Taxman — The Beatles

Let me tell you how it will be,
There’s one for you, nineteen for me,
‘Cos I’m the Taxman,

Tax policy and its relationship to housing is a big topic. This post will not be a comprehensive treatise on the subject. I will look at several areas of tax policy and see what incentives they create and how changes in these areas would impact housing prices. This includes three broad areas: ownership taxes and subsidies, debt subsidies, and appreciation taxes.

• Ownership taxes and subsidies include property taxes, special tax levies, and the impact of proposition 13.
• Debt subsidies include the home mortgage interest deduction and its relationship to the personal exemption.
• Appreciation taxes are capital gains and income taxes from the profitable sale of residential real estate.

Ownership Taxes and Subsidies

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. 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.

Proposition 13 tends to limit move-up trading because it requires owners to increase their property tax bill, sometimes dramatically. There are basis transfers and ways around this problem for certain people who qualify, but there is a documented tendency among California home owners to stay in their homes because they end up trapped there by the tax savings. This Wikipedia article has a good discussion of the impact of Proposition 13.

Many people who bought at the peak are seeing property tax relief as prices fall. Most do not realize that their property tax bills will rise with appraised values until they hit their purchase price. They are not locked in to the new lower tax basis. New buyers who enter at lower prices are. For instance, say a peak buyer paid $1,000,000 in 2006. In 2011, his tax basis has been reduced to $500,000 with the surrounding property values. A 2011 buyer who pays $500,000 also shares this $500,000 tax basis. However, as property values rise back to $1,000,000, the peak buyer is going to be reassessed every year until his cap is hit at $1,000,000 plus annual allowed increases. The buyer at $500,000 will not face these same increases in property tax. Timing Does Matter.

Proposition 13 opponents point to the deterioration of California’s public schools since its passage as a big reason it should be repealed. However, since our property prices are so volatile, repealing proposition 13 is very unlikely. If we could reduce volatility in the housing market, the impact of Proposition 13 would be negligible, and there would be no need to repeal or reform it. That being said, there is one reform I believe would bring some fairness to this tax. Right now, the yearly allowed increases are less than wage and price inflation. If the escalator in Proposition 13 were tied to the Consumer Price Index, much of the subsidy given to long-term homeowners would be reduced, and tax revenues would better match inflation.

Mello Roos taxes are paid to service and retire development bonds taken out by the original land developer. These taxes come out of a potential buyers money available for a payment, so Mello Roos depress housing prices. One good strategy is to buy in a neighborhood where Mello Roos payments are about to end. The other potential buyers bidding on these properties will all be limited in their loan amounts by the Mello Roos payments, so imminent expiration will not have much impact on pricing. However, your future buyer will not face these payments, and when they do expire, you will see an increase in property value.

Debt Subsidies

Debt subsidies, in particular the home mortgage interest deduction, are seen as a great benefit to home ownership. The benefit is widely overestimated and misunderstood.

First, people fail to understand that to obtain a debt subsidy, you must have debt. You must be making an interest payment on this debt in order to qualify, and you get to reduce your tax burden by a small percentage of the interest amount. In short, you are paying a dollar to save a quarter. There are people who actually seek to maximize their interest payments in order to increase this subsidy. This is really, really foolish. Anyone out there who believes it is a good idea to spend $1 to receive $0.25 in return, please send me as much money as you wish, and I promise to send back 25% of it.

Realtors try to con people with the “throwing your money away on rent” argument. Homeowners buy into the fallacy. Interest is the rent on money. You throw away money on interest just like you throw it away on rent. In fact, people who overpay for housing throw away more money on interest than renters do to obtain the same property, even after the tax subsidy. The only argument one can make for paying extra interest is if you are receiving a return on that investment through property appreciation. We all see how that is turning out.

The main reason the benefits of the home mortgage interest deduction are overestimated is because people forget they must give up the standard deduction in order to obtain it. This is one area where tax policy can have hidden and indirect impact on housing. Changes in the standard deduction greatly impact the benefit of the home mortgage interest deduction. As the standard deduction is increased, the positive impact of the HMID is decreased. In fact, if the standard deduction were doubled, the average American holding a $150,000 mortgage probably would not bother itemizing to obtain the HMID because it would be of no tax benefit at all. This would certainly simplify people’s tax returns. A higher standard deduction is also a boon to renters who do not have the option of obtaining the HMID.

When we set up the RentVsOwnulator, we put in a 25% tax benefit from the HMID. Some people have commented that this is too small a number. It is not. Several people have run the calculations both with and without the HMID, and the net difference is only 25% even at the highest tax brackets. Basically, if you want to figure out your real tax benefit, take your highest marginal tax rate and subtract 10%. That will be a much closer estimate to reality. This reduction is caused by losing the standard deduction.

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Another facet to the HMID is the cap level. Currently mortgages up to $1,000,000 are eligible for the deduction. Does anyone think this is right? Do you realize you as a taxpayer are subsidizing $1,000,000 mortgages? When the GSEs were set up, they established a conforming loan limit. The reason they did this is because they are mandated to subsidize mid and low income housing. Why is the limit on the HMID any higher than the conforming loan limit from the GSEs? Why are we subsidizing high income borrowers?

If we were to reduce the HMID cap level to $500,000 and adjust it by the CPI going forward, we are still subsidizing relatively high income borrowers ($500,000 is still almost triple the median home price in the US). A reduction in this cap would have the same impact as the lower GSE conforming limit is having: it would lower prices at the high end by eliminating the subsidies.

IMO, the government has no place in subsidizing house prices that are well above the median. One can argue that the government should not be subsidizing anything in housing, but the low and middle income subsidies are here to stay. If we raise the standard deduction and lower the HMID caps, we can greatly reduce the impact of the HMID and the cost we pay for it as taxpayers. This would have the effect of lowering prices on more expensive homes, but it would help stabilize the lower end of the market. That is what the market needs right now.

In a post last week, we examined a proposal from John Burns to subsidize housing further by temporarily doubling the HMID. The problem I have with this is the same one I have with all temporary subsidies: how do you end them? Anyone who buys under temporary terms will be hurt when the subsidies are removed. This will cause everyone involved to lobby Congress to make them permanent. Permanently increasing housing subsidies will only make the problem worse at taxpayer expense. In the short term, the Burns’ proposal probably would help stabilize the housing market. If it were not capped it would be a huge tax break for people with large mortgages. It might even ignite another unsustainable rally and postpone the crash temporarily. None of this benefits the housing market long term.

Appreciation Taxes

Should five per cent appear too small,
Be thankful I don’t take it all.

A couple of weeks ago, I was contacted by an author named Bill McKim. He has written a pamphlet titled The Financial Crisis of 2008. In it he makes one simple, yet far-reaching proposal that would eliminate volatility in California’s residential real estate market: Tax capital gains due to irrational exuberance at a 100% rate. I must admit, that certainly would do it.

Our current system of calculating and enforcing taxes on property appreciation are a big part of the problem, and reform here is necessary. In short, gains on the sale of a primary residence are largely untaxed (there are complicated rules I will not go into here). There is no other asset class that receives such a generous government subsidy. If you sell most any other asset class for a profit, and you will be paying either personal income taxes or capital gains taxes depending on how long you owned the asset. With housing, most people either qualify for the tax break, or they claim they do and don’t get caught.

For most very long-term homeowners, much of the gain they recognize when they sell their houses is due to inflation. Taxing capital gains caused by inflation actually hurts the long term homeowner. A homeowner who sells after 30 years may not see any gain in value beyond inflation. The money returned to them has the same buying power as when it was put in to the asset. For the government to take a percentage of this inflation-induced gain is to rob the long-term homeowner of buying power. This is a valid reason not to tax capital gains on housing.

Unfortunately, when the Congress looked for a method of overcoming the tax problem of capital gains on long-term home ownership, the method they chose was deeply flawed. They simply put in a large tax break without regard to ownership period. It becomes a huge tax break for property flippers. Rather than benefiting long-term homeowners and encouraging that behavior, the government ends up encouraging frequent property turnover.

The solution to this tax problem is simple. Adjust the purchase price tax basis by the Consumer Price Index. Long-term homeowners would see a significant adjustment in the tax basis of their home while flippers would not.

The next issue is how much to tax the gain itself. Bill McKim proposes that the government should take it all. This would remove all incentive to buy for appreciation, and it would stop irrational exuberance in its tracks. That is probably not a tax policy that would ever get implemented. However, the idea is sound. Once the basis is adjusted for inflation, the tax rate on gains will greatly impact buyers and sellers. The higher the tax rate on capital gains, the less people will seek them, and the lower the market price volatility will be.

Another way to encourage long-term home ownership is to provide a lower capital gains tax rate only to long-term homeowners. For instance, a person who buys and sells a property and holds it for less than 3 years could be taxed at higher personal income tax rates. People who hold a property for more than 3 years would be taxed at lower capital gains tax rates. This would greatly inhibit the mindless flipping done by people who do not improve property.

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Tax policy is complicated, and its impact on housing is important. The tax policies of The Great Housing Bubble contributed to its inflation, and there are many proposals to use tax policy to ease its deflation. There are some proposals I believe would be helpful, and some that would not. Now is a good time to take a hard look at the incentives these tax policies create and ask ourselves if the subsidies we provide as a society are providing us with the benefits we seek.

Today’s featured property is a small apartment condo. It is also a 2003 rollback (almost).

Asking Price: $335,000

Income Requirement: $83,750

Downpayment Needed: $67,000

Monthly Equity Burn: $2,791

Purchase Price: $450,000

Purchase Date: 5/18/2006

Address: 16 Lakepines, Irvine, CA 92620

I have never seen a period followed by an exclamation point before. Very creative.

As you might have guessed, this property was bought by a flipper with 100% financing. It was purchased on 5/18/2006 for $450,000. The owner used a $360,000 first mortgage, a $90,000 second mortgage and a $0 downpayment. The bank took back the property on 11/12/2008 for $320,000. If this property sells for its asking price, and if a 6% commission is paid, the total loss to the lender will be $135,100.

This property is being offered for 26% off its peak purchase price. IMO, that is not near enough to sell it…

Check out this price history.

This property is almost a 2003 rollback. By the time it sells, it almost certainly will be.

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1,2,3,4,1,2

Now my advice for those who die, (Taxman!)
Declare the pennies on your eyes, (Taxman!)
‘Cos I’m the Taxman,
Yeah, I’m the Taxman.
And you’re working for no-one but me,
(Taxman).

Taxman — The Beatles

This has been a long post. Monday’s often are.

King of Pain — Alanis Morisette (The Police)

Here at the blog we joke about the “analysis” put out there by some of the local realtors. Most of this is thinly-veiled, self-serving bull$hit, or utterly incompetent nonsense. In either case, the purveyors of this information are not widely respected in the world of land development where those with deep pockets often pay large fees for good information. However, there are a number of very good market forecasters who are respected in big-money land development, and these consultants are well paid for the analyses they provide.

There are four main market consulting firms in Southern California that provide detailed market studies for residential land development projects. These are Market Profiles, Real Estate Economics, The Concord Group, and John Burns Consulting. I have met with the principals of all four of these firms at one time or another. They are all highly reputed in the industry.

I recently had a meeting with John Burns just to network and find out what he is seeing in our industry. We ended up sitting and talking for almost 2 hours. He shared with me his proposal for Unlocking the Housing Market Recovery (PDF warning). It is a great report. Over the course of several posts, I intend to revisit many of his proposals to see what the IHB community thinks about it.

The core of his proposal is as follows (from the executive summary):

The U.S. is undoubtedly in the worst financial and economic crisis since the 1930s. Home prices are falling rapidly across the nation, which has resulted in more than $2 trillion in losses in the last two years. The declining stock market has wiped out trillions more. These tremendous losses have created a vicious downward spiral that requires government intervention to avoid a 1930s-style economic collapse. This problem is affecting both Wall Street and Main Street.

There has been a lot of rhetoric and not a lot of facts about the current economic and financial crisis. In this report, we use facts to assess the current situation and provide our recommendations to save the U.S. economy from collapse.

To stabilize home prices, we believe Congress needs to do four things in conjunction with the Federal Reserve and US Treasury Department. Some of our recommendations have already been accomplished, but many of them have not.

1. Stabilize The Banking System – Save local businesses by saving the local employers’ bank.

• Continuing insuring deposits up to $250,000 and unlimited amounts in payroll accounts
• Close all poorly managed and undercapitalized banks ASAP
• Keep lending money to stabilize the best and largest banks
• Properly dispose of bad loans, RTC-style, instead of the way it is currently being done
• Finance new banks to create competition for good loans
• Continue supporting commercial paper liquidity
• Continue liquidity guarantees on new bank debt

2. Stimulate Job Growth – Bring more jobs to the economy with short-term stimulus and smart government spending.

• Fund infrastructure projects to create jobs
• Stimulate short-term spending while recognizing that long-term saving is also needed
• Allow companies to utilize their current losses to recapture taxes paid over the last 4 years so they can keep enough cash in the bank to meet payroll
• Create government–backed initiatives to help banks lend

3. Stimulate Responsible Home Buying – Stop home price declines by stimulating home buying by responsible individuals, to bring demand and supply back into balance.

• Keep mortgage rates low
• Keep Fannie and Freddie lending and FHA insuring
• Temporarily provide a down payment match to all home buyers
• Temporarily double the mortgage interest rate deductions for all homeowners

4. Support responsible loan modifications – Stop home price declines by helping keep responsible people in their homes.

• Provide financial incentives for loan servicing firms to modify loans
• Create a vehicle to buy loans that have been responsibly modified

There you have it. There is much more detail in the report: Unlocking the Housing Market Recovery (PDF warning). I am not going to bias the comments with any of my own commentary at this time. As I mentioned previously, I intend to revisit some of these proposals.

Just for giggles, lets look at a property offered for sale at 37% off its peak purchase price.

I guess Im always hoping that youll end this reign
But its my destiny to be the king of pain

Asking Price: $359,000

Income Requirement: $71,800

Downpayment Needed: $89,750

Monthly Equity Burn: $2,991

Purchase Price: $567,500

Purchase Date: 1/25/2006

Address: 2321 Scholarship, Irvine, CA 92612

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Beds:	2
Baths:	2
Sq. Ft.:	1,037
$/Sq. Ft.:	$346
Lot Size:	–
Property Type:	Attached, Condominium
Style:	Other (See Remarks)
Year Built:	2006
Stories:	1
View:	Pool
Area:	Airport Area
County:	Orange
MLS#:	H09004177
Source:	MRMLS
Status:	Active
On Redfin:	1 day
New Listing (24 hours)

Agent Remarks: “The seller doesn’t care if this sells. He is planning to stay in the unit through foreclosure. I don’t care either because I will never see a commission on this property.”

Do you like how the agent got in the picture of the bathroom? At least he put something in the picture so we couldn’t see inside the toilet bowl. Did you notice the abundance of counter space in the kitchen? Great staging…

I don’t have any loan information on this property, but we know it is a short sale, and it is most likely a 100% financing deal (weren’t they all?) If this sells for its asking price, and if a 6% commission is paid, the total loss on the property will be $230,040. That is a quarter million dollar loss on a tiny condo. Ouch!

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Theres a little black spot on the sun today
Its the same old thing as yesterday
Theres a black hat caught in a high tree top
Theres a flag-pole rag and the wind wont stop

I have stood here before inside the pouring rain
With the world turning circles running round my brain
I guess Im always hoping that youll end this reign
But its my destiny to be the king of pain

King of Pain — Alanis Morisette (The Police)

Not Responsible — Tom Jones

Now let me ask you something:
Have you ever felt that you weren’t responsible for the things that you do?

I do not like government paternalism. When Ronald Reagan came to power and began our 25 year experiment with government deregulation, I thought it was a good idea. It used to really annoy me when I would see paternalistic politicians who believed they knew what was good for me and for society, and that their ideas of right and wrong should be legislated. Government intrusions into the lives of citizens should be kept to a minimum, and citizens should have the right to make their own decisions and live with the consequences.

Well, maybe not.

I used to believe all of that, but based on what I have witnessed during The Great Housing Bubble, I see good reasons to bring back a little government paternalism.

First, people are not willing to accept the consequences of their actions. People want the right to do what they want and obtain the benefits of their decisions when things go well, but as soon as things go badly, they want the government to bail them out. This goes for individuals, organizations, and entire industries. I have yet to see anyone step forward and say, “I screwed up, and I don’t think the government should do anything about it.” If gains are privatized and losses are collectivized, then there needs to be a paternalistic government regulator looking out for the collective interest. This means regulation and unpopular restrictions of the choices of individuals and organizations.

Second, even if people were willing to accept the consequences of their actions, sometimes these consequences have impacts on others who had nothing to do with the original decision. If every homedebtor accepted foreclosure, and if every lender accepted the losses without pleading for a government bailout, the economic consequences of their foolishness would still have enormous impacts on all of us who did not participate in the transaction. When people accepting responsibility for their actions still causes excessive collateral damage, then the activity should be regulated to save the rest of us.

Day after day on this blog, I profile properties where the borrowers have spent themselves out of their homes. There is a fascinating, “train wreck” quality to these stories. There are lessons to be learned about managing personal finances in general and mortgage debt in particular. However, most people will not learn these lessons. If given the chance, people will abuse their HELOCs, and lenders will extend the credit to people to allow them to do so. Without restrictions on mortgage equity withdrawal, people will spend their houses and lose their homes.

This conclusion is inescapable. The hundreds of properties I have profiled have clearly demonstrated this phenomenon is not isolated. The hundreds of thousands of foreclosures caused by refinancing and HELOC abuse are a testament to the depth and scope of the problem. If we do not change the system, we will see a repeat of this problem.

Some people are spenders, and some are savers. No amount of education is going to change that. Many of the outrageously pretentious spenders obsessed with conspicuous consumption are not going away. As I pointed out in Southern California’s Cultural Pathology, we have many spenders in our midst. These people will spend and spend until their creditors cut them off. Many are dealing with the painful reality of credit contraction right now. If these people were suffering in isolation and not asking for government handouts, I would be inclined to leave the system alone; however, these people are not suffering alone, and they are begging for the government to give them some of my money to support their foolish ways. This is where I draw a line.

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Regulating mortgage equity withdrawal would not be a difficult endeavor. The only problem would be the resistance from individuals who want to spend this money and from the lenders who want this business. That will be some significant resistance. It would take something like a million foreclosures and an economic catastrophe similar to the Great Depression caused by this behavior to provide the political will to make this happen. Well… it looks like the political will might be there.

I would ban all forms of cash-out refinancing except for reverse mortgages and home improvement projects with certain restrictions.

There is no good reason for people to increase their mortgages to fuel consumer spending. Anyone who makes this argument because of the economic benefit of mortgage equity withdrawal obviously has not been paying attention to the fallout of The Great Housing Bubble.

Many will argue that cash-out refinancing to fund businesses is a good thing. Tell that to all the failed business owners who are also losing their houses. I believe it is much better to encourage new business start-ups to find capital from other sources. This will prevent a great many dreamers who do not have a viable business plan from doing something stupid that costs them their family home.

I don’t have an opinion about reverse mortgages. I do see where retirees whose home equity is their primary savings would want a method of accessing this savings. Given the power of the AARP, banning reverse mortgages is probably politically untenable. Perhaps we have to wait until the baby boomers get evicted in large numbers due to these loans before they will be reformed.

Anyone who builds their own house has gone to the bank for a construction loan. These loans require the borrower to provide receipts and other proof of construction progress before the bank will release the funds. There is no reason that HELOCs for home improvement cannot be done the same way. This ensures that the money is only loaned for property improvements. I would also limit this to 50% to 75% of the actual cost. Home improvement projects do not add value on a dollar for dollar basis despite the BS you see on HGTV.

Short of an outright ban on mortgage equity withdrawal — which I think is necessary to really solve the problem — I would propose limiting the home mortgage interest deduction to purchase money mortgages plus approved home improvement projects. If people did not get a tax break by adding to their mortgage, they might be much less likely to do so. If they want the HMID on a HELOC, they would need to go through the construction loan process as outlined above. Years ago, Congress eliminated the deduction for interest on credit card debt. When the lending industry created HELOCs and allowed people to consolidate debts, they effectively eliminated the prohibition on deducting credit card interest. Basically, with HELOCs, all interest can be deducted through loan consolidation. This must stop.

As a society, we have created a system that strongly encourages a borrow-and-spend mentality. Saving in all its forms are punished while borrowing is strongly subsidized and encouraged. The credit orgy of the 00s saw this system taken to its ultimate extreme. The result was a vicious credit crunch, a collapse in asset values, and an economic downturn second in severity only to the Great Depression. Obviously, something needs to change. A little paternalism in the mortgage market is one of a number of necessary regulatory reforms, and despite the idealism of my youth, I now support these reforms.

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Today’s featured property was purchased in 1991. The owner is losing the home in a short sale. Any ideas how that might have happened?

Asking Price: $524,999

Income Requirement: $131,250

Downpayment Needed: $105,000

Monthly Equity Burn: $4,375

Purchase Price: $241,000

Purchase Date: 5/23/1991

Address: 21 Woodland Drive, Irvine, CA 92604

central air cupboards and shelves? Does cabinetry benefit from central air?

That $1 discount from the $525,000 asking price makes it seem so much less expensive, right?

This property was purchased on 5/23/1991 for $241,000. Fast forward 18 years, and the property is being offered for sale at more than double the price, and it is a short sale. This would not have happened if this owner had not been permitted to borrow against his home equity. This is a short-sale/foreclosure that could have been avoided if regulations were in place to prevent rampant mortgage equity withdrawal. This owner would have $250,000 or more waiting for him at a closing table. Instead he is going to walk away empty handed and get a demerit on his credit report.

Should this owner be prevented from borrowing and spending his way out of his home? Yes, if that behavior costs me and you money in tax relief and economic weakness.

Of course, it is easy to see this disaster now. As prices are going up and everyone has this free money that simply needs to be “liberated” and lenders are anxious to provide this money, there is enormous pressure to provide an outlet. Regulators have difficulty containing this pressure when both parties to the transaction want it to happen. It is only when the collective sees that they are a silent participant in this transaction providing insurance coverage for any losses that regulators are given the power to stop the practice.

In my opinion, we must regulate out of existence many of the bad lending practices we saw during the bubble. If we are all now parties to the transaction providing loss protection we have the right to stop the foolishness. In fact, if we do not stop it, then we are foolish, and then we deserve to pay for the future losses this behavior will produce.

BTW, I am quoted in the Wall Street Journal Today: Realtors’ Former Top Economist
Says Don’t Blame the Messenger: “Lawrence Roberts, author of “The Great Housing Bubble,” says the
Securities and Exchange Commission should regulate NAR the way it
regulates financial advisers. “Realtors are currently able to make any
statement they wish regarding the investment potential of real estate,
no matter how ridiculous,” he says.”

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Now let me ask you something:
Have you ever felt that you weren’t responsible for the things that you do?
When the girl that you are with is just too much
She is so out of sight, baby, that all you can say is:
Well, all right!

I’m not responsible, not responsible
For anything I do when I’m with you
I’m not responsible, it’s impossible
To be so very near and not feel part of you
You’ve got such a hold on me
You make it seem so easy, but it’s true, oh yeah
I get such a happy feeling
Knowing that you feel the same way too

I’m not responsible, not responsible
When you can make a man do what you want him to
I’m not responsible, it’s impossible
To be so very near and not know what to do
You got such a hold on me
You make it seem so easy but it’s true, oh yeah
I get such a happy feeling
Knowing that you feel the same way too
I get such a happy feeling
Knowing that you feel the same way too
Believe me baby, etc….

Not Responsible — Tom Jones

Tighten Up — Archie Bell and the Drells

We’re gonna tighten up
Let’s do the tighten up

Much of the analysis of the housing bubble has focused on the fundamental measures of price-to-income and price-to-rent. These are valid statistical measures of what the market should do, and they reflect the fundamental valuations to which prices ultimately return. However, debt-to-income ratios are very revealing of the buyer/borrower activity due to kool aid intoxication and irrational exuberance.

There was a significant price bubble in residential real estate in the late 1980s crashing in the early 1990s. This coastal bubble was concentrated in California and in some major metropolitan areas in other states, and it did not spread to housing markets nationwide. When comparing this previous bubble to the Great Housing Bubble, the macroeconomic circumstances were different: Prices and wages were lower in the last bubble, interest rates were higher, the economies were different, and other factors were also unique; however, the evaluation of personal circumstances each buyer goes through when contemplating a purchase is constant. The cumulative impact of the decisions of buyers is represented in the debt-to-income ratios – how much each household pays to borrow versus how much they make. Comparing the trends in debt-to-income ratios provides a great tool for elucidating the behavior of buyers.

Typically debt-to-income ratios track interest rates. As interest rates decline, it becomes less expensive to borrow money so borrowers have to put less of their income toward debt service. The inverse is also true. On a national level from 1997 to 2006 interest rates trended lower due to low inflation and a low federal funds rate. During this same period people were increasing the amount of money they were putting toward home mortgage debt service. If the cost of money is declining and the amount of money people are putting toward debt service is increasing, the total amount borrowed increases dramatically. Since most residential real estate is financed, this increased borrowing drove prices up and helped inflate the Great Housing Bubble.

Figure 21 – Debt-To-Income Ratio and Mortgage Interest Rates, 1997-2006

A refresher from Fundamentals at a Market Bottom:

The figure below shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006. It is calculated based on historic interest rates, median home prices and median incomes. Lenders have traditionally limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels. During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards are prone to high default rates once prices stop increasing. In 1987, 1988 and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.

Figure 22 – Debt-To-Income Ratio, California 1986-2006

Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. The psychology of buyers reflected in debt-to-income ratio is the facilitator of price action. In market rallies people put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. People are not passively responding to market prices, they are actively choosing to bid prices higher out of greed and the desire to capture the appreciation their buying activity is creating. This will go on as long as there are sufficient buyers to push prices higher. The Great Housing Bubble proved that as long as credit is available there is no rational price level where people choose not to buy due to prices that are perceived to be expensive. No price is too high as long as they are ever increasing.

In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining. In fact, it is possible for house prices to decline so quickly that no mortgage program can reduce the cost of ownership to be less than renting. The only thing justifying a DTI greater than 50% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even beginning to decrease, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. In a bubble market when the market debt-to-income ratio falls below 30%, the bottom is near.

The graphs and charts are pretty, and they do illustrate what is happening in a macro sense in the market, but now it is time to look at the micro. The reason prices are still so high is not because of interest rates, high incomes or any fundamental measure of pricing. It is due to the debt-to-income ratios lenders are still permitting and kool aid intoxicated buyers are still willing to utilize to buy real estate.

Take a look at how even small changes in the debt-to-income ratio used by a borrower can make a huge difference in the amount financed and ultimately in the amount paid for real estate. At very low interest rates, every 3% of gross income put toward a housing payment adds 10% to the amount borrowed. Of course, the phenomenon also works in reverse. As DTIs fall due to both lender reluctance and borrower reluctance, the amounts financed decline precipitously.

The example above uses the most recent Irvine Median Household Income Data. From this it calculates the gross monthly income. Notice this is the gross amount, not the after-tax income. Someone making $91,101 per year would be taking home between $5,000 and $6,000 a month depending on the number of exemptions claimed and the amount of their tax write-offs. Note the effect this has on the take-home DTI ratio. Someone using a DTI of 31% is really spending almost 50% of their take-home pay on housing and related expenses. The maximum loan amount is calculated using a 30-year fixed-rate conventionally amortizing mortgage assuming 85% of the payment, taxes and insurance amount will be going toward the mortgage payment.

The FHA currently allows a 31% DTI for housing debt. Years of experience has shown that DTIs in excess of this amount have high default rates. This isn’t terribly surprising when you see how much a higher DTI starts to cut in to other lifestyle expenses. Prior to the Great Housing Bubble, lenders only allowed DTI’s of 28% for housing debt and a total back-end DTI of 36% which includes car payments, credit cards, and other debt-service payments. That is where standards are headed.

That brings me to the final point of the day: The credit tightening cycle is not over. Lenders are still underwriting loans with DTI ratios that end up in default.

Let’s tighten it up now
Do the tighten up
Everybody can do it now
So get to it

When the government embarked on its loan modification program in an attempt to save borrowers, they had to pick a payment DTI level to which loans would be modified. The higher this DTI level, the less banks would lose on the modifications because borrowers would be paying more money. Of course, the higher the DTI level selected, the higher borrower default rates were going to be. So what did the government do? Did they pick a DTI that has historically been proven to have borrower stability? Of course not. They chose the DTI that maximized lender and investor revenues and prayed that people would not default. Well, they have been redefaulting on loan modifications at rates exceeding 50%. What a surprise.

If the powers that be really want to stop redefaults and foreclosures, they need to modify loans using a 31% DTI which the FHA has years of data showing it is the highest sustainable level. Further, they need to hope that underwater homedebtors don’t walk away anyway. Even a 31% DTI is pretty onerous when there is little or no chance for appreciation and you are merely renting from the lender.

Lenders have gone back to their historic data to relearn underwriting all over again. They know they must underwrite loans at DTIs in excess of 40% in order to support current pricing, so they limit these loans to people with significant downpayments, large cash reserves, and high FICO scores. In other words, it is the smallest possible borrower pool. Because the potential borrower pool is so small, and because there is a foreclosure tsunami coming, prices will continue to fall.

Over time lenders will continue to lower their allowable DTIs because the default rates will continue to be very high. As long as there are high default rates, there will be more foreclosures, prices will continue to fall, and the lenders will continue to lose money. This downward spiral will cause allowable DTIs to shrink until 28% to 31% DTIs are the maximum borrowers will be able to find in the marketplace. Anyone who thinks this credit crunch in mortgage lending is a temporary phenomenon is sadly mistaken.

Also, as people begin to realize that rapid appreciation is not right around the corner, they will not be so anxious to take on massive debt loads. Realistically, the only way a homedebtor can manage their finances with a DTI in excess of 31% is to Ponzi Scheme borrow from HELOCs, credit cards, or other sources. This will result in a voluntary decline in DTIs as well. If you look at the chart at the top of the page, you can see this in action from 1990-1997. We will see it again in the statistics from 2006-2012.

The importance of allowable DTIs cannot be overstated. Look at the math and notice how much of pricing is being supported by the allowable DTI. The debt-to-income ratio is the hidden and often forgotten variable that enormously impacts market prices. When everyone is focused on interest rates at historic lows, they will miss the much more important changes in allowable DTIs.

{book}

Asking Price: $499,000

Income Requirement: $124,750

Downpayment Needed: $99,800

Monthly Equity Burn: $4,158

Purchase Price: $656,500

Purchase Date: 5/30/2006

Address: 54 Ardmore, Irvine, CA 92602

Today’s featured property was purchased on 5/30/2006 for $656,500. The owners used a $525,200 first mortgage, a $131,300 second mortgage, and a $0 downpayment. If this house sells for its asking price, the total loss will be $187,440 after a 6% commission.

Let’s take a look at this property from a DTI perspective. Let’s assume this is a median property that should be affordable to a median income household. This is a small three-bedroom condo, so I think this is a fair assumption. Without toxic financing, a $656,000 loan would require a DTI of around 55%. Obviously, people cannot sustain ownership with such a large payment which is why it is being sold as a short sale right now.

What does the government think this owner should be able to afford? With a 38% DTI using conventional financing, the mortgage would be around $450,000, and with 20% down, that puts us at today’s $499,000 asking price. However, as experience is proving, people are still defaulting at DTIs of 38%, so this payment and price level is not sustainable either.

What does the FHA think this owner should be able to afford? With a 31% DTI and a 3.5% downpayment, the mortgage would be $372,643, and the downpayment would be $11,179. This property should be selling for $383,822 based on what an FHA buyer making the median income can afford. The median house price in Irvine should be around $400,000 based on incomes and reasonable, sustainable DTIs. The fact that the median is still near $600,000 should give you an indication of how far prices have yet to fall to reach a stable equilibrium.

{book}

Yeah, you do the tighten up
Yeah, now
I said, if you can do it now
It sure would be tough
Now look here, come on now
Now make it mellow

Do the tighten up
Come and tighten it up
Tighten it up now

Tighten Up — Archie Bell and the Drell

Shakey Ground — The Temptations

My car got repossessed this morning

'Cos I'm about to drown in my own tears

The Federal Government is contemplating rebuilding the housing market on shaky ground by attempting to lower mortgage interest rates to 4.5%. Now that they control the GSEs, they might be able to do it — at least temporarily. The Federal government's current borrowing costs are very low. Current yields on 30-day treasury Notes are essentially zero, and the yield on 10-year Treasury Bills is at its lowest level since… I don't know if they have every been this low.

All this means that the government can act like a bank and loan profitably even at 4.5%. So why do they want to do this? It is one way of temporarily supporting prices giving them the ability to control the implosion.

Interest rates went down during the price decline in the early 90s. That softened the impact and made the decline take somewhat longer. When interest rates are declining, bubbles take longer to deflate, and the bottom is at a somewhat higher price point. When interest rates are increasing, bubbles deflate faster, and the bottom is at a lower price point. Mortgage Interest rates during the Great Housing Bubble were at historic lows so a repeat of the steady decline in rates witnessed during the 90s is not very likely. Higher interest rates translate into diminished borrowing, lower prices and a lower bottom. A lower bottom means large bank losses and a weaker economy. Therefore, the government wants to control and limit the drop in house prices as much as they can.

During the early 90s while prices were declining, interest rates were also declining from 10.6% in 1989 to 7.2% in 1996. These 30% declines in interest rates made housing more affordable and helped limit the price declines in the early 90s. If interest rates had not declined, house prices certainly would have dropped further than they did. If the Federal Government were to engineer a mortgage interest rate decline of 30% from the 5.8% they were during the bubble down to an unprecedented 4.1% to match the debt relief of the early 90s, it would help control the implosion, but it will only temporarily arrest the decline of prices. As with any government attempt to manipulate prices, it will probably have unintended consequences.

Of course, also like a bank, the government would be borrowing short to loan long, and if the government's cost of capital were to increase, they would lose a lot of money. In short, any attempt by the government to lower interest rates would be temporary. They would not hold to 4.5% interest rates forever as a permanent housing market subsidy. Therefore, anyone foolish enough to buy when interest rates are 4.5% would know that their future buyer (remember Your Buyer's Loan Terms) would be paying a higher interest rate. So what does that mean for future home values?

I don't know if I can state this emphatically enough, so I will type it in realtorese:

ANYONE WHO BUYS AT 4.5% INTEREST RATES IS A FOOL WHO WILL LOSE MONEY!!!

The table above should be very handy to anyone contemplating buying at 4.5% interest rates. You can calculate the loss of home value based solely on increasing interest rates in the future. It is possible we will see 10% interest rates again? You only have to look back to the late 80s/early 90s to see interest rates that high, and that is half of what it was in the early 80s. In my opinion, 8% interest rates are likely during the next several years. When the FED starts raising interest rates after the current crisis is over, 8% interest rates may come faster than you think.

{book}

Today's featured property is another speculative venture funded by easy money that is turning out badly. These are not too difficult to find.

Asking Price: $539,900

Income Requirement: $134,975

Downpayment Needed: $107,980

Monthly Equity Burn: $4,499

Purchase Price: $589,000

Purchase Date: 2/26/2004

Address: 2 Madagascar, Irvine, CA 92618

Beds:	3
Baths:	3
Sq. Ft.:	1,750
$/Sq. Ft.:	$309
Lot Size:	–
Property Type:	Condominium
Style:	Spanish
Year Built:	2000
Stories:	3+
Floor:	1
Area:	Oak Creek
County:	Orange
MLS#:	S522833
Source:	SoCalMLS
Status:	Active
On Redfin:	286 days
Unsold in 90+ days

The standards for gourmet kitchens must be falling. It appears you don't even need granite, or stainless steel appliances, or anything better than an apartment to qualify as a gourmet kitchen. I guess I need to remember that lies like this are what we pay realtors for.

• This property was purchased on 2/26/2004 for $589,000. The owner used a $525,000 first mortgage and a $64,000 downpayment.
• On 6/7/2005 he refinanced for $529,989 with an Option ARM with a 1% teaser rate, and he opened a HELOC for $90,000.
• On 7/25/2006 he refinanced again for $592,000 with an Option ARM, and he opened a HELOC for $73,999.
• Total property debt is $665,999.
• Total mortgage equity withdrawal is $140,999 including his downpayment.

If this property sells for its asking price, Washington Mutual stands to lose $158,493.

{book}

Lady luck and the four leaf clover

Ever since you put me down

Shakey Ground— The Temptations