What will be the enduring legacy of market price supports and HELOC abuse? Will there be valuable lessons learned, or have we tainted the next generation by policies loaded with moral hazard?

Today’s featured property is yet another HELOC abuse case where they more than doubled their mortgage, and now they are walking away.

Asking Price: $499,000

Address: 91 Legacy Way, Irvine, CA 92602

The Legacy — Iron Maiden

But do you think that they care
They benefit from death and pain and despair

Have you ever stopped to ponder the issue of moral hazard? At its most basic, moral hazard is any change in behavior that comes about when people believe their actions have no consequences.

The housing bubble was built on moral hazard. None of the parties to the real estate transaction believed they had any risk. Borrowers and lenders both believed real estate always goes up, so there was no market risk. Some savvy borrowers realized that 100% financing was transferring all the risk to the lender, so they risked nothing other than their credit score. Most lenders believed they were transferring the risk either to investors or counterparties to their credit default swaps. The people assuming these risks ran their fancy actuarial analyses and determined the risk to be minimal. Nobody grasped the systemic risk that took down the entire house of cards.

The moral hazard of investing in California real estate has gotten worse with each subsequent real estate bubble. Prior to our first bubble in the 1970s, real estate prices were around three-times income just like the rest of the country (that would be like a $275,000 median in Irvine today). The fallout from this first bubble ruined the fortunes of many, but it did not wipe out everyone. The people who profited from this bubble spread the word of riches in California real estate — if you know how to play the game.

Prices never did fall back down to pre-bubble fundamentals. At three-times income, there is a premium for rental (as there should be). Once people equated ownership with investment, people concocted an ownership premium, and a new era dawned.

The bottom of that first bubble saw price levels reach four-times income. This is the approximate level of rental parity in the market. As prices found support here in the mid 80s, it was only a matter of time before the toxic beliefs spawned by the moral hazard of the first bubble inflated the next one.

{book2}

The bubble of the late 80s pushed prices up even higher, and when it collapsed, it resulted in widespread economic malaise, across-the-board declines in home prices, and more survivors who profited from the bubble. As interest rates declined during the 90s, prices became artificially supported at higher levels, and the decline was blunted. If interest rates had not declined 30% from 1990-1997, the overall market declines almost certainly would have been greater.

The bottom of that second bubble also saw price levels reach four-times income. With the lower interest rates, this was likely an improvement over rental parity in most markets. There was an overshoot of fundamentals caused by adverse market psychology. Everyone sobered up from kool aid intoxication.

I do not believe market bubbles are inevitable, but since California has a history of this behavior, it is prone to fall victim to its Siren’s Song. The State is a bit like an alcoholic: one drink of kool aid and California goes on a bender. In the late 90s, the markets witnessed several years of sustained appreciation. Many were still skeptical, and in 2000, there were open grumblings about prices being too high. They were. When they kept going up from here, we saw all the pent-up beliefs of kool aid intoxication get released on the populace. The Great Housing Bubble began to inflate.

The moral hazards of this latest housing bubble abound. People who bought between 2001-2003 paid too much. Right now, these people believe they are financial geniuses. If the market is not allowed to take its natural course down to 2001 price levels, people who overpaid at the beginning of the bubble will be imbued with moral hazard. They will not be punished for their mistake. We will create a new generation of people who believe in the myths of California real estate, and we will inflate another housing bubble — assuming of course that the lenders enable it.

In my opinion, all of the policies coming out of Washington that seek to prop up a flagging market only serve to create moral hazard. Another generation will have to endure a housing bubble complete with its commensurate fallout recession. If prices do not crash, if everyone who participated is not punished for their foolishness, we will almost certainly do this again. Perhaps Washington will put regulatory controls in place that prevent lenders from enabling this behavior, perhaps these regulations will be effective, and perhaps they will not be repealed before kool aid intoxication is purged from our collective memories. Perhaps not. I don’t have much faith in Washington getting it right.

We seem destined to live in fear
And some that would say Armageddon is near
But where there’s a life while there’s hope
That man won’t self destruct

Asking Price: $499,000

Income Requirement: $124,750

Downpayment Needed: $99,800

Monthly Equity Burn: $4,158

Purchase Price: $299,000

Purchase Date: 7/27/1999

Address: 91 Legacy Way, Irvine, CA 92602

neighbourhood?

washlet; wash-toilet. You have to check out this website. It is hilarious. I had no idea what a washlet was…

Today’s featured property is a profile in HELOC abuse. Look at what these people did:

• This property was purchased on 2/27/1998 for $299,000. The owner used a $239,200 first mortgage and a $59,800 downpayment.
• On 12/12/2002 the owner opened a HELOC for $30,000.
• On 6/3/2004 he refinanced with a $472,500 first mortgage.
• On 3/15/2006 he refinanced with a $576,000 Option ARM first mortgage.
• Total property debt is $576,000 plus negative amortization.
• Total mortgage equity withdrawal is $336,800 including his downpayment.

If this property sells for its asking price, and if a 6% commission is paid, the total gain on the property will be $170,060. The total loss to the lender will be $106,940 plus negative amortization. Lenders are stupid.

How are these people being punished? Is the lack of consequences for their behavior also creating moral hazard? Yes, it is.

I argue that the greatest moral hazard to come from the Great Housing Bubble is the enabling of HELOC abuse. Think about how desirable HELOC abuse makes California real estate. If you buy property in a state with price volatility as extreme as ours, you have the opportunity to convert this equity appreciation to cash and spend it with little or no repercussion for your activity. The greater the amount of volatility, the more money you can extract from your lender and spend. Why would anyone own in Kansas where prices are stable when they could own in California where they can live the good life off their houses?

The kool aid intoxication from appreciation created by the previous bubble helped inflate this last bubble. Add to that the ability to convert this appreciation to cash, and you have a recipe for major kool aid addiction. If previous bubbles brought us kool aid that is as addictive as cocaine, this last bubble with its refined ability to access the appreciation through HELOCS is as addictive as freebasing crack.

So what is the natural result of all the moral hazard we have created? We now have a population of kool aid intoxicated fools
waiting for the next credit cycle to enable them to bid up house
prices, create false equity, and convert that equity to cash so they
can spend it like the entitled, Nouveau riche they have become…

Just let me buy my house first.

{book5}

We seem destined to live in fear
And some that would say Armageddon is near
But where there’s a life while there’s hope
That man won’t self destruct

Why can’t we treat our fellow men
With more respect and a shake of their hands
But anger and loathing is rife
The death on all sides is
becoming a way of life

But if they do stop to think
That man is teetering right on the brink
But do you think that they care
They benefit from death and pain and despair

The Legacy — Iron Maiden