Jan302012
A Brief History of the Housing Bubble
A Brief History of the Housing Bubble
From 2003 to 2006, American lenders and borrowers inflated a massive housing bubble. From 2007 to 2012, this bubble has been deflating, but the bottom is proving elusive. The housing market is closer to the bottom than to the top, and if a viable solution can be found to bring supply and demand into balance, the tremendous affordability from low prices and low interest rates will help a bottom form in the near term.
The conditions preceding the housing bubble, serve as a baseline to establish a sense of normalcy, a guidepost to stable valuations. When the distortions of value due to the housing bubble are corrected, the preceding conditions will be restored.
Stable Market Conditions 1993-2002
The period from 1993 to 2002 is a useful decade to analyze for purposes of establishing normalcy in the housing market. For most of the country, this was an unremarkable period of gently rising prices as a response to wage growth and inflation in various markets. In California and select East Coast markets, this period represents the tail end of the previous housing bubble, the bottoming period, and the initial stages of the great housing bubble of the 00s. A variety of useful market data is available for this period for analysis.
The housing bubble was not without precedent in recent history. In the late 1970s and the late 1980s both witnessed minor housing bubbles. In California in particular these bubbles were quite large, and they both served to create a false sense of value in the minds of housing consumers. Most people in California believe they can become rich by owning residential real estate. Despite the cycles of boom and bust, most Californians continue to see residential real estate as a source of no-risk high-yielding returns. Hope springs eternal.
Figure 1: Inflation Adjusted Home Prices, 1890-2010
Rental Parity Is Fundamental Value
Rental parity is a mathematical relationship between rental rates and property values where rent is equal to the monthly cost of ownership. The relationship between rents and prices provides a conceptual understanding of value. Rental rates establish where property values should be. Rental Parity is a balance point where there is no financial advantage to choosing renting or owning, a point of theoretical indifference.
If we had a group of theoretically indifferent people who always acted rationally based on perfect information, prices would always be at rental parity; any price below rental parity would be perceived a bargain and bid upward, and any price above rental parity would be perceived as too high, and there would be no bid interest. In the real world, people are not indifferent; in fact, they can become very emotional about buying and selling real estate. When they participate in a market, they get caught up with the herd and move prices without regard to fundamentals; short-term price movements become accepted as the market’s long-term trajectory. People believe trees really can grow to the sky.
Rental parity becomes a baseline — a fundamental. Prices are loosely tethered and may depart for long periods, but prices always manage to return to rental parity in time because as a logical point of indifference; it is the natural resting point for a market purged of irrational exuberance.
Figure 2: Median Home Price and Rental Parity in Irvine, CA, 1988-2011
Rental parity relates the micro-economic decisions of individuals to the macro-economic forces in the market. In a housing market dominated by conventional financing (thirty-year fixed-rate mortgages with conventional amortization), rental parity is the best measure of value available.
The Housing Bubble Rally 2003-2006
By late 2002 many markets were overheating, and lenders sought solutions to keep activity high despite inflated prices. Their “innovative” solutions involved moving away from the thirty-year fixed-rate amortizing mortgage to products with adjustable rates, and either no amortization or negative amortization. Since any terms other than amortizing fixed-rate mortgages are unstable, lenders embarked on a Ponzi Scheme. Each “innovation” was more risky than the last, and only continually rising prices fueled by their own unstable lending kept the system going.
From 2003 to 2006, prices went up at unprecedented rates with no identifiable underlying fundamentals. Many economists tried to gloss over the price increases with arguments about job growth, low interest rates, and changes in consumer preferences for housing, but they all ignored the obvious distortions readily observable in conventional measures of value and the nearly vertical rise in prices corresponding to the widespread use of unconventional loan products.
Figure 3: The Credit Bubble and Housing Bubble in Irvine, CA 1988-2011
The unstable loan programs alone were not sufficient to create the housing bubble. The secondary loan market and securitization provided a conduit for money to flow into the market. Credit default swaps gave lenders and investors a false sense of security which permitted them to misprice risk, and with the low interest rates policy of the Greenspan Federal Reserve in response to the collapsing stock market bubble, capital poured into residential mortgages as a high yield alternative.
With unstable loan programs and a strong desire among investors to fund them, loan originators were under enormous pressure to meet the demand for mortgages. In response, they lowered loan qualification standards to near zero with such “innovative” programs as NINJA loans (no income, no job, no assets) and liar loans (stated income).
Borrowers are already prone to take any loan offered to them, and with the prospect of unlimited wealth in real estate, anyone with a dream and a pulse signed up with a toxic loan to buy houses at ever-increasing prices so they too could make a fortune in real estate. Like all Ponzi Schemes, this one went until no buyers remained. It was a self-fueling process that finally ran out of greater fools in late 2005.
Figure 4: Existing Home Sales 1994-2011
The Credit Crunch and Market Crash 2007
Since the loan terms of the housing bubble were unstable, and since the problems were only masked by the rapid appreciation caused by the introduction of the unstable loan programs, once prices began to fall, it was only a matter of time before borrower defaults began to cause lender losses. Once lenders started losing money, they stopped lending: a credit crunch.
Since the debt loads were much higher than what could be sustained by incomes, and since the borrower pool was compromised by degraded lending standards, many borrowers were insolvent and unable to service the debt or repay the principal. The elimination of unstable loan programs (Option ARMs and interest only loans) caused loan balances to drop 40% in a very short period. Sales volumes plummeted and prices soon followed.
Falling prices made it impossible for borrowers to sell the house for enough to repay the debt, so lenders began losing their capital. This exacerbated the credit crunch as caused an abrupt stop to nearly all private mortgage lending.
Ramifications of Borrower Delinquency
Following is an outline of the options and consequences for delinquent borrowers.
Figure 5: Ramifications of Borrower Delinquency
The Timing of Default and Foreclosure
With a dramatic increase in loan delinquencies, lenders began a plethora of loan modification and other programs to prevent foreclosures. These programs have largely failed to prevent foreclosure, but they have been somewhat successful in delaying them. Most insolvent borrowers ended up going through the foreclosure process.
Figure 6: ARM Reset through Foreclosure to Final Sale
Once a borrower defaults on a loan, in most states the lender is required to wait 90 days to give the borrower a chance to get current on their payments. Once a borrower is 90 days late, he receives a Notice of Default from the lender. Following the Notice of Default, there is another 90-day window where the borrower can make good on their payments. If he is unable (or unwilling) to do so, the lender will file a Notice of Trustee Sale and schedule a public auction for 21 days later. If the borrower cannot pay back the loan or find other ways to delay the process, the property is put up for public auction, generally on the courthouse steps in the jurisdiction where the property is located. At this auction, the lender will generally bid the amount of the outstanding loan and hope another party bids more and pays them off. If the lender is the highest bidder, which is often the case, the lender ends up owning the house.
Figure 7: Non-Judicial Foreclosure Process
In a normal market delinquencies over 90 days are issued a Notice of Default, but with the surge of delinquencies in the housing bubble, this timeline has been extended for years. The delinquent borrowers not yet served a Notice of Default are shadow inventory.
Subprime: The First Wave of Distressed Inventory 2008
The Adjustable Rate Mortgage Reset Chart produced by Credit Suisse in 2007 details the dollar amounts of mortgages facing payment resets in the six years from 2007-2012. The bulk of the first two years (24 months on the chart) are loan resets from subprime borrowers who purchased in 2005 and 2006. These subprime borrowers paid peak prices for properties. Most of these borrowers were given 100% financing (if they could have saved up for a downpayment, they probably would not have been subprime,) and they were often only qualified based on their ability to make the initial payment rather than on their ability to make the payment after the reset. There was a special loan program called a 2/28 that most subprime borrowers purchased. This loan fixed a payment for two years; afterward, the payment would increase to a higher interest rate and on a fully-amortized schedule over the remaining 28 years. The payment shock was extreme. This created a condition where most subprime borrowers could not refinance or make their payments, and many of these borrowers defaulted on their loans. Data from early 2008 showed the 2006 and 2007 vintage of subprime loans default rates running close to 50%, and this was before the resets were coming due. Most of these subprime borrowers who went into default lost their properties in foreclosure, and these foreclosures were added to the supply of an already overwhelmed real estate market.
Figure 8: Adjustable Rate Mortgage Reset Chart
Since the subprime resets came first, borrowers in areas dominated by subprime were foreclosed on first. The resulting carnage dropped prices 30% or more in some areas and prompted waves of strategic defaults by borrowers who lost hope of ever regaining equity in their properties. As a result, when the larger Alt-A and jumbo loans issued as adjustable rate mortgages were due to reset, lenders chose not to foreclose. As a result, many delinquent borrowers were allowed to squat in houses they still technically owned, but in which they had no equity and were not making payments.
Figure 9: Updated Adjustable Rate Mortgage Reset Chart – March 2010
False Stabilization Through Demand Stimulus and Supply Management 2009
As private lending retreated the government decided to step in by taking Freddie Mac and Fannie Mae into conservancy and ramp up its lending at the Federal Housing Authority. By the end of 2008 the federal government directly insured nearly 98% of the mortgage market. To further support the market, the government implemented a tax incentive program where borrowers could obtain an $8,000 tax credit for purchasing a home. Also, the Federal Reserve embarked on an unprecedented program of buying mortgage-backed securities. They paid prices the private sector would not in order to drive down the interest rates on residential mortgages and increase loan balances.
Despite the heroic efforts to stimulate demand, the supply of delinquent borrowers destined to become foreclosures and later REO needing liquidation greatly exceeded the demand. Prices crumbled.
Figure 10: Historic Delinquency Rates 1995-2011
In early 2009 lenders slowed their rates of foreclosure to balance supply with demand in an effort to stabilize prices. Since this disconnected delinquency rates from foreclosure rates, many borrowers who were delinquent were not pushed through foreclosure. Shadow inventory was born.
Figure 11: Historic Foreclosure Rates 1995-2011
In nearly every housing market across the country in early 2009, lenders slowed foreclosures and began building shadow inventory.
Figure 12: Monthly Foreclosures, Irvine, CA 2005-2010
Shadow inventory is a result of the disconnect between delinquency and foreclosure.
Figure 13: Foreclosure Starts Versus Serious Delinquencies
Eventually the shadow inventory must be pushed through the system. Lenders are not going to give away a trillion dollars worth of homes.
Market Double-Dip as Subsidies are Removed 2010-2011
Lenders, the Federal Reserve and the government responsible for the losses at the GSEs and FHA were all hoping the engineered bottom they created in 2009 would provide the market momentum that would carry forward. This was never a realistic possibility. In many markets prices were still inflated in 2009, and with the overhang of distressed inventory on the MLS, in the foreclosure pipeline and waiting in shadow inventory, and the depleted buyer pool needed to absorb this inventory, there was little chance of the market props forming a durable bottom.
Figure 14: National S&P/Case-Shiller Home Price Index, 1987-2011
The double-dip represents the second phase of the housing bubble deflation. The first phase was the removal of the toxic financing and government props. The second phase is the liquidation of supply left over from the debacle.
An uneven market decline
Because of differences in where subprime loans were concentrated, housing markets all over the country have declined at different rates. Contrary to popular belief, this is not because borrowers in prime areas were not experiencing mortgage distress. In many locations, the delinquency rates among high wage earners is actually higher than their subprime counterparts, but these borrowers have been allowed to squat in shadow inventory as banks hope to keep house prices up in those areas to increase their capital recovery when they do foreclose.
Figure 15: Price Declines by MSA from Housing Bubble Peak
The uneven nature of the market decline can be illustrated by comparing Orange County, California, to Clark County, Nevada.
Orange County, California
Orange County is characterized by large amounts of Alt-A and jumbo loans with relatively little subprime. The subprime areas in Santa Ana have fallen precipitously, but the prime areas have held up as delinquent borrowers live in their homes without making payments.
Figure 16: Orange County, CA, Median Home Price, 1991-2011
Orange County and other coastal markets have not finished deflating from the housing bubble. Rather than a sign of market strength, the markets that have fallen the least have the most danger of further declines from the liquidation of shadow inventory.
Clark County Nevada
Clark County Nevada is the most extreme bubble crash market. It shows the classic bubble pattern with a severe overshoot of fundamentals to the downside. It represents one of the best opportunity to acquire undervalued assets likely to rise significantly once the overhead supply is worked through the system.
Clark County, Nevada, has unprecedented affordability. Prices are the same as the mid 90s when incomes were less and interest rates were near 10%. It costs less to own a median home in Clark County on a payment basis than it does to lease basic transportation.
Figure 17: Clark County, NV, Median Home Price, 1991-2011
Directly comparing Orange County to Clark County reveals how uneven the crash has been.
Figure 18: Comparison of Orange County, CA to Clark County, NV, 1991-2011
The final chapter of the story of the housing bubble will be about inventory liquidation and a return to normalcy. It may take years to write, but the endgame is near.
Sorry, but housing is now a socialized industry, hence, the following statement simply can not be quantified, especially in places like OC ……
”The housing market is closer to the bottom than to the top”
Also, in an ultra-low interest rate environment, the overall demand for assets should far exceed the overall demand for cash, but that’s not happening this time due to financial repression.
BDI crashing this month (-64%) signaling carnage ahead.
http://www.alt-market.com/images/stories/bdi4.gif
The next leg down will be brutal 😉
I never heard of the Baltic Dry Index.
The Baltic Dry Index’s recent collapse reflects a substantial plunge in shipping rates as demand for shipping by sea plummets around the world. This precipitous drop in the BDI may well be a harbinger of tough times ahead. Conversely, it could indicate an aberration in the historically inelastic supply curve of shipping. Whichever way one reads it, however, the volatility in such an important index as the BDI is something to be concerned about.
Good index to follow. I also never heard of this index. Boy if this is the case, then we are looking into the 2nd half of the recession.
Maybe those mortgage rates will be ultra low, however with more fees and taxes, for several more years.
Great economics blog I have been reading lately.
http://scottgrannis.blogspot.com/
Excellent analysis and has been making me feel that we are moving along in a slow recovery rather than any impending doom on the horizon.
Here is a counter to the Baltic Index above. Domestic Truck Tonnage is doing great.
http://scottgrannis.blogspot.com/2012/01/truck-tonnage-is-very-impressive.html
Great post by the way!
Graph showed it going down 1 year ago too, just not as low as this time. It is still close enough where I won’t buy a gun yet.
el ORACLE has a long history of misinterpreting these graphs. 😉
It should be noted that international shipping rates are intrinsically very volatile.
When demand goes up, prices go up, but there is very little demand side response, because for most applications shipping is a small component of overall cost. Little supply side response as well – it takes years to build new ships. So very quickly bidders can drive up prices very dramatically.
Conversely, when demand goes down, there is very limited supply side response(did the 64% drop have any impact on selection or price in your local store?). Only when shipping prices start to approach the variable cost (e.g. fuel) do shippers take capacity off line.
So huge movements in shipping rates don’t necessarily indicate huge changes in the general economic picture.
Here we go again: Subprime Debt Insured by FHA Climbs in Bet on Housing Recovery
By North OC Housing News
In Honolulu, on the southern coast of the island of Oahu, there’s a four-bedroom home priced at $785,000 that has views of the sun setting over the Pacific Ocean. The beaches of Waikiki are 15 minutes away.
Starting this month, the property is available to buyers with a subprime credit score, limited cash reserves and a 3.5 percent down payment using a loan backed by the Federal Housing Administration. Without the agency, a buyer would need a 20 percent down payment and an unblemished financial history for a jumbo mortgage.
MORE
[…] A Brief History of the Housing Bubble – O.C. Housing News […]
Uh…oh….. busted!
Freddie Mac has invested billions of dollars betting that U.S. homeowners won’t be able to refinance their mortgages at today’s lower rates.
http://www.npr.org/2012/01/30/145995636/freddie-mac-betting-against-struggling-homeowners
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This is a great post and while I largely agree with it, there are a few points that I think should be made-
“With a dramatic increase in loan delinquencies, lenders began a plethora of loan modification and other programs to prevent foreclosures. These programs have largely failed to prevent foreclosure, but they have been somewhat successful in delaying them. Most insolvent borrowers ended up going through the foreclosure process.”
For the few homeowners lucky enough to qualify for HAMP, the efforts have largely been successful. Only 25% have redefaulted since program inception, which means a 75% success rate so far. Cutting PITIA payments down to 31% of documented income usually leads to a payment much, much lower than rental parity. It’s not uncommon to see PITIA payments reduced by 60-70% and this is locked for 5 years. Why would a borrower re-default and move to a rental when they can rent from the bank for cheaper?
“There was a special loan program called a 2/28 that most subprime borrowers purchased. This loan fixed a payment for two years; afterward, the payment would increase to a higher interest rate and on a fully-amortized schedule over the remaining 28 years. The payment shock was extreme. This created a condition where most subprime borrowers could not refinance or make their payments, and many of these borrowers defaulted on their loans. Data from early 2008 showed the 2006 and 2007 vintage of subprime loans default rates running close to 50%, and this was before the resets were coming due.”
The payment shock was also due to interest only loans converting to full amortization. In many cases, the rate on subprime ARM’s is now lower than the initial rate, but the payment shock of going from interest only to full amortization still caused a default. It’s also worth mentioning that many subprime loans were fixed rate, yet due to insane risk layering (low FICO, no down payment, no income/asset verification) these fixed rate loans still exhibited high rates of default, although a bit lower than 2/28’s and 3/27’s.
“In early 2009 lenders slowed their rates of foreclosure to balance supply with demand in an effort to stabilize prices. Since this disconnected delinquency rates from foreclosure rates, many borrowers who were delinquent were not pushed through foreclosure. Shadow inventory was born.”
I disagree that this was at the lender’s behest. In early 2009, Obama announced the creation of the HAMP program and that FORCED the lenders to slow things down.
“In many locations, the delinquency rates among high wage earners is actually higher than their subprime counterparts, but these borrowers have been allowed to squat in shadow inventory as banks hope to keep house prices up in those areas to increase their capital recovery when they do foreclose.”
High wage earners are also more savvy about gaming the system. They know how to hire lawyers, apply and re-apply for modifications, ask for numerous repayment plans, and if necessary, declare BK to fend off a foreclosure sale date.
“Only 25% have redefaulted since program inception, which means a 75% success rate so far.”
A 25% failure rate is still pretty bad. Historically mortgage default rates are less than 5%. a 25% default rate is five times that value. You have to see the glass as half full to call that a success.
“Cutting PITIA payments down to 31% of documented income usually leads to a payment much, much lower than rental parity. It’s not uncommon to see PITIA payments reduced by 60-70% and this is locked for 5 years. Why would a borrower re-default and move to a rental when they can rent from the bank for cheaper?”
The reason people default is because they are so far underwater the won’t have equity five years later. Many will stay on because their payment is below rental parity, but many of these people will default in five years when their payments go back up and they have no equity — assuming they are not given another loan modification.
“I disagree that this was at the lender’s behest. In early 2009, Obama announced the creation of the HAMP program and that FORCED the lenders to slow things down.”
Perhaps, but whether by choice or by force, lenders across the country delayed foreclosure, and it was the removal of this supply that helped stabilize the market.
“High wage earners are also more savvy about gaming the system. They know how to hire lawyers, apply and re-apply for modifications, ask for numerous repayment plans, and if necessary, declare BK to fend off a foreclosure sale date.”
That is true, but even high wage earners must feel there is a benefit to doing so. At some point, most of these people will strategically default. Many already have and they are just playing the game to get free housing for a while.
“A 25% failure rate is still pretty bad. Historically mortgage default rates are less than 5%. a 25% default rate is five times that value. You have to see the glass as half full to call that a success.”
I look at it as 100% of these mortgages were headed to foreclosure and now only 25% are. When you realize that many analysts were expecting HAMP re-defaults to mirror 2008 vintage mods, the program has exceeded all expectations on that front:
55-75% of HAMP Mods Could Re-Default under Fitch Projections
http://www.housingwire.com/2010/06/16/55-75-of-hamp-mods-could-re-default-under-fitch-projections
“The agency projects 65-75% of modified subprime and Alt-A loans, and 55-65% of modified prime loans, will redefault within 12 months of modification”
Orange County’s market time is about as quick as it was two years ago, during the tax credit-fueled mini-bubble. Are fundamentals fueling it this time?
http://lansner.ocregister.com/2012/01/26/demand-for-cheaper-o-c-homes-soars-30/157708/
I will pose that question in a post for tomorrow. Now that prices are below rental parity, an argument can be made that the demand is based on fundamentals.
[…] China’s Wen: govt debt risk “controllable”, sets reforms – Reuters A Brief History of the Housing Bubble – O.C. Housing News The Federal Reserve Is Doing It Wrong… – Delong Inflation […]
Maybe the HAMP success/failure rate would make more sense if you used actualy numbers instead of %.
Thank you for this summary review. Excellent. It still reads like a horror story though where the main characters never quite “get it”, especially Greenspan, Bernanke & Co.