Nov292013

Will lenders circumvent the 43% debt-to-income cap?

[dfads params=’groups=165&limit=1′]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. While this rule contains an interesting loophole (See: The 43% DTI cap strongly favors those with no consumer debt), this loophole fails to penetrate the rigid ceiling on affordability imposed by the 43% DTI cap on gross income and other ability-to-repay rules. If lenders are unable to find “innovative” ways of circumventing this cap, then future housing markets will be very interest rate sensitive.

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.

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Spending their nestegg and spending their golden years homeless

The former owners of today’s featured REO bought the property for 53,000 on 8/2/1968. This house is nearly as old as I am. After more than 45 years of home ownership, this family should have a house that’s paid off and a stress-free retirement. Instead, they lost the house in foreclosure. I don’t know where they ended up, but it probably isn’t as nice of circumstances as the house they left behind.

18662 VIA PALATINO Irvine, CA 92603

$1,299,000 …….. Asking Price
$53,000 ………. Purchase Price
8/2/1968 ………. Purchase Date

$1,246,000 ………. Gross Gain (Loss)
($103,920) ………… Commissions and Costs at 8%
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$1,142,080 ………. Net Gain (Loss)
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2350.9% ………. Gross Percent Change
2154.9% ………. Net Percent Change
7.2% ………… Annual Appreciation

Cost of Home Ownership
——————————————————————————
$1,299,000 …….. Asking Price
$259,800 ………… 20% Down Conventional
4.87% …………. Mortgage Interest Rate
30 ……………… Number of Years
$1,039,200 …….. Mortgage
$271,928 ………. Income Requirement

$5,496 ………… Monthly Mortgage Payment
$1,126 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$271 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$132 ………… Homeowners Association Fees
============================================
$7,025 ………. Monthly Cash Outlays

($1,798) ………. Tax Savings
($1,279) ………. Principal Amortization
$486 ………….. Opportunity Cost of Down Payment
$182 ………….. Maintenance and Replacement Reserves
============================================
$4,617 ………. Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$14,490 ………… Furnishing and Move-In Costs at 1% + $1,500
$14,490 ………… Closing Costs at 1% + $1,500
$10,392 ………… Interest Points at 1%
$259,800 ………… Down Payment
============================================
$299,172 ………. Total Cash Costs
$70,700 ………. Emergency Cash Reserves
============================================
$369,872 ………. Total Savings Needed
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