High debt-to-income ratios equal high default rates

The California housing market is volatile, but people only see the ups. Trying to capture appreciation, they “stretch” to get into a property by putting larger and larger percentages of their income toward housing (until the entire system collapses). This stretching is (1) recorded in the aggregate debt-to-income ratio for a particular market and (2) observed in the struggles of individual homeowners.

Irvine debt-to-income ratios 1975-2009


As you might surmise, the peaks in the DTI ratios correspond to peaks in our three California housing bubbles.

Comparison of home prices and value - Irvine California - 1975-2009


Today, I want to move from the macro down to the micro; the charts above show aggregate numbers and big-picture relationships, but what about the individual? What struggles does all of this mean for you and me?

From Mark Hanson (Mr. Mortgage):

Time-Tested DTI Standards Thrown out the Window

A long time ago in a mortgage market far, far away (circa-2000 and before!) there was responsibility in lending. Age-old underwriting standards only allowed fully-documented debt-to-income ratios of 28% for housing and 36% for total debt (referred to as front and back DTI). On Jumbo loans, the ratios were 33/38 because Jumbo borrowers typically have more disposable income. On occasion, banks would make exceptions to this rule if the borrower had a large equity position or liquid reserves. At 28/36, homeowners can pay debt, shop, take their annual vacation, and even save money. At 28/36 DTI a house is a place to live first and an investment, second.

Bubble year’s loan guidelines not only pushed the boundaries of risk by exotic loan structure but also income leverage. Circa-2002, time-tested DTI standards went out the window. Allowable DTI ratios on Prime loans rose to 50% and much higher when considering that so many loans were made with limited or no income documentation. Alt-A and Subprime full-doc loans would routinely go to 55% DTI…

This is the main reason we have an inescapable foreclosure crisis coming, and it is also why the FED is keeping interest rates so low. The only way to take a relatively small payment and apply some of it to principal is to extend the term of the loan and lower the interst rate. The Federal Government’s loan modification program will (1) lower interest rates to 2% (2) increase amortization to 40 years, and (3) defer principal like an Option ARM; this still doesn’t make the payment affordable. There are simply too many people in houses they cannot afford under any circumstances.

How bad is a 50% DTI?

Mark Hanson goes on:

1) What a 50% DTI Really Means?

  • Borrower Earnings: $100k per year
  • 50% Total DTI: $50,000 per year to housing PITI & all other debt on credit report
  • 25% Fed & State Taxes: $25,000 per year
  • Disposable income: $25,000 per year, or $2,083 per month

How does this well-above average household SAVE MONEY AND pay for utilities (power, water, cable, garbage, insurance (car, life, health), gas, food, car payment, fuel, clothes, household maintenance and more on $2,083 per month? How do they save an emergency fund or take even a drive-away trip for the weekend? How do they shop this holiday season when over a trillion dollar in consumer credit was taken away in the past year?

A 50% housing DTI turns the house into the largest investment of your life and ruins most household’s balance sheet at the same time unless the gross income – and disposable income – is much larger.

For most in a serious negative equity position, it is better to walk away. Earning your way out of a $200k hole is impossible with disposable income of $2,083 per month less expenses. Why not walk – the borrower’s credit will be trashed for a few years but as long as they maintain their credit rating on all other credit, their overall rating will not be damaged for as long as their house remains underwater.

2) Now, let’s look at this with 28/36 time-tested debt-to-income ratios.

Bottom Line – 60% MORE disposable income each month.

  • Borrower Earnings: $100k per year
  • 36% Total DTI: $36,000 per year per to housing PITI & all other debt on credit report
  • 25% Fed and State Taxes: $25,000 per year
  • Disposable income: $39,000 per year or $3,250 per month

With $3,250 per month, a $100k household can likely save $20k per year. Still, this is not enough to make a real dent in a $200k neg-equity position. But, with this much disposable income the homeowner is not missing out on much and they are saving money, meaning their house is a place to live.

What do households spend money in every year? The U.S. Census bureau provides the answers:

  • $200 billion on furniture, appliances ($1,900 per household annually)
  • $400 billion on vehicle purchases ($3,800 per household annually)
  • $425 billion at restaurants ($4,000 per household annually)
  • $9 billion at Starbucks ($85 per household annually)
  • $250 billion on clothing ($2,400 per household annually)
  • $100 billion on electronics ($950 per household annually)
  • $60 billion on lottery tickets ($600 per household annually)
  • $100 billion at gambling casinos ($950 per household annually)
  • $60 billion on alcohol ($600 per household annually)
  • $40 billion on smoking ($400 per household annually)
  • $32 billion on spectator sports ($300 per household annually)
  • $150 billion on entertainment ($1,400 per household annually)
  • $100 billion on education ($950 per household annually)
  • $300 billion to charity ($2,900 per household annually)

The average homeowner household spends $22,785 per year, or $1900 per month on the above. When making an allowance for some of the items that are typically financed, the outgo is still roughly $1500 per month.

At 50% DTI, the $100k earner with a disposable income of $2083 per month will have extra monthly income of $583 based upon typical spending. That does not leave a lot for savings, or items not listed such as auto insurance, vacations, gas etc. That definitely is not enough to ‘earn their way out’ of their negative equity hole.

However, the 36% DTI borrower will have an extra $1750 month, which allows for living life and saving money, significantly reducing the chance of loan default due to negative-equity..

Bottom Line – This shows vividly why 50% DTI – even with borrowers making $100k a year and with 20% equity in their property – is in fact over-leveraged and a recipe for loan default for any number of reasons.

When you see the hopelessness of the circumstances of the individual borrowers who either bought or refinanced at the peak, and it is difficult to see how they continue making payments and have a life without HELOC supplementation (it isn’t coming back soon). If many individual borrowers do not make it, lenders end up taking back large numbers of foreclosures — which is what we are seeing today — and what we will be seeing much more of over the next three to seven years.

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.

So far, despite the Government meddling, ratios are falling to their historic norms. The one that isn’t is the price-to-income ratio. It is being artificially held at over 5-times income with 5% interest rates.

With the Government manipulation it is difficult to predict where pricing will bottom, but we can be a bit more certain about payment affordability and DTI ratios. It isn’t likely that pricing will fall so low that people are putting less than 25% of their income toward housing. Many will chose to buy a larger house rather than save money. When DTI ratios fall into safe zones, properties enjoy payment affordability, and with stable loan terms of 30-year fixed-rate mortgages, markets enjoy price stability — at least they are supposed to — we have never witnessed the kind of market manipulation we are seeing today. I don’t feel our prices are stable, and neither should you.