Temporary Affordability and the Third Foreclosure Wave

Four and one-half percent interest rates create some unique opportunites, defer some big problems, and create other problems. The policy will probably save the Federal Reserve’s member banks billions of dollars, and that is all they care about anyway.

97 Weepingwood kitchen

Asking Price: $425,000

Address: 97 Weepingwood, Irvine, CA 92614


The Third Wave — Pain

No compromising, a nation going blind
The leaders are on their knees
The third wave has just begun

When I first wrote about the impact of 4.5% Mortgage Interest Rates, I decried the idea because the subsidy is obviously going to be temporary, and the removal of the artificial props will cause prices to resume their decline. The impact of rising interest rates on future home prices is dramatic.

With more time to contemplate the impact of 4.5% interest rates, I now see they open up unique opportunities for cashflow investors. People buying for cashflow are not concerned with resale value because they do not intend to resell. Profit and loss for a cashflow investor is determined by its income not its resale costs decades into the future. The Federal Reserve with the blessing of the Treasury Department of the US Government is orchestrating 4.5% interest rates to entice cashflow investors back into residential real estate. Without cashflow investors this mess will never get cleaned up.

If prices fall low enough, and if interest rates drop low enough, returns to cashflow investors become very large. In fact, they come to be greater than all competing investments in the marketplace. Under those circumstances, money will flow back into residential real estate, and the plethora of foreclosures both on the market and in the pipeline can be absorbed by cashflow investors seeking superior returns. The next several years represent a once-in-a-generation opportunity for cashflow investors to pick up long-term holds generating superior cash returns. If lenders are stupid enough to inflate another real estate bubble later, profiting by appreciation would be a nice bonus to the cashflow investor.

The very low interest rates also create opportunities for people to purchase 20+ year homes at or below rental parity and avoid the pain of further price declines; however, this is the harder play. Few properties in Irvine are trading at or below rental parity, but they are common in desirable areas of Riverside County (Yes, there are desirable areas there). This NOT a play where you overpay today and wait for appreciation to catch up to you. It only works if you are saving money over renting.

If there are properties in which you would be willing to live for the long term, and if they can be had for at or below rental parity, then you are only hurt by rising interest rates and declining prices if you must sell while resale values are depressed (an event that happens more often than most believe). Eventually–cue the 20 year holding time–fundamentals will rise to support prices at higher interest rates. On an inflation adjusted basis, you can never recover from overpaying up front, but in nominal terms, there will come a point when you can get out at breakeven. Keep in mind, you are trapped in an underwater situation once interest rates start going up and values start going down; however, you are trapped in a property that still costs you less than renting, so you are far better off than the typical homedebtor trapped in their homes today.

Do I recommend this play? No. But it is a legitimate way to acquire a property with 4.5% interest rates and not get burned. I still recommend waiting until (1) prices are even more depressed, (2) the foreclosure crisis begins to wane and (3) interest rates are higher. You will get a better price, and you have the possibility of refinancing into a lower payment if interest rates drop again. You can refinance into a lower payment, but not into a lower debt.

97 Weepingwood Cost of Ownership

If you look at the cost of ownership for today’s featured property, you see that it costs about $2,200 per month to own. With 4.5% interest rates, this is at least at rental parity and probably below it. If someone can find a rental listing where an updated 1500 SF 3/2 can be rented for $2,200 in Irvine, please post the link in the astute observations. I believe this property is at rental parity–not that people would want to live here for 20 years.

To illustrate why this play does not work for any property other than a very long term hold, consider the impact of an increase in interest rates to 7.25% illustrated below. The long term historic average for mortgage interest rates is 8%. It is realistic to think we will see 7.25% interest rates in the future. When and if that happens, the value of this property would drop another $100,000. Is this property nice enough to be trapped in for 20 years?

97 Weepingwood Valued at 7.25% Interest

Everyone who understands credit cycles knows interest rates are going to rise, it is only a matter of when and how far. As I outlined in Real Estate’s Lost Decade if the FED can somehow control the rate at which interest rates rise, they may be able to hold prices relatively stable. If they lose control (likely) and interest rates rise too fast, then prices will resume their descent. Buying at 4.5% interest rates is fraught with risk; however, many people will buy once prices are at or below rental parity. Usually, buying for cashflow is not quite so risky, but then again, our government usually does not manipulate home mortgage interest rates to such low levels to clean up after a housing bubble.

Updated ARM Reset Chart 5-9-2009

One of the first problems of the developing bubble was identified by bubble watchers as early as 2003; the widespread use of adjustable rate mortgages during a period of low interest rates. Once interest rates go up, so do the payments on ARMs, and so do the foreclosure rates.

There are three types of ARMs: (1) amortizing, (2) interest-only, and (3) negatively amortizing. When prices reached the practical limit of fixed-rate mortgages, many people turned to adjustable rate mortgages to increase affordability because they have lower interest rates. At first people turned to amortizing ARMs, but that soon gave way to interest-only ARMs and finally to negatively amortizing ARMs.

When the FED aggressively moved to lower interest rates, many cheered that the ARM crisis was averted; at best it was delayed.
The assumption most people made is that all the ARMs written are amortizing ARMs. There is no payment shock with an amortizing ARM unless interest rates rise; unfortunately, reality is that very few of the ARMs still utilized
by borrowers are amortizing ARMs.

The first wave of the foreclosure crisis was subprime. That wave has crested, and its devastation is nearly done.

The second wave that is building now is caused by the deteriorating economy and ARM mortgage recasts (Calculated Risk has a good post on this). As I wrote in The ARM Problem, it is not the reset of interest rates that is the problem, it is the recasting to a significantly higher payment caused when the mortgage goes from interest-only to fully-amortized. The negatively amortizing ARM, also known as an Option ARM is shown in
yellow on the chart above. It is the most toxic loan product ever
conceived. The Option ARM and the interest-only
ARM–and their associated recasts to amortizing loans–are the two loans responsible for the second wave of the
foreclosure crisis.

The third wave will come when everyone still clinging to their adjustable rate mortgage is wiped out by higher interest rates. Everyone who does not refinance into a fixed-rate mortgage while interest rates are this low, and the fools who actually buy a property with an ARM while rates are at historic lows will all be wiped out during the third wave of the foreclosure crisis. The timing of that wave is much harder to predict because nobody knows when interest rates will climb.

Four and one-half percent interest rates almost guarantee a third wave in the foreclosure crisis. Perhaps everyone will purchase with or refinance into a fixed-rate mortgage and this crisis will be averted. I doubt it. Based on what is still happening in our mortgage market, it looks like this third wave is still coming.

97 Weepingwood kitchen

Asking Price: $425,000

Income Requirement: $106,250

Downpayment Needed: $85,000

Monthly Equity Burn: $3,541

Purchase Price: $565,500

Purchase Date: 10/28/2005

Address: 97 Weepingwood, Irvine, CA 92614

Beds: 3
Baths: 3
Sq. Ft.: 1,582
$/Sq. Ft.: $269
Lot Size:
Property Type: Condominium
Style: Other
Stories: 2
Floor: 1
Year Built: 1983
Community: Woodbridge
County: Orange
MLS#: S545417
Source: SoCalMLS
Status: Active
On Redfin: 256 days



This guy did not abbreviate the word “throughout.” Hurray!

Today’s featured property was purchased on 10/28/2005 for $565,500. The owner used a $452,400 first mortgage, a $56,550 HELOC and a $56,550 downpayment. After opening a few other HELOCs, the owner finally consolidated into a $116,500 HELOC on 10/31/2007.

The total property debt is $568,900. If this sells for its current asking price, and if a 6% commission is paid, the lender stands to lose $169,400.


They tried to build a nation, greater than anyone
But what they didn’t know was that someone else would have control
The mob starts infiltrating, at gunpoint they will roam
They show no mercy and the government is on their payroll
No compromising, a nation going blind
The leaders are on their knees
The third wave has just begun

The whole world is corrupted, it’s spinning out of control
The third wave is on the roll
It’’s slipping through our fingers and rising to the top
The third wave is on the roll
Roll with me, roll with me

The Third Wave — Pain

33 thoughts on “Temporary Affordability and the Third Foreclosure Wave

  1. Curious

    Are there any graphs that show the correlation between interest rates and home values? I’ve repeatedly had discussions with people on why now is not the best time to buy. They always cite the low interest rates and when I argue that that is actually an argument against buying, they look at me like I’m crazy and tell me that home prices are independent of interest rates. It seems logical to me that they have to be related but what data is out there that supports this.

    1. LC

      I think that interest rates were a factor in the last real estate bust, so people must still remember that. In the early 90s prices would drop as soon as the rates went up, and rates were over 8% then. The thinking was that the payment had to 28% of income, the same way dumb people buy cars. Now, with low rates that are not going anywhere but up, I only see pricing falling further. The Fed can affect rates, but so can the bond market. Look out if GM goes BK.

  2. cara

    I think there’a a subtlety that you’re missing here. Actual wage inflation and it’s relationship to interest rates. It has come to be my understanding, that the “reason” that interest rates are at any given level is to attempt to account for those debts being paid back with less valuable money in the future, due to inflation. Thus, while interest rates are at historic lows in absolute terms, the interest rate to inflation spread is not.
    (for the cash-flow investor this is all irrelevant as you rightly point out).

    So, when interest rates go up to 7.5%, it will be in part because inflation has returned to a more “normal” 2-3% level. If wage inflation is part of this (which it mainly wasn’t from 2001 on other than the incomes houses were “earning” ), then a reasonable buyer can expect their wages to keep going up with inflation, and thus feel that they can support a higher house payment. Thus the price people are willing to pay may not be as closely tied to interest rates as you think.

    And illustration of that is on Rich Toscano’s blog:


    scroll down to the 3rd and fourth graphs. Apparently, people willingly continued to pay the same dollar amount for houses relative to their incomes regardless of the immediate interest rate environment from the years 1977-1986.

    In Irvine, where there’s still a ton of price drops yet to happen, this is mostly moot. But in other areas where prices are reaching rental parity, I don’t think it’s safe to assume that house prices will drop 15% more when rates go up to 6.5% or whatever.

  3. cara

    Monthly payments are only half the story. In the bubble they limited people’s ability to buy speculaitve purchases for future appreciation gains.

    Once the bottom sets in, the motivation for buying changes. Then people buy to fix their monthly costs low, avoiding future inflation-tied rent increases, and inflation-tied house price increases. Interest rates charged are as large as they are because people pay the debt back in inflation-debased dollars. Thus, mortgage rates of 7-8% for prime loans imply an underlying CPI of about 3%. Buyers may then push the envelope of their initial purchase price, having a few rough years of paying a large chunk of their net incomes towards the house payment, but do so with the rational expectation that their wages will keep up with inflation, thus that paying for that house will become less and less onerous, while simultaneously the house itself will act as an inflation hedge, is they need to move in the future.

    Check out Rich Toscano from the voice of san diego for a chart of house price versus mortgage rates and make your own conclusions.

    1. IrvineRenter

      There are three components of mortgage interest rates: (1) base rate, (2) risk premium, and (3) inflation expectation.

      The base rate is the short-term Federal Funds rate set by the Federal Reserve. That is currently at 0%-0.25%. They are giving away free money. If there is any hint of inflation in the economy, the Federal Reserve will raise this rate. It will not happen soon.

      The risk premium was at historic lows during the bubble because nobody thought they could lose money in real estate. Rising risk premiums could cause mortgage interest rates to rise without a changed in the base rate or inflation expectations. In fact, if the government did not control the GSEs, risk premiums would almost certainly be rising. Lenders realize there is risk in mortgages now.

      The inflation expectation works as you and Rich Toscano describe. If people believe the currency will inflate, rents will go up and that they will receive pay raises, then they will stretch to buy housing because after a few years, the payment will not be so onerous.

      This more nuanced explanation is important because the reason for higher interest rates is important to understand what will happen to house prices. If interest rates move higher because the economy is picking up and people anticipate higher incomes and inflation, prices will hold steady as people will be willing to stretch to buy. This stretching will counteract the impact of rising rates, and prices will hold steady.

      However, if interest rates move higher because investors demand higher risk premiums, and there is no expectation with consumers for higher incomes and inflation, then prices will simply fall to a new equilibrium level to match the higher interest rates. People will not stretch to compensate when they do not think they will have the money in the future to make the payments.

      1. CapitalismWorks

        But the GSEs exist with the very objective of minimizing the impact of “risk premium” on mortgage rates. I believe that they will continue to fulfill that role indefinitely. As a result conforming rates should continue to trade at a fairly tight spread to the reference risk free nominal.

        I think the larger question is the source of inflation. Just because inflationary expectations increase, does not mean that so too will wages. Rather the ability to pass on wage increases is predicated on increasing labor productivity and or growth top line revenue growth. Increases in these factors allows for, though not necessarily necessitates, wage increases. Increased wages allow for increasing housing prices.

        However if inflation is driven by cost of inputs increases (i.e. commodities price increases), then the corresponding increase in revenue could be offset by increased costs, reducing operating margins, and ultimately leading to stagnate wages. Under this scenario housing prices would have a difficuly time rising without the support of increasing wages.

        1. thrifty

          You’ve just very nicely described stagflation as was experienced in the early 70’s.

        2. tonye

          I’m afraid you’re right on the money.

          Obama’s current populist policies will end up devaluing the dollar vs. commodities (I think the Euro and other currencies are also all being devalued alongside the dollar).

          The end result maybe global inflation due to increase cost of raw materials.

          As you note, the end result here will be the unexpected drop of RE prices, even with inflated dollars.

          Remember Gerald Ford’s “Whip Inflation Now”… WHIP bumper stickers? We’re gonna go back to that.

  4. cara

    Thanks for the more nuanced explanation.

    So it boils down to, how long can the government keep the Fed(treasury?) buying MBS’s from the GSEs to keep funding mortgages at these low risk premiums?

    I would contend, that if high FICO scores, low LTVs, and low DTI’s are used, then risk premiums actually can remain low. So long as the government is trying to force rates to be under 5%, lenders will continue to react by reducing risk the only way they can, better underwriting. If this improved underwriting is maintained, then fewer foreclosures will happen in the coming years, stabilizing the market.

    As the fed backs away from its purchases, if the underwriting continues, rates may remain relatively low.

    This leaves only the slow drag of reduced numbers of eligible borrowers. As people begin to realize that their capital reserves, high incomes and great credit scores should mean they get more house for that money. But that’s much slower than a risk-related rate hike.

    1. IrvineRenter

      “So it boils down to, how long can the government keep the Fed(treasury?) buying MBS’s from the GSEs to keep funding mortgages at these low risk premiums?”

      For low- to mid- range of the market subject to GSE financing, the answer is yes. In fact, the correction in risk premiums is main reason jumbo financing is so difficult to get and so expensive if you find it. Many seem to think this is a temporary condition in the jumbo market. It is not. The spreads between conforming and jumbo loans show the risk premiums being manipulated by the government using the mechanism you describe.

    2. thrifty

      Cara: Below are a couple of paragraphs from a NY Times article May 7 by economist Paul Krugman. It addresses your question about how long the Fed, etc can keep the home loan market going. The link to the entire article follows the exerpt.

      “Can the economy recover even with weak banks? Maybe. Banks won’t be expanding credit any time soon, but government-backed lenders have stepped in to fill the gap. The Federal Reserve has expanded its credit by $1.2 trillion over the past year; Fannie Mae and Freddie Mac have become the principal sources of mortgage finance. So maybe we can let the economy fix the banks instead of the other way around.

      But there are many things that could go wrong.

      It’s not at all clear that credit from the Fed, Fannie and Freddie can fully substitute for a healthy banking system. If it can’t, the muddle-through strategy will turn out to be a recipe for a prolonged, Japanese-style era of high unemployment and weak growth.”

  5. Geotpf

    I have calculated that the house I’m scheduled to close on tommorow (crosses fingers) in Riverside could rent for double my monthly payment (including taxes and insurance), based on a quick browse through the rental section of Craigslist. I’m not going to do that, but it’s good to know. Now, I am putting 20% down, and even bought some points to lower my monthly payment, but even without the points and a minimal down, the payments would still be signficantly below rental parity.

    Now, if you want to do this, the best area might be to find a bargin near UCR and rent to students. (My house is not particularily near UCR, but that was a big selling point in many of the Craigslist ads I saw.) Of course, that means the house might get a little beat up, and sit empty two or three months each year, but who cares if your monthly rent is double or triple your payment?

    I’ll give you an example:


    Cosmetic fixer near UCR. Good neighborhood; I actually grew up near this house and my mother still lives nearby. 4 beds, 2 baths, 1,242 square feet, .25 acre lot. List price is $156,750, which, at 4.75% and 20% down, is $654 a month before taxes and insurance.

    This could rent for at least $1,600 a month:


    Anything in that neighborhood under $175-200k, especially a 4 bedroom, would be a good play, IMHO. If I had the money, I’d do it myself.

    1. OC Progressive

      And I even called the broker in Riverside who was handling it. Lots of offers on the Wendell place, so it looks like the bank priced it low to gather multiple offers.

    2. Lee in Irvine

      Your example is great, and further validates my opinion that rental-parity will be less relevant as the OC market starts to capitulate.

      I don’t think there’s any doubt (at this point in the RE cycle) that investors will be a lot safer buying real estate in the Inland Empire, instead of Orange County.

    3. tonyE

      $35K down payment.
      $15K cash reserves.
      $14K per year if rented for nine months.
      $11K per year carrying costs… (1600 tax, 1600 insurance).

      Net before taxes is 3K per year.

      Rate of return is 3K/35K = 8.5%

      I suppose after taxes and taking into account perhaps $5K of yearly maintenance…

      I’m no MBA… anyone care to think?

  6. scott

    Question and may apply to the ability of people to refi into 4.5% mortgages – what is the LTV requirement these days for FNMA particularly if you are in a market that is deemed by FNMA to be one where property values are declining?

    I’m in NYC Metro Area, which is a ‘declining price market’. Fortunately I bought in the late 90’s, never HELOC’d so my LTV is still far below 80% even now, so I’m fine and will be closing in a couple weeks @ 4.375%, though some of my neighbors who bought later say they are having a harder time refinancing. What is the max LTV for FNMA if you are in a declining market and can one mitigate a weak LTV by buying PMI (assuming it is available which may be the issue)?

  7. Texas Triffid Ranch

    Captain Pedantic speaking: yes, the realtor didn’t abbreviate “throughout”, but s/he did misspell “travertine”. It’s understandable: both “travertine” and “traventine” sound like they should be supporting character names in an episode of Babylon 5.

  8. cara

    but shouldn’t the risk premium on jumbos be inherently higher, since the price volatility on the underlying collateral shoudl be greater since it is much further disconnected from fundamentals like median incomes and a thinly traded asset?

    I know, most of Irvine houses are currently listed in the jumbo conforming if not the jumbo category, but still…

  9. Blueberry Pie

    Went to an open house on Saturday (beautiful duplex with one of the rooms painted with red walls). As we were leaving, the realtard was telling us that there will never be a better time to buy a house than right now.

    1. Chris

      Yeah and the same realtard will say the same thing next year, 2 years from now, 3 years from now,…………………until he/she gives up this profession 🙂

      1. Scrawny Kayaker

        Yep, and I love the “it’s not a commercial, it’s sponsorship copy” that the NAR had (has?) running lately on NPR: “…agents who understand that every market is different,” and yet, you’ll find they ‘understand’ that now is a great time to buy in EVERY LAST ONE of them. Yeah, sure it is…

  10. idrnkurmlkshk


    I don’t know why people think you are such a bear?? Look at you! finding a silver lining already! LOL! Although I wouldn’t dive into the cash-flow market yet, I applaud your bullish perspective. It may not be ideal..but at least your pointing it out. 🙂

    I still think there is another wave of pain coming in the jumbo loans. As prices fall again, so will rents.

    1. IrvineRenter

      I wouldn’t go quite so far as considering me bullish…

      Up until very recently, buying any property in any market was foolish optimism from those hoping for the return of rapid appreciation. Now, there are certain properties in certain markets where buying is not complete idiocy. One does not need to buy at the bottom for the purchase to make financial sense; although the closer one gets to the bottom, the better the deal becomes.

      Yes, jumbo prices are going to get crushed, and rents will continue under pressure at least until the economy turns around. Jobs and incomes determine rents; resale home prices impact them slightly, but not near as much as jobs and incomes.

  11. hormiguero

    rates used to be a function of the 3 factors IR mentioned.

    then, in 02-08, they were a function of supply and demand, with significant distortions from petrosheiks and mercantilist east asian economies.

    now, they are just whatever the fed and treasury conspire to create.

    real interest markets still exist on the fringes – the 15% which junk bonds pay, the 20% APRs on consumer credit, etc, the 10%+ which many california municipalities (and perhaps even the CA GOs will soon be paying) – but they’re just as much a product of a system which is utterly warped by moral hazard and imaginary currency as treasuries.

  12. tlc8386

    If inflation comes back and we get higher interest rates this does not automatically mean higher incomes. A company will hire and pay what they want to and not be forced to especially with supply so high.

    When we moved here our company was paying much less than the Bay area and the housing here was at least half a million higher for the same home I was in. So I did not buy a house and now three years later they finally raised everyone’s salaries but it was because they could afford to do so. Not because the economy forced them to.

    So my point is inflation does not necessary translate to higher wages.

    an excellent post on analysis by the way IR !!!!!

    My take on it pretty much cements my thoughts on housing here in Irvine and surrounding expensive areas unless you know you will live here a long time and you can find a home you can afford with a very stable job it’s really useless to buy now.

    Just going on this home worth 450k owning it you are spending 2k a month or so—

    Well compared to my rental valued at 700k plus pool and spa–larger home –rent is 3k–

    Still not close enough to rental parity. We have a long way to go I fear.

  13. idrnkurmlkshk

    This my take on everything:

    This is just another “business cycle”. I hate that term btw, nothing business about it.

    Too much money was lent out to blind the consumer into believing they were rich.
    Lending stops, now consumer is reluctantly realizing they are not rich. In fact they most often OWN NOTHING.
    But before they can better themselves, the cycle will start over again with money easily being lent again.
    Once again inflating bubbles, only later to be bust, triggering large transfers of wealth and inflation all over again. Probably more frequently too.

  14. newbie2008

    I see an overall theme that for a rent vs. own without taking upkeep into account. It’s more expensive with colder or hotter the weather.

    For a cash flow investor, the interest rate will not be 4.5% (if it is please tell me which bank). For non-owner occuppied houses, add about 2% to the interest rate (4.5 plus 2.0 = 6.5%). Add taxes 1.2%, repairs, RE fees, inspection fees, lawn and garden, water, etc. Bad neighorhood not only raise insurance cost but also repair bills.

    1. jimfromJaxFla

      Exellent points, Newbie…
      Here in FLA the investor/second home purchaser has to put down a min. of 20%. currently FHA loans for owner/occupied properties only have to put down 3.5%. Soon, I believe these Down payment %s will have to increased. Also watch DTI (Debt-to-income)ratios. These will be tightened making it much more difficult to qualify, further erroding prices..
      And Finally, Ivy Zelman from Zelman and assoc stated the Banks have only filed 30% of their foreclosures, leaving 70% MORE on the way.(If I have my #’s correct)

  15. E

    If real estate doesn’t always “go up”, why should we assume “inflation adjusted” for the future?

    Why not deflation adjusted?

    Today’s “cashflow investor” could be next years “bagholder”.

Comments are closed.