The affordability ceiling is the ultimate limit on home prices

The housing market experiences a friction point where prices can’t move any higher, the affordability ceiling.

Over the last 50 years, California inflated three different housing bubbles. Starting in the 1970s with regulations like CEQA, California began to restrict growth, preventing builders and developers from meeting demand. As a result, demand pressures increased prices.

People reacted to rising prices with enthusiasm instead of revulsion. The sudden upward price movements catalyzed more buying as homeowners became speculators hoping to cash in on rapid appreciation.

As with all financial manias where asset values become detached from fundamentals, the first three housing bubbles resulted in housing busts with each one being more severe than the last. As a result of the most recent horrendous crash in housing values, government regulators stepped in and put new rules in place designed to prevent future housing bubbles from inflating. (See: New mortgage regulations will prevent future housing bubbles) For as cynical as I am about the ability of regulators to get anything right, the rules put in place, if enforced, will do much to prevent future housing bubbles.

The housing bubble of the 1970s was inflated because lenders abandoned long-held standards for debt-to-income ratios. Prior to the housing bubble of the 1970s, lenders would only allow a front-end ratio (the percentage of income directly attributable to housing costs) of 28%. Further, lenders would only permit a back-end ratio (total debt service as a percentage of income) of 36%. These standards were completely abandoned during the 1970s because lenders reasoned that with 10% yearly wage inflation, a borrower’s onerous front-end ratio in the early years would become affordable after a few years of steadily rising wages. Of course, they were wrong.

The housing bubble of the late 80s and early 90s was inflated by lenders who again allowed debt-to-income ratios get out of control, and they experimented with “innovative” loan programs such as interest-only and negative amortization. And the latest housing bubble was inflated by the proliferation of those same toxic loan programs.

The common denominator behind the previous housing bubbles was an abandonment of affordable debt-to-income ratios and the use of loan products that didn’t amortize. Shockingly enough, regulators figured this out, and the new qualified mortgage rules specifically ban interest-only and negatively-amortizing loans. Further, these rules but a cap on debt-to-income ratios of 43%. This effectively eliminates the primary tools lenders abused to inflate housing bubbles.

Affordability Ceiling

Lenders don’t set out to inflate housing bubbles. The pressures on lenders to obtain business prompts them to expand loan programs and develop “innovative” loan products in order to keep sales volumes up when prices reach the limit of affordability. Sellers could always rely on lenders to arm borrowers with dangerous loans to finance ever-higher asking prices. That will not be the case in the future.

The result of the new regulations will be a much more rigid ceiling on affordability. Borrowers will be required to document their income, and that income will be applied to amortizing loans with a reasonable debt-to-income ratio. They can either afford the property or they can’t. Their bids will be limited.

If borrowers don’t have the ability to raise their bids due to limits on financing, then future housing markets will be very interest rate sensitive. Rising interest rates will lower the affordability ceiling if salaries don’t rise to compensate.

As mortgage interest rates climb, the local bubbles that have quietly been inflating in a number of markets will reveal themselves.

Imagine global warming raises sea levels so high that all the land is underwater (remember the movie Waterworld?). This is analogous to lenders who created so much housing debt they put all homeowners underwater.

Now imagine rising interest rates are like falling sea levels. Beneath the surface, volcanic islands may still be growing and plate tectonics is still raising mountains just like our efforts to reflate the housing bubble is raising values in some markets more than others.

Interest rates are a blunt instrument. Lenders can’t charge one rate in Coastal California that doesn’t need stimulus and another in Las Vegas that does. Interest rates will raise or lower the affordability ceiling everywhere, just like global warming raises sea levels everywhere. As the sea levels recede (interest rates rise), the areas nearest the surface will poke above the water and become islands. These islands will represent exposed housing bubbles.

Perhaps wave action and erosion will knock these islands down and prevent them from reaching the sky, but as long as the interest rate stimulus is being applied, and as long as inventory is overly restricted, there is always the danger of inflating an echo bubble.

As interest rates rise, if wages don’t rise with them, the affordability ceiling will put pressure on house prices. Buyers today expect this rally to continue until prices double again. It’s entirely possible that rising interest rates will cause the best markets to pull back while the weaker ones catch up. That’s what the analysis at Fitch Ratings believes, and I concur with their analysis.