Oct232015

Prudent borrowers embrace the 43% debt-to-income cap

Debt-to-income lending caps prevent wild swings in house prices based on irrational exuberance, which benefits everyone.

stupid_and_irresponsiblePrudent borrowers generally didn’t participate in the housing bubble. Those who refused to borrow and spend waste their equity watched with pleasure as their net worth increased, but they weren’t impacted by either the rise or fall of house prices. Those who refused to use toxic mortgage financing didn’t buy homes and remained renters.

Why did many prudent borrowers sit out the housing bubble? Lenders were underwriting loans with debt-to-income ratios approaching 100%, creating a generation of Ponzis.

Prudent borrowers were competing with borrowers who were leveraging many times what they could reasonably afford, so unless they were willing to sacrifice quality dramatically, prudent borrowers resigned themselves to being out-competed by fools making far less money who were borrowing far too much.

The 43% DTI Cap

I expressed the view that new mortgage regulations will prevent future housing bubbles. These new qualified mortgage regulations forbade the measures lenders employed to inflate previous housing bubbles. One of these restrictions caps debt-to-income ratios at 43% of gross income. This was in response to the enormous debt burdens exposed when lenders abdicated all lending prudence and gave Ponzis unlimited debt.

The back end ratios of the average borrower, not the extreme, the average borrower, was over 75%. Remember, this is of gross income, so unless these people don’t pay taxes or don’t eat, they were obviously Ponzis relying on fresh infusions of debt to sustain their lives.

The 43% debt-to-income cap is a good idea. Nobody should be paying more than that to lenders, and realistically, nobody can unless they go Ponzi. Right now, the GSEs cap front-end ratios at 31%, and since they are most of the market, finding a loan with a front-end ratio in excess of 31% is difficult. The FHA will do it, but their costs and fees are so high, there isn’t much leverage advantage to doing so.

Small changes in a borrower’s debt-to-income ratio make a huge difference in the amount financed and ultimately in the amount paid for real estate. At very low interest rates, every 3% of gross income put toward a housing payment adds 10% to the amount borrowed. Of course, the phenomenon also works in reverse. As DTIs fall due to both lender reluctance and borrower reluctance, the amounts financed decline precipitously.

The figure below shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006, calculated based on historic interest rates, median home prices and median incomes. Traditionally lenders limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels.

During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards exhibit high default rates once prices stop increasing.

In 1987, 1988, and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble — a bubble that wouldn’t have occurred if lenders had followed stricter debt-to-income guidelines. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.

Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. Buyer psychology facilitates price action as reflected in debt-to-income ratio. In market rallies people commit larger and larger percentages of their income toward purchasing houses because houses appreciate wildly.

People are not passively responding to market prices, they actively choose to bid prices higher out of greed and the desire to capture the appreciation their collective buying activity creates. This self-reinforcing price action continues as long as sufficient buyers remain to push prices higher.

The Great Housing Bubble proved as long as credit is available, no price level exists where rational people choose not to buy due to perception of expensive pricing. No price is too high as long as prices are going up.

In market busts, people assign smaller and smaller percentages of their income toward house purchases because the value is declining. The only justification for a DTI greater than 43% is the belief in rapid appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment?

Once prices level off or decline even briefly, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. Prices dipping below rental parity helped motivate buyers when the market bottomed in 2012.

The qualified mortgage rules will prevent future housing bubbles partly due to the cap on total debt-to-income ratios in concert with the ability-to-repay rules. Each of the last three housing bubbles witnessed debt-to-income ratios gone wild. If the DTI cap succeeds, future housing bubbles are much less likely.

So will lenders find a way around the DTI cap?

The qualified mortgage rules don’t provide an absolute prohibition of excessive DTIs or other forms of toxic financing. Instead, the law relies on MBS pool put-backs, a 5% risk retention requirements, and the threats of consumer lawsuits to make these loan programs so costly that no lenders bother with them. Currently, no lenders will underwrite these loans, and no investors are willing to buy them, but that might change in the future.

Hopefully, we learned some of the lessons of the housing bubble, but when you see countries like Great Britain inflating their fourth major bubble in 50 years, people are wise to be vigilant about lender foolishness. If we allow lenders to circumvent these rules and inflate another housing bubble, the losses will fall upon the US taxpayer. With the moral hazard residual from the bailouts of the last bubble, if we inflate another one, it will be truly epic.reluctance

The DTI cap supports fence-sitters

The real estate industry hates homebuying fence-sitters. Those who make their incomes on real estate transactions aren’t concerned about whether or not buyers are ready to buy or if they can sustain ownership; transactions are income, and the real estate industry wants more transactions, irrespective of how this may impact anyone else.

Fence-sitters are a group of potential homebuyers who for a variety of reasons are not ready to buy today — they are capable of buying, and they may plan to buy in the not-too-distant future, but for now, they are content to rent and watch the market. realtors take it as their mission in life to knock these people off the fence, create false urgency, and generate a real estate commission — today. realtors don’t concern themselves with whether or not fence-sitters are making the right choice for their families because they aren’t generating any income for realtors.

Fence-sitters don’t buy for a number of reasons: they are unsure about their jobs, they want the flexibility to move, they worry about high house prices, they can’t find the right property, they just aren’t ready. In the past realtors were able to create false urgency by scaring fence-sitters with the possibility of being priced out of the real estate market forever. The housing bust appears to have rendered this bullshit realtor ploy permanently impotent.

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In the past, there was a grain of truth in realtors fear-mongering about being priced out forever — it was possible to be priced out for a very long time. The housing market finds stability after a bust (it’s happened three times in California) by retreating to safe mortgage loan products like the 30-year fixed-rate mortgage. After the market stabilizes and begins to heat up, affordability becomes a problem, so lenders offer unstable affordability products like interest-only mortgage, adjustable-rate mortgages, and the most toxic of all, negative amortization mortgages. This goes on until lenders realize these unstable mortgage products cause borrowers to default, so credit tightens, prices crash, and the cycle begins all over again — at least until legislators passed the Dodd-Frank financial reform law and implemented new mortgage standards.

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With new mortgage regulations in place preventing the proliferation of toxic mortgage products, buyers no longer need to fear being priced out. House prices stabilized at prices affordable by local incomes, and these prices won’t move higher unless incomes go up or mortgage rates go down. A buyer three years from now will be limited to putting 31% of their income toward housing costs just like they are today.

For me personally, caps on debt-to-income ratios and banned affordability products gives me peace-of-mind that the window of opportunity for home ownership under stable loan terms will not close again. It removes the false urgency from the market that used to force prudent buyers to participate only when lenders weren’t inflating another housing bubble. I think that’s a good thing. It’s a fifth trait of the new normal in the US housing market.

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