Help — The Beatles

Our new President will need help to address the problems in the residential real estate financing system that resulted in The Great Housing Bubble. My full proposal is here: Preventing the Next Housing Bubble.pdf. The following is an exerpt from this proposal:

The secondary mortgage market was created in the 1970s by the government sponsored entities, Freddie Mac, Fannie Mae, and Ginnie Mae. This market was expanded by the creation of asset-backed securities where mortgage loans are packed together into collateralized debt obligations (CDOs). This flow of capital into the mortgage market is a necessary and efficient tool for delivering money to borrowers for home mortgages. This market must remain viable for the continued health of residential real estate markets. The problem during the Great Housing Bubble was that the buyers of CDOs did not properly evaluate the risk of loss through default on the underlying mortgage notes that were pooled. The reason these risks were not evaluated properly is due to the appraisal methods used to value real estate serving as collateral backing up these loans.

There is one potential market-based solution that would require no government regulation or intervention that would prevent future bubbles from being created with borrowed capital: change the method of appraisal for residential real estate from valuations based exclusively on the comparative-sales approach to a valuation derived from the lesser of the income approach and the comparative-sales approach. Both approaches are already part of a standard appraisal, so little additional work is necessary – other than appraisers will have to focus on doing the income approach properly. In the current lending system, the income approach is widely ignored. This change of emphasis in valuation methods could come from the investors in CDOs themselves. When the fallout from the Great Housing Bubble is evaluated, it is clear that the comparative-sales approach simply enables irrational exuberance because the past foolish behavior of buyers becomes the basis for future valuations allowing other buyers to continue bidding up prices with lender and investor money. Prices collapsed in the Great Housing Bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. There is no way to prevent future bubbles, and the commensurate imperilment of our financial system, as long as the comparative-sales approach is the exclusive basis of appraisals for residential real estate.

Investor confidence in the market for CDOs and all mortgages was shaken
during the decline of the Great Housing Bubble – and rightly so.
Investors were losing huge sums, and nobody clearly understood why.
There was a widespread belief these losses were caused by some outside
factor rather than a systemic problem enabled by the lenders and
investors themselves. For investor confidence to return to this
market, investors must first ascertain a more accurate evaluation of
potential losses due to mortgage default. This requires an accurate
appraisal of the fundamental value of the residential real estate
serving as colla-teral for the mortgage loans that comprise the CDOs.
Since the fundamental value of residential real estate, the value to
which prices ultimately fall during a price decline, is determined by
the potential for rental income from the property, revaluing properties
using the income approach would provide a more accurate measure the
value of the mortgage note and thereby the CDO.

The ratings agencies who rate the various tranches of
CDOs must adopt the method of valuation utilizing the lesser value of
the income approach and the comparative-sales approach. The ratings
agency’s recommendations and ratings carry significant weight with
investors, and the ratings agencies clearly made a tragic error in
their ratings of CDOs during the Great Housing Bubble. If the ratings
agencies properly evaluate the underlying collateral backing up the
mortgages that are pooled together in a CDO, investors will regain
confidence in the ratings, and money will return to the secondary
market. If investors in CDOs recognize the chain of valuation as
described, they would be unwilling to purchase CDOs valued by other
methods. If investors are unwilling to purchase CDOs where the
underlying collateral value is measured using the comparative-sales
approach and instead demand a valuation based on the income approach,
the syndicators of CDOs will be forced to respond to investor demands
or they will not be able to sell their syndications. Investors and the
ratings agencies can mandate a new valuation method for residential
home mortgages.

In September of 2008, the Federal Government
took “conservatorship” of the GSEs responsible for maintaining the
secondary mortgage market. With the collapse of the asset-backed
securities markets and CDOs, the GSE swaps were the only viable market
for mortgage paper. This provides a unique opportunity for changing the
market dynamics with limited government intervention. If the government
in its role as conservator were to decide to mandate a change in
appraisal methods, the secondary market would be forced to accept this
change. Like any sweeping change in methodology, it could be phased in
over time to properly train appraisers and work out the details of
implementation. If the GSEs lead, the rest of the market will follow.

The
main objection with the income approach is the difficulty of evaluating
market rents, particularly in markets where there may not be many (or
any) comparative properties for rent in the market. This is an old
problem, one that has been studied in great detail by the Department of
Labor Bureau of Labor Statistics. Comparative rents have been
collected by the DOL since the early 1980s as part of their calculation
of the Consumer Price Index. The problem of irrational exuberance in
the late 1970s in coastal markets, particularly California, caused the
consumer price index to rise rapidly. Since the CPI is widely used as
an index for cost-of-living adjustments, volatility in this measure
caused by the resale housing market needed to be urgently addressed.
After over a decade of study, the DOL decided to value the change in
housing costs by a comparative rental approach rather than a change in
sales price approach used previously. This smoothed the index and
reduced volatility because the consumptive aspect of housing services
were tethered to rents and incomes rather than being subject to the
volatility caused by irrational exuberance in the housing market.

The
Department of Labor Bureau of Labor Statistics measures the market
rental rate in markets across the United States. It breaks down the
market into subcategories based on the number of bedrooms, and it does
a good job of estimating market rents in the various subcategories.
These numbers are updated each year. The figures from the DOL would
serve as a basis for evaluation of market rents, and it may be the only
basis in areas where there are few rentals. In submarkets where there
is sufficient rental activity, the income approach can use real
comparables to make a more accurate evaluation. Appraisers will decry
the lack of available data on rentals as many rentals, particularly for
single-family detached homes are done by private landlords who do not
report these transactions; however, if this method of appraisal were
the standard, private companies would spring up to track these
transactions and maintain an up-to-date database. Valuing properties
based on the income approach may be more difficult than the
comparative-sales approach, but when the latter method is fundamentally
flawed, ease-of-use is not a compelling reason to continue to rely on
it.

{book}

There is also the objection that the income approach
method of valuing residential real estate has the same problems as the
comparative-sales approach because both approaches rely on finding
similar properties and making an estimation of market value by
adjusting the values of comparative properties. In both approaches the
appraiser must explain their reasons for the adjustments to justify the
appraised value of the subject property, and this is a potential source
of abuse of the system. No system is perfect, but the potential to
inflate prices though manipulating appraisals based on the income
approach is far less than the potential problems emanating from the
comparative-sales approach because the basis of adjustment in the
income approach is a properties fundamental value whereas the basis of
adjustment in the comparative-sales approach is the prices paid by
buyers subject to bouts with irrational exuberance. If lenders start
accepting appraisals where the income approach contains adjustments to
value that increase the appraised amount 100% – something that would
have been required to justify pricing seen during the Great Housing
bubble – then the system is hopelessly broken. The main argument for
using the income approach is that its basis is the fundamental value
whereas the basis for the comparative-sales approach is whatever price
the market will currently bear. Prices are not likely to decline below
a properties fundamental value where as a property may decline
significantly from a point-in-time estimate of market value. Using the
income approach lessens the risk to lenders and investors and ensures
the smooth operation of the secondary mortgage market. Using the
comparative-sales approach exclusively results in the turmoil witnessed
during the price decline of the Great Housing Bubble.

Asking Price: $5,000,000

Income Requirement: $1,250,000

Downpayment Needed: $1,000,000

Monthly Equity Burn: $41,666

Purchase Price: $5,500,000

Purchase Date: 11/22/2006

Address: 28 Salt Bush, Irvine, CA 92603

Beds:	5
Baths:	6
Sq. Ft.:	6,000
$/Sq. Ft.:	$833
Lot Size:	0.54 Acres
Property Type:	Single Family Residence
Style:	Tuscan
Year Built:	2006
Stories:	2
View:	Canyon
Area:	Turtle Rock
County:	Orange
MLS#:	R805382
Source:	SoCalMLS
Status:	Active
On Redfin:	164 days
Unsold in 90+ days

When this beautiful property was purchased on 11/22/2006, the owner used a $4,175,000 first mortgage, a $500,000 HELOC, and a $825,000 downpayment. I suspect some of you may have laughed to yourself when I put the income and downpayment requirements for such an expensive home. When homes start getting over $2,000,000 they tend to be cash purchases with much smaller loans. Part of the reason for this is because anyone rich enough to afford a house like that doesn’t need credit, and since you can only deduct the first $1,000,000 it doesn’t pay to have such a large mortgage. However, the owner of today’s featured property did take out a massive mortgage. Can you imagine those payments? Yikes!

The high end is showing signs of stress. This one is almost 10% off. That doesn’t sound like a lot, but when you are talking about such an expensive property, 10% is $500,000. With two years of payments on combined mortgage of $4,675,000 and a $500,000 loss just on the asking price, this owner can’t be too happy.

.

Help, I need somebody,
Help, not just anybody,
Help, you know I need someone, help.

Help me if you can, I’m feeling down
And I do appreciate you being round.
Help me, get my feet back on the ground,
Won’t you please, please help me, help me, help me, oh.

Help — The Beatle

Liar — Rollins Band

Wonder why things are going so well
You want to know why?

cause Im a liar, yeah, Im a liar

Remember all the fun speculators had with stated-income loans? Loan documentation is
usually a routine part of obtaining financing. Lenders ordinarily
require a borrower to provide documentation proving income, assets and
debt. However, during the final stages of the Great Housing Bubble,
loan documentation was seen as an unnecessary barrier to completing
more transactions, and loan programs which circumvented normal
documentation procedures flourished. In short, liar loans were everywhere.

So are these people getting their comeuppance? No. In fact, they are getting a second chance, and this time they get to lie about income in the other direction. Let me explain.

So you stagger back home and wait for nothing
But the solitary refinement of your room spits you back onto the streets

Everyone is doing loan modifications now: Citibank, the GSEs, everyone. They must. You saw in yesterday’s post how destructive the upcoming wave of ARM resets is going to be, and the lenders know this. They will do every loan workout they can to avoid more foreclosures. Part of the loan workout requires the borrower to demonstrate they are unable to make payments, and their income is going to be used to figure out how much principal reduction and other loan terms the bank will adjust to accommodate them. I think you can see where this is going… All the people who exaggerated their incomes to obtain more house than they can afford, are now trying to look as poor as Church mice to get the biggest mortgage principal reduction they can: the reverse liar loan. They lied to get in, now they get to lie in order to keep it. We have a great system in place, don’t you think?

The problem is even bigger than that. The whole loan modification process has built-in moral hazard that is going to burn lenders on a grand scale. I received an email from a realtor friend (yes, some realtors actually like me) that had this story to tell:

A
friend of mine from college purchased a new home in Victorville for
around $450,000. At the same time many others in his neighborhood
purchased as well. My friend and his neighbor were both paying their
mortgage. However, his neighbor called his mortgage company requesting
a loan modification. The mortgage company explained that he is not in
default and therefore they will not complete a loan modification. My
friend’s neighbor decided to quit paying his mortgage while he
continued to make payments on his four-wheeler, quad, and other toys
and make trips to the desert weekly. He called the mortgage company
back a couple of months later and received a principle reduction of
circa $100,000. My friend, a very smart person, math thesis of the year
award winner in college, with a masters degree in math, vice principle
at a high school making excellent money, expresses to his neighbor that
he is upset that his home is worth $100,000 less than he paid for it,
however his neighbor then explains that he received a $100,000
principle write down by not paying his mortgage and negotiating a loan
modification. Stopping by his house a few weeks ago on the way back
from Las Vegas my friend explained this to me and said he thinks that
he is going to get a modification as well.

These loan modifications are going to cause a chain reaction through entire neighborhoods and communities. Are you going to be the only one in your neighborhood who didn’t quit making payments in order to get a loan modification? It is really that simple: stop making payments, and you will get a loan modification. Keep making payments, and you will not.

What is the morality of this? Is this wrong? The holder of your mortgage is offering to give you a great deal of free money if you stop making payments. You are not forcing them; they are freely offering the loan modifications to anyone who qualifies. By not making a few payments, you qualify. If Uncle Sam said to you that you must pay your full tax bill by April 15th, but if you are 90 days late, we will knock 1/3 off. What would you do? Is it immoral to take the discount?

The government’s and the lender’s response to this financial crisis is evolving from an irritating curiosity to a complete WTF-are-you-doing series of terrible missteps. How much more wrong could they be? How much more damage are they going to do by trying to solve the problem? How much is this going to end up costing the rest of us? Is this where our $700,000,000,000 is going? Let them eat cake.

Today’s featured property is a typical Irvine rollback. The owner bought at the peak with an Option ARM, and now he is giving up and letting the property go. Perhaps he should just do a loan modification and get $200,000 knocked off his mortgage…

Asking Price: $799,000

Income Requirement: $199,750

Downpayment Needed: $159,800

Monthly Equity Burn: $6,658

Purchase Price: $950,000

Purchase Date: 9/8/2005

Address: 4471 Elm Tree Lane, Irvine, CA 92612

Beds:	4
Baths:	3
Sq. Ft.:	2,643
$/Sq. Ft.:	$302
Lot Size:	5,500 Sq. Ft.
Property Type:	Single Family Residence
Style:	Contemporary
Year Built:	1970
Stories:	2
Area:	University Park
County:	Orange
MLS#:	S539024
Source:	SoCalMLS
Status:	Active
On Redfin:	128 days
Unsold in 90+ days

I really don’t know what these owners are thinking. This property was originally listed in July for $799,000, and then it was pulled from the market. It was relisted at a higher price in September (must have been that huge rally we had), and now they have lowered the price back to the original asking price. It is still too high. If it was a reasonable price, they would have had offers months ago. I guess losing a lot of money has affected their judgment.

This property was purchased at 9/8/2005 for $950,000. The owner used an Option ARM for $712,500, a HELOC for $100,000, and a downpayment of $137,500. They then spent a lot of money renovating the property and got another HELOC for $143,000 (They probably paid off the other one). The total debt on the property is $855,500 assuming the final HELOC is fully tapped. There is a good chance it isn’t. This seller may be in a holding pattern at $800,000 because that is what they need to pay off the loans. They know their downpayment is gone. All that work, and they get to lose all their money. Bummer.

{book}

You think youre going to live your life alone
In darkness and seclusion… yeah, I know
Youve been out there and tried to mix with those animals
And it just left you full of humiliated confusion
So you stagger back home and wait for nothing
But the solitary refinement of your room spits you back onto the streets
And now youre desperate and in need of human contact
And then you meet me and yur whole world changes
Because everything I say is everything youve ever wanted to hear
So you drop all you defenses, Im perfect in every way
cause I make you feel so strong and so powerfull inside
You feel so lucky
But your ego obscures reality that you never bothered to
Wonder why things are going so well
You want to know why?

cause Im a liar, yeah, Im a liar
Ill tear (rip) your mind up, Ill burn your soul
Ill turn you into me, Ill turn you into me
cause Im a liar, a liar, a liar, a liar…

Liar — Rollins Band

Stuck in the Middle With You — Stealers Wheel

All bailout measures have embedded within them serious issues of moral
hazard. Both lenders and borrowers were extremely foolish during the
real estate bubble. To bail them out at the expense of the wise and
prudent will discourage fiscally responsible behavior and encourage
wild risk taking and speculation. For instance, lets say both you and
your neighbor bought a house in 1998 before the bubble inflated. You
both paid $200,000. You sacrificed and paid down your mortgage in the
intervening 10 years, and now you owe $150,000 on your house. Your
neighbor was lured by the free money accumulating as appreciation and
took out an additional $400,000 in home equity lines of credit and
refinancings and lived the good life. This neighbor was driving around
in new cars, taking vacations, buying expensive toys and pretending to
be rich. Now you owe $150,000 on your house, and your neighbor owes
$600,000. Your neighbor cannot make the payments and is asking for a
government bailout, principal reduction and a whatever other handouts
he can get. So now, you the taxpayer, is going to be asked to pay off
your neighbors bills. You, who was responsible while you neighbor was
not, are being punished for your responsibility while your neighbor has
no consequences. What will stop your neighbor from doing this again?
What will stop you from doing this next time? I profile individual
properties every day, and I can tell you
from the property records I view daily that this conduct was not the
exception, it was the rule. There is no bailout program currently
proposed or enacted that does not have this moral hazard issue.

Clowns to the left of me,
Jokers to the right, here I am,
Stuck in the middle with you.

There are provisions that could be added to a more wide-reaching
bailout proposal that might address some of these problems. In the
recent FHA bailout program, the owner must give up a percentage of
equity to participate. This is a great idea, and I have witnessed
homeowners who were in trouble pass on this option because they were
too greedy to give up future appreciation. Equity sharing needs to be
part of any bailout program. The programs enacted now are offering
workouts, but they are only dangling a carrot in front of borrowers,
there is no real stick to compel them. Ordinarily losing one’s home
would be enough of an incentive to do a workout, but when homeowners
are hugely underwater; their best financial move is to let the property
go in foreclosure. This incentive needs to be changed. Congress made a
serious mistake when they decided to forgive the tax indebtedness on
people who do not pay back mortgage debt. This simply made it easier
for people to walk away. It needs to be harder, much harder. If you
really want to compel people to participate in loan workout programs,
there needs to be serious financial repercussions for not doing so.
Taxing debt forgiveness is one potential incentive, but the bigger one
is to make this debt permanent — don’t let people discharge this debt
in a foreclosure or a bankruptcy. If walking away from their mortgage
debt benefits them in no way, people will not walk away.

I would propose the following: When Obama takes office we might see
a 90-day moratorium on foreclosures (by itself, this is a horrible
idea). Put all borrowers on notice, you have 90 days to begin a workout
plan with your lender. If you fail to do so, and if you then go into
foreclosure, you will pay taxes on the loss, and if you have capacity
to pay back the debt, you will be required to work out a repayment
plan. Bankruptcy judges already have the power to force people into
chapter 13 rather than chapter 7 bankruptcy, so this would be easy to
enforce. There is precedence for this kind of bankruptcy protection for
certain loans: government insured student loans are not dischargable in
bankruptcy. Since the government insures these loans, they ensure the
insurance program does not lose money by preventing forgiveness of this
debt. Now that the government is “conservator” of the GSEs, they are
providing a similar government-backed insurance to mortgage debt. They
should have a similar no-bankruptcy policy on this debt as well. The
effect of this policy would be to strongly compel those who need a loan
workout to get one. For those who fail to qualify for a loan workout,
they are exempted from these consequences.

This proposal would effectively force everyone into a loan
modification program who needed one to make their payments. It would
greatly reduce the number of foreclosures that are still in the
pipeline, and it would give the banks as much cashflow as they will see
as the fallout from this mess continues. However, this will not stop
home prices from falling. If stabilizing home prices is truly a
priority, there is no program that can accomplish this. Houses are too
expensive. Prices must fall down to levels of affordability before
prices will stabilize. There are only two ways to make houses more
affordable: either prices must fall or incomes must rise. The housing
bubble was about experimenting with financing terms to increase
affordability. That experiment failed miserably. Making incomes rise is
not something that can be accomplished through bailouts or any
government policy directed at housing. Since financing innovations
failed, and since raising incomes is not a viable alternative, prices
will continue to fall.

Trying to make some sense of it all,
But I can see that it makes no sense at all,
Is it cool to go to sleep on the floor,

Today’s featured property hass owners who would not mind the “carrot and stick” approach to solving the housing crisis: they were fiscally responsible. I see so few of these, that I would like to celebrate them when I do come across them.

Asking Price: $699,000

Income Requirement: $174,750

Downpayment Needed: $139,800

Monthly Equity Burn: $5,825

Purchase Price: $235,000

Purchase Date: 6/25/1994

Address: 15172 Nantes Circle, Irvine, CA 92604

Another crappy description in ALL CAPS and littered with exclamation points.

What is that over the kitchen? Is that the bat cave?

When these people bought the property for $235,000 on 6/25/1994, they used a $164,500 first mortgage and a $70,500 downpayment. The only other mortgage note in the records is a HELOC from 2000, that probably was not used (there is no pattern of borrowing here). I salute these people. They did not get caught up in the foolishness of the housing bubble. If they get anything close to their asking price, they stand to make a lot of money. Good for them.

{book}

Well I don’t know why I came here tonight,
I got the feeling that something ain’t right,
I’m so scared in case I fall off my chair,
And I’m wondering how I’ll get down the stairs,
Clowns to the left of me,
Jokers to the right, here I am,
Stuck in the middle with you.

Trying to make some sense of it all,
But I can see that it makes no sense at all,
Is it cool to go to sleep on the floor,
‘Cause I don’t think that I can take anymore
Clowns to the left of me, Jokers to the right,
Here I am, stuck in the middle with you.

Stuck in the Middle With You — Stealers Wheel

Desire — U2

The last line of defense for the housing bulls is the fallacy of pent-up demand. Belief in this fallacy relies on people’s inability to distinguish between desire and demand.

Most people want a house. About 65% of Orange County residents own their homes, but probably 95% of residents wish they did. The desire for housing always exceeds the supply because there is always some segment of the market who is unable to obtain home ownership due to the cost of housing and a lack of available credit. True demand is the amount of money those with the desire for housing can raise to put toward the purchase of real estate. If those with the desire for real estate do not have savings and if they cannot qualify for a loan, they create no measurable demand. When realtors make the assertion that there is pent up demand, they are correctly surmising that there is an increasing number of people who want real estate who cannot obtain it, they are totally incorrect in their idea that this demand is merely sitting on the fence waiting to enter the market at a time of their choosing.

California’s residential real estate market is completely controlled by loan terms and the availability of credit. I first discussed this phenomenon in the posts Your Buyer’s Loan Terms and The Anatomy of a Credit Bubble. When credit terms are restrictive, when 30-year fixed-rate conventionally-amortized mortgages are the only available financing product, prices reflect the amounts of money people’s incomes can finance under those terms (as they were before the bubble). When credit terms are loose, when stated-income, Option ARMs, low interest rates, high DTIs and other terms and conditions allow people the ability to borrow two or three times the amounts available under restrictive terms, prices in the residential real estate market will be reflective of those terms (as they were in the bubble). Local supply and demand issues may temporarily halt the rise and fall to a new equilibrium level, but supply analysis alone completely fails to predict this new equilibrium or explain how prices got there.

Analyzing supply and calculating the time on the market is one method of trying to predict future price movements. The theory is that when inventory is low and sales volumes are high that prices must rise, and visa versa. This market snapshot of the balance between supply and demand can be useful, but it is notoriously unreliable because it does not examine the cause of the demand and it falsely assumes that demand is ever increasing. When you look at the chart below showing months of inventory from 2002-2007, you see a false spike in 2004. This signal would ordinarily foretell the collapse of market pricing, but since demand was stimulated in 2004 through the widespread sales of Option ARMs and the near elimination of lending standards, the inventory was quickly absorbed and prices continued higher. Similarly, right now in our market, inventory is down from the peak, and months on the market has fallen below 6 months. This would ordinarily be a signal of a price stabilization or future price increases. However, since credit is continuing to tighten and loan terms are becoming more restrictive, demand, as properly measured by dollars, will continue to weaken, and prices will continue to fall.

California has had a chronic housing shortage for many years. The
mechanisms for bringing supply to the market are slow and cumbersome,
and many local municipalities restrict the ability of developers to
bring new supply to the market or outright forbid it. It is not
uncommon in California for price points to favor the construction of
new dwelling units and for municipalities to forbid its construction.
In these circumstances, the normal mechanism for rebalancing supply and
demand do not function. In most states, when there is a demand for
housing, homebuilders will go to work and provide dwelling units to
meet this demand. The increase in supply blunts the price impact
greater demand has on market prices. This is why many states where
there are fewer land-use controls, they experience much less volatility in
their housing markets.

Of course, this is one other factor that contributes to the wild
volatility in California’s residential real estate market: irrational
exuberance (kool aid intoxication). In California’s markets, when
prices start to rise, fear and greed creates a positive feedback loop
that compels people to buy more (if credit is available) and drive
prices even higher. In other markets rising prices creates a negative
feedback loop that causes people to shun higher prices and not buy real
estate. This psychological reaction to market price fluctuations is
different for each market. Because supply delivery mechanisms are
dysfunctional in California, it is easier for Californian’s to drive
prices higher quicker than it is in other markets. This feeds the local
psychology and creates even more volatility.

Prices have already dropped 20%-25% in Irvine from their peak in
2006. This initial price drop did not occur because of foreclosures or
supply issues. It occurred because tightening credit has stopped market
participants, those desirous of real estate, from bidding prices as
high as they could in the past. The rate of decline is certainly
impacted by foreclosures and inventory problems, but the overall price
levels are determined by incomes and the amount of money people can
borrow based upon it. Credit will continue to tighten, and the amounts
people will be able to borrow will continue to decline. We have already
witnessed a spike in jumbo interest rates as risk premiums are being
priced in to the loans that are not backed by the GSEs. As the
repricing of risk continues, interest rates will continue to rise. This phenomenon will be most noticeable for jumbo loans (the high end is doomed). Also, as the
recession begins to impact incomes, the borrowing power of potential
buyers will be reduced even further. Currently, there are still many
5-year and 10-year ARMs being used to purchase real estate with very
high DTIs. As these products become less common (they are just dragging
out the foreclosure problem,) and as DTIs continue to decrease, bids
will decline, and prices will decline with them.

Some of the people I know that purchased in this market did so
because they saw the tightening credit as something that was going to
take away their ability to finance the sums large enough to buy real
estate. In short, they thought they would be priced out forever. This
reasoning puts the cart before the horse. The tightening of credit
terms is going to cause prices to fall because it directly determines
the market bids. Right now, the high end market is characterized by
very large bid/ask spreads. Sellers are holding out for wishing prices
while buyers are seeing their bids get smaller and smaller due to
tightening credit. Transaction volumes are very low, and while sellers
hold to their fantasies, there will be very few transactions. This will
not change until the Alt-A and Prime ARM resets force asking prices
lower. We have seen this phenomenon before. The low end of the market
in the areas most decimated by subprime ARMs is already at rental
parity, and there may be overshoot in these areas. The bid/ask spreads
in these submarkets are tight because there are few sellers bothering
with wishing prices, and sales are dominated by REOs.

In the post Houses Should Not Be a Commodity, I went into some detail on the stages of market psychology and buyer behavior. In this first stage of the decline, there are still people who are willing to extend themselves to the maximum to obtain real estate because they believe they must. The bubble psychology has not really changed, but the technical factors of credit availability and terms have begun to limit bids. This is why prices have only corrected about half way to date. In the next stage, people will start voluntarily reducing their debt-to-income ratios because they don’t want to stretch themselves to buy what is obviously a depreciating asset. I discussed that phenomenon in more detail in Our Changing Relationship to Debt. The next phase in the drop is going to be characterized by a reluctance to purchase exacerbated by even more stringent financing terms.

If you really want to understand the real estate cycle in California, you need to understand the credit cycle. The changing availability of credit and the fluctuations in the amounts of money financed with people’s incomes are the key determinants to price levels in our residential real estate markets. Right now, we are in a tightening cycle, and this will cause prices to continue to drop. Someday, long after our current credit crisis has passed and the credit markets recover, we will see a loosening of credit, and we may build another residential real estate bubble. Perhaps lenders and borrowers alike have learned the painful lessons of the Great Housing Bubble, or perhaps not. Greed springs eternal.

.

Yeah…
Lover, I’m on the street
Gonna go where the bright lights
And the big city meet
With a red guitar…on fire
Desire

Desire…

Desire — U2

Y.M.C.A. — Village People

With 100% financing available in the Great Housing Bubble, it is a wonder all the Y.M.C.As didn’t close down. If you are down and out, all you needed to do was fill out a liar loan application and move into your new house. Wait a few months, and you could open a HELOC and start spending all that free money. What could be better?

Today’s featured property is representative of stress at the high end of the market. Most of the properties I have profiled to date have been at the low end because this is where the market stress is the most acute. The big push in prices occurred because many people took out 100% financing to buy starter homes. More expensive homes were generally move-up properties, and the buyers transferred the equity from the sale of their starter home. This puts many of them in a somewhat stronger financial position, so the acute stress of the credit crunch hasn’t impacted them to the same degree. Plus, many of these borrowers used Alt-A loans which are not due to reset until 2009-2011. A great many of these borrowers have taken on huge debt loads well in excess of their incomes, and many will collapse when their resets hit. This hasn’t happened yet, but it will.

Asking Price: $999,888

Income Requirement: $249,972

Downpayment Needed: $199,977

Monthly Equity Burn: $8,332

Purchase Price: $1,150,000

Purchase Date: 3/14/2007

Address: 5 Villager, Irvine, CA 92602

Beds:	5
Baths:	4
Sq. Ft.:	3,027
$/Sq. Ft.:	$330
Lot Size:	–
Property Type:	Single Family Residence
Style:	Mediterranean
Year Built:	2002
Stories:	2 Levels
Area:	Northpark
County:	Orange
MLS#:	S521208
Source:	SoCalMLS
Status:	Active
On Redfin:	196 days
Unsold in 90+ days

How did they come up with that asking price. Is the next price reduction going to be down to $888,777? It might sell there…

Did you realize they were giving out 100% financing on $1,150,000 properties in March of 2007? No wonder the median didn’t really drop until the credit crunch hit. Today’s owners (occupants who have stopped paying rent to the bank,) used 100% financing, and now they are walking away. This isn’t as common at the high end, but it still occurs. If this property sells for its asking price, Countrywide is going to lose most of the second mortgage they provided. The total loss after a 6% commission will be $210,105. I wonder if gobbling up Countrywide is giving Bank of America indigestion.

.

Several people have asked about the accuracy of my post Predictions for the Irvine Housing Market.
I have the DataQuick numbers through April of 2008, so we can take a
look. First, when I first made the chart below, I did not have accurate
numbers. The base number I used of $687,000 was incorrect.

Using the three-month moving average of prices, the real number was
$723,750. With this new, more accurate number, we can compare the
projected drop with the real figures.

Well, it is even worse than I imagined. When I first suggested that
Irvine’s median home price might decline 12% in a single year, it was a
bold prediction. Prices had never dropped that much in Irvine — ever
— much less in a single year. Given the condition of the market, I
felt the number was conservative, but to see it actually drop more than
my prediction is remarkable. I guess the bulls should be glad, it isn’t
as bad as bad can get:

.

Young man, there’s no need to feel down.
I said, young man, pick yourself off the ground.
I said, young man, ’cause you’re in a new town
There’s no need to be unhappy.

It’s fun to stay at the y-m-c-a.
It’s fun to stay at the y-m-c-a.

Y.M.C.A. — Village People