I Want It All — Queen

We all want affordable housing. There are numerous government programs designed to provide low-cost rental and ownership properties to people in all walks of life. Lenders, builders, realtors and buyers all benefit from affordable housing because affordability means an increase in transaction volumes and more money into the pockets of those dependant on the real estate market. The difficult problem with affordable housing is how to provide it without making it unaffordable. Finance is not the answer.

Most of those who worked in the mortgage business really believed the “financial innovation” meme. I have contended that the entire idea is a fallacy. At its core, the belief among financiers is that affordability products reach more customers and permit home ownership for a larger number of people. The statistics during the Great Housing Bubble seem to warrant this enthusiasm.

Home Ownership Rates from 1984-2005

Unfortunately, increasing the home ownership rate also dramatically
increased prices and created an unsustainable bubble in both. Why is
that? As with all macroeconomic concepts, it emerges from the
microeconomic circumstances of individual borrowers and buyers. If you
look back to the lending practices which endured the crash of the last
housing bubble in the late 80s, you see that the financing arena was
dominated by 30-year conventionally amortizing loans with 20%
downpayments and conservative debt-to-income ratios. This is the only
loan program that has relatively low default rates even if prices
decline. So what happens when a new “affordability” product is introduced into this stable system?

Let’s look at an example. Assume our would-be buyer makes $100,000 a
year and could qualify for a $300,000 loan using conventional
financing. He has save $100,000 for a downpayment and costs. He is
looking to buy a $375,000 home. In our stable system, he would find a
home relative to his income. If he is making the median income, then he
would be able to afford a median priced home. Now let’s say that
lenders “innovate” and start offering interest-only loans with a
10-year fixed term followed by an interest rate reset and a recast to a
fully amortized loan on the remaining 20-year schedule (sound
familiar?) Our buyer is conservative and does not want to purchase on
these risky terms and take the risk on future interest rates or the
need to refinance later because he may not be able to afford the higher
payment in 10 years. However, other potential buyers will ignore
these risks and embrace the new financial innovation because it allows
them to buy a house they previously could not afford. The same payment
on an interest-only schedule now finances 15% more money, so other
potential buyers in the marketplace who are making $100,000 can now
finance around $345,000 instead of $300,000. When our conservative
buyer goes out in the open market to bid on properties, he now finds
himself being consistently outbid on properties. At this point, he has
a choice to make: either embrace the new financial innovation and bid
15% higher for the same property, accept a lower quality property, or
not buy a home. The affordability product did not make houses more
affordable, it made them less so.

Our stable system without affordability products saw annual appreciation of around 4% because this is how much incomes and rents were rising (this was true for most national markets outside of California,)
and it reflects the amount of increased borrowing power available to
homebuyers each year. With appreciation only running at 4%, market
participants do not get excited about making millions in real estate,
nor are they worried about buying today because they may get priced out
tomorrow. Affordability products change all that. With the introduction of interest-only borrowing to the system, prices can very quickly appreciate 15% as the financing system seeks a new equilibrium dominated by the new affordability product. This sudden and dramatic rise in appreciation can be the precipitating factor that ignites a housing price bubble. Once people start drinking the appreciation kool aid, they begin to stretch their debt to income ratios to buy properties with the belief that the extra investment will be recouped by rising home values. Plus the fear of being priced out compels people to buy for fear of not being able to later. The value of real estate detaches from its fundamental value, and the perception of value is driven by appreciation alone.

Behavioral Finance Theory

The bubble of the late 80s became dominated by interest only products, and buyers began using DTIs well in excess of the normal 28% limit. However, that bubble rally was of much shorter duration and of much lower volume toward the peak, so the majority of owners still had conventional financing. Mortgage equity withdrawal was much less common, so not as many households were overextended. The result was a period of moderate foreclosure activity and slowly declining prices until affordability returned based on conventional financing products.

Debt-To-Income Ratio 1986-2006

What really sets the Great Housing Bubble apart was the “innovation” which took off in late 2003: the Option ARM. As you can see in the table above, the Option ARM, or negative amortization loan, allowed borrowers to finance twice amount a conventional mortgage would provide. Hence, prices were bid up to twice the price level sustainable with conventional mortgage financing — a price level to which the market is in the process of returning.

In short, affordability products did not make prices more affordable, they inflated a massive housing bubble.

This fact is important because if the truth of affordability products is not recognized for what it is — a series of unstable loan programs that inflate house prices — these products may return to ravage our housing market again. Affordability products do not help buyers get into homes, they prevent buyers from getting into homes under terms which are sustainable. Temporary home ownership is renting. Affordability products simply allow people to rent from a lender. Perhaps some may sustain home ownership, but unless they were one of the first to embrace affordability products, and unless they refinanced later into a conventional mortgage, they will ultimately lose their illusion of home ownership and go back to renting from a landlord rather than the lender. What good came from all of that?

Will lenders learn the right lessons from The Great Housing Bubble? I doubt it…

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Adventure seeker on an empty street
Just an alley creeper light on his feet
A young fighter screaming with no time for doubt
With the pain and anger cant see a way out
It aint much Im asking I heard him say
Gotta find me a future move out of my way
I want it all I want it all I want it all and I want it now
I want it all I want it all I want it all and I want it now

It aint much Im asking if you want the truth
Heres to the future
Hear the cry of youth (hear the cry hear the cry of youth)
I want it all I want it all I want it all and I want it now
I want it all (yeah yeah yeah) I want it all I want it all and i
Want it now

I Want It All — Queen

Time — Pink Floyd

Whenever someone overpays for real estate, it is justified with platitudes like “if you used conservative financing and stayed within your income, then you will be OK.” Or “If you love the home and you can afford it, everything isn’t about money.” I hope people take comfort with statements like these because the financial cost is much greater than most realize. That is the topic of today’s analysis post: how much is buying at the peak really going to cost?

Today, we will look at two families, the Peakers and the Troughers (gotta love those names, right?) Both families have a combined family income of $150,000 per year, and they have both saved $100,000 they can put toward a downpayment on a house.

It is the Summer of 2006, and each family is looking at a $1,000,000 home. The Peakers think the property is a good deal, so they put their $100,000 down and borrow $900,000 with an adjustable-rate mortgage starting at 6% with a 10-year fixed period followed by a 20 year fully amortized payment at a new interest rate. Their monthly payments are $4,500 a month, but after all of the adjustments for taxes and fees and the other costs of ownership, their total monthly cost of ownership is $6,000 per month. (Please don’t turn the comments into a discussion on the true cost of ownership without reading the linked post.)

The Troughers, on the other hand, made the same calculation and decided that the cost was simply too high. They decided to rent and wait for prices to drop to rental parity. As it turns out, this $1,000,000 home can be rented for $3,000 per month (the cost of ownership was double the cost of rental in the summer of 2006.) In order to make this comparison apples-to-apples, the Troughers have decided that will live the same lifestyle as the Peakers, so they will put $3,000 per month into their downpayment fund while prices are dropping.

Fast forward to 2011: five years later, rents have been increasing at about 4% per year, so the Troughers are now paying $3,500 per month in rent, houses similar to the Peakers are now selling at rental parity which is about $560,000. During this five-year period, the Peakers and the Troughers have enjoyed exactly the same lifestyle: both have had use of a house with similar characteristics, and both have been living on the same amount of disposable income. The Peakers are now $340,000 underwater 5 years into their 10-year fixed term, and they are stressed about what will happen. The Troughers have a mountain of cash, and they are about to buy a home.

The Troughers have accumulated $325,000 in their downpayment fund by adding the rent savings each month and having this compound at 5% interest (the calculations are too cumbersome to post.) The Troughers now buy the comparable house for $560,000 using all of their $325,000 downpayment. This only leaves a $235,000 first mortgage. These Troughers are thrifty people, and in keeping with our all-things-being-equal example, the Troughers are going to continue to put away the same $6,000 a month the house is costing the Peakers. They will put $4,543 toward their mortgage, and the remainder toward other ownership costs. By making this $4,543 monthly payment — something they were used to doing from their 5 years of renting and saving — they will pay off the mortgage completely in 5 years.

Fast forward to 2016: It is now 10 years since the Peakers have purchased, and they still owe $900,000 on the house. Let’s assume they got very lucky, and we quickly inflated another housing bubble that brought the resale value of their home up to $1,000,000 — breakeven. The Peakers are facing a dramatically escalating payment as the 900,000 is about to convert to a fully-amortizing loan over the remaining 20 year term. Their payment will now rise to $6,447. Let’s hope they are making more money to pay for it.

Here we are in 2016, both families have enjoyed the same amount of spending money each month and the same lifestyle (remember the tax benefits are already figured in to the cost of ownership.) The Peakers have a $1,000,000 house on which they owe $900,000. They will either need to make a $6,447 payment or refinance again. The Troughers also own a $1,000,000 house, but their mortgage is completely paid off. Their only cost of ownership is reduced to taxes, insurance and maintenance. Whereas the Peakers are trying to figure out how they are going to make payments, the Troughers suddenly have $4,500 a month extra in their monthly budget, and their net worth is $900,000 higher than the Peakers.

What happens if we do not inflate another bubble, and comparable houses are only worth $800,000? What if interest rates go up to 8% or higher? The Troughers couldn’t care less, they are saving money versus renting, and they have plenty of equity; however, the Peakers are in trouble, and they may lose their home. People who bought at the peak are betting on appreciation, and they are betting against higher interest rates. Not a good bet to make when interest rates are near historic lows and prices relative to fundamental valuations are at unprecedented highs.

You can spin this example any number of ways, no matter how the Troughers save or spend their money, they will come out far, far ahead of the Peakers. They could either enjoy a better lifestyle (no mortgage equity withdrawal for the Peakers,) or save for retirement, or save for their larger downpayment. In the real world, those who did not buy at the peak can balance those options to best suit their needs and wants, the Peakers do not have these options. They are imprisoned in their house. Let’s hope it is a gilded cage.

.

I would like to thank MalibuRenter for providing the conceptual framework for this post in a comment he made last week. I would also like to publically thank him for the editorial job he did on my upcoming book.

.

Ticking away the moments that make up a dull day
You fritter and waste the hours in an off hand way
Kicking around on a piece of ground in your home town
Waiting for someone or something to show you the way

Home, home again
I like to be here when I can
And when I come home cold and tired
Its good to warm my bones beside the fire
Far away across the field
The tolling of the iron bell
Calls the faithful to their knees
To hear the softly spoken magic spells.

Time — Pink Floyd

Swords in the Wind — Manowar

“The wolf also shall dwell with the lamb, and the leopard shall lie down with the kid; and the calf and the young lion and the fatling together; and a little child shall lead them.” Isaiah 11:16

Builders are now leading the charge in our race to the market price bottom. We have made much about the presence of REOs in the market and the downward pressure they put on prices. However, REOs are not the only form of must-sell inventory. The builders also must sell homes or go out of business. Early in the deflation of the bubble, particularly on the Irvine Ranch, builders held to peak prices and watched their sales volumes drop to near zero. Since the credit crunch signaled the end to crazy financing, the builders have been consistently lowering their prices to generate sales and liquidate their inventories. This has happened without much fanfare here on the blog because we focus on the resale market; however, since the builders are also competing with resellers for the small number of available buyers, their activities are important as they will strongly impact resale home prices.

The builders have already trashed the resale market in the Villages of Columbus. Check out 22 Honey Locust now being offered for $350,000 off the original purchase price. The price drops in VOC have little to do with the quality of the homes, the location or anything else. It is almost exclusively due to the activities of the builders trying to get out of the project. It is my opinion that VOC will be on price parity with Westpark in 5 years, and this will not happen through appreciation in VOC.

Today’s featured property is a new home being offered in Portola Springs at $275/SF. That is new construction for $275/SF. What do you think that will do to the resale market? In a normal real estate market (if such a thing exists in California,) new homes command a premium of around 10% over resale mostly because they are new. If you look at the listing price history, you can see this home has already seen a 5% haircut, and it seems likely that builders will need to drop prices further to generate sufficient sales volumes to stay in business. I believe new home sales prices will bottom between $225/SF and $250/SF while most resales will fall to $200/SF or below. Even now at $275/SF, why would someone go pay someone $350/SF or more for a used house when you can get a new for much less? The fact that the builders are at these price levels and still lowering price to generate sales speaks volumes about the future prices of resale homes.

Asking Price: $578,880

Income Requirement: $144,720

Downpayment Needed: $115,776

Monthly Equity Burn: $4,824

Address: 128 Long Grass, Irvine, CA 92618

Beds:	3
Baths:	4
Sq. Ft.:	2,106
$/Sq. Ft.:	$275
Lot Size:	–
Property Type:	Condominium
Style:	Spanish
Year Built:	2008
Stories:	3+ Levels
Area:	Portola Springs
County:	Orange
MLS#:	S524595
Source:	SoCalMLS
Status:	Active
On Redfin:	150 days
Unsold in 90+ days

The realtors in Irvine could learn something from John Laing Homes on how to write a description and stage a home for photography.

If you pan back in Redfin to get a broad area of homes, they will provide a summary at the bottom of the page showing the average asking prices for resale homes. Depending on where you look, this average goes from over $400/Sf down to about $360/SF. If builders are willing to provide homes for $275/SF, and they are still lowering their prices, resellers have little or no hope of achieving these asking prices. Just based on this simple analysis alone, it appears that resale prices in Irvine still have to fall 30% to 40%. Granted, the asking prices are not where the transactions are, but it is where the fantasies of resellers resides. It certainly appears these asking prices have a deep decline in front of them…

.

I Surrender My Soul Odin Hear My Call
One Day I’ll Sit Beside Your Throne In Valhalla’s Great Hall
Like So Many Before Me I’ll Die With Honor And Pride
The Right Of A Warrior Forever To Fight By Your Side
Send A Sign Raise The Sail Wave A Last Goodbye
Destiny Is Calling Immortality Be Mine

I Will Lead The Charge My Sword Into The Wind
Sons Of Odin Fight To Die And Live Again
Viking Ships Cross The Sea, In Cold Wind, And Rain
Sail Into The Black Of Night Magic Stars Our Guiding Light

Swords in the Wind — Manowar

Right Place Wrong Time — Dr. John

Financial markets are fickle monsters. Whichever way the herd moves the market will go the other direction. I first described this phenomenon in the post How Subprime Lending Created the Housing Bubble, and I extrapolated on that idea in What is Past is Prologue. If you were not a reader of the site in early 2007, I suggest you click on those links and check them out.

During the bubble rally, prices were pushed up the herd mentality. As prices rose, more and more people were convinced prices would continue to rise, so the pool of buyers swelled. Credit standards dropped to qualify more buyers, and the party went on and on. When credit standards were basically eliminated in 2004 and downpayments were eliminated, the buyer pool saw one last burst of activity until everyone that could buy, did buy. The herd had all “gone long” on real estate. The problem came when the pool of available buyers was exhausted and there was nobody left to push prices any higher. Once the herd had all purchased, the only thing they were able to do was sell. When the entire herd became sellers and there were no more buyers available, sales volumes dropped off, inventories increased and prices began to fall.

The behavior of the herd can be illustrated through the behavior of the individual participants. Today’s featured property was purchased by a realtor in late 2003 for no money down. He pulled out a bunch of equity, and now he has listed the property at a price that will pay off the debt and get him out of the transaction. There are hundreds if not thousands of people out there just like today’s owner trying to get out of their properties. The collective term for this group is called “overhead supply.” It is overhead supply that will prevent any appreciation until the market clears them out. The way markets normally do this is through a process known as “capitulatory selling.” People resign to their fate and sell at a loss. Some will do it willingly, and some will do it through foreclosure, but the market will clear them all out eventually. The way it looks right now, the process of capitulatory selling is increasing, and it will likely continue to increase through 2009.

Asking Price: $789,000

Income Requirement: $197,250

Downpayment Needed: $157,800

Monthly Equity Burn: $6,575

Purchase Price: $594,000

Purchase Date: 9/30/2003

Address: 36 Canopy, Irvine, CA 92603

Fabulos? AMINITIES+GIM? What is a GIM?

I guess proper punctuation is optional. What IS the DEAL with INTERMITTENT caps LOCK?

I suppose the owner is responsible for this bad description because the realtor is the owner.

[adsense-ir}

The property was purchased on 9/30/2003 for $594,000 (ignore what Redfin says.) There was a $475,000 first mortgage, a $118,750 second and a $250 downpayment. On 11/19/2004 he refinanced with a $616,000 first mortgage and a $115,500 second pulling out $137,250 bringing the total debt up to $731,000. Thus we have an asking price of 789,000 — he needs to pay off the debt. It is hard to say what this property is worth as there have been no recent comparable sales. Somehow, I doubt he will get his asking price. After the debt service consumes him, this will be a foreclosure candidate.

.

I been in the right place but it must have been the wrong time
I’d have said the right thing but I must have used the wrong line
I been in the right trip but I must have used the wrong car
My head was in a bad place and I’m wondering what it’s good for
I been the right place but it must have been the wrong time
My head was in a bad place but I’m having such a good time

I been in the right place but it must have been the wrong time
I’d have said the right thing but I must have used the wrong line
I’d have took the right road but I must have took a wrong turn
I’d have took the right move but I made it at the wrong time
I been on the trip road but I must have used the wrong car
My head was in a good place and I wonder what it’s bad for.

Right Place Wrong Time — Dr. John

What a Fool Believes — The Doobie Brothers

Kool Aid intoxication is synonymous with irrational exuberance as I outlined in the post What is a Bubble.
It has not always been part of the culture here in California as people have not always believed such foolish ideas. Kool Aid
intoxication is a pathology that infected the populace of California in
the 1970s. Up until the mid 1970s, California had a median home sales
price of approximately three-times income just like the rest of the real
estate markets in the country. (Data: Median Income of Households by State: 1984 to 2006, Median Family Income by State: 1959, 1969, 1979, 1989, and 1999, California median home price since 1968.)

Median Home Prices 1968-2006

In the late 1970s, the country was in the grips of a wage/price inflationary spiral.
Under those conditions, people began to bid up the value of real estate
partly as a hedge against inflation, and partly because rising wages
made fixed payments more affordable. If you expect your wages to go up
10% every year, even a debt-to-income ratio over 50% becomes affordable
after just a few years. During the late 1970s, prices were bid up very
high, very fast, and many people made fortunes in real estate. It was
during this time that residents of California learned they could bid up
the price of real estate, and they could make money from it. This
realization spread like a virus throughout the state. The bust of the
early 80s did impact specific properties in various markets, but the
median only leveled out and did not fall. As Robert Shiller noted in
his paper in 1988 (Warning, big PDF file,) this taught people that after a big boom, prices do not fall.

Inflation Adjusted Median Home Prices 1968-2006

By 1985, incomes had risen to where house prices were at four-times
income. This became the new floor beneath prices, and it was the
beginning of the “sun tax” here in California. The combination of lower
interest rates and strong employment started people buying again. By
this time it had been over 10 years since prices were at three-times
income, and it looked as if they would never get down there again. Thus
the fear of being “priced out forever” was born. At this point, people
believed in rapid appreciation, they did not fear a decline in prices,
and now they had the fear of being priced out. Kool aid intoxication
had gripped the society, and people began buying real estate and created the first real bubble in California real estate. Prices rose dramatically, but when the limit of affordability was reached with the loan products of the time, prices stopped rising, and it looked like there was going to be another leveling off period like there was in the early 80s. However, this time, prices were bid up much higher than incomes could support, and the median actually fell across the state by almost 20%. Just as in the first crash, prices of individual properties fell more than the median, and in fringe markets the decline was spectacular.

Affordability as Measured in Debt-To-Income Ratios 1986-2006

The long decline of the early 90s might have been the end of kool aid intoxication. Prices of individual properties dropped below four-times income, and a relative level of affordability had returned. After 6 consecutive years of falling prices, some of the core beliefs of kool aid intoxication had fallen out of favor and a degree of sanity had returned to the California real estate market. Prices began rising in 1997, and there was solid appreciation for 3 straight years as the market recovered from its slightly oversold condition. However by 2000, prices were high relative to incomes, and it looked as if the market might be at a top. Of course, prices did not top in 2000, and with a dramatic drop in interest rates engineered by the Federal Reserve, the conditions were created for another housing bubble. The beliefs of kool aid intoxication crept back in to the California psyche, and the rest of the story is The Great Housing Bubble (Warning, big PDF file.)

It is my greatest hope that people see that there is nothing special about California real estate. Prices here go up and down because we make them do so. The fallacious beliefs of Kool Aid intoxication makes people behave foolishly and buy properties not because they are a good value but because prices are going up. This price crash is going to be very, very painful to a great many people, and Kool Aid intoxication may fall from favor again. However, As long as this behavior is not seen for what it is, people will continue to repeat the mistakes of the past, and we will have another painful housing bubble crash.

He came from somewhere back in her long ago
The sentimental fool dont see
Tryin hard to recreate
What had yet to be created once in her life

Somewhere back in her long ago
Where he can still believe theres a place in her life
Someday, somewhere, she will return

What a Fool Believes — The Doobie Brother