Payment or price: what defines home affordability?

During the housing bubble, house prices became very inflated relative to rents and incomes. Basically, there was no justification for prices, only wishful thinking and delusion about the “new paradigm.” In response to the collapse of the housing bubble, the federal reserve lowered interest rates to allow borrowers to finance the same bloated mortgage balances of the bubble, but this time, the loan terms are stable. However, that still leaves us with house prices that are greatly elevated by historic measures of price-to-income or price-to-rent. So what really defined affordability? Is it the ability to make a stable monthly payment, or it is the price relative to historic measures?

My monthly housing market reports take the view that stable monthly loan payments based on conventional 30-year fixed-rate mortgages define affordability. The actual price in the open market is largely determined by how much this payment will finance, so it’s very sensitive to mortgage interest rates. This is why the federal reserve lowered rates so much. Because without lower rates, borrowers had no chance of financing bubble-era prices. However, I am willing to question my assumptions, and the author of today’s article does so directly.

What’s killing the US housing recovery?

Heidi Moore — Friday 13 September 2013 10.10 EDT

Don’t believe the hype about rising interest rates smothering housing market improvement. Homes are simply unaffordable

Picture it: a hopeful young couple wants to buy a house. They’ve been reading stories about a housing recovery, and interest rates are low. They start their search in the late spring. Things start to turn over the summer: as interest rates on 30-year mortgages suddenly rise to 3.5%, 3.7% and then 4%, they start to get discouraged. Eventually, they walk away and keep looking. The housing recovery dies as examples like this happen all over the country. Banks start laying off mortgage professionals, grousing all the time that rising rates are ruining their profits.

Some version of this narrative has been playing out in the mortgage coverage of many major newspapers.

There’s only one flaw: none of that is happening.

That’s a very bold assertion. Anecdotally, Shevy tells me this scenario has happened many times. It isn’t that people are necessarily priced out, but they are forced to substitute down in quality so much they just aren’t’ motivated. When you thought you could buy a detached 3/2, and suddenly all you can afford is a 2/2 condo, what is your natural reaction? The real question is what’s causing this. Is it the rising interest rates or rising prices. Both happened at the same time. I would argue it was rising interest rates because the rising prices came about much more gradually, and it wasn’t until interest rates spiked that buyer motivation really changed.

Rising interest rates are not wrecking the housing recovery; what’s wrecking the recovery is that house prices are rising faster than the ability of people to afford them. Maybe we thought we could cheat history, and that a housing recovery would bring about an economic recovery. That can’t happen. The housing recovery can’t start until the economic recovery begins.

On this I agree with her totally. Many politicians seemed to believe that reflating the housing bubble would bring back HELOC abuse and stimulate the economic recovery. The economy of the 00s was a Ponzi scheme based on housing debt, and despite efforts to go back to that economic model, banks have so far proven unwilling to give free money to deadbeats.

Typically, a durable housing market recovery would begin with a durable economic recovery. People would go back to work, earn a salary, and they would use their new wages to form households and bid on houses. This in turn puts homebuilders back to work which creates more jobs, and the two sources of new households causes the recovery to strengthen. Unfortunately, you can’t have one without the other. It takes a spark of recovery in some other part of the economy to get housing back on its feet.

Unfortunately, the economic recovery is overblown; in fact, the economy is stagnant, and there’s no evidence of any progress despite years of stimulus by the Federal Reserve.

Similarly, the housing recovery was an illusion: the best housing stock has gone to large private investors, not individual homeowners.

There is no denying the fact that owner-occupant participation in the reflation of the housing bubble has been negligible. If not for investors and restricted inventory, there would be no housing recovery.

So let’s look at why the housing recovery is weak.

You can forget the idea that it’s somehow due to higher interest rates. Rates are historically low. In 2003 through 2006, when the housing market was booming, the interest rate on mortgages over 30 years was around 6% or even higher, and that never hurt buying. That’s because at the same time, incomes were also rising, after adjusting for inflation. The year at the height of the housing bubble, 2006, was also a peak for income growth. By comparison, look at this chart to see how interest rates are correlated to housing bubbles: it shows that they aren’t, really.

The chart she refers to is the long-term interest rate chart. It shows there is no correlation between interest rates and housing bubbles. She is making the same mistake nearly everyone in the MSM makes when discussing this issue. Just because the correlation was weak in the past doesn’t mean it won’t be strong in the future. The mechanisms lenders used to get around interest rate fluctuations are now banned in the qualified mortgage rules. I explored this in great detail in Future housing markets will be very interest rate sensitive.

So, if interest rates are still at rock bottom in historical terms, we know that “rising” mortgage rates are probably not a big enough deal to hurt the housing recovery.

Wrong! What will a long-term rise in interest rates do to home prices? Rising rates will be a long-term drag on home price appreciation. The math is inescapable.

So what is?

In a nutshell, what’s hurting the housing recovery is that there aren’t enough houses to buy, and those that are available are too expensive.

I can’t argue with that. But what defines “expensive,” price or payment?

First, the supply of affordable homes has diminished. In the aftermath of the housing crash, one-third of all home sales were distressed homes, and those houses tend to be sold for affordably low prices by banks.

But, as home prices have risen, there is evidence that banks and lenders are not selling those foreclosed houses and instead holding on to some of them to sell for a higher price later. They’re also not selling them now because flooding the market would result in low sale prices – and those lenders want to get high prices.

It’s a bit more complicated than that, but she has the basics right. The banks aren’t holding much of their own REO off the market. What they are doing is preventing distressed inventory from coming to market by simply choosing not to foreclose and by denying short sale requests. Lenders are can-kicking with loan modifications to get a few more payments out of borrowers who simply can’t afford their homes.

That strategy by lenders seems to be working. House prices have rocketed in the past year, rising too fast for buyers to keep up, even with a 30-year mortgage. In July 2012, home prices were still falling from the housing bust. In the past year, they have rocketed up 12%.

I do have to give credit where credit is due (no pun intended). The banks did a remarkable job of reflating the housing bubble. If you had told me in late 2011 that by mid 2013 prices would be up over 20% in OC, I would have flatly said it was not possible. To get a cartel to act as one unit and restrict supply so completely and effectively is almost unheard of in modern economics. The fact that the banks pulled this off is almost a miracle.

At the same time, rental prices have also zoomed up, which is perhaps why mortgage applications seemed to rise earlier this year: a high rent will make people think about buying a home instead.

But neither renting nor buying looks great any more at these prices, because people still don’t have much money.

(See: Can it be a good time to buy and a good time to rent?)

Personal incomes have collapsed since the recession, meaning households – many still struggling with heavy debt – can’t afford the sudden rise in house prices and are not applying for mortgages any more. Anyone who manages to buy a house for the first time right now is not feeling rich: the National Association of Realtors found recently that 42% of first-time buyers have to make sacrifices to afford a new home.

This issue of home prices is a huge factor in why there’s no actual housing recovery.

Affordability and home ownership are far more closely correlated than interest rates and home ownership. Interest rates may make mortgages more expensive, but they don’t affect the underlying price. That price is what drives people away.

This is a bold assertion, and she provides no evidence to back it up. Interest rates do impact house prices because they directly control how much most buyers can borrow to get a house.

Some may argue that interest rates don’t impact all-cash buyers because they aren’t getting a mortgage, but that’s not true either. All-cash buyers are also looking for the best place to park money. If there were better competing investment alternatives, all-cash buyers would be putting their cash there instead of in real estate. Interest rates impacts the pricing of all asset classes.

The low demand for overpriced houses may be why banks are laying off mortgage professionals.

Actually, the collapse in refinance volumes cause by higher mortgage rates is what’s causing mass layoffs of mortgage professionals.

Reuters, Bloomberg, the Los Angeles Times, and, most recently, the Wall Street Journal have all written stories about the layoffs in mortgage departments. They attribute those layoffs to rising rates. That’s not the whole story, however.

Laying off mortgage professionals is, at this point, an ancient trend – one that precedes rising interest rates by months and years. Demand is low, and when demand is low, banks lay off people. It has happened every year since 2008, and continued into 2011, after the crisis.

Earlier this year, Chase said it would lay off mortgage professionals because business was improving as foreclosures fell; now the bank and other rivals are suggesting that they’re doing more layoffs because business is bad. They can’t have it both ways. The truth is that banks will most likely continue layoffs as they slim down the incredibly bloated infrastructures they built up during the boom years and then during the foreclosure and mortgage-cleanup time of 2009 to the present day.

It’s amazing how many people made a living from mortgages back in 2006. The guy who built the first version of this website was telling me about his mortgage business back during the bubble. It seems everyone was doing a few mortgage deals back then. Perhaps I get a skewed perspective living in Orange County, but it isn’t surprising that the number of people making a living from mortgages is steadily declining.

In order to drum up business, banks are walking down a well-worn and dangerous path. According to Bloomberg, those banks are loosening their mortgage standards, dropping the bar for down payments and income requirements in order to get more customers in the door, as Bloomberg reporters perceptively found this week.

Mellow Ruse, one of our favorite astute observers, mentioned this months ago. Lenders adjust their standards on the margins to increase their business when they want to. Most lenders are still shell-shocked from the housing bubble, and they worry about the buy-back clauses in their contracts with the GSEs and the FHA, but they have been lowering standards to recapture some of the volume they are losing through the dramatic decline in refinances.

Loosening mortgage standards? That’s a fantastic idea; what could possibly go wrong? Except of course, for a replay of the last housing crisis. Weaker underwriting standards help more people get homes, but they also sow the seeds of trouble as unqualified people make their way into the system.

She is correct in her assessment.

Banks still have not proven that they know how to judge the risk of a mortgage, so they turn their spigots either all the way on, giving mortgages to everyone, or all the way off, giving mortgages to almost no one.

That’s the nature of a credit crunch. The spigot generally gets turned on very slowly after a credit crunch. Lenders in in no hurry to discover where loans start going bad again. I see little or no risk of the credit spigots being opened fully any time soon.

John Carney, at CNBC, theorizes that the rising home prices are proof of a bubble. The idea is directionally sound, but has a major flaw: bubbles require mass participation.

There’s no bubble right now because many people can’t get the homes they want. Paradoxically, that will create less of a bubble even though housing prices are growing at bubble rates.

That’s a very good point. Further, a bubble generally requires some form of debt arrangement to really get going. Right now, much of the rise in prices is all-cash buyers. Aggregate loan balances are still falling nationwide as lenders continue to write down bad loans.

What this all means is that people are going to stay locked out of the housing market until the economy recovers, they have more money in their pockets, and there’s a larger supply of affordable houses. Until then, don’t believe the hype about interest rates.

I am not convinced by her arguments. Price matters, but terms matter even more. I always remember a conversation I had with my mentor not long out of college. He was a seasoned negotiator and land developer. He told me “I’ll let you determine the price if you let me dictate the terms.” It was such a sweeping statement that it really caught my attention. After spending the last 20 years in the business world, I have a much better understanding of what he meant. In my opinion, affordability is defined by the terms, not the price.

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12502 PINE St Garden Grove, CA 92840

$798,000 …….. Asking Price
$315,000 ………. Purchase Price
7/17/1997 ………. Purchase Date

$483,000 ………. Gross Gain (Loss)
($63,840) ………… Commissions and Costs at 8%
$419,160 ………. Net Gain (Loss)
153.3% ………. Gross Percent Change
133.1% ………. Net Percent Change
5.6% ………… Annual Appreciation

Cost of Home Ownership
$798,000 …….. Asking Price
$159,600 ………… 20% Down Conventional
4.37% …………. Mortgage Interest Rate
30 ……………… Number of Years
$638,400 …….. Mortgage
$156,519 ………. Income Requirement

$3,186 ………… Monthly Mortgage Payment
$692 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$166 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$0 ………… Homeowners Association Fees
$4,043 ………. Monthly Cash Outlays

($781) ………. Tax Savings
($861) ………. Principal Amortization
$254 ………….. Opportunity Cost of Down Payment
$220 ………….. Maintenance and Replacement Reserves
$2,876 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$9,480 ………… Furnishing and Move-In Costs at 1% + $1,500
$9,480 ………… Closing Costs at 1% + $1,500
$6,384 ………… Interest Points at 1%
$159,600 ………… Down Payment
$184,944 ………. Total Cash Costs
$44,000 ………. Emergency Cash Reserves
$228,944 ………. Total Savings Needed
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