Sep102012

Debt-to-income ratios must be limited to prevent future housing bubbles

In The Great Housing Bubble, I wrote about how we could prevent the next housing bubble:

Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:

  1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
  2. The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
  3. The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
  4. The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.

The primary focus of my proposal was to limit lending to amounts buyers could afford to pay back. Eliminating toxic loan programs and keeping equity in the property help keep prices stable, but limiting debt-to-income ratios are critical to preventing delinquencies and foreclosures which ultimately ravage the housing market.

The parameters of the forming limitations on the debt-to-income ratio and combined-loan-to-value are essential to prevent bubbles in the housing market and to prevent the banking system from becoming imperiled in the future. People will commit large percentages of their income to house payments when prices are rising quickly; however, they do this out of fear of being “priced out” and greed to make a windfall from appreciation. These are the beliefs that inflate a bubble. Borrowers cannot sustain payments above the traditional parameters for debt service without either defaulting or causing a severe decline in discretionary spending. The former is bad for the banks, and the latter is bad for the entire economy. This must be prevented in the future.

Notice that excessive borrower is bad for both banks and the broader economy, and not because the banks are so important. The real problem with our economy today is that people are broke. They have a hangover from excessive debt the banks are unwilling — and perhaps unable — to purge.

Apparently, the economists at the federal reserve have come to the same conclusions I have, albeit four years later.

we find that a loan-to-income constraint is the most effective tool for dampening overall excess volatility in the model economy.

The full paper is below:

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Household leverage in many industrial countries increased dramatically in the years prior to 2007. Countries with the largest increases in household debt relative to income tended to experience the fastest run-ups in house prices over the same period.

Banks completely lost their minds and ignored the amount of debt they were issuing relative to the borrower’s income. Banks everywhere simultaneously began running Ponzi schemes which imploded and took the world economy down with it.

The same countries tended to experience the most severe declines in consumption once house prices started falling (Glick and Lansing 2010, International Monetary Fund 2012).1

In a Ponzi scheme, the borrower comes to rely on fresh infusions of debt to service debt and fuel consumption. The borrower does not have the income to do either of those things, so the influx of new debt is essential to keeping the system going. When lenders withhold this debt, borrowers abruptly stop making debt service payments, and lenders respond by increasing interest rates, demanding repayment, and curtailing new debt issuances — a credit crunch.

Within the United States, house prices during the boom years of the mid-2000s rose faster in areas where subprime and exotic mortgages were more prevalent (Mian and Sufi 2009, Pavlov and Wachter 2011). In a given area, past house price appreciation had a significant positive influence on subsequent loan approval rates (Goetzmann et al. 2012).

This is the statistic that is most shocking. The more insane the market became, the most lenders relaxed their lending standards to contribute to the insanity. Lending snowballed out of control and fueled the rapid appreciation in price until the market collapsed.

Areas which experienced the largest run-ups in household leverage tended to experience the most severe recessions as measured by the subsequent fall in durables consumption or the subsequent rise in the unemployment rate (Mian and Sufi 2010).

I noted back in 2008 that the California economy is dependent upon Ponzi borrowers. Economists struggle to explain the lackluster recovery from the Great Recession, but in reality it’s quite simple. California’s HELOC economy collapsed due to the elimination of the free-money stimulus banks were giving loanowners. Even a massive government spending program is no enough to make up for millions of loanowners irresponsibly spending hundreds of thousands of dollars each.

Overall, the data suggests the presence of a self-reinforcing feedback loop in which an influx of new homebuyers with access to easy mortgage credit helped fuel an excessive run-up in house prices. The run-up, in turn, encouraged lenders to ease credit further on the assumption that house prices would continue to rise. Recession severity in a given area appears to reflect the degree to which prior growth in that area was driven by an unsustainable borrowing trend–one which came to an abrupt halt once house prices stopped rising (Mian and Sufi 2012).

I am quite relieved to see the federal reserve finally gets this. Their verbose explanation is a fancy way of saying lenders were running a Ponzi scheme.

much of the run-up in U.S. house prices and credit during the boom years was linked to the influx of an unsophisticated population of new homebuyers. Given their inexperience, these buyers would be more likely to employ simple forecast rules about future house prices, income, etc.

Most bubble buyers were kool-aid intoxicated fools. In their defense, they were merely believing the “experts” from the NAr who were telling them house prices only go up, their running out of land, buy now or be priced out forever, and so on.

Historical episodes of sustained rapid credit expansion together with booming stock or house prices have often signaled threats to financial and economic stability (Borio and Lowe 2002). Times of prosperity which are fueled by easy credit and rising debt are typically followed by lengthy periods of deleveraging and subdued growth in GDP and employment (Reinhart and Reinhart 2010). According to Borio and Lowe (2002) “If the economy is indeed robust and the boom is sustainable, actions by the authorities to restrain the boom are unlikely to derail it altogether. By contrast, failure to act could have much more damaging consequences, as the imbalances unravel.” This point raises the question of what “actions by authorities” could be used to restrain the boom?

There is no question something should be done to prevent asset bubbles in general and housing bubbles in particular. Houses have historically been a reservoir of retirement savings, although lenders have worked to ruin that with unrestricted mortgage equity withdrawal. The stability of house prices is paramount if we are to have a functioning economic system.

Intuitively, a loan-to-income constraint represents a more prudent lending criterion than a loan-to-value constraint because income, unlike asset value, is less subject to distortions from bubble-like movements in asset prices. … the ratio of U.S. household debt to disposable personal income started to rise rapidly about five years earlier, providing regulators with a more timely warning of a potentially dangerous buildup of household leverage.

For this to work, the banking industry must accept that fact that financial innovation is folly. Part of the reason everyone ignored the obvious warning signs of excessive debt is because they believed the financial innovation meme. If industry insiders come to believe the next Ponzi loan program is a viable financial innovation, we will watch the debt-to-income ratio grow wildly out of control, and we will be assured everything will be okay — until it isn’t.

In our view, it is much easier and more realistic for regulators to simply mandate a substantial emphasis on the borrowers’ wage income in the lending decision than to expect regulators to frequently adjust the maximum loan-to-value ratio in a systematic way over the business cycle or the financial/credit cycle.

It is very much simpler to focus on regulating debt-to-income ratios. It’s a simple, measurable mathematical relationship that’s hard to ignore.

Needless to say, I fully agree with the conclusions reached in this paper.

Why their model works

The reason limiting debt-to-income ratios works is because beyond a certain point, rising debt service becomes a Ponzi scheme. Remember, debts are supposed to be paid off. People forget that simple fact and take on debt as if it is something to be endlessly serviced. Those that embrace the debt-service mentality try to surf on the edge of the abyss.

Treading financial water occurs is when the amount a borrower pays toward principal on debt is matched by taking on new debt. When the amount of new debt exceeds the amount debt was paid down, particularly if debt was used to pay debt, the borrower is Ponzi borrowing. There is a point beyond which a borrower cannot pay down debts without continued borrowing, a point where the debt service exceeds the ability to income to support it. This is the dilemma of insolvency, and the brink of insolvency is the Ponzi limit.

Unfortunately, the Ponzi limit is fluid. Many borrowers creep up on the Ponzi limit without knowing it. Lenders often extend credit to borrowers beyond their ability to service it putting the sum of all credit lines beyond the Ponzi limit. Once borrowers cross this unseen threshold, lenders begin to raise the borrower’s interest rates and force them to Ponzi borrow in order to make ends meet. At that point, the borrower is insolvent, but ongoing Ponzi borrowing can mask that for a time.

Once borrowers have gone Ponzi, there is no hope — they can’t borrow their way out of debt, and they can’t afford to earn and pay their way out either. It is only a matter of time before insolvency leads to delinquency and forgiveness of debt usually through a bankruptcy.

The problem with the Great Housing Bubble is insolvency. Lenders underwrote too many loans for too much money. Borrowers everywhere are insolvent, and the main mechanism for curing real estate debt insolvency – foreclosure — is being shunned by our government, lenders and borrowers alike. Thus our government encourages useless loan modifications programs and lenders allow delinquent borrowers to squat. These are not solutions to the problem; these are avoidance mechanisms to prevent dealing with the problem. The debt must be purged.

The fate of Ponzis

The Ponzis have two options once they are insolvent: (1) find another borrower who will loan them money, or (2) experience the The Unceremonious Fall from Entitlement as their lifestyle expenses are reduced to their income level regardless of their needs and wants.

Ponzi borrowing is not sustainable. Once borrowers cross the Ponzi limit, they will financially implode, and any lenders who extend credit to those borrowers will lose their money. Since lenders have so much money tied up in the Ponzis right now, they are working to expand the Ponzi scheme by getting the government involved as the bagholder for the bank’s Ponzi loans. The government and the central bank are the lenders and bagholders of last resort. It isn’t very likely private lenders will step forward to extend Ponzi loans any time soon. That leaves only one option for the Ponzis….

Unless Ponzis are given more debt, they will all succumb to the weight of their obligations. As each one exhausts their credit lines, bank losses will mount, and pressures on capital reserves will increase. Lenders will remain cautious and zombie-like. Since the spending of the Ponzis has become such a large part of our local and national economy, we may experience a long period of deflation similar to Japan as the Ponzis collapse. As I see it, we will not experience a robust economic recovery as long as the Ponzis keep their debts and banks keep pretending these Ponzis will pay them back. And since amend-extend-pretend has been officially sanctioned bank policy for the last four years, it shouldn’t be surprising the economy is weak, and we are constantly worried about tipping back into recession.