A sense of entitlement, enabled by prodigious amounts of borrowing, can overcome fiscal responsibility and prudence.

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I think we can all agree whether you are a housing bull, bear or giraffe that jobs and wage growth are primary factors to a healthy housing market. This has become quite the hot topic amongst the bulls and bears with various facts and myths that have been slung around. One fact is that much of the job growth in the last several years has been in the RE industry. Lansner over at the OC Register has mentioned this several times and has noted that in the last four years RE accounted for 52% of the job growth. It is also a fact that other jobs have been created but at a very weak rate. Does this seem like a healthy job market when real estate sales are down 40% from the peak, mortgage companies are going BK or laying people off every quarter and homebuilders are slashing staff to bare bone levels just to function? Well let’s take a look at what I have found and you can make your own judgment.

The Data

I used the data from the EDD which gets their data from the BLS. The best info I can find on the actual jobs numbers are from this spreadsheet from the EDD. I have my own spreadsheet that uses the same data. I added the employment numbers and rates that are missing from the EDD spreadsheet and I have done several various calculations. I know it is not as organized or as pretty as some of Irvinerenter’s but the data is there. For RE related jobs I use construction, credit intermediation and related activities, real estate and architectural, engineering and related services. These categories compiled together are what I like to call the RE jobs and will known as such from here.

A Little History and Some Averages

Historically RE jobs have accounted for an average of 11.5% of the total non-farm jobs in OC since 1990 to 2006.

In 1990 the average was 11.5% and did not reach that high again until 2001. In between that time the average was 10.6%.

In 2006 the percentage of RE jobs accounted for 14.2% of the non-farm jobs for a new all time high.

The reason why this is an important way to look at RE jobs and why the percentage matters is the RE industry is a need based employment sector. So in other words when jobs other than RE are being created the RE jobs would increase in number but not as a percentage. RE jobs need other jobs to be created or they would not increase and they definitely should not increase as a percentage.

From 2000 to 2006 131,200 total non-farm jobs were created and 62,400 of those jobs were RE related accounting for 47.6% of the job growth.

It doesn’t make much sense when only 68,800 non-RE related jobs were created that OC would need to have that much RE jobs growth. Considering that from 2000 to 2006 non-RE related jobs grew by an amazing 5.3% and RE related jobs increased by 29%.

This clearly paints a picture that OC has been very dependent upon RE job growth in the last six years. That dependence on sector that is a need based industry when the need was self fed poses a serious risk to the overall employment in OC.

The Aerospace Myth

The typical bull mantra about the 90s was that the aerospace industry killed the housing market. This is a serious error when the numbers are not there. Manufacturing jobs which include aerospace did have a significant decline but it wouldn’t call for such a steep decline in the RE related jobs or a decline in the housing market.

Between 1990 and 1993 OC had lost a cumulative total of 57,000 non-farm jobs and in 1994 only had lost a cumulative total of 45,600 non-farm jobs.

Between 1990 and 1994 aerospace had lost a cumulative total of 7000 jobs accounting for only 15.4% of the non-farm job losses.

Between 1990 and 1994 manufacturing had lost a cumulative total of 37,300 jobs accounting for 82% of the non-farm job losses.

Between 1990 and 1994 RE had lost a cumulative total of 20,500 jobs accounting for 45% of the non-farm job losses.

As can be seen in those numbers RE and manufacturing accounted for more than the cumulative total non-farm job losses. That means that other sectors were creating jobs which would create a need for RE related jobs. This didn’t start to happen. The reason had more to do with housing prices and buyer psychology.

The Wage Growth Myth

The bulls all say that wages are up and people are making more money than ever. This couldn’t be further from the truth when you exclude RE related jobs. I actually believed that this mythical statement might have been true. I was disturbed that when you break it down the way that I have that it shows a loss. I had to use data from 2000 to 2005 because the annual data for 2006 is not available yet.

Between 2000 and 2005 payroll wages grew by slightly over $14 billion.

Between 2000 and 2005 payroll wages for RE grew by slightly over $6.6 billion accounting for 47% of the growth.

Between 2000 and 2005 payroll wages for non-RE related jobs grew by slightly over $7.4 billion accounting for 53% of the growth.

When you break down how many non-RE related jobs there were in 2000 compared to 2005 there were 48,600 more jobs. So what you have to do is take the annual payroll and divide it on a per job basis. After adjusting for California’s inflation rate of 15.9% between 2000 and 2005 non-RE related payroll wages shrank by -$662 million in that time.

Using the same break down RE related payroll wages soared by nearly $2.1 billion. This adds for more evidence that the industry was self feeding itself and how much OC was dependent upon the industry for growth. With sales down nearly 40% since 2005 it will be interesting to see this stat in the next few years.

The Overwhelming Evidence

I may be a housing bear but these are the numbers and the numbers do not lie. It can be said that a liar can lie about the numbers but that is why I provided my own spreadsheet for anyone to check the numbers. The proof is OC has had very poor job growth when excluding RE related jobs. What is even worse is wage growth has actually been negative when excluding RE related jobs. So how or why have we had such a huge run up in the prices of homes? It makes absolutely no sense what so ever and anyone who tells you that wages have been growing is lying.

The other troubling statistic is with all the layoffs and overall slow down is where will these people find jobs? The response you will hear from the bulls is they will find a new job or return to the industry they came from before. Some of the more educated and talented in the RE industry will either stay in the business or find another industry. However the majority will have difficulty finding a career that pays as well. The RE industry is more than just sales agents and loan brokers but underwriters and escrow officers. Many of the other jobs have paid well and required very little training or education. The jobs currently being created are in professional and technical services, medical services and education. These categories require higher education and unless the person who is no longer in the RE industry had this education from before they will have to get it now. This will either take job seekers out of the market to get the education needed or they will have accept lower paying jobs or be unemployed.

Now do you see a problem or is it sunny today?

So, bye-bye, Miss American Pie
Drove my Chevy to the levee
But the levee was dry
And them good old boys were drinkin’ whiskey and rye
Singin’ this’ll be the day that I die
This’ll be the day that I die

Don McLean – American Pie

One of the hallmarks of a great song is its ability to be interpreted in different ways. American Pie is an allegory of our times, an ode to the death of our housing market. With leverage drying up, the party is over. The last drink is for the death of the market itself, and with it’s death, the death of the American Dream of home ownership for thousands of overextended homedebtors.

When a bubble in a financial market pops, it doesn’t explode in spectacular fashion like a soap bubble, it is more comparable to a breached levee which releases water slowly at first. Once the financial levee is ruptured, the equity reservoir loses money at increasing rates. It washes away the imagined wealth of homedebtors everywhere until the reservoir is nearly empty and the torrent turns to a trickle. Ultimately, the causes of failure are examined, the financial levee is repaired, and the reservoir again holds value, but not until the dreams and equity of homedebtors are washed away.

New Century Financial

Do you recall what was revealed
The day the music died?

The poster child for the great residential financial bubble of the 00’s will be New Century Financial. The date of their financial implosion will be regarded as the Day the Market Died. The death of New Century Financial will come to represent to death of loose lending standards and the beginning of the cycle of credit tightening as I described in my last post, The Anatomy of a Credit Bubble. Many people currently see the elimination of sub-prime lending as being the problem. It is much larger than that. It is the changes in behavior caused by loose lending standards epitomized by New Century Financial that will be the undoing of the housing market.

100% Financing

The most damaging change in buyer behavior was caused by 100% financing: potential buyers quit saving. Once 100% financing became widely available, it was enthusiastically embraced by all parties: the lenders suddenly had a huge source of new customers to generate high fees, the realtors and builders now had plenty of new customers to buy more homes, and many potential buyers who didn’t have savings were now able to enter the market. It seemed like a panacea; for two or three years, it was.

Now for ten years we’ve been on our own
And moss grows fat on a rollin’ stone
But that’s not how it used to be

There is a problem with 100% financing (which was masked by the rampant appreciation brought about by its introduction): high default rates. If you want a glimpse into the irresponsible mind of a typical 100% financing borrower, go read the post and comments in Update: an FB situation 14 months later. The FB stated in the comments,

“However, I take exception to the idea that I’m taking food out of someone’s mouth by sticking the bank with the loss. An appraiser made the valuation, and I got a loan. No one forced New Century to give me the loan to buy the house, but they did. They confirmed the value, and thus, assumed all risk, especially since I went no money down with an, at the time, 720 mid-FICO, and the wife as well.”

This borrower signed papers promising to repay money to New Century. He gave his word. How does it follow that New Century took all the risk? How does the presence or absence of a downpayment impact whether or not a borrower will live up to their commitments and responsibilities? We all know the answer: When people don’t put their own money into the transaction, they don’t feel responsible for what happens. At one point, the FB was celebrating, “I was planning on claiming insolvency to the IRS through my job loss, anyway, but they didn’t even give us a 1099!” Does it make you want to turn him in?

The courtroom was adjourned
No verdict was returned

The more money people have to put in to the transaction, the less likely they are to default. It is that simple. Taken to its extreme, 100% financing becomes the ideal tool for fraud. The FB from above probably intended to repay the loan when he got it, he just didn’t feel much of a sense of responsibility to the loan when the going got tough. People who commit fraud have no intention of repaying the loan from the start. Fraud is much easier to commit with 100% financing because the bank will loan you the full amount of an inflated appraisal. It is much harder to commit fraud when the bank will only loan you 80% of a property’s value.

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The point here is not about being irresponsible or committing fraud, it is about defaults. High loan-to-value loans have high default rates; this will cause 100% financing to disappear, and it will make other high LTV loans much more expensive, so much so as to render them useless. OC Fliptrack documented the elimination of the 100% LTV loans at HSBC. It is all part of the ongoing credit tightening cycle.

The problem for the future housing market created by 100% financing is that people quit saving money for downpayments. People respond to incentives. This is basic economic theory. The availability of 100% financing removed the incentive to save for a downpayment. People responded; our national savings rate went negative as people stopped saving and borrowed instead. This is going to create a huge problem going forward: nobody has the newly required downpayments.

Elimination of Entry Level Buyers

Oh, and there we were, all in one place
A generation lost in space
With no time left to start again

People who currently own entry level housing (2 bedrooms or less and small 3/2s) are bagholders. With the elimination of 100% financing, they have missed their chance to sell to a greater fool. Even if these fools were still out there (they have been decreasing in number), they no longer have the ability to borrow all the money required to buy, and they have no way to make up the difference. The entry level market was destroyed the moment 100% financing was eliminated because nobody has a downpayment.

Collapsing from the Bottom Up

The players tried for a forward pass
With the Jester on the sidelines in a cast
Now the half-time air was sweet perfume
While the Sergeants played a marching tune
We all got up to dance
Oh but we never got the chance

Housing markets collapse from the bottom up. The first sign of a troubled real estate market is a dramatic reduction in volume. This is particularly pronounced at the lower end of the market for reasons outlined above. Since the lower end of the market has a more dramatic drop in volume than the top of the market, the median stays at artificially high levels which is not reflective of pricing of individual properties in the market. In other words, things look better than they are.

The graphic on the right (borrowed from Calculated Risk) shows the problem when the entry level is eliminated. For a more detailed analysis, please read Why the Sub-Prime Meltdown is a Problem. As the problem at the entry level becomes more serious, more and more transactions higher up the house chain fall out of escrow. Volume plummets, and the whole market seizes up. That is where we are today. There will be no summer bounce this year.

Helter Skelter in a summer swelter
The birds flew off with a fallout shelter
Eight miles high and falling fast

Eight Miles High and Falling Fast

The market will not stay seized-up forever. Many bitter renters have complained about greedy sellers, but it isn’t the sellers who determine market prices, it is the buyers. Think about this: what if every seller in the market decided they would not sell for less than $10,000,000? Would houses suddenly become worth $10,000,000? Of course not because no buyers could afford to pay that much. Buyers determine the market price by putting in competing bids. Sellers can decided to accept or reject the highest bid. If all bids are rejected, there is no market because there is no transaction.

Buyers are never forced to buy, it is always a choice; however, sellers may face circumstances when they are forced to sell. Over the past several years, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. None of them were forced to buy. The exotic financing was not a result of high prices, it was the cause of high prices. Those of us who are financially conservative and do not wish to take on debt under terms which will put us into bankruptcy have been competing with those afflicted with Southern California’s Cultural Pathology. It is a competition we were all better off losing.

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Now the tables are turned. The once greedy buyers are becoming desperate sellers, their dreams of riches from perpetual appreciation in tatters. Many will be forced to sell due to their inability to make their mortgage payments. Those that hang on will be homedebtors with 50% or more of their income going toward paying off an asset which will be declining in value. It is not a set of circumstances I envy.

Prices will fall. We will see weakness at the bottom first, but it will work its way through all market strata. It is only a matter of time. Will you remember The Day the Market Died?

A long, long time ago…
I can still remember
How that music used to make me smile…

I can’t remember if I cried
When I read about his widowed bride,
But something touched me deep inside
The day the music died…

I met a girl who sang the blues
And I asked her for some happy news
But she just smiled and turned away
I went down to the sacred store
Where I’d heard the music years before
But the man there said the music wouldn’t play

And in the streets the children screamed
The lovers cried, and the poets dreamed
But not a word was spoken
The church bells all were broken
And the three men I admire most
The Father, Son and the Holy Ghost
They caught the last train for the coast
The day the music died

Link to YouTube Video – American Pie – Don McLean

Financial markets represent the collective result of individual actions. To fully understand how our current housing bubble was inflated, one needs to understand how the actions of the individual market participants impacted house prices. In my last analysis post, Your Buyer’s Loan Terms, I discussed future interest rates and debt-to-income ratios and their impact on future housing prices. In that post, I made a blanket assumption that interest-only and negative amortization loans will simply not be available in the future. It is a debatable assumption. In this post, I want to show more clearly how these two loan types created this bubble and why I believe they will not be available in the future. In short, I will describe the anatomy of a credit bubble.

To illustrate how this loosening and tightening of credit creates housing market bubbles, I will examine the last two bubbles similarities and differences. I will demonstrate how the bubble from 1987 to 1990 was very similar to our current bubble from 2001 to 2004. The last two years of our bubble, 2005 and 2006, were uncharted territory created by "innovation" in the lending industry.

How People Buy

When people decide they want to buy a house, they figure out how much they can afford and then go find something they want in their price range. For most people, what they can "afford" depends almost entirely upon how much a lender is willing to loan them. In the past, lenders would apply debt-to-income ratios and other affordability criteria to determine how much they were willing to loan. Buyers were generally limited in how much they could borrow because lenders were wise enough not to loan borrowers so much that they might default.

Buyers / borrowers behave much like drug addicts — they will borrow all the money a lender will loan them whether it is good for them or not. Most are not wise to the differences between the various loan types, and they have limited understanding on the risks they are taking on. This financially irresponsible borrower behavior is particularly bad here in California due to Southern California’s Cultural Pathology. If you need a primer on the various loan types, start with Financially Conservative Home Financing or Your Buyer’s Loan Terms.

Comparing the Bubbles

The circumstances during each bubble was different. Prices and wages were lower in the last bubble, interest rates were higher, the economies were different, etc. What is the same is the evaluation of personal circumstances each buyer goes through when contemplating a purchase. The cumulative impact of these decisions in 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 seeing how this bubble compared to the last one.

The chart above 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. The last bubble is pretty obvious. In 1987, 1988 and 1989 people believed they would be "priced out forever," so they bought in a fear frenzy. Mostly people stretched with conventional mortgages, but interest-only was used, and helped propel the bubble to a high level of unaffordability. Basically, prices couldn't get pushed up any higher because lenders would not loan any more.

The Affordability Limit

When affordability limits are reached, prices must fall. This is caused by two related phenomenons:

• People will stretch to buy an asset that is appreciating; when appreciation stops, so does the stretching to buy. During the bubble rally, rising prices justifies paying too much because you obtain a return on your investment. Once prices quit rising due to the affordability limit (lenders won't loan more money), there is no justification for the high prices, and people quit buying. The lack of buying causes volume to wither and inventories to spike; prices start coming down as sellers are forced to sell.
• Banks will not loan large percentages of the value for a depreciating asset, nor will they allow borrowers to utilize high debt-to-income ratios. Banks don't like to lose money. Banks used to demand 20% down payments to give them a cushion if values dropped. Banks used to limit debt-to-income ratios to 28% to make sure the borrowers could afford to pay them back. The only assurance banks have for getting their money back is the value of the collateral (house). If house values start declining, banks want even more cushion to protect their investment. The era of 100% financing and 60% DTI is gone because houses stopped going up in value. As prices start to decline, down payment requirements will continue to rise and DTI will continue to fall which in turn reduces the number of available buyers which makes prices drop even further: a downward spiral.

What starts as buyers being unable and unwilling to buy turns into a downward spiral of tightening credit. This continues unabated until 20% down payments are the norm, and debt-to-income ratios fall back to their historically "safe" levels for banks of 28%. This is exactly what occurred from 1990-1997, and What is Past is Prologue.

Cheating on Affordability

Despite what the affordability charts show. People do not really make payments which are 62% of their gross pay. They cheat. They do this by utilizing risky financing options including interest-only and negative amortization.

Interest-only loans artificially "adds" affordability to the market because it allows for larger sums of money to be borrowed with lower payments. For example:

The median income in Irvine is $83,891. Applying a 28% DTI leaves a payment of $1,957. At current interest rates, a payment of $1,957 on a fixed-rate 30-year mortgage at 6.4% would finance $312,866. This same $1,957 payment on a 5-year ARM at 5.6% would finance $419,454. As you can see, the interest-only loan terms allows borrowers to increase their loans by 25% thus artificially increasing prices 25%.

2004's False Top

On the DTI chart, notice the similarities between the periods 1987-1989 and 2001-2003. Both were rising DTI's moving through the affordability zone pushing prices to the top of the range. If history had repeated itself, lenders would have become cautious in 2004 just as they did in 1990, and the market would have topped in 2004.

As you can see from the chart of available inventory above, 2004 would have indeed been the top. Inventory exploded, time-on-the-market went way up, and it looked like the party was over. It should have been; however, the lending industry "innovated" and came up with the negative amortization loan.

Negative Amortization Loans

When lenders "innovate" trouble is brewing. Banking has been around over 500 years. Everything has been tried at least once. Innovation in banking is a matter of trying something which has probably failed dozens of times before and hoping for a different outcome (the definition of insanity if you didn't notice). It should not surprise anyone when the negative amortization experiment fails brilliantly.

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From our example above, we can see how changing the terms from a conventional, fixed-rate mortgage with a 30 year term to an interest-only adjustable rate mortgage artificially increases home prices by 25%. Now look at what negative amortization does. In 2004, prices reached the limit imposed by interest-only. The only way to push prices higher would be to finance even larger sums with the same available payment. Option ARMs differ widely due to differences in their teaser rate, but for the sake of this calculation, I will assume a 3.75% teaser rate (I have seen them as low as 1%). The $1,957 payment finances $312,866 with a conventional mortgage, $419,454 with an interest-only mortgage, and a whopping $626,239 with negative amortization. In 2004, 2005 and 2006, people took out Option ARMs, bought the huge inventory spike from the summer of 2004, and sent prices into the stratosphere.

32% of loan originations in Orange County in 2006 were negative amortization (Option ARM).

Stop for a moment and ponder the math: the same payment now finances 100% more money. Is it any wonder our real estate market was 100% overvalued at the top? People purchasing with Option ARMs are buying at the rental equivalent value. From a financing perspective, the market is not overvalued. People are paying exactly what they should be paying. They are just doing it with loan terms which are going to destroy them — hence the term "suicide loan."

Foreclosures

These exotic financing terms are going away for one simple reason: foreclosures. People simply cannot make the payments when interest rates rise. If you look at the foreclosure rates in the early 90's, you can see what happens when lenders get too loose with credit. Lenders overcooked the market then, and they got burned. You think they would have learned their lesson…

(One note on the foreclosures: defense industry layoffs are often blamed for the problems with the housing market. These layoffs came after the housing market was already in trouble. It slowed the recovery, but it was not the cause.)

Lenders faced high foreclosure rates in the early 90's because they were too aggressive with their lending practices in the rally of the late 80's: it was their own doing. As you can see from the above chart, the ultra-aggressive lending practices of the early 00's are just now starting to show up in the foreclosures. Just as in the early 90's, this is being caused by the past sins of the lenders: karma on grand scale. If does not take an expert to extrapolate from the chart above to see that foreclosures are going to shatter the old records set in the 90's.

Price to Income Ratios

Just in case you still don't believe there was a credit bubble. Examine the chart below of historic price-to-income ratios.

Very high price to income ratios signify borrowing large sums with small payments just as illustrated in the previous financing example. Ratio's greater than 5 are considered very unaffordable and prone to high rates of default. The bubble of the early 90's did not exceed 6 partly because interest rates were higher and partly because they did not use negative amortization.

Elimination of Exotic Financing

I have speculated that exotic financing is going to disappear. To be more accurate, exotic financing is going to become so expensive for borrowers as to render it practically useless. These loans will always be available, but the interest rate spreads will grow and the qualification standards will tighten to make them not usable. For example, in the heyday of negative amortization loans, lenders would qualify borrowers based only on the teaser rate payment without regard to whether or not they could afford the payment at reset. For more sophisticated borrowers, lenders allowed stated income or "liar loans." Basically, a borrower would tell the lender how much they wanted to borrow, and the lender would fill out fraudulent paperwork showing the borrower was making enough money to afford the payment. This is amazingly irresponsible lending, but it was widespread. Now, lenders are requiring borrowers be able to actually afford the payments; of course, this makes many borrowers unable to obtain financing. That is credit tightening; that is how the downward spiral begins.

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The next phase in the tightening of credit is an increase in interest rate spreads between prime loan terms and exotic loan terms. This is driven by the defaults and foreclosures. Mortgage rates for prime customers are very low because they rarely default. During the rally nobody was defaulting because prices were rising; people just sold if they got in trouble. This allowed banks to originates risky loans at very low interest rates because the loans didn't look risky. Now that the market has stopped rising, the underlying risk is starting to show with dramatically increasing default rates. The true risks of these loans will become apparent over the next few years.

Banks have to make enough money on their good loans to pay for the losses on their bad loans and still make a profit. As exotic loans start showing very high default rates, banks have to start charging higher interest rates to cover the losses. Higher interest rates make for lower amounts of borrowing.

When banks realize the true risk associated with exotic financing terms, they may have to charge much more than they are charging for conventional loans. As you can see from the table above, if the interest rate is only 3% higher, the amount financed is 25% less. If the default rates are very high, no amount of interest rate spread can compensate the bank for the risk, and that loan program will be eliminated. This will be the fate of the negative amortization loan.

The 2006 vintage sub-prime negative amortization loans have already defaulted in record numbers. These loans are less than a year old. It is forecast that over 20% of these loans will default, and this is without a crashing housing market. If lenders have to make enough money on 4 loans to cover the loss on 1, interest rate spreads will be very high. If a negative amortization loan costs 13.75% rather than 3.75%, nobody will want it, and if lenders require borrowers to actually afford the 13.75% interest rate, nobody will qualify. Either way, negative amortization loans will die. The fate of stated income and interest-only loans may be no better.

When prices crash, defaults rates will increase for all borrower classes. Prime borrowers will not default at the high rates of sub-prime borrowers, but they will still default at rates higher than in the past; therefore, interest rates will rise for prime borrowers as well. The crash in house prices will cause all mortgage interest rates to rise.

What Happens Next?

Over the next several years, interest rates will rise to at least 8%, 20% down payments will become the norm, and debt-to-income ratios will fall back to their historically "safe" levels for banks of 28%. What will that do to prices?

At some point in the future, the market will bottom near the values above. How it gets there will depend on the number of foreclosures. If there are a great many foreclosures, it will happen quickly, if there are fewer, it could take longer. Either way, the median prices shown above will occur, it is just a matter of when. I have constructed two different scenarios as to how and when: Predictions for the Irvine Housing Market and How Bad Could Bad Get?

The conditions for the above disaster are already in place. Right now, we are in the lull before the storm, but the storm is coming; there isn't much anybody can do about it.

Over the last several years, buyers have not concerned themselves with the day they were going to become sellers. Why would they? There was an endless demand for properties, and buyers were going to pay whatever was asked. Those days are gone. They are not coming back any time soon.

In one of my first posts, I talked about Financially Conservative Home Financing. There has been much discussion on these boards about the high debt-to-income ratios and adjustable rate mortgage terms now required if you chose to buy in today's market. For anyone considering buying a home right now, I would like you to think about the buyer who is going to buy your home from you at some point in the future, and more specifically, what debt-to-income ratio and loan terms will this buyer utilize. This is important, because the amount of money this take-out buyer will pay you for your home is completely dependent upon these variables. Your house is only worth what your buyer can pay for it. For you to get out at breakeven or better, your take-out buyer must be leveraged more aggressively than you are, or you must wait for fundamental valuations to catch up to today's pricing. In this post, I will examine both scenarios, and I will present a range of valuations for homes based today's income and prospects for the future.

Fundamental Valuations

As a primer, please read How Inflated are House Prices? In that post I discuss a simple method to calculate a house's fundamental valuation. In short, 160 times the monthly rental rate is a useful number. The monthly rental rate can be calculated as follows: Median Income / 12 (months) x debt-to-income ratio = monthly payment = monthly rental rate. For example, in Irvine in 2006, the Median Income was $83,891 / 12 = $6,990 monthly median income. Financial planners (and your banker) will tell you not to put more than 28% of your gross income toward housing (Realtors will tell you to put 55% or more if that is what it takes.) Assuming a more rational 28% debt-to-income ratio, the median monthly payment (and thereby the median rent) is $1,957. Based in a 160 multiplier, the median house price should be $313,120 or 3.7 times earnings. Since the borrower should have a 20% downpayment, it can be argued that the median home price should be $375,744.

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So how does all the above compare to reality? The median rent in Irvine is $1,660. This is going to include many 1 and 2 bedroom apartments and very little at 4 bedrooms and above. The housing stock in Irvine is generally larger and nicer than the rental units, so a median house rental of $1,957 is probably not too far off. If you go to OCRealEstateFinder or FirstTeam and search for rentals, you will find what I would consider a median type property renting between $2,250 and $2,500 a month. This means that most Irvine renters are probably spending more like 35% of their gross income on housing instead of the suggested 28%. So if you recalculate the theoretical median based on $2,500 a month, the median home price should be $400,000; add a 20% downpayment, and the median could be as high as $480,000. The last statistics I saw for the Irvine median home price was $687,000: No reasonable metric can be constructed to justify that price.

As you can see from the discussion above, there is a range of values which can be used as a "reasonable" fundamental valuation. For the sake of simplicity, I am going to use $360,000 which is the number I used in the post Predictions for the Irvine Housing Market.

Debt-to-Income Ratios

The table below shows the impact of debt-to-income ratio on house price.

As you can see, the current debt-to-income ratio in Irvine is 60.8%. Even if you assumed ever buyer is puttting 20% down (which is laughable), the DTI ratio is 50.1%. Remember this is gross income; as a percentage of take-home pay, the number is much higher. Will your buyer be willing to spend that much of their income on housing?

Amortization

The above table shows the DTI assuming a 30-year conventional mortgage. Only 20% of loan originations in Orange County were conventional mortgages in 2006. People have bid prices up using interest-only and negative amortization loans. The table below shows the impact of these loan terms.

This is where the action is. There are many factors which contributed to this bubble, but it is the combination of these loans with Southern California’s Cultural Pathology that really made this bubble happen. The biggest gamble current buyers are taking is the availability of future financing options. If defaults continue to increase at the current rate, these products will likely be eliminated: the banks are losing to much money. Will these loan terms be available for your future buyer?

Interest Rates

Mortage interest rates on 30-year fixed rate mortgages with no points are running about 6.4%. This is about 20% less than the historical average of 8% for home mortgages.

As you can see from the above table. The higher interest rates go, the less a borrower can finance utilizing the same payment. If interest rates go up from the current 6.4% to the normal 8%, buyers will be able to bid 15% less than previously; therefore, house values will decline 15% as a result. If interest rates spike to 10%, house values decline 30%. What will interest rates be when your buyer wants to buy your house?

Appreciation over Time

I will use an appreciation rate of 3% to reflect the normal growth of wages and rental rates. It can be argued that appreciation will be higher, but it can also be argued that Appreciation is Dead.

Fundamental valuations are directly tied to wage growth. How much money will the buyer of your house be making in the future?

Future Value Table

Pulling together all of the above variables is a challenge. Below is a table which attempts to do so. Please click on the table to enlarge.

To make it easier to read and follow, I have broken down the above table into three sections based on the DTI ratio of your future buyer.

The most likely scenario is that your future buyer will pay from the second column in the above table. A 28% DTI is not just advisable, it may become a limit imposed by lenders — liar loans and high DTI ratios cause defaults and may be eliminated. Interest rates will likely climb back to their 50-year historical average of 8%. Notice that today's median home price is not reached in the 29 years shown on this chart if interest rates rise.

If you believe the "sun tax" is alive and well in Southern California, and you believe lenders will allow DTI's in excess of 28% in the future, future values may be found in the above chart. This DTI is what house renters are currently paying in Irvine.

Of course, there are those who believe we have reached a permanently high plateau, and buyers will continue to either utilize exotic financing or put 60% or more of their income toward housing (You have to believe those things to think prices can appreciate from current levels.) If you believe these conditions will persist, or occur again in a future bubble, then the above chart is for you. Who knows, maybe those of us who buy at the bottom can sell at these prices at the top of the next bubble…

Don't get greedy.

Think about what terms and conditions your buyer will face, and you may save yourself a lot of problems today. Right now the market has been pushed up to unsustainable heights, and it will fall. Don't buy when the conditions are not favorable. If interest rates are low, debt-to-income ratios are high, and exotic financing is the norm, it is a bad time to buy. You want to purchase when credit is tight and values are depressed — this is coming soon. Be patient and wait for the conditions to be right because you want your buyer to buy from you when credit is loose and prices are inflated. Remember, your house is only worth what your buyer will pay for it.

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P.S. If you want to run this spreadsheet for yourself, below is a link. You can input your own income and house price assumptions and see what happens.

Buyer’s Loan Terms