…CLICK!!!…Hello, Hello!
    2nd try: “Hi this is Bill calling ba…CLICK!!!…ck.

  35. No_Such_Reality

    “Basing appraisals strictly on rental value will have an unrealistic flattening effect on larger homes… there is only so much demand for 4000+ sq. foot rental homes”

    I think it is a hallmark of conspicious consumption that we buy 4000 SF homes on an installment plan. They aren’t bought on an installment plan because it’s good finance and tool to manage their wealth, but the majority bought with mortgage and 30 years of installment payments because that is the only way they can do it.

  36. No_Such_Reality

    IrvineRenter, yet another good article. Only one minor point to make, it is dependent on the financial houses and other involved parties being concerned with it being a sustainable business and market.

    They aren’t. It’s the same problem many publically traded corporations have, they are literally being fleeced from the inside out by their management chain trying to drive short-term explosive stock growth so they can cash out and go away.

  37. Formerbanker

    You are a great writer, IR. I agree with 99% of what you say, in general. But I totally disagree with the premise that the income approach is the way that SFR’s should be valued. Please, please spend some time researching the history of the appraisal process, USPAP guidelines, etc. and spend some time picking the brain of a competent appraiser (there are some out there!) I could go on and as to why but it will be a dissertation…but as some other commenters have touched on it previously here, the benefits one feels are derived from owning a particular home, aside from potential rent, are reflected…in the sales price itself. I have commented in other posts that it is completely irrelevant to me what my house would rent for. The value I ascribe to being able to do what I want aesthetically, when I want, how I want, on my property (non-HOA ), down to the swingset in my backyard,etc., is reflected in my willingness to purchase a particular property for a certain price! My primary residence is not an ‘investment’ that I consider to be part of my wealth generating portfolio of assets. That’s a mistake a lot of people made. This bubble resulted from lax underwriting, greed, anxiety for income, etc. and unscrupulous lenders who pressured appraisers (and less than ethical appraisals) made the situation terrible…and if LTV’s required borrowers to have some skin in the game, even 10%, geez we’d be in a different boat now. But using the sales approach to value real estate ? not the reason.

  38. IrvineRenter

    I agree with your comments on the intangible benefits of ownership, and nothing in my proposal would stop you from obtaining these benefits, and even overpaying for them, if you do it with your money. The comparative sales approach allows people to overpay with the bank’s money which is why the collapse of the bubble is causing problems with our banking system. The main purpose of mandating the income approach is to reduce the risk lenders face.

  39. zaleriana

    They aren’t bought on an installment plan because it’s good finance and tool to manage their wealth

    Uh, yes, yes, it is a good finance/wealth-management tool. In what other way can an individual borrow $500,000 (or $1mm) for a net interest rate of under 5%? If you have that kind of investable cash sitting around, you should be able to profitably arbitrage.

    There are frequent questions here about why corporations get to do certain things that individuals can’t–well, financing assets is something that corps do as a matter of course–and individuals should to. If you have an irrational hatred of debt, so be it, but don’t think that the use of debt by someone else is stupid or only “because they have to”.

  40. zaleriana

    How is the “mandate” going to be enforced? Does it involve passage of laws of general application? Or would it just be limitations on Fannie/Freddie?

    Interest only mortgages and option ARMs and other “exotic” mortgages have been around for a (relatively) long time, but had been the near-exclusive province of high net worth clients of wealth management firms. Would you propose to prohibit such accomodations?

    Sure, it would be great (in some ways) if everyone in the financial markets acted in a prudent manner all of the time. But the downside is that a large part of the success of the American economy is the very freedom (and even encouragement through gov’t policy) to sometimes act very stupidly.

    There is no doubt that lax standards and non-existant underwriting has caused a tremendous problem, but that doesn’t necessarily call for drastic measures. Overreaction to prevent similar problems in the future often has unintended consequences. Maybe any FDIC-insured entity should be prohibited from holding potentially problematic mortgages directly or indirectly to prevent the government from having to bail them out. But to require that all lenders of all types comply with a set of rigid standards is going too far.

  41. Formerbanker

    I hear your point, IR…

    obviously, in a free market economy, there is no one forcing investors to buy the stock of a company that is making ridiculous loans, or buy the securities backed by them. Clearly the rating agencies missed the boat big time in this mess. The risk was there all along. I have no doubt that many who evaluated these loans as part of their jobs (either working for rating agencies, credit risk managers at banks, etc.) knew it. I was in a position to walk when I thought things were getting out of control from a credit perspective (did not deal with subprime, but did deal with jumbo stated income product), and that was back in late 2003. But most people need to work and everyone in town was playing the same game. Tough times.

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