Tighten Up — Archie Bell and the Drells

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

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

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

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

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

A refresher from Fundamentals at a Market Bottom:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

{book}

Asking Price: $499,000

Income Requirement: $124,750

Downpayment Needed: $99,800

Monthly Equity Burn: $4,158

Purchase Price: $656,500

Purchase Date: 5/30/2006

Address: 54 Ardmore, Irvine, CA 92602

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

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

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

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

{book}

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

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

Tighten Up — Archie Bell and the Drell