One of my earliest posts in May of 2007 was about the impact future loan terms have on future home prices. Most people just assume house prices always go up. Their faith was shaken by a precipitous decline over the last six years, but once the bottom is securely in the rear-view mirror, kool aid intoxication in faith-based appreciation will undoubtedly return. I want to revisit the idea of future house prices depending on future loan terms because it makes a strong case for weak home price appreciation going forward. The how and why matters, and before kool aid takes hold again, it pays to understand what it would take for house prices to go up from here.
Over the holiday, I reposted a series on cost of ownership. In the post Ownership cost: income, payments and house prices, I lay out the four variables that determine market price:
- borrower income,
- allowable debt-to-income ratios,
- interest rates, and
- down payment requirements.
Interest Rates
In another recent post, Orange County monthly cost of ownership falls to 1980s levels, I noted that the cost of ownership is the same today as it was in 1989; therefore, all appreciation over the last 23 years is due to a decline in interest rates from 10.77% in April 1989 to 3.5% in October 2012. Was it reasonable for a buyer in 1989 to assume house prices would rise because interest rates would decline 70%. If so, it is reasonable to assume we will have 1% mortgage interest rates 25 years from now to keep prices rising?
The above example shows the dramatic impact interest rates have on house prices, and unless mortgage interest rates keep making new record lows for the next 25 years, that engine of home price appreciation will run out of gas. When interest rates finally do move higher, the math dictates that loan balances will get smaller. That could negatively impact resale prices.
I covered this issue in detail in Will rising interest rates cause house prices to crash?. The bottom line is this; If interest rates go on a sustained rise, financing home purchases will become more expensive. That is the math. The real question then is whether or not these rising interest rates are compensated for by rising wages. If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again.
Borrower income
That brings us back to the first of the four variables listed, borrower income. Ordinarily, incomes rise over time as the economy expands and workers can demand higher pay for their services. However, in an era of high unemployment, wages generally do not rise because workers do not have the leverage to demand higher pay. In fact, in many industries, wages actually go down as the supply of workers exceeds the demand for their services and those who wish to remain in the field lower their expectations. All economic indicators point to continued high unemployment for the next several years. The only way the federal reserve can hope to overcome this is to print more money, a policy with its own drawbacks.
Borrower income and the interest rate cycle and inflation all come together to create a set of conditions at the bottom of a credit contraction recession that does not favor rapid house price appreciation. The bottom of the interest rate cycle typically drags on for several years as the federal reserve tries to boost the economy. Sustained low interest rates causes inflation to flare up, and the federal reserve is usually one step behind rising inflation.
Rising interest rates would slow economic activity and hurt home affordability, so the federal reserve will resist doing so for as long as possible. Inflation will ultimately force their hand, but that could be many years into the future. During the 1960s and 1970s each time the federal reserve raised interest rates, it triggered a recession that forced them to lower rates once again. It wasn’t until inflation got completely out of control due to a collapsing dollar that the federal reserve raised rates enough to curb inflation. That caused the double-dip recessions of 1980 and 1982, what is now the second-worst recession since the Great Depression (our recent recession was even worse).
Debt-to-income ratios
The inflation of the 1970s did cause both wages and house prices to go up, but the two didn’t go hand-in-hand. Lenders lost control of one of the other key variables: debt-to-income ratios.
During the 1970s lenders threw out their standards for debt-to-income ratios and underwrote loans at 60% DTIs and higher. So why did they do it? Well, with runaway wage inflation, which we had in the 1970s, what is a 60% DTI this year becomes a 55% DTI next year, and a 50% DTI a year after that and so on until the mortgage payment is manageable after just a few years. 
This is where the erroneous conventional wisdom about stretching to get a starter home comes from. If you could survive on nothing for a few years, over time the rapid wage inflation would make your house payment small and manageable. Plus, the owner got a boatload of appreciation to boot. Of course, this is a Ponzi scheme because it relies on ever-increasing wage inflation which may not come to pass. And when Paul Volcker tamed inflation in the 1980s, wage inflation did stop, house prices crashed in California, and the Ponzi scheme unraveled.
It’s unlikely lenders will permit DTIs much higher than today’s. The current allowable DTIs are as high as they can possibly be to sustain home ownership. We know this because during the first round of loan modifications in 2008 (which nearly all failed), the DTIs were reduced to 38%. That was far too high. Lenders had to reduce DTIs to 31% before people stopped defaulting. Absent Ponzi borrowing or rapid wage growth, the current 31% standard is as much as people can afford. It isn’t likely these allowable DTIs will go up unless lenders want to start losing more money.
Down Payments
That leaves us with one final determinant of home prices. And this one cuts both ways. People are not good savers, and Ponzis don’t save anything. If people were saving and accumulating equity, the move-up market would be healthy and vibrant. In an era of unrestricted HELOCs, equity is squandered rather than accumulated. Have you noticed that the only communities where supply is abundant is the beach communities and other move-up markets?
The demand is tepid in these areas despite low interest rates because potential buyers simply don’t have the down payments necessary to complete the sale. Unless we put some restrictions on mortgage equity withdrawal, people will not accumulate equity to support these markets. I anticipate the low end of the housing market will recover strongly while the high end continues to languish mostly due to the lack of sufficient down payments to push prices higher.
What conditions will your future buyer face?
For those who believe California house prices will begin a new phase of sustained rapid appreciation, what conditions will future buyers face that will cause prices to go up so much?
Will interest rates continue to go down?
Will incomes go up?
Will debt-to-income ratio standards be relaxed?
Will future buyers accumulate larger down payments?
One or more of those questions must be answered positively for house prices to go up. Appreciation doesn’t happen by magic. House prices must be bid up by future buyers, and based on the conditions I see, once the market reaches a new equilibrium (it is currently undervalued), future home price appreciation will be tepid at best.
She got her share
The former owner of today’s featured REO was a typical OC Ponzi. She was fortunate to buy at the bottom of the last housing bubble and rode the equity wave and nearly doubled her mortgage with mortgage equity withdrawal. She put less than $4,000 down to acquire the property, and she extracted about $115,000 in HELOC booty.
Despite the foreclosure on her record, I imagine she will want another home again soon. She was handsomely rewarded last time.
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Proprietary OC Housing News home purchase analysis
209 North SINGINGWOOD St #109 Orange, CA 92869
$334,900 …….. Asking Price
$128,000 ………. Purchase Price
4/2/1998 ………. Purchase Date
$206,900 ………. Gross Gain (Loss)
($10,240) ………… Commissions and Costs at 8%
============================================
$196,660 ………. Net Gain (Loss)
============================================
161.6% ………. Gross Percent Change
153.6% ………. Net Percent Change
6.6% ………… Annual Appreciation
Cost of Home Ownership
——————————————————————————
$334,900 …….. Asking Price
$11,722 ………… 3.5% Down FHA Financing
3.45% …………. Mortgage Interest Rate
30 ……………… Number of Years
$323,179 …….. Mortgage
$99,051 ………. Income Requirement
$1,442 ………… Monthly Mortgage Payment
$290 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$84 ………… Homeowners Insurance at 0.3%
$337 ………… Private Mortgage Insurance
$406 ………… Homeowners Association Fees
============================================
$2,559 ………. Monthly Cash Outlays
($213) ………. Tax Savings
($513) ………. Equity Hidden in Payment
$13 ………….. Lost Income to Down Payment
$62 ………….. Maintenance and Replacement Reserves
============================================
$1,907 ………. Monthly Cost of Ownership
Cash Acquisition Demands
——————————————————————————
$4,849 ………… Furnishing and Move In at 1% + $1,500
$4,849 ………… Closing Costs at 1% + $1,500
$3,232 ………… Interest Points
$11,722 ………… Down Payment
============================================
$24,651 ………. Total Cash Costs
$29,200 ………. Emergency Cash Reserves
============================================
$53,851 ………. Total Savings Needed
The property above is available for sale on the MLS.
Contact us for a comparative market analysis, a cost of ownership analysis, or information on how you can make an offer today!
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33 Responses to “Future loan terms determine future home prices”
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Wow! The City of Orange’s rent has increased $300 in 10 months. That’s is just nuts.
Delinquency rate falls slightly, still up over August
After suddenly jumping 7.7 percent in September, the nation’s delinquency rate fell in October, according to “first look” data from Lender Processing Services (LPS).
The delinquency rate stood at 7.03 percent in October, a decrease of 4.91 percent from September and 7.19 percent from last year. Historically, LPS says the delinquency rate is actually expected to tick up in October due to seasonal effects.
Overall, the number of properties 30 days or more past due or in foreclosure numbered 5.3 million. Of that total, 3.5 million are 30 days or more past due but not in foreclosure, while 1.8 million remain in pre-sale foreclosure inventory. Of the properties that are past due but not in foreclosure, 1.5 million are seriously delinquent or 90 days or more past due.
Foreclosure inventory continued to diminish in October, with the foreclosure presale inventory rate at 3.61 percent, down 6.77 percent from September and 15.99 percent from last year.
The states that held the highest percentage of delinquencies and foreclosures were Florida, Mississippi, New Jersey, Nevada, and New York. The states with smallest share of unpaid loans were Montana, Wyoming, South Dakota, Alaska, and North Dakota.
The November numbers should be interesting with the Sandy defaults starting to show up.
I wonder too if the government loan modification programs, which have been the main source of “cures,” has reached the point of diminishing returns. If the defaults keep pace and the cures slow down, the delinquency rate will rise again.
Lack of inventory keeping prices up during off season
October marks the 12th consecutive month of monthly home value increases, according to Zillow, which reported a 1.1 percent increase over the month.
Home values were up even higher on an annual basis, climbing 4.7 percent over the year and representing the greatest increase since September 2006.
Home values now stand at $155,400, according to Zillow.
“Those dubious about the durability of the housing recovery will point to the large role that investors are playing in the recovery, or to the large number of foreclosures yet to hit the market, as factors to be wary of,” said Stan Humphries, chief economist at Zillow.
“But the bottom line is that homes are more affordable now than at any time in recent memory, and buyers are seizing this opportunity,” he continued.
Chicago was the only one of the 30 largest metro areas Zillow measures to experience a monthly decline in home values in October.
On an annual basis, four of the 30 metros experienced value declines.
The metros measuring the highest annual value increases in October include Phoenix (22.3 percent), San Jose, California (11.4 percent), Denver (10.4 percent), San Francisco (9.5 percent), and Miami-Ft. Lauderdale (8.8 percent).
Zillow reported another positive sign for the housing market: decreasing foreclosures. Foreclosures declined 0.8 percent in October, and the annual decrease was even greater—1.9 percent.
In October, 5.57 out of every 10,000 homes were in some stage of foreclosure.
Looking forward, Zillow anticipates “increasing numbers of potential buyers entering the market as the broader economy continues to recover and household formation picks up further.”
“We’re hopeful that negotiations over the ‘fiscal cliff’ don’t derail this momentum,” Humphries said.
Mortgage bankers expect loan originations to plummet next year
Mortgage originations for one- to four-family homes have risen steadily over the year, yet refinances made up a bulk of the activity recorded to date, according to the latest forecast from the Mortgage Bankers Association (MBA).
Over the third quarter of this year, about $471 billion in mortgage loans were originated, up from $395 billion in the second quarter. MBA expects to end the year with about $507 billion in originations in the fourth quarter.
The total dollar amount of mortgage loans originated for the year should be about $1.746 trillion, according to MBA.
Despite the steady rise over this year, MBA predicts somewhat of a lull next year, with about $431 billion in
loans originated in the first quarter, dropping to about $233 billion by the fourth quarter of 2013.
Additionally, while originations have risen each quarter so far in 2012, so has the share refinances making up that total. In the first quarter of this year, refinances made up about 68 percent of all loan originations. MBA expects refinances will make up 77 percent of fourth-quarter originations.
Purchase originations have not moved quite as steadily over the year. First-quarter purchase originations totaled about $119 billion. They rose to $132 billion in the second quarter before dropping in the third and are expected to end the year where they started, with about $119 billion in originations.
However, 2013 will be a year of reversing trends in originations, according to MBA’s forecast. Refinances, after ending the fourth quarter of 2012 with about $388 billion in originations, are expected to fall to a mere $93 billion by the fourth quarter of next year.
The opposite will occur for purchase originations, which are expected to rise to $125 billion in the first quarter and reach $140 billion in the fourth quarter of next year.
The share of refinances in total mortgage originations will fall from 71 percent overall in 2012 to 56 percent in 2013 and even further down to 33 percent over the year in 2014, according to MBA.
At least this organization is being somewhat honest. But a 75% drop in origination, that’s just a massive drop. With more new homes being built they must expect that existing home sales will just dry up.
Also, if they are predicting refinancing increasing next year, then maybe they are expecting sub 3% 30-year fix mortgages.
I think the MBA made similar prediction for 2012, that refis would dry up, but they failed to factor QE-Infinity into their model. Heli-Ben is the only person that knows what refi volume will be in 2013.
Yes. If he pushes mortgage rates down below 3%, refi volume will pick up once again.
Any increases in price will simply be viewed as ‘noise’ around a declining trend.
1) Corporations are in the wage suppressing business
2) US wages are not indexed to inflation
3) Since creditor nations essentially import the income from debtor nations, expect US ”borrower income” to remain in decline for years to come.
As a result, many 4% mortgages that are servicible today can become unservicible in just a few short years.
I would add that the federal reserve is in the wage suppressing business. They hide their intention under the guise of fighting inflation, but since rising wages are one of the biggest causes of inflation, what they are really doing is working to keep wage growth to a minimum. Of course, this works against their desire to reflate a housing bubble.
“…Corporations are in the wage suppressing business…”
Not necessarily by choice.
‘Global Wage Arbitrage’ is very real.
In my business (software development) an ever increasing trend to outsource to Elbonia has been in place for over 10 years.
In a nutshell, cheap fast computers and cheap fast networks have been the enablers. In other words technology is most definitely a 2 edge sword.
In my case (very large, well known global company) I honestly believe the only reason management has embraced the trend is simply because market / global competition forces the issue. If they (the management) didn’t have to they wouldn’t. (Typical reasons given: Weird time zones in Elbonia, Elbonian’s don’t speak/read/write/document in good English, it’s always festival time in Elbonia, etc.)
I don’t see my own wages growing any time soon.
It may be different in other business segments, but other professionals I know in the Irvine area (teachers, finance, medical) pretty much echo the same story.
Is the quality of the outsource as good as domestic work?
To be fair, code quality can be very good.
The biggest issue from my perspective is how to manage by remote control.
Another issue in Elbonia: Rising wages. [exactly opposite to what is going on in the USA] Naturally the most ambitious, creative and smart Elbonian’s job hop frequently.
My own theory is that some day the differential in wages will be so small and the extra overhead/management issues so large that some kinds of outsourcing will no longer make any economic sense.
The big unknown: When is ‘some day’??
My uncle works for HP, and he told me about an ambitious program they had to outsource much of their tech support. They ran into all the issues you described and decided to bring much of it back to the US. The labor savings was offset by customer dissatisfaction and inefficiency.
I predict another era of creative financing products to offset the effects of rising rates. Expect 40-50 yr loan terms, 5 year teaser rates that slowly step up in years 6-10, balloon payments, and interest only loans.
Obviously, the lenders are on board with this, but why would the government support it you ask? Well, they already do. Just look at the structure of HAMP modifications and everything I’ve described are key components.
It’s those “affordability” products that created the housing bubble to begin with. There will certainly be pressure to return to these products, and if we do, the housing market will be doomed once again.
You’re probably right, though. The government gave its endorsement to all manner of these crazy and unstable ideas in their loan modification programs.
Dude, fyi…. that dog already failed to hunt.
Also, if that really is your prediction, logic would dictate that you’re mid to long term bearish. Welcome.
I am mid- to long-term bearish. Next crash will begin in 2019.
Smart money has been accumulating RE for the past few years and will continue to do so for another 2-3. Then sell everything in 2017-2018 and sit things out for awhile. Rinse and repeat.
I am beginning to see the same scenario. The stimulus is going to reflate a bubble, the hedge funds will cash out, then they will all wait for the next go-round.
MR: ”Smart money has been accumulating RE for the past few years”
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go back to school
CS LA/OC
Mar 2009: 160.89
Sep 2012: 174.80
Gold
Mar 31 2009: $918oz
Sep 2012: $1764oz
Next!
“smart money” visualized/quantified…..
http://www.sharelynx.com/chartstemp/free/USHomePricesAU01.php
Thanks for sharing. I sold my physical gold in August 2012 to Manny at HB Coin Exchange. My cost basis on everything was $630 or less. You don’t make money by buying high and hoping/praying it goes a little higher. According to your chart, either gold is severely overpriced, houses are severely underpriced, or both.
MR: You don’t make money by buying high and hoping/praying it goes a little higher.
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Tru-dat… ie., see post Y2K housing.
Also, OC housing crashed when prices were about 30% higher so the prospect of houses being ”severly underpriced” is nada, zippo, zilch.
1) Govt can’t afford to finance their debts at current rates so lower or continued ZIRP is the new normal.
2) International wage pressure impinges wage growth in USA and other developed markets. The inflation is cost push increases not wage pull driven.
3) Govt programs like FHA, VA, Fannie & Freddie will continue to bleed losses and make govt intervention in mortgage finance a contentious topic and could lead to withdrawal of govt support
4) Mis allocated economy will continue to suffer unemployment and slow growth which will contribute to malaise in housing market.
5) 400,000 people in CA will lose unemployment benefits as of Jan 1
Very true. The US government can’t afford to raise rates as it gets deeper and deeper into debt.
The global wage arbitrage is well documented. It was even discussed in a comment above. The only way wages can go up is if the value of the US dollar plummets so our wages are on par with other country’s.
I hope support for government subsidized mortgages will wane, but I have my doubts. Perhaps one more housing bubble where we collectively lose a trillion dollars might give people reason to change their minds.
3) Govt programs like FHA, VA, Fannie & Freddie will continue to bleed losses and make govt intervention in mortgage finance a contentious topic and could lead to withdrawal of govt support
Can FHA, Fannie, and Freddie get loans directly through the Federal Reserve? Or maybe the Fed pays premium of for their bonds that gives them extra profit that makes up for their losses? I keep say that too, but it seems the government/fed always finds away to bailout them out.
Just as we were talking about it.
Proposed mortgage rules threaten private RMBS comeback
By Kerri Ann Panchuk November 27, 2012 • 2:12pm
It’s likely the future mortgage market will feature a standardized, almost plain-vanilla mortgage product, some analysts suggest.
But on the other hand, analysts in the mortgage finance space believe the market will be perpetually lost without the return of private capital and a more robust system of lending.
Paul Miller with FBR Capital Markets suggests in a new report that the “ability to repay rule” and the qualified-mortgage rule are almost ensuring the long-term survival and “dominance” of the 30-year, fixed-rate mortgage and the end of products that surfaced during the housing bubble.
And with that being the case, private capital may likely find less room to flourish. Fewer mortgage products mean fewer mortgage players. Miller estimates the Dodd-Frank rules will, therefore, give preference to loans securitized by Fannie Mae and Freddie Mac.
“This preference, the guarantee on principal and interest on Fannie Mae and Freddie Mac securities, and the removal of subprime product features should make the return of meaningful private securitization extremely unlikely, in our opinion,” he wrote. “These changes should also prevent new entrants from eroding underwriting standards in an attempt to increase market share.”
But the marketplace generally has been anticipating a focus on getting private capital back into the market and sees little room for growth without it.
Companies like Redwood Trust ($16.14 -0.05%) have already made a play in this space over the course of the past few years and emit a certain confidence about private-label RMBS deals. Redwood Trust recently launched its sixth residential mortgage-backed securities transaction of the year, highlighting a deal complete with high-quality, fixed-rate mortgages.
“We cannot see a recovery in housing without a private MBS market,” noted Christopher Whalen, an investment banker with Tangent Capital Markets. “This market is already forming and the names will be more familiar in time.”
Yet, the market also is saying it’s too early to tell what the ultimate effect of the CFPB’s final draft rules will be until they surface. Mortgage Bankers Association CEO David Stevens suggested in the past few months that the CFPB has been open to market concerns about the 20% downpayment requirement and other draft rules being too stringent. For segments of the market, this suggested the possibility of final rules that are more flexible in scope. Although, it’s unknown at this point.
“Before anyone comments, it is important to see what the CFPB comes out with,” said Suzanne Mistretta with Fitch Ratings. “How the QM comes out has huge reprecussions for securitizations and private-label RMBS.”
Reminder: once CONfidence is lost, things can unravel rather quickly.
Student Debt Bubble Officially Pops As 90+ Day Delinquency Rate Goes Parabolic
http://www.zerohedge.com/news/2012-11-27/scariest-chart-quarter-student-debt-bubble-officially-pops-90-day-delinquency-rate-g
Great story. Thanks for posting it. I need to go back and read his post where he predicted it. I’m not sure what the causes of such a large and sudden change in delinquency rates on student loans, other than they can’t get a job…
An interesting read on the Vegas market.
Hmm, link didn’t show up.
http://seekingalpha.com/article/1030741-dark-forces-manipulate-u-s-housing
That’s a great article. As an investor in Las Vegas real estate, I’ve watched in fascination as prices have gone up. I was actually hoping the rally would have been delayed for a few more years until I had acquired as many as I could.