Troubling evidence of new Coastal California housing bubble

The housing market shows early signs of a new housing bubble; market psychology shifts toward foolish optimism, and lenders provide toxic loans to enable foolish buyers.

The rapid increase in house prices since early 2012 concerns many housing market analysts. Federal reserve economists noted the 2013 housing recovery was different, in a bad way. Further, Mark Hanson and Nobel prize winner Robert Shiller warn of a housing bubble because of rising prices, excessive valuations, and changing consumer psychology. In the post OCHN Housing Market Update: Is OC forming a bubble?, I argued that we are not in a housing bubble — at least not yet. My analysis of value — a method of establishing value that properly identified the housing bubble — shows house prices are not yet overvalued. Also, I place some faith in the belief the new mortgage regulations will prevent future housing bubbles. However, my faith may be misguided and misplaced; the new mortgage regulations may not go far enough. If interest-only loans and other toxic loan products return, the sheeple will foolishly use them, and we will inflate yet another housing bubble.

Housing Markets and Drag Racing

My father is a motor-sports enthusiast. I spent many evenings in my youth attending auto races at the oval short-tracks across Central Wisconsin: Dells Raceway Park, Golden Sands Speedway, State Park Speedway, Madison International Speedway, Rockford Speedway, and the Milwaukee Mile Speedway. I have many fond memories, and to this day, the smell of burning rubber and the uproar of racing motors reminds me of those exciting evenings. For several years we attended drag races at Great Lakes Dragaway, where I watched the stars of the sport compete.

Each drag race begins with a ritual; first, the drivers warm up their tires with a crowd-pleasing, high-power tire burn, and as the anticipation builds, the drivers position their cars near the starting line. From that point on, the drag strip’s Christmas Tree lights direct the show.

The starting line has two sensors: the first lets a driver know they are near the starting line, and the second tells them they are on the line. Once both cars are staged (both lights are on), the Christmas Tree begins a countdown through three yellow lights followed by the green light signal. (Have you been on the Xcelerator at Knotts?) If a racer starts too soon, a red light appears, and they are disqualified.

So what does this have to do with housing markets?

Some of the cartoons I create contain valuable conceptual teachings (and some are just silly). The graphic below illustrates the stages of a loan-induced housing bubble by comparing the stages of the process to the beginning of a drag race.

Housing bubble rallies are just like drag races. First, the preconditions for a bubble must be established; like drag racers positioning themselves, the housing market must first stabilize and prices must start rising again. Without these preconditions, lenders won’t loosen credit standards, offer toxic loan products, and inflate a housing bubble. At this stage, the 30-year fixed-rate mortgage, the only stable loan product known, forms the bedrock of the market.

The very first sign of a housing bubble is the increased use of adjustable-rate mortgages. People generally use ARMs because they can’t afford the higher interest rates of a fixed-rate mortgage; in other words, they are buying houses they can’t afford.

The second sign of a housing bubble is the use of interest-only mortgages. In the past, the housing market would proceed to this stage without hindrance or hesitation, but with the new Dodd-Frank qualified mortgage rules in place, rules which ban interest-only mortgages, the inevitable progression to this toxic form of financing should at least be slowed down. Ideally, the next housing bubble will not inflate because its growth will stop at this stage. If we are fortunate, private equity won’t embrace this toxic product again and cause it to proliferate.

The final stage is the widespread proliferation of toxic loan products like Option ARMs. Once financing crosses the Ponzi threshold of interest-only loans, the market destabilizes, mortgage defaults accelerate, and a credit crunch becomes imminent; it’s only a matter of time before lenders realize their folly and abruptly stop making bad loans. Once that happens, credit tightens, and lenders retreat to the stability of 30-year fixed-rate mortgages.

Mellow Ruse spots the troubling signs

I greatly value the astute observations on this blog because I learn a great deal from the people who take the time to offer their thoughtful remarks. Without the unique perspectives and watchful eyes of many readers, it would be easy for me to start believing my own bullshit or fail to see the bigger picture. Today’s post was inspired by a reader comment.

Mellow Ruse says:

“For now, his interest-only loan costs him about 35% less per month than a 30-year fixed mortgage, he said. But he’ll have a much bigger monthly bill in 10 years, when the loan terms require him to start paying off principal at potentially high rates.”

Am I the only one that noticed this article about ARM’s features a borrower that received a 10 year interest only loan? In all likelihood his starting interest rate is already equal to or greater than a 30 yr fixed rate mortgage. His savings are entirely from avoiding principal repayment for 10 years, not from having a lower upfront interest rate.

The article is attempting to highlight the risks of adjustable rate loans, but misses the forest for the trees. While focusing on the interest rate reset, it ignores this borrowers greatest risk: the recast event that takes him from interest only to a 20 year accelerated amortization term. This will double his payment amount. The interest rate risk, while also present, is actually secondary.

This illustrates perfectly the type of bubble behavior that is re-entering the market. Ironically, by trying to highlight the increased risks that borrowers are taking, the article also manages to shed light on the ignorance of mainstream reporters. All the pieces for another bubble are falling into place, and the reporter misses the biggest part of the story.

He is correct; the reporter did miss the bigger story here. That story is this post.

I say we start a pool right now. On which date, will Larry concede that a new bubble is forming? Since the data he uses has a lagging component, I’m going with April 1st. :)

I will concede a new bubble is forming when my reports provide me the data to back up that contention. I am concerned about the possibility, just as Mark Hanson and Nobel prize winner Robert Shiller are, but until the data shows a significant degree of price inflation, I can’t write that prices are due for a tumble. Prior to today’s article, I hadn’t heard of any borrowers embracing toxic financing again, and I didn’t realize how many borrowers were embracing adjustable-rate mortgages at the bottom of the interest-rate cycle. These are added causes for concern, and they make the likelihood of a bubble that much higher.

Adjustable-rate mortgages regain popularity as prices, rates rise

In November, 11.2% of homes bought with loans carried adjustable-rate mortgages. That’s double the rate of a year earlier.

[ARM rates doubled? I really hoped people would be wiser than that, particularly after witnessing the housing bust.]

By Andrew Khouri — January 1, 2014, 5:21 p.m.

When Michael Shuken recently bought his family’s first home, a four-bedroom in Mar Vista, his adjustable-rate mortgage helped them stay on the pricey Westside.

For now, his interest-only loan costs him about 35% less per month than a 30-year fixed mortgage, he said. But he’ll have a much bigger monthly bill in 10 years, when the loan terms require him to start paying off principal at potentially high rates.

“What is going to happen if I can’t restructure my loan and extend it? Are interest rates going to be 7%, 8%?” the 43-year-old commercial real estate broker said. “The home is big enough for me to grow into. The question is, will I be able to?”

This guy obviously selected this loan product because he couldn’t afford the house he wanted. He is willing to risk his primary residence, pay far more in interest than he would in rent, and for what? To have his name on title? To make a fortune on appreciation? How foolish is that?

And what’s worse is that this guy knows the risks and is willing to do it anyway. He is sentencing himself to a decade of worry, and ten years from now, he may be no better off than he is today. How do you tell your wife and your young children that you have to leave their family home after ten years because of a foolish decision you made?

Adjustable-rate mortgages, which all but vanished during the housing bust, are again gaining popularity. Home prices and interest rates rose last year, and adjustable mortgages can help keep the monthly payment affordable — at least temporarily. Such mortgages offer a lower initial rate, but that rate can rise over time with market changes.

More homeowners in Southern California were willing to take that risk last year.In November, 11.2% of homes bought with loans carried adjustable-rate mortgages, or ARMs. That’s double the rate of the same month a year earlier, according to San Diego-based research firm DataQuick.

“You saw a big swing in people taking adjustable versus fixed rates” when prices and rates shot up last year, said John Ciolino, a senior loan consultant with Luther Burbank Mortgage.

With interest rates expected to rise this year, the proportion of ARMs could increase further. …

This is a troubling sign. The increased use of ARMs as affordability products is the first stage of a new bubble. This is particularly foolish given the near certainty of higher rates when these mortgages reset.

ARMs have been most popular in the region’s higher-priced communities, such as Newport Beach, La Jolla and Pacific Palisades. …
This is further evidence the bubble was not allowed to deflate in these communities. The people driving up prices there can’t afford the houses they’re buying. This should be a troubling sign to those who believe these markets are immune to normal market forces.
Shuken, the Mar Vista borrower, says he understands the risks. He plans to pay down some principal before such payments are required, he said. And he’ll start planning years before the interest rate adjusts to either restructure the loan or sell the house.”If people aren’t thinking about that,” he said, “they need to.”

He may plan to pay down the principal, but 99% of people in his circumstances don’t.

Put yourself in his shoes; you owe $800,000 on an interest-only ARM. It’s the end of the month, and you are paying your bills. You have an extra $1,000. Do you pay off 1/800th of your mortgage voluntarily, or do you spend that money on any of a thousand competing demands with immediate impact on your life? Do you send you child to summer camp or pay 1/800th of your mortgage? Do you spend a weekend in Palm Springs or pay 1/800th of your mortgage?

This is about human nature. If you can obtain the same item — in this instance a house — with two different payments, you will always chose the lower amount, even if you know paying more may have a long-term benefit. And when the amount is such a tiny fraction of the total debt, the tangible benefit from immediate consumption is always going to outweigh the intangible benefit of retiring long-term debt — always.

People who believe they will pay down principal on an interest-only loan are fooling themselves. Anyone who possessed that much discipline would likely have opted for the 30-year fixed-rate mortgage at the outset. Those that use adjustable-rate mortgages, especially interest-only mortgages, are not nearly as disciplined and as sophisticated as they believe, and they are the ones contributing to the next housing bubble..

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1235 East 1ST St Tustin, CA 92780

$305,000 …….. Asking Price
$108,000 ………. Purchase Price
4/28/1996 ………. Purchase Date

$197,000 ………. Gross Gain (Loss)
($24,400) ………… Commissions and Costs at 8%
$172,600 ………. Net Gain (Loss)
182.4% ………. Gross Percent Change
159.8% ………. Net Percent Change
5.9% ………… Annual Appreciation

Cost of Home Ownership
$305,000 …….. Asking Price
$10,675 ………… 3.5% Down FHA Financing
4.54% …………. Mortgage Interest Rate
30 ……………… Number of Years
$294,325 …….. Mortgage
$94,928 ………. Income Requirement

$1,498 ………… Monthly Mortgage Payment
$264 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$64 ………… Homeowners Insurance at 0.25%
$331 ………… Private Mortgage Insurance
$295 ………… Homeowners Association Fees
$2,452 ………. Monthly Cash Outlays

($272) ………. Tax Savings
($385) ………. Principal Amortization
$18 ………….. Opportunity Cost of Down Payment
$58 ………….. Maintenance and Replacement Reserves
$1,871 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$4,550 ………… Furnishing and Move-In Costs at 1% + $1,500
$4,550 ………… Closing Costs at 1% + $1,500
$2,943 ………… Interest Points at 1%
$10,675 ………… Down Payment
$22,718 ………. Total Cash Costs
$28,600 ………. Emergency Cash Reserves
$51,318 ………. Total Savings Needed
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