Potential buyers can’t afford peak prices at higher interest rates

The current plan lenders have to resolve their bad loans from the housing bubble is to prevent the sales of the afflicted properties until prices are pushed back above the outstanding balance of the loan so that the bank won’t lose any money. To this end, banks stopped foreclosing on delinquent borrowers, offered them all loan modifications under generous terms, and began denying short sales to any borrower with assets. They’ve also permitted a lot of delinquent borrowers to stay on as squatters.

For the banks to achieve their goal, the have to push prices back up to near peak levels. Most of the delinquent borrowers either bought or refinanced between 2004 and 2007, so the outstanding balance on their loans is near the peak. Amortization in normal payments will bail out some of these borrowers at prices below peak levels (these are many of the listings we see today); however, many borrowers are not paying down their mortgage balances.

One of the big misconceptions about shadow inventory is that normal amortization will make it go away in time. It won’t. First, many borrowers are not paying their mortgages at all. 700,000 borrowers quit paying their mortgages in June alone. The national mortgage delinquency rate has been falling, due almost entirely to short-lived loan modifications, but the rate is still well above historic norms. Mortgage balances are increasing for borrowers who aren’t paying their mortgages as banks add on lost interest, late fees, and other costs.

Second, many borrowers are merely treading water. Many loan modifications, particularly those offered by private lenders, do not amortize. The banks want to maximize profits, so they put these loan modifications on interest-only terms. Further, when the borrowers were delinquent in order to qualify for the loan modification, the missed payments and fees were merely added to the outstanding loan balance, so the balances on these loans became larger in the past, and they aren’t getting any smaller now. There are also still a large number of borrowers who are surviving with their bubble-era interest-only loans. I know one borrower who bought with an interest-only loan in 2007 who didn’t apply for a loan modification because he didn’t want to miss any payments and trash his credit. He’s been underwater and unable to refinance otherwise. He’s not alone.

The idea that loan amortization will make shadow inventory (now cloud inventory) is mere fantasy perpetuated by bankers hoping for the best. Amortizing loans are helping some borrowers, but it isn’t going to make the problem go away.

That leaves lenders with the need to force prices back up to peak levels to liquidate their most troubled loans. The restricted inventory condition caused by their can-kicking has dried up the supply, so buyers have been forced to bid higher to get a deal. However, the recent spike in mortgage interest rates has removed over 10% of a potential buyer’s bidding power. That puts lenders 10% farther away from their goal of fully reflating the housing bubble (See: Rising interest rates spoiling efforts to reflate the housing bubble).

The following is a series of historic price charts for various Southern California counties. The current affordability limit is noted by the lower red line. To better understand why this limit will be more constraining in the future, please read Future housing markets will be very interest rate sensitive. Some of the markets are still undervalued, but Orange County is the first to hit the limit on affordability. It will be the test case for the strength of this barrier.

We could easily see a temporary push through this limit due to the restricted inventory and extremely high percentage of cash buyers (See: With depleted MLS inventory, all-cash buyers rule the market). Cash buyers are not restrained by financing limits. If prices push through the financing limit imposed by affordability, the percentage of all-cash sales will rise even higher as they completely take over the housing market. I don’t see that phenomenon as long-lived, but it would create a short-term mini-bubble lenders and loan owners would be happy to take advantage of.

Los Angeles county shows a similar pattern to Orange County.

Riverside and San Bernardino Counties still have a long, long way to go to reach peak pricing. Even with 3.5% interest rates, those counties were never going to reach the peak.

I have no idea what lenders are going to do about those two counties. We may see restricted inventory and artificially high prices for a decade or more once the undervalued condition is squeezed out of the market.

As I’ve noted before, these are still great investment opportunities for small investors.

Ventura County is much healthier. The 3.5% interest rates would have financed peak pricing there. The recent spike in interest rates has pushed the peak out of reach, but it’s not so far away that a few years of wage growth could bring it back withing reach — assuming interest rates don’t keep going up and further spoil the party for lenders.

What is the bank’s end game?

I give lenders far too much credit for intelligence and planning when it comes to their current market manipulations. This is not the flawless execution of a well-conceived plan. They spent six years groping for answers until they came up with the current set of policies that caused the housing market to bottom. They haven’t figured out exactly how to resolve their legacy loan problem.

They will continue to follow their current policies of delaying foreclosure and restricting MLS inventory until that no longer works for them. One by one, markets will hit the affordability ceiling, and appreciation will grind to a slow crawl — punctuated by air pockets as mortgage rates continue their volatile rise. Perhaps they can maintain this series of policies for another decade or more until every market in the country reflates back to peak prices, but I rather doubt it. It will take far too much time, and there are too many headwinds to keeping such a policy in place for such a long time (See: The 10 biggest obstacles to reflating the housing bubble).

Further, the longer this goes on, the less control they’ll have over the market. Those borrowers who do have amortizing loans will pay them down, and the percentage of remaining bad loans may become too small to exert such a strong influence over supply as they do today. Lenders may find themselves undercut by a recovering organic sales market long before peak prices are reached. If that happens, lenders will have to finally take the write downs on their bad loans, foreclose on the squatters, and recycle those legacy loan properties back into the market.

Don’t hold your breath. That won’t happen until the banks have no other options.

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[idx-listing mlsnumber=”PW13173960″ showpricehistory=”true”]

19120 BEACHCREST Ln Unit D Huntington Beach, CA 92646

$450,000 …….. Asking Price
$420,000 ………. Purchase Price
10/21/2003 ………. Purchase Date

$30,000 ………. Gross Gain (Loss)
($36,000) ………… Commissions and Costs at 8%
($6,000) ………. Net Gain (Loss)
7.1% ………. Gross Percent Change
-1.4% ………. Net Percent Change
0.7% ………… Annual Appreciation

Cost of Home Ownership
$450,000 …….. Asking Price
$15,750 ………… 3.5% Down FHA Financing
4.47% …………. Mortgage Interest Rate
30 ……………… Number of Years
$434,250 …….. Mortgage
$138,342 ………. Income Requirement

$2,193 ………… Monthly Mortgage Payment
$390 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$94 ………… Homeowners Insurance at 0.25%
$489 ………… Private Mortgage Insurance
$409 ………… Homeowners Association Fees
$3,574 ………. Monthly Cash Outlays

($542) ………. Tax Savings
($575) ………. Principal Amortization
$26 ………….. Opportunity Cost of Down Payment
$76 ………….. Maintenance and Replacement Reserves
$2,559 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$6,000 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,000 ………… Closing Costs at 1% + $1,500
$4,343 ………… Interest Points at 1%
$15,750 ………… Down Payment
$32,093 ………. Total Cash Costs
$39,200 ………. Emergency Cash Reserves
$71,293 ………. Total Savings Needed
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