Dec262012
The inner workings of house prices and housing markets (redux)
Californian’s believe house prices go up by magic. Real estate appreciation is religion in California as people blindly accept the Truth of never-ending price increases. Few question current prices or wonder why current pricesgo up as most fool themselves with wishful thinking, cockeyed optimism, and kool aid intoxication. Most people do not understand real estate prices — they think they do — every Californian is an expert on real estate, after all, we have about half a million realtors, but few people really understand markets. Motivated by greed, blinded by ignorance and enabled by lenders, borrowers inflated The Great Housing Bubble.
A foundational understanding of house prices and housing markets is critical. From 2003 onward, with exception of those who purchased houses with conservative financing, which was rare, most buyers bought in ignorance. Some were undeniably stupid and irresponsible, but most were simply ignorant going with the herd believing everyone couldn’t be wrong. Well, they were wrong, and the errors they made are easily identifiable and correctable with a better conceptual understanding of house prices and housing markets.
My understanding of housing markets permeates my posts, but the foundational work upon which I base my posts comes from my education and experience — something unique to me and heretofore undocumented; consequently, this post lays down foundational concepts of house prices and housing markets for future reference.
Three primary variables determine house prices
House prices are set by supply and demand in the market, but demand is arguably more important because house prices cannot rise higher than buyers’ abilities to pay. Therefore, this discussion will focus first on demand, then on how supply impacts prices set by market demand.
The three variables directly responsible for determining house prices are (1) savings, (2) interest rates and (3) allowable debt-to-income ratios. A buyer’s ability to bid for real estate is limited by their savings (and their willingness to put savings toward housing) and their borrowing. Amounts borrowed depend on interest rates and underwriting standards. Of the various loan underwriting standards, the most important is the allowable debt-to-income ratio because it is the direct link between income and the loan amount.
Notice that borrower income did not make the list, at least not directly, because borrower income is only important to the degree it is applied toward making debt service payments. The allowable monthly payment when amortized over 30 years at current interest rates yields the borrower loan balance. The current price-to-income ratio distortion is caused by the combination of very low interest rates and very high allowable DTIs. As I noted in, House Prices Will Decline in 2010, prices can fall even when interest rates are low if lenders simultaneously reduce allowable DTIs. In fact, the credit crunch which began in August of 2007 is crushing the housing market due primarily to declining allowable DTIs. The credit crunch is not over, and IMO, aggregate DTIs have not bottomed for this cycle.
Borrower income is important because it serves as a measurable base for market demand. Aggregate incomes rise with economic growth and inflation, and since income plugs in to the house price equation through the allowable debt-to-income ratio, house prices rise in concert with local incomes. Over the long term house price appreciation and income growth must move together; trees cannot grow to the sky.
A Buyer’s budget
Each prospective buyer investigates current financing terms as part of their process. Lenders apply current underwriting standards and determine the loan balance they will approve and downpayment required before they will fund. Since loan plus downpayment equals maximum bid amount, prospective buyers house-shop with the budget established for them by their lender. As is human nature, most people spend their full budget.
Every buyer goes through this basic process, and since financed purchases dominate the resale market, price levels of individual properties become tethered to the incomes of individuals who desire that property. If high wage earners suddenly became enamored with living in condos, prices would rise substantially. The substitution effect to similar resale and rental properties keeps income, price and quality in balance.
Link to Census data table for Irvine
Irvine has a large number of high wage earners, and its income distribution is not as “downward tilting” as other cities. As a result, wage earners at the mid to high end tend to settle for less in Irvine than they could obtain in other markets because the product in Irvine is not McMansion dominated. The opposite exists in cities like Palmdale where a sea of McMansions trickles down to the maids and field hands at the bottom of the income distribution.
High wage earners can both borrow more and save more of their disposable income. Also, high wage earners are generally long-time wage earners who probably already own a home, so in addition to their formidable saving power, many high wage earners also transfer stored equity from one property to the next, assuming they did not spend it.
A distribution of prices based on income
If you take the income distribution for Irvine, apply conservative underwriting standards of four-times income, a reasonable downpayment and an allowance for stored equity, the resulting distribution of housing prices looks like the chart below.
So why doesn’t our market look like that? Well, to a large degree, it does, although low interest rates and residual bubble inflation has increased the above numbers to an unsustainable level. In addition, the current market is mismatched between the number of people capable of supporting house prices and the number of houses for sale at various price points.
For instance, according to the data, about 22,000 of our 69,000 households can support prices over $750,000. That is 32% of the market. When more than half of Irvine properties have comparable values sustainable by less than a third of the population, something has to give. If you look at what is for sale, over 40% of listings are over $750,000, and as we know, much of this market is tied up in Shadow Inventory.
As inventory is released at the mid- to high- end, prices of individual properties will decline, but the median will not. People will still spend the same amount on housing, but they will get more for their money. That plus the changing mix from low to high will make the median less reliable. Just as the median has overstated the decline to date in most markets, it will show strength later where only weakness exists. If mortgage interest rates do not rise, the story of 2010 may be a rising median with continually falling prices on individual houses.
Demand, supply and football
Demand is measured by a borrower’s ability to put money toward real estate, and contrary to popular belief, desire is not demand. Excess supply lowers base market prices established by demand. To better illustrate this concept, consider the following football analogy:
Sellers (supply) are blitzing linebackers and buyers are offensive linemen. If more linebackers blitz than offensive linemen block, then the offense gets thrown for a loss. If more sellers want to sell than buyers want buy, then prices decline; buyers have to be enticed from the sidelines. However, if enough offensive linemen pick up the blitzing linebackers and push the scrum forward, the offense advances the ball. If buyer demand exceeds seller offerings, prices go up as sellers have to be enticed from the sidelines.
In football, the offense generally advances the ball just as buyers generally advance prices with their rising incomes. However, in football, each team is limited in the number of players. In housing markets, no limit exists which can create enormous supply and demand imbalances. When subprime lending took off, we sent hundreds of offensive linemen on the field, and they pushed prices across the goal line. Now, we have a much smaller and leaner offensive unit facing a defense composed of the zombie debt holders who previously were celebrating in the end zone.
Lenders are ordering linebackers not to blitz to prevent further losses, but the number of linebackers building on the defensive side of the ball ensures the offense will not be advancing the appreciation ball very far (imagine being the running back buried in the picture). Such is the nature of overhead supply — banks may hold on to properties to prevent a loss, but they will sell swiftly if they can get out at breakeven, and realistically, being an unruly group of zombies — cartels are inherently unstable — a few linebackers are going to blitz anyway.
It starts at the bottom
The entry level buyer utilizing only their savings plus a loan is the foundation of the housing market. If you follow the chain of move ups backward, it eventually leads to the entry level buyer, and as a result, nobody in the real estate market gains move-up equity until the entry level buyer does. If owners of entry level properties do not gain equity over time due to price declines or stagnation, they do not have the equity necessary to move up, and neither will any other seller in the move-up equity chain.
I want to be careful here because the equity move-up market does not function like most people think it does; buying a home is not the first stop on the equity train leading straight to a Laguna Beach mansion. Each step up also requires an increase in income to support a larger mortgage. With each step homeowners transport their equity — at least those who did not spend it through HELOC abuse — and bid up prices on the next property rung. Over time this produces significant stored equity in neighborhoods most desired.
During the rally of the Great Housing Bubble, subprime financing doubled or tripled the borrowing power of the entry level buyers. Rich Toscano pointed out (sorry, I can’t find the link) housing prices in San Diego rose $250,000 across all property classes in 2004. If you add $250,000 to the average loan balance of your move up buyer, the owner selling that entry level property just received a $250,000 windfall they can use to bid up prices at the next level. This reverberates through the entire system and inflates housing bubbles.
Move-ups must come down
If you examine the three main sources of buyer funding; loan, savings and equity; all three have been under pressure since 2007, and this trend will continue.
Loan balances have been getting smaller because lenders had to go back to rational underwriting standards. Incomes only supported about 50% of the average loan balance in 2006, and the greatest single cause of lower house prices, by far, has been smaller borrower loan balances. The Federal Reserve temporarily helped by lowering interest rates, but mortgage interest rates will almost certainly rise making future loan balances even smaller.
Personal savings rates went negative during the bubble, and much of the reason for our current economic contraction is that people stopped spending and started saving again. With the long term erosion in savings rates experienced during the bubble, fewer borrowers have sufficient savings to buy a home, and those that do have savings have less of it. The result is smaller downpayments — at least outside of Irvine.
Equity has been declining because during the bubble, everyone spent it, and after the bubble, everyone lost it. I have documented on numerous occasions the perils of mortgage equity withdrawal and HELOC abuse. Equity has been crushed by falling prices since 2006 with exception the delusional high end where move ups terminate. The foundation of the housing market is crumbling from below, and only the lack of transaction volume sustains high-end bubble equity. With equity disappearing at the bottom of the market, the high end has nobody to sell to but each other. There is a limit to how many properties even Nicolas Cage can own.
What is required for a healthy real estate market?
The low end of the market is resetting. Based on payment affordability, it is inexpensive to own a low-end Irvine condo like today’s featured property. Prices may go down further as interest rates rise, but payment affordability on these low-end condos is at a bottom. That is a good thing because until these condos find a pricing bottom, the housing market is doomed. There is no chain of moves ups when there is no equity.
Before there will be a sustainable market recovery, we need (1) entry-level units like these to find a pricing bottom, (2) unemployment to go down, (3) wages to go up, and (4) people to start saving. We may be finding a bottom at the low end (I still have doubts), and savings rates are improving, but the savings baseline is zero, unemployment is still rising, and wages are still stagnant. We do not have the building blocks of a sustained housing market price recovery. When the stars and the moon align, loan balances expand, downpayments enlarge, and move-up equity accumulates; those are the three essential elements of an appreciating market.
Once we return to sanity after a few more years of decline and clean up, lenders will be responsible (which worries me) to ensure the growth of loan balances never again exceeds our collective ability to pay. Everyone enjoys the ride up, but once we cross the threshold of insolvency, the market collapse is truly devastating. Let’s not do it again.
Now that FHA will needs bailout, the feds want Freddie and Fannie to do underwater refinancing to non-federally backed mortgages. Taking over the subprime role from FHA.
U.S. may expand mortgage refinance program: WSJ
Published December 26, 2012 Reuters
The U.S. government is considering expanding its mortgage refinancing program to include borrowers whose mortgages are not backed by Fannie Mae and Freddie Mac , the Wall Street Journal reported, citing people familiar with the discussions. (http://link.reuters.com/mej84t)
The refinancing program now being considered also seeks to include “underwater” borrowers who owe more than their homes are worth, the Journal said.
The proposal would also transfer potentially riskier loans held by private investors to the government-sponsored mortgage entities Fannie Mae and Freddie Mac, the paper said.
Such a move would require congressional authorization to temporarily change the charters of Fannie Mae and Freddie Mac, according to the Journal.
About 22 percent of all homes with a mortgage, or around 10.8 million homes, down from 12.1 million last year, were worth less than the outstanding balance at the end of June, the Journal said, citing data from CoreLogic.
Under the proposal, Fannie and Freddie would be allowed to charge higher rates to borrowers in order to compensate for the risk of guaranteeing refinanced loans that are underwater and more likely to result in default.
Officials at the U.S. Treasury could not be reached for comment by Reuters outside of regular U.S. business hours.
Combined with Fannie Mae and Freddie Mac, which buy loans and repackage them as securities for investors, Washington’s footprint in the market has grown to account for nearly nine of every 10 mortgages.
(Reporting by Sakthi Prasad in Bangalore; Editing by Matt Driskill)
Read more: http://www.foxbusiness.com/news/2012/12/26/us-may-expand-mortgage-refinance-program-wsj/#ixzz2GAgdIQln
As Fiscal Cliff Looms, Here’s The Expiring Tax Break That Will Hurt Housing Most
The year is quickly coming to a close and, with House Speaker John Boehner’s ‘Plan B’ scrapped, a deal to thwart the so-called fiscal cliff has yet to be reached. The $600 billion in simultaneous tax hikes and spending cuts that’s set to take effect in January have been front and center, but there’s one housing-related tax cut set to expire that deserves attention too. No, it isn’t the mortgage interest deduction, contrary to all of the attention that has been receiving. I’m referring to the Mortgage Forgiveness Debt Relief Act.
Established in 2007 with the onslaught of the foreclosure crisis, the Mortgage Forgiveness Debt Relief Act grants distressed homeowners an exemption from paying federal taxes on forgiven mortgage principals. So if, say, a homeowner facing foreclosure offloads his underwater home with a $295,000 mortgage attached in a short sale for $200,000, he would not have to pay federal taxes on that $95,000 forgiven principal amount that neither he nor the lender will ever see again.
Come January, this is set to change. That homeowner who has been forgiven $95,000 in mortgage principal could owe as much as $33,000 in taxes. That’s tens of thousands in taxes on so-called “earned income” that no longer exists anywhere but in the loss column of a bank’s balance sheet.
“There are so many people who are now selling short who wouldn’t do it if they had to pay tax on the money that the bank is going to forgive them. This is what changed the housing economy,” says Glenn Kelman, chief executive of Redfin, a Seattle-based online real estate brokerage. “It’s the most significant change and hopefully [Congress] will take care of it, but if they don’t, we will be in a pickle.”
Indeed. Thanks in part to the $25 billion mortgage relief act rolled out in February, short sales have surged this year. In the third quarter, roughly 40% of all home sales were distressed, according to RealtyTrac, an Irvine, Calif.-based real estate data firm. Short sales alone comprised about 75% of that distressed activity. Pre-foreclosure short sales were up 22% from a year earlier and short sales of distressed properties for which foreclosure filings had not yet commenced were up 17% over the same time.
That short sale flurry has been a major reason home prices started to stabilize and even tick up in some markets this year. While these kinds of transactions still sell at discounts off of traditional home sales, the discounts aren’t typically as steep as foreclosure sale prices or bank-owned sale prices. In November, for example, short sales fetched 16% discounts on average while foreclosures fetched 20%, according to the National Association of Realtors.
Besides smaller discounts, short sales represent win-win scenarios for all parties affected by default. The lender takes a smaller loss and does not have to assume the property on its books; the home seller can escape the financial burden of an underwater home without decimating his credit; and the neighbo0rhood fares better than it would with another foreclosure because the property doesn’t become vacant nor does its sale price impact local home values nearly as much as a foreclosure or REO (real estate owned properties) would.
If the Mortgage Forgiveness Debt Relief Act expires, all of this could change. Exacting a federal tax on that forgiven principal amount would de-incentivize the short sale process and essentially push distressed homeowners to walk away from properties entirely. More worrisome still, the tax would also be leveled at those folks who have their underwater loans modified, a process that reduces the principal so that the homeowner can better manage payments and stay put.
“The prospect of being taxed on potentially tens or hundreds of thousands of dollars in additional income may motivate more distressed homeowners to forgo a short sale and allow the home to be foreclosed,” warned Daren Blomquist, vice president of RealtyTrac, in a recent report. “Additionally, if the mortgage interest deduction is eliminated due to the fiscal cliff quagmire, it would give many underwater and otherwise distressed homeowners one less reason to hang on to their homes.”
Some of the markets with the biggest home price rebounds this year could be the most vulnerable, particularly those areas where huge sums of distressed homes have been flushing through the system in short sales this year. “This is why Phoenix, Ariz. took off in 2012. There used to be three times more foreclosures than short sales there and now it’s the reverse…People in California, Las Vegas, Florida are in a tizzy about this,” says Kelman.
States like New Jersey and New York, where foreclosure starts have ballooned 538% and 209% respectively since this time last year, would feel the effects of this act’s expiration, too.
Compared to the vast 12-figure sum associated with the fiscal cliff, a one-year extension of the Mortgage Forgiveness Debt Relief Act would cost the federal government a piddly $1.3 billion in tax revenues over the next decade, according to Congressional estimates. The act cleared the Senate Finance Committee in August and politicians from both governmental parties have expressed support for its extension. But it’s been bogged down in the larger fiscal cliff debate.
As Rep. Jim McDermott, a Democratic Congressman for Washington state, so bluntly put it earlier this year: “The expiration of that provision is a hidden time bomb.”
Get to it, Uncle Sam.
Loan Delinquencies Rising
Lender Processing Services, Inc. (LPS) offered an early look into delinquency and foreclosure trends for November.
The data provider found the delinquency rate increased slightly to 7.12 percent from 7.03 percent in October, representing a 1.2 percent increase.
Compared to November 2011, the delinquency rate has fallen by 9.06 percent.
The foreclosure pre-sale inventory rate decreased to 3.51 percent, with inventory falling monthly and yearly by 2.84 percent and 16.42 percent, respectively.
The number of properties past due, or properties 30 days or more delinquent or in foreclosure, totaled 5,350,000. Of that figure, 1,767,000 were in foreclosure presale inventory, while 1,584,000 were days or more past due.
The states with the highest percentage of past due loans, which includes delinquencies and foreclosures, were Florida, New Jersey, Mississippi, Nevada, and New York.
The states with the lowest number of past due loans were Montana, Wyoming, South Dakota, Alaska, and North Dakota.
LPS’ report represents about 70 percent of the overall market.
Price Gains Driven by Composition Changes, Not Appreciation
After tracking home price trends in 25 metropolitan statistical areas (MSAs), Radar Logic found prices in October are now 6.9 percent higher than a year ago, according to the company’s RPX Composite price.
“However, this increase was driven by a change in the composition of sales rather than price appreciation,” Radar Logic stated in a recent report.
Upon closer scrutiny, the analytics company explained the price increase is mainly the result of a decrease in distressed sales, or “motivated sales,” and the actual price increase for “non-motivated sales” is much smaller than the overall yearly gain.
For example, the report points out that as of October, 23 of the 25 MSAs saw a decline in sales of foreclosures and REOs. And, motivated sales represented just 13 percent of all sales in the 25 MSAs, down from 24 percent a year ago. In addition, motivated sales were priced 32 percent lower than non-motivated sales in the 25 metros.
“The decline in relatively low-priced motivated sales as a percentage of total sales has put upward pressure on RPX prices for many MSAs, as well as the RPX Composite,” the report explained.
While the composite follows trends in just 25 MSAs, Radar Logic says it suspects the same holds true for most major housing indexes.
When non-motivated sales are observed separately from motivated sales, Radar Logic found “prices in such sales have not increased nearly as much as the aggregate figures suggest.”
For non-motivated sales, prices increased 2.7 percent during the same time period, less than half of the overall RPX composite, the report noted.
IR, with these two news stories you are raining on the housing recovery. 🙂
[…] increases. Few question current prices or wonder why current prices … … Read more: The inner workings of house prices and housing markets (redux … ← Is Another California Housing Bubble Possible? Median Home Price […]
Debt Ceiling to be hit by Monday! I just wonder how real or is it pressure to go with plan “C”?
The article posted on December 26 is old but seems mostly correct. One point I would challenge is the writer’s excepting from “ignorance” those who bought houses “with conservative financing” after 2003. Heck, those who paid cash just lost their own money instead of losing borrowed money.
I’m not usually a grammar Nazi, but the author of this piece makes himself look very silly by bragging about his education, when his knowledge of English grammar goes no further than the sixth-grade level. Shall I enumerate his many errors? Nope, too boring. He’d have done well to proofread his own work, though. Some of the mistakes are obviously just typographical.
I think you are abusing the term Debt-To-Income in the above, in particular in the “DTI” graph. I think what the graph shows is
Debt-Payments-To-Income
In other words, the ratio of debt payments to income, not the ratio of debt to income. These two concepts are NOT the same!
Furthermore, the “inflation spike” label at 1980-82 is also wrong. There was an INTEREST RATE SPIKE that caused debt PAYMENTS to spike i 1979-1982.
The inflation spike was earlier, in the 1970s. The interest rate spike was Fed Chairman Volcker’s cure to stop inflation.
Otherwise the post is very good, covers the basics of housing prices on a supply-constrained (California) market driven by speculation and magical thinking.