Occasionally people in Government tell the truth. Usually this is a gaffe, but the Trustee in charge of the TARP program has written a well-researched and accurate report on the miserable state of the TARP program. I am impressed.

Today's featured property is a ridiculously priced Northwood tract home. I am not impressed.

Irvine Home Address … 2 BLUE SPRUCE Irvine, CA 92620

Resale Home Price …… $1,249,000

{book1}

Do what I want cause I can and if I don't

I do believe I told you so.

The Hives – Hate To Say I Told You So

People ignore contrary or inconvenient information, particularly once they have made up their mind to do something. When our Government decided to act to save stupid wankers bankers, they ignored the obvious problems their solutions were going to create — or to be more accurate, Government officials knew public relations problems were on the horizon due to the way taxpayers are being defrauded, and that these problems would require a bounty of bullshit to smooth over, but saving corporate campaign contributors (and enriching Goldman Sachs) was deemed more important, so you and I pay the price.

I came across the story TARP overseer says bank bailout program has mixed results that lead me to the SIGTARP Quarterly report to Congress (PDF). When I browsed the report, I was pleasantly surprised to read robust analysis and an accurate evaluation of the success (or lack thereof) of the TARP program:

This time of transition provides an opportunity to take a step back and examine whether Treasury’s efforts in TARP thus far have met the goals of the program. On the positive side, there are clear signs that aspects of the financial system are far more stable than they were at the height of the crisis in the fall of 2008. Many large banks have once again been able to raise funds in the capital markets, and some institutions — including some that appeared to be on the verge of collapse — have recovered sufficiently to repay their TARP investments years earlier than most would have predicted. These repayments and the sales of the warrants associated with them have meant that Treasury (and thus the taxpayer) has turned a profit on some of the individual TARP investments; as a result of these repayments, among other positive developments, it now appears that the ultimate cost of TARP to the American taxpayer, while still substantial, might be significantly less than initially estimated.

Many of TARP’s stated goals, however, have simply not been met. Despite the fact that the explicit goal of the Capital Purchase Program (“CPP”) was to increase financing to U.S. businesses and consumers, lending continues to decrease, month after month, and the TARP program designed specifically to address small-business lending — announced in March 2009 — has still not been implemented by Treasury. Notwithstanding the fact that preserving homeownership and promoting jobs were explicit purposes of the Emergency Economic Stabilization Act of 2008 (“EESA”), the statute that created TARP, nearly 16 months later, home foreclosures remain at record levels, the TARP foreclosure prevention program has only permanently modified a small fraction of eligible mortgages, and unemployment is the highest it has been in a generation. Whether these goals can effectively be met through existing TARP programs is very much an open question at this time. And to the extent that the Government had leverage through its status as a significant preferred shareholder to influence the largest TARP recipients to carry out such policy goals, it was lost with their exit from TARP. As important as assessing the effectiveness of TARP programs is, in the final analysis, TARP can truly only be a success if TARP is both managed well and its positive effects are enduring. The substantial costs of TARP — in money, moral hazard effects on the market, and Government credibility — will have been for naught if we do nothing to correct the fundamental problems in our financial system and end up in a similar or even greater crisis in two, or five, or ten years’ time. It is hard to see how any of the fundamental problems in the system have been addressed to date.

• To the extent that huge, interconnected, “too big to fail” institutions contributed to the crisis, those institutions are now even larger, in part because of the substantial subsidies provided by TARP and other bailout programs.

• To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.

• To the extent that large institutions’ risky behavior resulted from the desire to justify ever-greater bonuses — and indeed, the race appears to be on for TARP recipients to exit the program in order to avoid its pay restrictions — the current bonus season demonstrates that although there have been some improvements in the form that bonus compensation takes for some executives, there has been little fundamental change in the excessive compensation culture on Wall Street.

• To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices — as discussed more fully in Section 3 of this report — risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.

Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.

Kevin R. Puvalowski, SIGTARP's Deputy Special Inspector General, just earned my respect. The honesty and clarity of this assessment is remarkable for a bureaucrat — the program is not working, and the administrator says so. Perhaps I shouldn't be so cynical about our Government, but truth and reality are in short supply in Washington's public pronouncements, and this report contrasts and demands attention.

As Christopher Thornberg noted in Beacon Economics 2010 Orange County Forecast the main problem with our financial system is incentives and moral hazard, and Mr. Puvalowski hammers Congress with the truth — not that anyone is listening — but at least truth is being told.

Section 3 of the report (pages 109-130) contain great historical and current information on the GSEs, FHA and other programs the Government controls and uses to prop up house prices. It is worth taking the time to read in full:

Mechanisms for Supporting Home Prices

Supporting home prices is an explicit policy goal of the Government. As the White House stated in the announcement of HAMP for example, “President Obama’s programs to prevent foreclosures will help bolster home prices.”

In general, housing obeys the laws of supply and demand: higher demand leads to higher prices. Because increasing access to credit increases the pool of potential home buyers, increasing access to credit boosts home prices. The Federal Reserve can thus boost home prices by either lowering general interest rates or purchasing mortgages and MBS. Both actions, which the Federal Reserve is pursuing, have the effect of lowering interest rates, which increases demand by permitting borrowers to afford a higher home price on a given income. Similarly, the Administration is boosting home prices by encouraging bank lending (such as through TARP) and by instituting purchase incentives such as the First-Time Homebuyer Tax Credit. All of these actions increase the demand for homes, which increases home prices. In addition to direct Government activity, home prices can be lifted by general expectations among homebuyers of future price increases. Figure 3.7 provides a graphic representation of the relationship between possible Government actions and their impact on home prices.

Little things jumped out at me as I scanned the report. Did you realize that the Federal Reserve's program of buying GSE debt has now printed more money to buy toxic mortgages than it previously held in Government Treasuries? The Federal Reserve's balance sheet is bloated and holding more waste than patrons at an all-you-can-eat buffet.

Northwood is Immune?

When I saw the asking price on this home, I was floored. Can you pick out the estate asking $1,249,000 in the images below?

If the asking price was about half of what it is, the price may be reasonable, particularly when you factor in the upgrades, but I can see no justification for this asking price; in fact, I can see no rational for any price over $1,000,000. When I first saw the nearby 20 SILVEROAK for sale asking $958,000, I thought it was overpriced and likely to sit, but it wasn't so far out of reality to earn a WTF award; in contrast, today's featured property's pricing is beyond the pale, and both the realtor and the owner should be embarrassed.

Irvine Home Address … 2 BLUE SPRUCE Irvine, CA 92620

Resale Home Price … $1,249,000

Income Requirement ……. $260,092

Downpayment Needed … $249,800

20% Down Conventional

Home Purchase Price … $326,500

Home Purchase Date …. 12/19/1996

Net Gain (Loss) ………. $847,560

Percent Change ………. 282.5%

Annual Appreciation … 10.1%

Mortgage Interest Rate ………. 5.05%

Monthly Mortgage Payment … $5,394

Monthly Cash Outlays …..….… $7,110

Monthly Cost of Ownership … $5,100

Property Details for 2 BLUE SPRUCE Irvine, CA 92620

Beds 5

Baths 3 full 1 part baths

Home Size 2,900 sq ft

($431 / sq ft)

Lot Size 5,917 sq ft

Year Built 1998

Days on Market 4

Listing Updated 2/5/2010

MLS Number S604335

Property Type Single Family, Residential

Community Northwood

Tract Lexi

THIS IS IT!!! A beautifully remodeled Lexington home that shows like a model. The main living area has been opened into a spacious and elegant Great Room. The kitchen boasts granite counters, distressed hard wood cabinetry, double convection ovens, 5 burner range, built-in fridge/freezer, island with wine fridge, and more…. There are two entertainment areas, one down with surround sound and the other up in the added bonus room / loft. This home has a full bedroom and 3/4 bath downstairs and a full downstairs office. The outside is also an entertainers dream, with a large corner lot, the rear yard has a BBQ island, fridge, and sit up bar, covered eating area with a built in space heater and ceiling fan. There is a nice size yard and a raised 12 seat spa that is built into a vault. This home is a must see!!!

THIS IS IT!!! Is it just me, or do you smell the word shit in there somewhere?

This home is a must see!!! Can you feel the urgency?

entertainers dream? Perhaps Tempo MLS does not permit apostrophes?

Congratulations New Orleans Saints!

Sometimes Super Bowls are super duds, but last night's game was very well played by both teams on both sides of the ball, and I enjoyed the game thoroughly. As the Colts were driving for what looked like a game-tieing touchdown, only to be denied by a decisive interception, I thought it was a shame that one of these two great teams had to lose. The game was a marvelous capstone to a great NFL season.

Investment Value

The United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence). They make this distinction because a house has both a consumptive purpose and an investment purpose. The consumptive value is measured by rent or rental equivalence. There is legitimate financial reason to pay more than the rental equivalence price. The normal rate of house appreciation–not the unsustainable kind witnessed during the Great Housing Bubble–can provide a return on investment. The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage. The investment premium, which is about 10%, is less than most people think.

The rental equivalence value is the fundamental value of real estate, and it is also its consumptive value. This value can be easily measured as demonstrated in the previous section. There is an independent investment value that can also be measured and added to the consumptive value to arrive at the maximum resale value of the property. Investment value is derived from two sources: the increase in property value through appreciation and the long-term savings over renting caused by inflation. These two components are measured separately to demonstrate how they function and how much each of them is worth.

Since the return on investment generated from residential real estate occurs in the future, a discounted cashflow analysis is required to determine the net present value of the future returns. Calculating net present value sounds complex, and manually going through the calculations is quite cumbersome, but electronic spreadsheets make this an easy task. The concept is simple: how much money would investors put in an investment today if they knew the rate of growth and the cash value to be realized in the future. For instance, if investors put $100 in a bank earning 5% interest, they would have $105 at the end of the year. Net present value looks at the situation in reverse. If investors knew they would receive $105 at the end of the year and the market interest rate was 5%, they would be willing to pay $100 for it today. Similarly, the investment value of residential real estate is the value today of an amount of money to be received in the future either through sale or savings on rent.

Discount Rates

The investment value of a property can only be measured against other investment opportunities available to an investor. If investors can earn 4.5% by investing in government treasuries, they will demand a higher return to invest in an asset as volatile and as illiquid as residential real estate. The rate of return an investor demands is called a “discount rate.” The discount rate is different for each investor as each will have different tolerances for risk. During the Great Housing Bubble discount rates on most asset classes were at historic lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the investment value. Because of the risks of investing in residential real estate, a strong argument can be made that a low discount rate is unwarranted and investors would typically demand higher rates of return for assuming the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate underestimates the investment premium and makes an investment appear less valuable.

The US Department of the Treasury sells a product called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS increases with inflation, and it pays a semi-annual interest payment providing a return on the investment. When a TIPS matures, they buyer is paid the adjusted principal or original principal, whichever is greater. This is a risk-free investment guaranteed to grow with the rate of inflation. The rate of interest is very low, but since the principal grows with inflation, it provides a return just over the rate of inflation. Houses have historically appreciated at just over the rate of inflation as well; therefore a risk-free investment in TIPS provides a similar rate of asset appreciation as residential real estate (approximately 4.5%). Despite their similarities, TIPS are a much more desirable investment because the value is not very volatile, and TIPS are much easier and less expensive to buy and sell. Residential real estate values are notoriously volatile, particularly in coastal regions. Houses have high transaction costs, and they can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the yield on TIPS or the rate of appreciation of residential real estate as the discount rate in a proper value analysis.

Another convenient discount rate to use when assessing the value of residential real estate is the interest rate on the loan used to acquire the property. Borrowed money costs money in the form of interest payments. A homebuyer can pay down the loan on the property and earn a return on that money equal to the interest on the loan as money not spent. Eliminating interest expense provides a return on investment equal to the interest rate. Interest rates during the Great Housing Bubble on 30-year fixed-rate mortgages dropped below 6%. An argument can be made that 6% is an appropriate discount rate; however, 6% interest rates are near historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid 80s after the spike of the early 80s to quell inflation. The average contract mortgage interest rate from 1986 to 2007 was 8.0%. If a discount rate matching the loan interest rate is used in a value analysis, it is more appropriate to use 8% than 6%.

Investors in residential real estate (those who invest in rental property to obtain cashflow) typically ignore any resale value appreciation. These investors want to receive cash from rental in excess of the costs of ownership to provide a return on their investment. Despite their different emphasis for achieving a return, the discount rates these investors use may be the most appropriate because it is for the same asset class. Cashflow investors in rental real estate have already discounted for the risks of price volatility and illiquidity. Historically, investors in cashflow producing real estate have demanded returns of near 12%. During the Great Housing bubble, these rates declined to as low as 6% for class “A” apartments in certain California markets. [1] It is likely that discount rates will rise back to their historic norms in the aftermath of the bubble. If a discount rate is used matching that of cashflow investors in residential real estate, a rate of 12% should be used.

Once money is sunk into residential real estate, it can only be extracted through borrowing–which has its own costs–or sale. Money put into residential real estate is money taken away from a competing investment. When buyers are facing a rent versus own decision, they may choose to rent and put their downpayment and investment premium into a completely different asset class with even higher returns. This money could go into high yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-return investment vehicles. An argument can be made that the discount rate should approximate the long-term return on high yield alternative investments, perhaps as high as 15% or 18%. Although an individual investor may forego these investment opportunities to purchase residential real estate, it is not appropriate to use discount rates this high because many of these investments are riskier and more volatile than residential real estate.

The discount rate is the most important variable in evaluating the investment value of residential real estate. Arguments can be made for rates as low as 4.5% and as high as 18%. Low discount rates translate to high values, and high rates make for low values. The extremes of this range are not appropriate for use because they represent alternative investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because these represent either credit costs (interest rates) or the rate used by professional real estate investors. The examples in this section will use these two rates to illustrate the range of values rational investors in residential real estate would use to value an investment premium.

Appreciation and Transaction Fees

The portion of investment value caused by appreciation can only be evaluated by an accurate estimate of appreciation during the ownership period. The general public grossly overestimates the rate of home price appreciation. [ii] Historically, houses have appreciated at a rate 0.7% over the long-term level of inflation. From 1983 to 1998, a period of low inflation and declining mortgage interest rates before the Great Housing Bubble, the rate of house price appreciation was 4.5% nationally which was 1.4% over the rate of inflation. [iii] Appreciation rates are tied to income and rents because this is the fundamental value of residential real estate.

Profiting from house price appreciation requires getting more money from the sale of a property than was originally paid for it and not having that profit cancelled out by moving costs, transaction fees, and a large spreads between the cost of ownership and the cost of rental during the ownership period. Buying and selling residential real estate incurs significant transaction costs that are not reflected in the price. It is quite common for properties to sell for more than their purchase price and still be a loss for the seller. When people purchase residential real estate they pay numerous closing costs including title insurance, recording fees, document stamps and taxes, mortgage application fees, survey fees, inspection fees, appraisal fees, et cetera. These fees often total between 2% and 4% of the purchase price not including any prepaid interest points on the mortgage. When people go to sell residential real estate they generally go to real estate broker who will charge them a 6% commission. There has been an increasing popularity in the use of discount brokers, but the National Association of Realtors has done a remarkable job of keeping brokerage commissions at 6% despite market pressures to lower them. These transaction costs are part of every residential real estate transaction, and they take a substantial portion of the profit on properties with short holding periods, and if the holding period is not long enough, transaction fees create losses.

The negotiating abilities of buyers and sellers and the overall market environment greatly impact the profits from real estate. Sellers almost universally believe their properties are worth more than the market will bear. People become emotionally attached to their houses, and because it is very valuable to them, they assume it is just as valuable to a person who is not attached to the property. Sellers always hope to find the buyer who will appreciate their home as much as they do and thereby pay top dollar for it. The vast majority of homeowners have unrealistic expectations of appreciation. The combination of emotional attachment and unrealistic appreciation expectations cause sellers to believe their house is more valuable than it is, and when it comes time to sell, they price it accordingly.

Sellers usually are forced to discount a property from their perceived value in order to sell it, except in raging bull markets when sellers can sometimes get more than their asking price. In bear markets, they may have to discount the property significantly in order to sell it. Bear markets are the most difficult because sellers have difficulty lowering their prices, particularly if they must sell at a loss. [iv] Sometimes the difficulty in lowering price is caused by the amount of debt on the property, and sometimes it is caused by seller’s emotional issues. No matter the cause, the seller’s aversion to lowering asking price often results in a failure to sell the property. Since this process of discounting to sell is already reflected in the historic appreciation rate, no further adjustment is required to account for it.

The key variables for the calculation of the portion of investment value due to appreciation are the rate of appreciation, the investment discount rate and the transaction fees. In the calculations that follow the rate of appreciation is 4.5%, the discount rate is 8%, and transaction costs are 2% for the purchase and 6% for the sale. There is a 20% downpayment, and the loan is assumed to be an interest only to avoid the complications of a decreasing loan balance in the calculation and isolate the appreciation premium.

Due to the high transaction costs, the property does not reach breakeven until two full years of ownership. In a discounted cashflow basis, the property does not break even until after 4 full years of ownership. It is these high transaction costs that compel many with short-term housing needs to rent rather than own. Assuming an 8% discount rate and a term of ownership of 10 years or more, there is a premium for ownership of approximately 10%. This means the owner could pay up to 10% over the rental equivalent value and still obtain an 8% return on their money–assuming they can sell it for 10% over rental equivalent as well.

There is a tendency in the general public to assume the leverage of real estate provides excessive returns. It does magnify the appreciation, but since the historic and sustainable rate of appreciation is a low 4.5%, the leverage is applied to a small growth rate resulting in less than stellar investment returns. In the previous examples, if the downpayment is lowered to 10%, the investment premium at an 8% discount rate rises to 15%, and with a 12% discount rate, there are some ownership periods justifying a premium. If the downpayment is dropped to 1%, the ownership premium rises as high at 20%. At its most extreme with 100% financing, any positive return becomes infinite because the investor has no cash investment. Ownership premiums of 10% to 20% sound large, but in coastal markets during the Great Housing Bubble, buyers were paying ownership premiums in excess of 100%. There is no fundamental valuation justification for these price premiums, only rationalizations and hopes that a greater fool will appear and pay continually higher prices, or in the case of 100% financing speculation, that losses can be passed on to a lender if market prices decline.

Table 3: Appreciation Premium and Holding Period using an 8% Discount Rate

Larger discount rates eliminate the appreciation premium on residential real estate. The money tied up in a 20% downpayment on residential real estate appreciating at 4.5% provides a rate of return less than 12%; therefore when the gains from appreciation are discounted at 12%, the net present value never goes positive. When investors demand returns equal to or greater than 12%, there is no investment value from appreciation in residential real estate.

Table 4: Appreciation Premium and Holding Period using a 12% Discount Rate

What they are saying about The Great Housing Bubble

“The author, Larry Roberts, is best known for his daily posts as
IrvineRenter on the Irvine Housing Blog. Long before Lehman crashed,
Fannie Mae was taken over, and even before home prices were dropping
nationally, he was one of the few voices presenting real information on
the housing bubble.

The author’s background is in new housing development in Southern
California. It was a good start to understanding how things worked.
Supplemented by knowledge from countless posters at the housing blog,
he has been able to show why home prices couldn’t stay elevated. Price
to income ratios, price to rent ratios, and other factors detailed in
the book showed how far out of line prices had become by 2006. A full
year before house prices started to crash, he was predicting it, and
many of the crash’s details. While some people are permanently bullish
or bearish on housing, the best are able to understand and explain the
mechanisms, tell you what will happen in what sequence.

The Great Housing Bubble is an excellent read, and an important one.”

Brian Whitworth – Principal, FinancialPatents.com

Fundamental Valuation of Houses

The fundamental value of all housing prices is equivalent rents.
Rents define the fundamental value of real estate because rental is a
direct proxy for ownership; both rental and ownership provide for
possession of property. Equivalent rents are a major component of the
United States Government’s Consumer Price Index (CPI). [1] According
to the US Department of Labor, “This approach measures the change in
the price of the shelter services provided by owner-occupied housing.
Rental equivalence measures the change in the implicit rent, which is
the amount a homeowner would pay to rent, or would earn from renting,
his or her home in a competitive market. Clearly, the rental value of
owned homes is not an easily determined dollar amount, and Housing
survey analysts must spend considerable time and effort in estimating
this value.” Prior to the first California housing bubble in the late
1970s, the housing cost component of the CPI was measured using actual
price changes in the asset. When this bubble created an enormous
distortion in this index, the rental equivalence model was constructed.
It has been used to smooth out the psychologically-induced housing
price bubbles ever since.

An argument can be made for the real cost of construction as the
fundamental valuation of houses. If house prices in a market fall below
the cost of new construction, no new houses will be built because a
builder cannot make a profit. If there is continuing demand for
housing, the lack of supply will create an imbalance which will cause
prices to increase. When new construction becomes profitable again, new
product will be brought to market bringing supply and demand back into
balance. If demand continues to be strong, builders will increase
production to meet this demand keeping prices near the real cost of
construction.

Based on a theory of rational market participants, one would expect
that when prices go up and the cost of ownership exceeds the cost of
rental, people choose to rent rather than own, and the resulting drop
in demand would depress home prices: The inverse would also be true.
Therefore, the proxy relationship between rental and ownership would
keep home prices tethered to rental rates. However, this is not the
case. [ii] If there were only a consumptive value to real estate, the
cost of ownership and the cost of rental probably would stay closely
aligned; however, since there is an opportunity to profit from
speculative excesses in the market, rising prices can lead to
irrational exuberance as buyers chase speculative gains.

Rental rates tend to keep pace with wages because people normally
pay rent out of current income. As people make more money, they compete
for the available rentals and drive prices up at a rate about 1%
greater than the overall rate of inflation. [iii] There are times when
supply and demand issues in local markets create fluctuations in this
relationship, but as a rule, rents track wages pretty closely. Since
house prices are tied to rents, and rents are tied to wages, house
prices are indirectly tied to wages. When house prices increase faster
than wage growth, the price levels become unsustainable, and if the
differential is too great, a bubble is inflated. [iv]

Figure 10: National Rent-to-Income Ratio, 1988-2006

Ownership Cost Math

A useful way to look at the cost of housing is to evaluate the total
monthly cost of ownership. There are 7 costs to owning a house.
Although some of these costs are not paid on a monthly basis, they can
be evaluated on a monthly basis with simple math. These costs are:

1. 1. Mortgage Payment
2. 2. Property Taxes
3. 3. Homeowners Insurance
4. 4. Private Mortgage Insurance
5. 5. Special Taxes and Levies
6. 6. Homeowners Association Dues or Fees
7. 7. Maintenance and Replacement Reserves

Mortgage Payment

The mortgage payment is the first and most obvious payment because
it is the largest. It is also an area where people take risks to reduce
the cost of housing. It was the manipulation of mortgage payments that
was the focus of the lending industry “innovation” that inflated the
housing bubble. The relationship between payment and loan amount is the
most important determinant of housing prices. This relationship changes
with loan terms such as the interest rate, but it is also strongly
influenced by the type of amortization, if any. Amortizing loans, loans
that require principal repayment in each monthly payment, finance the
smallest amount. Interest-only loan terms finance a larger amount than
amortizing loans because none of the payment is going toward principal.
Negatively amortizing loans finance the largest amount because the
monthly payment does not cover the actual interest expense.

Property Taxes

Property taxes have long been a source of local government tax
revenues. Real property cannot be moved out of a government’s
jurisdiction, and values can be estimated by an appraisal, so it is a
convenient item to tax. In most states, local governments add up the
cost of running the government and divide by the total property value
in the jurisdiction to establish a millage tax rate. California is
forced to do things differently by Proposition 13 which effectively
limits the appraised value and total tax revenue from real property.
[v] Local governments are forced to find revenue from other sources.
Proposition 13 limits the tax rate to 1% of purchase price with a small
inflation multiplier allowing yearly increases. [vi] The assessed value
can only increase 2% a year regardless of actual market appreciation.
The assessed value is set to market value when the property is sold.
Often the lender will compel the borrower to include extra money in the
monthly payment to cover property taxes, homeowners insurance, and
private mortgage insurance, and these bills will be paid by the lender
when they come due. If these payments are not escrowed by the lender,
then the borrower will need to make these payments. The total yearly
property tax bill can be divided by 12 to obtain the monthly cost.

Homeowners Insurance

Homeowners insurance is almost always required by a lender to insure
the collateral for the loan. Even if there is no lender involved, it is
always a good idea to carry homeowners insurance. The risk of loss from
damage to the house can be a financial catastrophe without the proper
insurance. A standard policy insures the home itself and its contents.
Homeowners insurance is a package policy which covers both damage to
property and liability or legal responsibility for any injuries and
property damage by the policy holder. Damage caused by most disasters
is covered with some exceptions. The most significant exceptions are
damage caused by floods, earthquakes and poor maintenance.

Private Mortgage Insurance

Mortgages against real property take priority on a first recorded,
first paid basis. This is known as their lien position. This becomes
very important in instances of foreclosure. The first mortgage holders
get paid in full before the second mortgage holder get paid and so on
through the chain of mortgages on a property. In a foreclosure
situation, subordinate loans are often completely wiped out, and if the
loss is great enough, the first mortgage may be imperiled. Because of
this fact, if the purchase money mortgage (first lien position) exceeds
80% of the value of the home, the lender will require the borrower to
purchase an insurance policy to protect the lender in event of loss.
This policy is of no use or benefit to the borrower as it insures the
lender against loss. It is simply an added cost of ownership. Many of
the purchase transactions during the bubble rally had an 80% purchase
money mortgage and a “piggy back” loan of up to 20% to cover the
remaining cost. These loan pairs are often referred to as 80/20 loans,
and they were used primarily to avoid private mortgage insurance. There
were very common during the bubble.

Special Taxes and Levies

Several areas have special taxing districts that increase the tax
burden beyond the normal property tax bill. Many states have provisions
which allow supplemental property tax situations. The State of
California has Mello Roos fees. A Community Facilities District is an
area where a special tax is imposed on those real property owners
within the district. This district is established to obtain public
financing through the sale of bonds for the purpose of financing
certain public improvements and services. These services may include
streets, water, sewage and drainage, electricity, infrastructure,
schools, parks and police protection to newly developing areas. The
taxes paid are used to make the payments of principal and interest on
the bonds.

Homeowner Association Dues and Fees

Many modern planned communities have homeowners associations formed
to maintain privately owned facilities held for the exclusive use of
community residents. These HOAs bill the owners monthly to provide
these services. They have foreclosure powers if the bills are not paid.
It is given the authority to enforce the covenants, conditions, and
restrictions (CC&Rs) and to manage the common amenities of the
development. It allows the developer to legally exit responsibility of
the community typically by transferring ownership of the association to
the homeowners after selling off a predetermined number of lots. Most
homeowners’ associations are non-profit corporations, and are subject
to state statutes that govern non-profit corporations and homeowners’
associations. In cases where a large number of houses are unsold, in
foreclosure, or are owned by lenders, remaining homeowners may
encounter large increases in assessments. In some cases, the additional
cost can become unaffordable to remaining homeowners pushing more of
them to sell or be foreclosed on by their own homeowners association.

Maintenance and Replacement Reserves

An often overlooked cost of ownership is the cost of routine
maintenance and the funding of reserves for major repairs. For example,
a composite shingle roof must be replaced every 20-25 years. It may
take $100 a month set aside for 20 years to fund this replacement cost.
Also, condominium associations often levy special assessments to
undertake required work for which the reserves are insufficient. In the
real world, most people do not set aside money for these items. Most
will attempt to obtain a Home Equity Line of Credit (HELOC) to fund the
repairs when they are necessary. Of course, this assumes a property has
appreciated and that such financing will be made available.

Tax Savings

There are two other variables people often consider when evaluating
the cost of ownership that is not included in the prior list: income
tax savings and lost downpayment interest. When a borrower takes out a
home loan, the interest is tax deductible up to a certain amount. For
borrowers in the highest marginal tax bracket, the savings can be
significant, and this can make a dramatic difference in the true cost
of ownership. However, this benefit diminishes over time as the loan is
paid off and the interest decreases. Plus, contrary to popular belief,
it is never good financial planning to spend $100 to save $25 in taxes.
Also, these benefits are almost universally overestimated by people
considering a home purchase. Renters considering home ownership will
need to remember that they will be giving up the standard deduction
when they itemize to obtain the Home Mortgage Interest
Deduction (HMID). [vii] A “married filing jointly” taxpayer will forgo
a $10,700 deduction in 2007. This reduces the net impact of the HMID.
Anecdotally, even those in the highest tax brackets usually do not get
more than a 25% tax savings.

Hidden Savings

This is the forgotten benefit of a conventionally amortizing loan:
forced savings. Most people are not good at saving. The government
recognized this years ago when they started taking money out of
people’s salaries to pay income taxes because they knew people would
not do it on their own. People who become homeowners during their
lifetimes often have the equity in their home as their only source of
retirement savings other than social security. To accurately calculate
the cost of ownership, this hidden savings amount needs to be deducted
from the total cost of ownership because this money will generally come
back to the borrower at the time of sale. Since taxpayers in the United
States get a capital gains exemption up to $250,000 per person or
$500,000 per couple, this savings amount does not need to be adjusted
for capital gains taxes in most circumstances.

Lost Downpayment Interest

Unless 100% financing is utilized, a cash downpayment will generally
be withdrawn from an interest bearing account to purchase a house. The
monthly interest that would have accrued if the downpayment money was
still in the bank is a cost of ownership. This is perhaps the most
overlooked ownership cost. For instance, if you are putting 20% down on
a $244,900 property, you will be taking $48,980 from a bank account
where it would have earned 5% in 2007. This $2,449 in interest comes to
$204 in lost interest the moment this money gets tied up in real
property. If someone chooses to rent rather than buy, this interest
income would be earned. Of course, this earned income is also taxed, so
75% of this number is the net opportunity cost of a downpayment.

To establish the cost of ownership, each of these costs, if
applicable, must be quantified. When the total monthly cost of
ownership is equal to the rental rate, the market is considered to be
at fair value for owner-occupants. In fact, this is the equilibrium in
most real estate markets across the nation. In a strange way, the
bubble did not upset this equilibrium. The use of negative
amortization loans with artificially low teaser rates allowed borrowers
to obtain double the loan amount with the same monthly payment: double
the loan; double the purchase price. This is how prices were bid up so
high so fast without a commensurate increase in wages. The elimination
of these loans is also the reason prices collapse.

Running the Numbers

Below is a typical cost of ownership for a $244,900 Median property in the US (2006):

Equation 1: Cost of Ownership for 2006 Median Property in United States

Notes:

• The mortgage payment assumes a 30-year fixed-rate conventionally amortized mortgage at 6.5% interest.
• The property taxes are set at the 1% limit imposed by Proposition 13.
• The homeowners insurance is estimated at one-quarter of one percent per year.
• Private Mortgage Insurance is estimated at one-half of one percent
  per year. It is not included in the calculation above because this
  example utilized 80% financing. If the financing amount required PMI,
  the costs would have been over $100 a month higher.
• Special Taxes or Levies (Mello Roos) is estimated at one-quarter of
  one percent per year. Some neighborhoods do not have Mello Roos as the
  bonds have been paid off. Some Mello Roos fees are as high at 1%.
• HOA dues are estimated at $100: some are lower, and some are much higher.
• Maintenance and replacement reserves are estimated at 1.5%. This
  may be the most contentious estimate of the group because most people
  assume they will simply borrow their way around these costs when they
  are incurred. This certainly has been the pattern during the bubble
  years when credit was free flowing. This method of home improvement and
  maintenance may be significantly more difficult as the credit
  crunch and declining values make financing much more difficult to
  obtain. In any case, these costs are real, and failing to acknowledge
  them denies the realities of home ownership.
• The sum of the above costs is the monthly cash cost of ownership. A
  homeowner may not write a check for each of these costs every month,
  but the costs are still incurred, and renters do not pay them.
• The tax savings are based on the maximum interest payment at the
  beginning of a loan amortization schedule. This tax savings will
  decline each month as the mortgage is paid off. Contrary to popular
  belief, this is not a bad thing. Also, the property taxes are also
  deductable, but Mello Roos are not fully deductible (even though most
  people mistakenly deduct it).
• The opportunity cost of lost interest assumes a 5% interest rate on
  the downpayment reduced by 25% for taxes on this earned income.

The actual cost of ownership on a typical $244,900 property would be
approximately $1,648 per month. Some will be higher and some will be
lower, but the calculation above, when adjusted for the specific
property details being examined, yields the cost of property ownership.

Price-to-Rent Ratio

So what general relationships can be inferred from the ownership
cost breakdown provided above? First, notice the relationship between
monthly cost and price. This property is worth 154 times the monthly
cost when you fully examine the cost of ownership. Also, notice the
relationship between monthly payment and price. This property is worth
198 times the monthly payment. Common mistake homebuyers make when
considering a home purchase is to look at only the payment and ignore
the other costs of ownership. Most assume, or have been told by
realtors and mortgage brokers trying to make a commission that the tax
benefits offset the other costs of ownership. Clearly, this is not the
case. The true cost of ownership is about 30% higher than the monthly
payment.

The price-to-cost and price-to-payment relationships become
important when one wants to evaluate the relative value of the property
compared to market rents. Since housing is a consumer good that can be
obtained through either renting or owning, it is rational to compare
the costs of each method of possessing property to see which provides a
better value to the consumer. Just as stocks have price-to-earnings
ratios (PE Ratios) used to establish relative value, houses have a
price-to-rent ratio to establish relative value. [viii] When a property
can be rented for an amount equaling its monthly cost of ownership, it
is at rental parity. This is the breakeven point where a consumer would
be indifferent in financial terms to own or to rent. Of course there
are reasons to own or to rent which are not financial, but from a
strictly financial standpoint, this is where the fundamental value lies.

The price-to-rent ratio is very sensitive to changes in interest
rates. When interest rates are low, the cost of money is low, so larger
sums can be borrowed and vice-versa. Nationally, the price-to-rent
ratio increased steadily from 1988 through 2004 in a range from 157 to
199 while mortgage interest rates declined from 10.34% in 1988 to 5.84%
in 2004. This increase in price was mostly the result of lowered
interest rates as the out-of-pocket expense remained relatively
constant. The dramatic increase in prices after 2004 was not supported
by incomes or rents, and it is part of the evidence of a real estate
bubble. [ix]

The price-to-rent ratio is also the basis for a commonly used
valuation measure used in the property management business, the Gross
Rent Multiplier (GRM). The GRM is a convenient way to evaluate whether
or not a rental rate will cover the monthly cost of a particular
property. It was developed by landlords seeking a method to quickly
evaluate the purchase price of a property to see if it would be a
profitable investment. When performing such an evaluation, a cashflow
investor will typically look for a GRM near 100 to find a property with
positive cashflow. This method can also be easily adapted to calculate
the breakeven point where an owner/occupant would break even compared
to renting. Considering the full cost of ownership–including those
costs often ignored–the price-to-rent ratio and Gross Rent Multiplier
is lower than most think. The GRM is a convenient measure of value
because it spares you the toil of performing the above, detailed
calculation to evaluate a large number of properties.

Figure 11: National Price-to-Rent Ratio, 1988-2007

[1] There are a number of research papers discussing the pros and
cons of various methodologies for calculating equivalent rent. Hedonic
Estimates of the Cost of Housing Services: Rental and Owner-Occupied
Units (Crone & Nakamura, 2004) Treatment of Owner-Occupied Housing in the CPI (Poole, Ptacek, & Verbrugge, 2005).

[ii] Robert Shiller noted “that real owners’ equivalent rent and
real building costs track each other fairly well, as one might expect.
But neither of them tracks real home prices at all, suggesting that
some other factor – I will argue market psychology – plays an important
role in determining home prices.”

[iii] Depending on the market, rental rates grow at a rate around 1%
over the rate of inflation. Rental rates are closely aligned with
income growth, and in markets where income growth is strong, rental
rates increase at approximately the same rate.

[iv] John Krainer, chief economist for the Federal Reserve Bank of
San Francisco, pointed out in 2004 “The price-rent ratio for the U.S.
and many regional markets is now much higher than its historical
average value.” (Krainer & Wei, House Prices and Fundamental Value, 2004) This is one of the first papers (other than those by Robert Shiller) to recognize the data was pointing to a housing bubble.

[v] The full text of the Proposition 13 law can be found at http://www.leginfo.ca.gov/.const/.article_13A

[vi] In California, the first half of regular secured property tax
bills are due November 1st, and delinquent after December 10th; the
second half are due February 1st, and delinquent after April 10th each
year. If the delinquent date falls on a Saturday, Sunday, or government
holiday, then the due date is the following business day.

[vii] All information regarding tax rates comes from the Internal Revenue Service. http://www.irs.gov/

[viii] There are many studies that have mentioned the use of
price-to-rent ratios as being similar to price-to-earnings ratios of
stocks. Some of the studies are good, and some are not. Bubble, bubble,
toil and trouble is of the latter variety (Haines & Rosen, 2006).
Typical of these studies is that they will look at the data, see the
obvious signs of a bubble, and proceed to dismiss the obvious as
something else. Even though the national data for price-to-rent clearly
shows a bubble, even in their own graphs, the authors dismiss the idea
because “all real estate is local.” The paper was written for the
Federal Reserve, but it could have been written for the National
Association of Realtors. Another silly statement they make is “Thus,
what appears to be a bubble in some markets might just be a reflection
of normally high volatility in those markets.” This is like saying
“what appears to be a bubble isn’t a bubble because bubbles are normal
in these markets.” When the authors can look right at the data and not
understand what they are seeing, there is little hope the paper will
draw the right conclusions.

[ix] The study A Trend and Variance Decomposition of the Rent-Price
Ratio in Housing Markets by Sean D. Campbell, Morris A. Davis, Joshua
Gallin, and Robert F. Martin (Campbell, Davis, Gallin, & Martin, 2005)
uses method of estimating the investment premium people pay for homes
in bubble markets based on the expectation of future rental growth.
This entire approach is flawed as it assumes people are investing based
on cash flows. This would be a rational approach, but most people who
buy in financial manias know little or nothing about cashflow or how to
value it. The real reason they are “investing” is to capture
speculative price changes. Trying to determine a fundamental valuation
based on cashflow is an interesting exercise in math and statistics,
but it completely fails to capture the real motivation behind buyers in
the marketplace.

What they are saying about The Great Housing Bubble

“…the author has a background in real estate that’s far removed from
the sales process, he’s able to step back and provide the sort of
unemotional, macro-economic overview that seems quite atypical for a
guide to investing in real estate.

…Filled with 64 exhibits, 146 footnotes and a nine-page bibliography
of source material, “The Great Housing Bubble” is probably not a casual
read during a day at the pool or the beach. But for real estate
professionals wanting to educate themselves or their clients on how to
successfully build wealth through the buying and selling of real
property, this author has a lot to teach.”

Patrick S. Duffy – Principal with MetroIntelligence Real Estate Advisors and author of The Housing Chronicles Blog.

Mortgage Equity Withdrawal

Mortgage Equity Withdrawal or MEW is the process of obtaining cash
through refinancing residential real estate using the accumulated
equity as collateral for the loan. Before MEW homeowners would have to
wait until the property was sold to get their equity converted to cash.
Apparently, this was deemed an inefficient use of capital, so lenders
found ways to “liberate” this equity with home equity lines of
credit or cash-out mortgage refinancing. Home equity lines of credit
are popular with lenders despite the additional risk of being in the
second or third lien position because borrowers are less likely to
default or prepay than non-cash-out refinancing. [1] The impact of MEW
on equity is obvious; it reduces equity by increasing the loan balance.
It has been noted that equity is a fantasy and debt is real, and MEW is
the process of living the fantasy with the addition of very real debt.
MEW has been utilized by homeowners for home improvement for decades,
but the widespread use of this money for consumer spending was largely
an innovation of the Great Housing Bubble. [ii] Since consumer spending
is almost 70% of the US economy, mortgage equity withdrawal was the
primary mechanism of economic growth after the recession of 2001–a
recession caused by the deflation of another asset bubble, the
NASDAQ technology stock bubble.

Figure 9: Mortgage Equity Withdrawal, 1991-2006

Many people who extracted their home equity lost their homes for
lack of ability to refinance or make their new payments. After so many
people lost their homes due to their own reckless borrowing, it is
natural to wonder why these people did it. Why did they risk their home
for a little spending money? First, it was not just a little money.
Many markets saw home values increase at a rate equal to the local
median income. It was as if their home was another breadwinner. The
lure of this easy money was too much for many to resist. The rampant,
in-your-face, marketing of these loans in every available media outlet
touting the glossy “lifestyle” of over-the-top consumerism was a drug
to many spending addicts. Also, during the bubble rally people really
believed their house values would go up forever, and they would always
have the ability to refinance enormous debts at low interest rates and
maintain very low debt service costs. Most people did not think it
possible they would end up in circumstances where they would lose their
homes; however, they were mistaken. Given these beliefs, the equity
accumulating in their house was “free money” they just needed to access
in order to live and to spend like rich people. Even though they were
consuming their net worth, and making themselves poor, they believed
they were rich, and they wanted to spend accordingly.

Most homeowners do not save money for major improvements and
required maintenance, and these homeowners often take out home
equity lines of credit as a method of mortgage equity withdrawal to
fund home improvement projects. The logic here is that renovations
improve the property so an increase in property value offsets the
additional debt. In reality, home improvement projects rarely adds
value on a dollar-for-dollar basis, particularly with exterior
enhancements which often only return 50 cents on the dollar in value.
[iii] The home-improvement craze was so common that the term
“pergraniteel” was coined to describe the Pergo fake wood floors,
granite countertops, and steel appliances that defined the Great
Housing Bubble era in much the same way as shag carpeting and wood wall
paneling defined the interior decorating of the 1970s.

Much of the money homeowners borrowed fueled consumer spending and
reinforced poor financial management techniques. It was common during
the bubble rally for people to run up enormous credit card bills then
refinance every year and pay them off. [iv] It is foolish enough to
finance consumer spending, but it is even more foolish to pay for this
spending over the 30-year term of a typical mortgage. The consumptive
value fades quickly, but the debt endures for a very long time. Many
people responded to the “free money” their house was earning by
liberating their equity as soon as they could so they could buy cars,
take vacations, and generally live the good life. This borrow-and-spend
mentality was actually encouraged by lenders who were eager to make
these loans and even the government which was benefiting by economic
expansion and higher tax receipts.

The recession of 2001 was caused by the collapse of stock prices and
the resulting diminishment of corporate investment. The recession was
shallow, but the economy had difficulty recovering mostly due to
continued erosion of manufacturing jobs. [v] The Federal Reserve under
Alan Greenspan was desperate to reignite economic growth, so the
FED funds rate was lowered to 1% and kept there for more than a year.
It was hoped this increased liquidity would go into business investment
to restart the troubled economy; instead, it went into mortgage loans
and consumers’ pockets through mortgage equity withdrawal. Basically,
the economic recovery from 2001 through 2005 was an illusion created by
excessive borrowing and rampant spending by homeowners. The economy did
not grow through production; it grew through consumption.

There are many theories as to the decline and fall of the Roman
Empire. [vi] One of the more intriguing is the idea that Rome fell
because it was weakened by the parasitic nature of Rome itself. Rome
existed to consume the resources of the empire. Boats would come to the
city loaded with goods and leave the city empty. Consumption kept the
masses happy and thereby quelled civil unrest. The Roman Empire was the
world’s only superpower with an unsurpassed military might. Equally
unsurpassed was its ability to consume resources. Does any of this
sound like the United States? The United States has clearly become a
consumer nation, and the government continues to borrow huge sums of
money to keep the economic engine of consumption going. In early 2008,
Congress passed a “stimulus” package where many people would receive
direct gifts of money in the hope they would spend it and keep the
economy going. Since the Federal Government was already running a
deficit, this money was borrowed from future tax receipts. In other
words, this handout was obtained from future generations. With house
prices crashing, direct handouts of borrowed government money were
necessary to make up for the loss of borrowed private sector money that
used to be available through mortgage equity withdrawal.

The Fallacy of Financial Innovation

The cutting edge is sharp. Innovators often pay a heavy price for
attempts at advancement. Sometimes these advances lead to quantum leaps
in human knowledge and understanding. Sometimes the time, effort, and
money are merely thrown into the abyss. The financial innovations of
the Great Housing Bubble are of the latter category. When the lending
industry developed exotic loan products, they touted them as
“innovation,” and they sold these toxins far and wide. [vii] Since
these loans achieved the highest default rates ever recorded, it is
apparent the “innovations” of the bubble rally were not entirely
successful. It is amazing that a group of assumingly intelligent
bankers came up with these loans and expected a positive outcome.
[viii] The “innovation” meme is nothing more than a public relations
effort to convince brokers the products were safe to sell and borrowers
the products were safe to use. It is hard to fathom the widespread
acceptance of this nonsense, but that is the nature of the pathological
beliefs of a financial mania.

Many in the lending industry think their work is like science that
continually advances. It is not. It is far more akin to assembly line
work where the same widgets are pumped out year after year. When
lenders start to innovate, trouble is brewing. The last significant
advancement in lending was the widespread use of 30-year amortizing
loans that came into favor after World War II. Prior to that time, home
loans were interest-only, short-term loans with very high
equity requirements (50% was most common). This proved problematic in
the Great Depression as many out-of-work owners defaulted on their
loans. A mechanism had to be found to get new buyers into the markets
and allow them to pay off the loan. The answer was the 30-year,
fixed-rate amortizing loan. To say this was an innovation is a stretch
as this loan has been around as long as banking has existed, but it did
not become widely used until equity requirements were lowered. The
lenders were willing to lower the equity requirements as long as the
loan was amortizing because their risk would decline as time went by
and the loan balance was paid off.

Over the last 60 years since World War II ended, a number of
experimental loan programs have been attempted. These include
interest-only loans, adjustable rate loans, and negative
amortization loans among others. It is this group of loans that has
consistently failed in the past for one simple reason: if payments can
adjust higher, people will default. The Option ARM is certainly the
most sophisticated loan ever developed. It is also a dismal failure,
not because it lacks sophistication, but because it has embedded within
it the possibility (near certainty) of an increasing payment. Any loan
program that has the possibility of a higher future payment will fail
because there will be a certain number of people who cannot afford the
higher payment.

Here is where the lenders delude themselves and deceive the general
public after a financial debacle like the Savings and Loan problems of
the 1980s or the Great Housing Bubble. They blame the collapse and the
high default rates on some outside factor rather than the terms and
conditions the lenders created all on their own. There are still many
out there who believe the high default rates and problems in the
housing market in the 90s in California were caused by a weak economy.
This is rubbish. House prices declined for 6 years. The decline started
before the economy went soft, and it continued well after it had
recovered. People defaulted because they overextended themselves on
loans to buy overpriced housing, and toward the end of the mania, many
were using interest-only loans. Whenever lenders start loaning people
money with total debt-to-income ratios over 36% people will default.
Whenever lenders start loaning more than 80% of the purchase price,
people can sink underwater and when they do, they will default. This is
not new. It happened in the early 90s; it happened during the Great
Housing Bubble, and it happened for the same reasons: lax lending
standards.

Someday the lending community may actually innovate and come up with
some financial product that has low default rates which most people can
qualify to obtain–or not. Unless you change human nature, there are
always going to be people who are too irresponsible to make consistent
payments. People either do or do not make their payments. This is the
key to any loan program. New terms and schedules can be reinvented over
and over again, and it will always boil down to people making payments.
When complicated loan programs contain provisions that make it
difficult for people to make payments–like increasing payment
amounts–they will default, and the loan program will fail. This is
certain.

Whenever lenders create new, “sophisticated” loan programs that
require advanced financial management on the part of the borrower, both
the lenders and the borrowers fall victim to the Lake Wobegon effect.
[ix] Everyone thinks they have above average abilities when it comes to
managing their finances. In reality, perhaps 2% of borrowers have the
financial discipline to handle an Option ARM loan. Unfortunately, 80%
of borrowers think they are in this 2%. The reason for this comes from
the inherent conflict between emotions and intellect. Eighty percent of
borrowers may understand the Option ARM loan (or think they do,) but
when the pressures of daily life create emotional demands for spending
money on one’s lifestyle, the intellectual knowledge that this money
should go toward a housing payment is conveniently set aside. It is
this 2% of the most disciplined borrowers who will cut back on
discretionary spending to make their full housing payment. Everyone
else will make the minimum payment, fall behind on their mortgage, and
end up in foreclosure.

It seems lenders forget basic facts about lending every so often and
create a new financial bubble. Perhaps they succumb to the pressure of
the investment community or their own shareholders, or perhaps they
just start believing their own “innovation” marketing pitch and forget
the basics of sound lending practices. This is why there are recessions
at the end of a business cycle. These pathologic lending practices must
be purged from the system or else they will survive to build an even
bigger and costlier bubble. Although it is difficult to imagine a
bubble bigger than the Great Housing Bubble, it is still possible.

In the aftermath of a financial fiasco, lenders return to the
practices that did not fail them in the past. The only program lenders
know empirically to be stable is a 30-year, fixed-rate, conventionally
amortizing loan based on 80% of appraised value taking no more than 28%
of a borrower’s gross income (36% maximum total debt). The credit
crunch facilitated the decline in housing prices after the Great
Housing Bubble. Large downpayments came back, and government assisted
financing became widely used by first-time homebuyers to overcome the
high equity requirements. The credit crunch was not caused by some
unexpected or unknown factor; it was caused by the failure of lenders.
Credit continued to tighten until lenders stopped making bad loans. The
bad loans did not disappear until lenders returned to the stable loan
programs with a proven track record. That is how the credit
cycle works. [x]

Summary

To be financially conservative is to accumulate wealth and to be
risk adverse. It requires managing equity, paying down a mortgage loan,
and allowing net worth to accumulate rather than depleting it via
consumer spending through mortgage equity withdrawal. Many people do
not realize the risk they take on when they use some of the innovative
loan programs developed during the bubble. Exotic financing terms are
not exotic anymore. Interest-only, adjustable rates and negative
amortization have become so ubiquitous that nobody seems to remember
why 30-year fixed-rate mortgages are used. A home should be financed
with a fixed-rate conventionally-amortized mortgage and a sizable
downpayment. The reason for this is simple stress management: nobody
wants to spend the next several years worried about a loan reset or the
need for increasing house values or future salary increases. People
should not buy with the desire to make a fortune in real estate.
Instead, they should purchase with the intent to have a stable housing
payment, and a stress-free life.

[1] The conclusion of the paper Subprime Refinancing: Equity Extraction and Mortgage Termination (Chomsisengphet & Pennington-Cross, 2006)
is as follows, “Consistent with survey evidence the propensity to
extract equity while refinancing is sensitive to interest rates on
other forms of consumer debt. After the loan is originated, our results
indicate that cash-out refinances perform differently from non-cash-out
refinances. For example, cash-outs are less likely to default or
prepay, and the termination of cash-outs is more sensitive to changing
interest rates and house prices.” The sensitivity to changes in
interest rates is not surprising as borrowers will take the money if it
is a good deal, and they will repay it when the deal is less favorable.
The observation that these loans have lower default rates and are less
likely to be paid back early is quite surprising. This may have been an
artifact of the bubble rally, and future data may show these loans do
not perform as well as in previous years.

[ii] Robert Shiller wrote a paper on Household Reactions to Changes in Housing Wealth (Shiller, Household Reaction to Changes in Housing Wealth, 2004).
He reached no definitive conclusions concerning the reactions to
households to increasing home prices. At the time of his writing, the
bubble was inflated enough to be obvious to him, and he does mention
the bubble and its potential problems. The impact of mortgage
equity withdrawal had not reached absurd height in early 2004, but by
2006, the pattern of household spending had become fairly obvious. In
2007 Oxford professor John Muellbauer wrote Housing, Credit and
Consumer Expenditures (Muellbauer, 2007).
His conclusion is that the spending “wealth effect” was insignificant
in the past due to more restrictive credit policies which limited
access to home equity (financial prudence on the part of lenders.)
After the “liberalization” of credit markets and the dramatic increase
in prices of the housing bubble, the consumer spending brought about by
the wealth effect became pronounced. The wealth effect observed in the
Great Housing Bubble was much larger than the wealth effect of the
stock market bubble which preceded, and the effect was twice as large
in the United States as it was in Great Britain.

[iii] There is a lack of scholarly studies on the financial results of home improvement projects (Baker & Kaul, 2002).
Builder behavior is often revelatory of the state of the market. In
most markets new home builders do not put in rear yard landscaping
because they are not able to obtain a return on the investment. Also,
the fact that builders have multitudes of upgrade options from a base
package indicates the premium finishes do not provide a market return
unless specifically requested by a purchaser. Builders can profit in
that circumstance.

[iv] The evidence of consistent refinancing is anecdotal, but it is
reinforced by national statistical trends from the US Governments Flow
of Funds accounting.

[v] In the paper (Leamer, Housing Is the Business Cycle, 2007), the author has graphs showing the loss of manufacturing jobs after the recession of 2001.

[vi] (Gibbon, 1999)

[vii] In the paper Innovations in Mortgage Markets and Increased Spending on Housing (Doms & Krainer, Innovations in Mortgage Markets and Increased Spending on Housing, 2007),
Mark Doms and John Krainer document how financial innovation helped
facilitate the housing bubble. Their abstract is as follows:
“Innovations in the mortgage market since the mid-1990s have
effectively reduced a number of financing constraints. Coinciding with
these innovations, we document a significant change in the propensity
for households to own their homes, as well as substantial increases in
the share of household income devoted to housing. These changes in
housing expenditures are especially large for those groups that faced
the greatest financial constraints, and are robust across the changing
composition of households and their geographic location. We present
evidence that young, constrained households may have used newly
designed mortgages to finance their increased expenditures on housing.”
Notice the “innovation” reduced financing constraints. This is the
definition of loose credit. They also note the increase in home
ownership and the increase in debt-to-income ratios. The latter is a
telltale sign of a housing market bubble. The exotic loans tended to be
concentrated in younger households who used to be excluded from the
housing market due to lack of downpayments and insufficient income.
Basically, exotic loans were given to persons who were not ready for
home ownership, and the high default rates among this group should not
have been a surprise.

[viii] In response to the dramatic increase in subprime
delinquencies in 2007, the Federal Reserve Bank of San Francisco
commissioned a report on Subprime Mortgage Delinquency Rates (Doms, Furlong, & Krainer, Subprime Mortgage Delinquency Rates, 2007).
The report’s conclusions were as follows: “First, the riskiness of the
subprime borrowing pool may have increased. Second, pockets of regional
economic weakness may have helped push a larger proportion of subprime
borrowers into delinquency. Third, for a variety of reasons, the recent
history of local house price appreciation and the degree of house price
deceleration may have affected delinquency rates on subprime mortgages.
While we find a role for all three candidate explanations, patterns in
recent house price appreciation are far and away the best single
predictor of delinquency levels and changes in delinquencies.
Importantly, after controlling for the current level of house price
appreciation, measures of house price deceleration remain significant
predictors of changes in subprime delinquencies. The results point to a
possible role for changes in house price expectations for explaining
changes in delinquencies.” In later sections the relationship between
default rates and default losses is explored. When prices decline,
default losses increase because lenders get less money from the
collateral in a foreclosure. This report from the FRBSF demonstrates
that lenders also face higher default rates, probably due to borrowers
“giving up” when they owe more on their mortgage than their house is
worth. These two phenomenon have a negative synergy. In a related
report by Kristopher Gerardi, Adam Hale Shapiro, and Paul S. Willen
titled Subprime Outcomes: Risky Mortgages, Homeownership Experiences,
and Foreclosures (Gerardi, Shapiro, & Willen, 2007),
the authors make the following observations, “First, homeownerships
that begin with a subprime purchase mortgage end up in foreclosure
almost 20 percent of the time, or more than 6 times as often as
experiences that begin with prime purchase mortgages. Second, house
price appreciation plays a dominant role in generating foreclosures. In
fact, we attribute most of the dramatic rise in Massachusetts
foreclosures during 2006 and 2007 to the decline in house prices that
began in the summer of 2005.”

[ix] In the paper Unskilled and Unaware of It: How Difficulties in
Recognizing One’s Own Incompetence Lead to Inflated Self-Assessments (Kruger & Dunning, 1999),
the authors noted the tendency of individuals to overestimate their own
competence and abilities. Their primary conclusion is as follows
“People tend to hold overly favorable views of their abilities in many
social and intellectual domains. The authors suggest that this
overestimation occurs, in part, because people who are unskilled in
these domains suffer a dual burden: Not only do these people reach
erroneous conclusions and make unfortunate choices, but their
incompetence robs them of the metacognitive ability to realize it.” It
is a perfect description of the general public and their relationship
to complex financial agreements like Option ARMs.

[x] The author is a believer in the Austrian School of Economics.
Two of the sources of research and understanding on the credit
cycle are The Hedge Fund Edge: Maximum Profit / Minimum Risk Global
Trend Trading Strategies (Boucher, 1999), and Money, Bank Credit, and Economic Cycles (Soto, 2006).