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.
[idx-listing mlsnumber=”OC13236598″]
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%
============================================
$1,142,080 ………. Net Gain (Loss)
============================================
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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Irvine Great Park to be covered with 4,606 Additional Homes
IRVINE – The Orange County Great Park will have 688 acres of sports fields, a golf course, trails and more along with 4,606 more houses neighboring it after the City Council voted 3-2 early Wednesday in a vote that alters the park’s future.
It was hardly that simple, though.
Mayor Pro Tem Jeff Lalloway, considered the swing vote since he suggested and voted to postpone an earlier vote two weeks ago, maintained his poker face until just before midnight Tuesday.
That’s when he revealed the conditions he would need met before he would agree to the plan proposed by developer FivePoint Communities to spend about $200 million toward building parts of the Great Park, in return for FivePoint being allowed to build homes on its property east of the park.
“Why not lay my cards out on the table?” Lalloway said.
His demands ignited a last-minute frenzy of deal brokering and huddles among the developer and city officials during a 10-minute recess that stretched longer as people read the legal language of Lalloway’s requests for the first time.
At one point, Lalloway and Emile Haddad, CEO of FivePoint Communities, stood inches apart on the steps inside the council chambers talking about the proposal. Haddad left and came back, closing his flip phone in his hand, asking if anyone had seen where Lalloway had gone. The councilman had walked into the area on the side of the dais where council members typically exit for closed session, or emerge from after a break.
“Can I go back?” Haddad asked no one in particular, and then he did.
In the meantime, Councilwoman Christina Shea and Mayor Steven Choi huddled with FivePoint representative Brian Myers and FivePoint staff. After Haddad returned, Choi went up to him, visibly agitated, holding Lalloway’s three-page proposal in one hand.
The new deal points were so last-minute that there weren’t even enough printed copies for the city clerk or FivePoint. City Manager Sean Joyce lent his copy to the developer.
Lalloway wanted the city to assume control of the park features right away once FivePoints begins to finish them starting in 2016. FivePoint had proposed handling the operations and maintenance through 2023, spending an estimated $10 million. Now, instead, FivePoint will pay the city $10 million over time.
“I will defend to the death Irvine’s ability to run its parks,” Lalloway said before the vote.
Lalloway also wanted more improvements to Marine Way, the primary entrance to the park off Sand Canyon Avenue north of I-5. FivePoint already is obligated to make substantial improvements to the road, but the developer agreed to provide an additional $10 million worth of work on the entry’s right of way starting in 2018 to satisfy Lalloway.
“I’m not really happy about it,” Choi said of Lalloway’s last-minute additions.
Choi and Shea had been ardent supporters of FivePoint’s proposal. Shea questioned the need for the city to seize control of the operations and maintenance of the park features right away without really researching what it would cost the city.
“It’s a big switch,” she said.
Still, she voted in favor of the motion along with Lalloway’s additions, as did Lalloway and Choi. The three, part of a political alliance that had fractured in recent months, also voted in favor of certifying the developer’s environmental impact report and to grant it a general plan amendment and zone change allowing the company to build 4,606 homes instead of 410,000 square feet of commercial space.
The developer still plans to develop nearly 5 million square feet of commercial and mixed-use development east of the park. Council members Larry Agran and Beth Krom voted not to approve the environmental report, the amendment and zone change and FivePoint’s proposal to build more than half of the Great Park. …
What would happen to acreage at the former El Toro Marine base has been a tense issue for decades even before the 2002 countywide Measure W vote that determined the land’s destiny: It would be a park, akin to Central Park in New York, and not an airport.
A private developer, Lennar, bought all of the land and gave Irvine more than 1,000 acres for a park. The city sought a designer and chose New York landscape architect Ken Smith, who crafted a master plan in 2007 for a park that was expected to cost $1.4 billion to build.
The city had its hopes set on redevelopment funding to pay for it, but redevelopment disappeared in early 2012. In the ensuing years, the city spent a majority of some $200 million it received in developer fees to build the park and the developer struggled amid the Great Recession. FivePoint emerged as a spinoff of Lennar.
After the meeting, Lalloway called FivePoint the city’s partner.
Krom called the process “sloppy” during the meeting and likened it to a leg amputation gone wrong. Better a swift single slice than a messy operation, she said.
Agran, who showed concern about the location of a proposed fifth high school, also said he didn’t like the golf course and that the city would be stuck with it if they approved the deal with FivePoint. He asked FivePoint representative Myers if the developer would consider giving it up and removing it from the design.
“The answer is no. Unequivocally,” Myers said.
FivePoint has said it added the golf course when a city subcommittee suggested the developer come up with a way to make the park financially self-sufficient. The golf course could support some areas of the park that wouldn’t be taking in any revenue.
This is good news. There’s no need to rush into the current buying frenzy and purchase in Pavilion Park, when thousands of more homes will be built south of Pavilion Park (better location). It’s just hard to imagine these million dollar homes won’t face any pricing pressure with so much supply built over the last few years and planned.
Makes a person wonder if they have had the benefit of a legal opinion on the ability of the City of Irvine to so drastically alter what ALL the voters of the entire County voted for.
Should We Bail Out Cities?
In the latest City Journal, Steve Malanga writes about an issue that hasn’t yet gotten a lot of attention but is virtually guaranteed to become a serious topic of national debate in the not-so-distant future: Do we bail out cities that have become insolvent?
Malanga quotes a Steve Rattner op-ed from the summer: “The 700,000 remaining residents of the Motor City are no more responsible for Detroit’s problems than were the victims of Hurricane Sandy for theirs, and eventually Congress decided to help them.” Rattner is right, of course; Detroit was largely undone by massive structural changes in the auto industry, which now employs only a small fraction of the people that it used to. And yet, there’s more to the story, isn’t there? Detroit’s biggest problem is the combined burden of its pension funds and retiree health benefits. And the reason that its pensions are in such a state is that they were bizarrely mismanaged by people who apparently didn’t quite get fifth-grade math.
It’s true that it would be easier to deal with these problems if Detroit were more like New York and less like, well, Detroit. But it’s also true that if Detroit had been responsible about its pension contributions instead of underfunding the pensions while simultaneously handing out extra benefits above and beyond what the city already couldn’t afford, its retirees would not now be facing dire straits. New Yorkers did not get to vote for the corrupt Detroit politicians who appointed the terrible Detroit pension managers who made all of Detroit’s problems so much worse than they had to be. Why should they have to pick up the check for all those mistakes?
This is going to be a hot issue going forward, because there are a lot of cities in trouble, and there are probably a lot of city employees who won’t get paid what they were expecting. There will be pressure to shift those costs to the federal taxpayer, often with some version of this argument: The city was beset by some circumstance beyond its control, an industry that withered or a public works project that got out of control. We have to step in because it’s not the fault of the workers or the citizens — just the inscrutable machinations of a cruel and relentless fate.
Rattner is right that this is the political equivalent of Hurricane Sandy, but not in the way that he thinks. In fact, Hurricane Sandy’s victims were created by the decision, decades ago, to built substantial permanent homes on beachfront property — property that was previously underdeveloped because beaches tend to be periodically scoured by storms that destroy the homes you build there. And Detroit’s victims were created by the decision, decades ago, to erect lavish pension schemes that were built on sand rather than bedrock.
Those victims should not be abandoned — no American should be allowed to starve in retirement. But the federal government should not step in to guarantee those false promises, any more than it should attempt to re-create the vulnerable housing developments that were washed away by the storm.
Nope, unless and until 401k balances are guaranteed a certain return over the course of 30+ years, then public pensions should be subject to the same limited insurance private pensions are.
I agree. If these cities are bailed out, it will embolden the public unions to make even more onerous demands knowing full well the cities can’t make good on them because they know the federal government will bail them out. It allows them to use local political pull to extort money from the federal government.
That’s correct, IR.
However, there’s a more compelling reason not to bail out failing municipalities, which is that there just isn’t enough money in the world to do it, and to attempt it would mean indebting the population of the next 4 generations out to make good on promises made during this country’s “high” of prosperity and productivity in the 50s & 60s, by people long in their graves, who made these promises knowing that they would not be the ones who had to deal with things when they hit a wall.
I live and own in Chicago, which will be one of the many falling dominoes, if not the next. My principal concern as a tax-paying citizen is to find a way to make the people who benefited from the plunder of the city’s treasury and from the false promises, be the ones to pay, not the taxpaying residents who are being plundered for public servants’ COLA raises and pensions, and the multimillion dollar subsidies to corporate cronies that our last 2 mayors have tossed around with such reckless disregard for the financial condition of the city and the welfare of its residents. Let the pensioners take a haircut on the pensions and learn that there is NO WAY that we can afford to support platoons of public employees in retirement from the age of 48 onward, on 85% of their salaries. Let the bondholders who bought our debt even though they could have and should have known the risk, take the hit.
And let the citizens who sat out here passively and let incumbents become entrenched and corrupt as long as their brother-in-law got hired by Streets & San, learn what can happen when all you think about is getting your alley paved and your kid a no-work job with the city.
Lenders are working at a fevered pitch to prepare for January 10th’s QM effective date. They not only must simply comply with its complicated restrictions, but they must also prove compliance to secondary market participants and regulators. Our office is swamped with questions and we expect no slow-down for some time.
Do you think the cost of this compliance will drive up interest rates? Or perhaps make mortgage money less available?
It definitely increases the cost of making each loan, but it’s probably nominal. More lenders will use third party automated compliance engines and many bolster their compliance departments hiring more compliance analysts and maybe an attorney or two. The MBA has done studies on this. I think it’s at most, a low-$100s increase in cost per loan – and these studies are performed with the purpose of discouraging more regulation.
Mortgage availability is far more affected by the regulations themselves, rightly so.
A long but well written description of the issues surrounding the GSEs.
How to save the housing market – save Fannie Mae and Freddie Mac
Look down your street: chances are, there’s a neighbor whose mortgage is held by Fannie Mae or Freddie Mac. In Washington, policy wonks and lawmakers have been debating, with glacial slowness, whether that should come to an end.
Fannie and Freddie are the outgrowth of the New Deal belief that housing is a public good, and an effective government will do what it can to make home ownership possible for as many people as possible. Fannie and Freddie are middlemen: they exist to make sure you can get a mortgage by promising your bank that if you don’t pay, they’ll take on the risk.
As a business model, you could a lot worse: Fannie and Freddie own or guarantee roughly nine of every 10 U.S. residential mortgages. Their dominance of the market has made them massively profitable in recent years, and they’ve paid back almost all of the $188 billion they borrowed from the Treasury five years ago when they came under government control in the bailouts; one payment from Fannie and Freddie actually was big enough to raise the debt ceiling for a few months. The new mortgages backed by Fannie and Freddie have record low defaults, despite a rocky economic recovery.
Here’s the twist: despite the dramatic turnaround in the two firms, the current debate in Washington is not about bolstering Fannie and Freddie. It’s about eliminating them. The attacks on Fannie and Freddie are, at their source, biblical in belief: perhaps a flood of legislation can wipe out the old sins of the mortgage market and make room for some newer, more moral system of financing mortgages.
All of the competing proposals for housing finance reform share basically the same structure: winding down Fannie and Freddie, and having private financial firms – including banks – take responsibility for buying mortgages and packaging them into bundles to be bought and sold. Lenders would make new loans, making housing more affordable and accessible; investors in the mortgage bundles, sold as bonds, get a nice return on their money; and the banks who bundle and sell the mortgage bonds would take their profit.
What’s not being discussed – at least enough – is how much the destruction of Fannie and Freddie could damage the mortgage industry, the financial system, and the economy. Despite the chatter in Washington, one thing remains clear: if Fannie and Freddie are eliminated, there are few plausible alternatives.
What is often omitted from all the grand plans wending their way through the legislative alleyways, for instance, is who would benefit if Fannie and Freddie were destroyed. The answer: all their financial power in mortgages, and their government backing, would shift to the nation’s big banks. The last time that happened, it led to the financial crisis and the Great Recession.
“The main actors in this debate are financed by the banks and real estate lobby,” says economist Dean Baker. “As a result, we see a solution that is very conducive to their interests.”
2014 ushers in 5% mortgage rates
The housing market is just around the corner from the new year, and besides an onslaught of new regulations, the year 2014 is also estimated to bring a new high: 5% mortgage rates.
By the end of 2014, Frank Nothaft, chief economist with Freddie Mac, predicts that mortgage rates will approach and perhaps touch 5%, mostly due to the Federal Reserve’s quantitative easing.
At some point the Fed will scale back their bond purchases, Nothaft said, but when they will start and how gradual it will be, is very unclear.
“I do think in the first half of the year they will announce something on tapering, and they will start to pull back. But when you have a big investor like the Fed scale back their purchases, it will lead back to an uptick in yields, which will translate into higher mortgage rates,” Nothaft said.
Personally, Nothaft said he believes that if Janet Yellen is nominated as chairman, one of her first acts will be to get a consensus statement from the Federal Open Market Committee that is as transparent as possible as to what the Fed will do about tapering.
And while mortgage rates will take a hit from the tapering in the beginning, the pull-back will be gradual in order to avoid further volatility, he estimated.
But the true consequence of tapering and 5% rates falls into the hands of the borrowers.
“As rates climb, I see the issue lying in move-up houses,” said Chris Randall, Real Estate Mortgage Network Capital Markets Vice President. “It will be much harder for the family to make the next step as interest rates rise. Supply will be tight and there will be a lot of people trying to make the next step.”
There will be a lot of consolidation across the industry and fewer players and refinance shops in the market, Randall explained.
Overall, Nothaft emphasized that affordability will remain high in most markets, but not in all.
“Even if rates go up to 5%, given the level of house prices and family income, most markets would remain affordable, and the monthly PITI would be below 28%. But high-cost markets are a challenge,” Nothaft said.
Furthermore, if rates do continue to increase, it will reinforce Freddie Mac’s estimate that 2014 will usher in a purchase-driven market, which will be the first time since 2000.
However, Nothaft cautioned that a purchase-driven market will not make up for the lack of refinance volume and predicts $1.4 trillion in primary mortgage originations for 2014.
As a result, Randall said lenders need to drive their purchase business and make sure they are doing things efficiently. Most lenders who have been around awhile and are more prepared will be OK, but those who are not will have difficulties.
IR,
One thing I think you should push even harder than you already do, is that by historical Worldwide standards 5% is an EXTREMELY LOW rate for a fixed-interest long-term mortgage.
From a non-US viewpoint, I don’t know whether to laugh or cry whenever I read about RE spokesweasels talking about 5% as if it were the end of the world.
One one hand the pundits say interest rates don’t matter, but on the other hand they decry any rise in rates as horrible for real estate.
Which is it?
I think we all know the answer to that one.
The fact that sales are down in the West is the canary in the coal mine. Our markets are the first to hit the affordability ceiling, and rising rates are killing sales. As prices go higher, rates must come down, or sales will slow even further. And as you point out, 5% rates are very low by historical standards. I still believe will will see 5% next year, and it will impact the California housing market.
The tollroads do not and will not EVER pay for themselves.
Those who say that more tollroads or tollroad extensions will relieve traffic are ignorant of the facts. Think for a second; which tollroad in California has ever relieved traffic in ANY PLACE in California?
“And like the Bruce Dickinson and the cowbell, these same Orange County political lifers and Transportation Corridor Agencies (TCA) staffers in Irvine say the prescription to cure this financial affliction is more toll road.
Comparing the financial state of the Foothill-Eastern Toll Road and the Motor City madness comes not from the dirty hippies and unwashed surfers who have banded together to save Trestles but that anti-capitalism tool known as Bloomberg Businessweek.
The report cites a consultant to California Treasurer Bill Lockyer’s Debt and Investment Advisory Commission saying earlier this summer that the TCA risks default on $2.4 billion in debt. To put that in perspective, the 1994 Orange County bankruptcy, the largest U.S. municipal bankruptcy at the time, totaled $1.7 billion.”
“As I try to wrap my head around new toll road lanes historically creating new homes and traffic rather than taking care of the existing bottlenecks, Telles is claimed to go on that when the housing bubble burst inland homes lost value, Orange Countians lost jobs and the toll roads remained lightly traveled.”
[…] government is the only game in town. However, there is nothing to prevent lenders from approving DTIs as high as 43% in the future. Since this will inflate prices, it will enable Ponzi borrowing, and the entire […]
[…] debt and consumer debt to run personal Ponzi schemes. Dodd-Frank changed all that by imposing a limit on a borrowers back-end DTI at 43% in the ability-to-repay […]