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  • Leverage and the Housing Bubble

    Posted by Carl from Chicago on November 16th, 2008 (All posts by )

    The housing bust has been well chronicled elsewhere and I won’t add much to it by summarizing it; let’s assume that readers of this blog know the outlines (and details) of the story. But while everyone has learned the (often bitter) lesson that housing doesn’t always go up, it also comes down, they haven’t fully digested other elements of the financial picture. High LEVERAGE on a flat or declining investment makes the “buy” vs. “rent” even more skewed away from “buying”.

    PROS AND CONS OF PURCHASING REAL ESTATE

    The case for housing as an investment (positive returns) is generally based on the following elements:

    - LAND has value; most of the value in any sale is driven by LOCATION
    - The premises atop the land can add some value and entice buyers, especially since buyers often want to move in and don’t want to do a lot of work. Generally enhancements to a property don’t pay off specifically, with rare exceptions
    - if you have tenants or renters, you can bring in income for use of your property. If you have renters, improvements to the property are likely to bring in more rental income or increase the likelihood of your property being rented at all
    - if you live there yourself, you avoid the “cost” of renting an equivalent property

    Tax Benefits

    - the government provides tax deductions on interest for real estate loans, and property taxes, within some guidelines
    - the government allows individuals selling real estate used for their primary residence (in general) to exclude a significant portion (or all) of the gains from income tax purposes upon sale

    The COST of real estate has the following elements:

    - property taxes on the land and the improvements made to structures on the land
    - transaction fees paid to governments and realtors when you buy and sell the property
    - ongoing maintenance of the land and buildings atop the land (or assessments for condominiums)
    - the cost to purchase the land and buildings atop the land
    - legal, accounting, and other fees paid tied to your property, or the value of your time in running and managing the property

    If you don’t pay cash outright on your property:

    - the interest rate on the cash borrowed to pay for the property
    - fees to take out the loan or modify the loans’ terms

    THE IMPACT OF LEVERAGE

    What people generally fail to think about in depth is how LEVERAGED the typical home purchase is. Many buyers are putting down 0-5% on a loan; the FHA and Federal institutions (with the death of many mortgage players the Federal government is often the only game in town) are trying to move up the down payment but housing activists (and builders) are trying to keep it in the 3% range. Note also that many of these buyers have their initial down payments “gifted” to them by the seller; for example if you are a builder, you are indifferent to whether the cost of your house is reduced from $100,000 to $97,000; but you could keep the sales price at $100,000 and “give” the buyer $3,000 for their down payment; this can help them to “qualify” for a loan. In the “old” days 20% down was considered typical; if 20% down was the norm today our housing market would go from ice-cold to a deep freeze.

    The problem with any investment with 95% leverage is that you pay a tremendous amount of interest. Your “equity” portion (in this case, your down payment plus the part of your mortgage payment that goes towards principal) is very low; in any sort of down turn your equity value will almost instantly turn negative (meaning that you have to bring money to the closing, and should probably just walk away from your home if you can stomach the horrendous damage this will do to your credit rating).

    Leverage MAGNIFIES your returns, upwards and downwards. If you put in $5000 on a $100,000 house and it goes up to $150,000, your $5000 investment has returned $50,000, or a 10x return (awesome!). On the other hand, if your house goes from $100,000 to $90,000, you owe $5000 IN ADDITION to those monthly mortgage payments you need to make for the next 30 years (should you be lucky enough to have a 30 year mortgage, fixed) should you sell it.

    I am simplifying here, but if housing is going to stay flat for the next five years or so (a reasonable assumption, although no one knows) then if you are heavily leveraging your house, you probably would be better off walking away and renting. While you can make a case for home ownership based on the value of the tax deductions and the “implied rent” value of not having to pay rent, it probably dies with the high transaction costs, zero value of the “tax free” gain on sale, and the fact that property taxes are going UP for the foreseeable future as cities grope for more revenue (don’t worry – even if the VALUE of your house goes down – the city will increase the RATE that they imply to your value to more than compensate – in fact the highest rates are in the poorest and most down-trodden neighborhoods).

    Let’s use a parallel analogy – does it make sense to use borrowed money to invest in the stock market right now? No – you are spending a lot of interest to put down money that seems just as likely to stand still as it is to go down or up. People would look at you like you were CRAZY if you told them you were going to borrow money and “go long” (invest) in the stock market now (I am not talking shorting the market because that analogy does not hold true – by buying a house you are effectively going LONG the market).

    When the Federal government pushes banks and their own brethren Fannie and Freddie to do loan modifications (reducing payments) to allow people to “stay” in their homes, it seems like they are doing these families a favor, but more likely they are helping the banks. Virtually all of these buyers are heavily leveraged; their payments are almost all interest. Many of these individuals would be better off walking away, if the home values were to decline modestly or even to stay flat for the next 5 years or so. Paying interest for an asset that is flat or declining is like a double hit in the face; you still suffer the loss, but you pay interest on the “old” value prior to the loss.

    Another element that falls apart in these models is the “implied rent” model. People who buy houses generally purchase nicer houses than the average renter; the delta between what people would do if they were renting vs. what they purchase when they buy a house is probably due to the fact that people think housing is a “good” investment so that buying more now just leads to bigger gains later. Don’t forget that rent rates will decline along with the overall economy; many landlords are vying for decent tenants and they are willing to discount rental rates or minimize raises to keep up with expense growth in order to keep “good” paying tenants.

    A final, sadder blow to these models is that if you don’t have income coming in the door, the tax advantages are minimized. Even if you had savings and could continue your house payments (mostly interest) while out of work, your reduced income would reduce your tax benefits at a corresponding rate. Without the “value” of the sales gain (the tax exclusion) and the interest deduction, and the value of the sale itself, purchasing a house (with leverage) looks even more like a suckers’ game.

    CONCLUSION

    Many models that value real estate have come unglued with the changes to market behavior. Take them all with a grain of salt. Don’t be sold that the positives of real estate outweigh the negatives, and glib realtor talk is often misguided.

    In particular, piling leverage atop a zero growth asset class is not a solid financial strategy, even if the government lets you deduct a portion of this on your taxes.

    Letting people stay in homes when they have no equity, so they are essentially paying almost 100% interest (no principal reduction) in the forseeable future, isn’t in their best interest, although it seems like you are doing them a favor, because they aren’t “losing” their homes (homes that they have almost no equity in, so they don’t “own” at all). These programs really benefit the bank, because they avoid having to recognize (in accounting terms) a loss on the property, pay transaction costs on the sale, and the legal / maintenance costs of kicking out the “owner” (who really owns nothing). Time is the banks friend; as long as you are paying some interest on this declining asset, maybe the value will turn around and the bank can avoid the loss entirely.

    Cross posted at LITGM

     

    29 Responses to “Leverage and the Housing Bubble”

    1. sol vason Says:

      1. Although property taxes rise on single family homes they also rise even more on apartment buildings. These tax increases are passed on to the tenant, except in NYC.

      2. people like to look on their homes as an investment. They also look at engagement rings, education, an automobile, a washer and dryer, a rifle or pistol, children, or even a dog as an investment. Homes always pay off better. I have never met anyone who bragged about the money they made from selling an engagement ring.

      3. Homes deliver more satisfaction than do equivalently priced T-Bills. Normally homes are sold for more than the purchase price. However homes should be looked at as a consumption item with a kicker because they give many intangible benefits such as good schools, low crime rates, good neighbors, access to baby sitting co-ops, neighborhood watches, status, credit rating, comfort and a canvas for self expression through gardening or home improvement.

      4. A good way to go broke trading stocks is to sell without making a profit. This same rule applies to residential real estate. Of course one should always buy stocks with outstanding fundamentals. Same rule applies to one’s own home. Historically, the Dow always goes up. So do home prices. It just takes patience. And not getting over-leveraged. Homes are different from other because of the intangibles.

      5. Never put all your eggs in one basket and never invest all your money in one asset class.

    2. Jonathan Says:

      Many models that value real estate have come unglued with the changes to market behavior.

      This is a problem with many popular models (see also: global warming). But you can’t easily explain this to people, because during the period when their houses are increasing in value they tend to believe that the model works. They don’t see the risk that comes with the big returns. The riskiest models are often highly profitable in the short run, which is why they are popular. And there are many businesspeople with agendas (builders, bankers, realtors, mortgage insurers et al) whose behavior reinforces the bad decisions made by house buyers.

    3. david foster Says:

      Here’s an interesting study of housing prices over 350 years in an upscale neighborhood in Amsterdam.

      There were peaks and valleys, of course, but over the total period, the real (inflation-adjusted) price appreciation was only .2% per year.

    4. Ginny Says:

      Sol’s 3rd reason: Homes as satisfaction. I always worked hard because I wanted money for my children and a house for my family. Some women choose to stay home – investing in children and homes. With such assumptions, paying off mortgages early is a priority, over-leveraged houses seems building lives on sand.

      I would be curious how much different approaches to such thinking are governed by a) gender, b) ethnic background, & c) early experience. My intuition is that many would look at this post’s reasoning, accept it, but buy because at gut level desire for land and love of home are felt deeply.

      Of course, much farmland was overleveraged a few decades ago and those people lost both home and job in that gamble. Our guts aren’t always wise; sometimes it takes generations to adjust to new circumstances. And many of our forefathers immigrated precisely because here they could own land.

    5. Anonymous Says:

      Sol said:
      “Homes always pay off better…” and “Homes deliver more satisfaction than do equivalently priced T-Bills…”

      The first point should read “homes HAVE always paid off better”, they are NOT paying off better now.

      But the “satisfaction” factor mentioned combined with the belief that Sol, and I, have about a home’s *probable* payoff in the future still make them a good bet. It’s a buyers market and my advice is, if one needs a home, grind out a good deal.

    6. Chris Says:

      “..The first point should read “homes HAVE always paid off better”, they are NOT paying off better now. ..”

      Overall, yes they still pay off better. If you are talking about someone who bought a home 3 years ago and is trying to sell now by choice, well then they are an idiot and that is a ridiculously short timespan for looking at the payoff of investing in a home. Flippers or prospectors are not the average person buying a home. Some people will be stung, many by their own risky buying behavior by this housing bubble burst, but many of us will use this as a rare opportunity and make even more than we could have without the housing bust.

    7. Carl from Chicago Says:

      What I find interesting about this comment thread is that a lot of it doesn’t address my central point.

      What I was saying is – if you have a financial model, in your head, that you are using to purchase a home, and you utilize high leverage in an environment where prices are flat or declining, you are likely to be on the wrong end of that trade.

      As far as the long time horizon, I heartily agree – but people with long time horizons generally don’t pick up almost no down loans and / or loans that require refinancing in the near term, which is very common today.

      I can’t discuss the psychic satisfaction of owning your own home… I rented for over a decade when I could easily have bought, and I found it quite satisfying, since I lived in the city (mostly) in a high rise and renters and buyers lived relatively interchangeable lives.

      Even today we are issuing / modifying millions of loans with tiny down payments, meaning that mortgage payments made by “owners” (how can you own something when you have 2-3% equity, by the way) are almost all interest, and appreciation is (likely) years away (and appreciation is needed just to get them BACK to where they first took out the loan; they will need lots more appreciation to make any money).

      Also – as far as passing on costs to renters – that hasn’t always been the case. Right now here in Chicago out in the suburbs there are tons of places for rent, and owners, desperate to keep the cash coming in, are taking what they can get. The fact that health care costs rise doesn’t mean that GM can get away with charging more for the car, in the short and medium term.

      My advice right now to anyone considering buying would be to wait for a few years and try to extract as good a deal as possible on renting. If you do buy, put a lot down, since you are paying interest on a flat investment for the next few years.

    8. Jonathan Says:

      Oh yeah, speaking of financial models that don’t always work, how about dollar-cost averaging in a bear market?

    9. Michael Kennedy Says:

      Houses are a bit like gold. They have never been worth zero. Buying a house to live in should be a rational decision and should include understanding of the power of leveraging. Most older people are wealthy, relative to younger people, because they bought their homes years ago and watched property appreciate. The present crisis was brought on by speculation and excessive leveraging. A complicating factor is the tendency of Americans to move every few years for job reasons. They might be better off renting until they have a prospect of staying in one location for years. This was not true of California, for example, the past 25 years. People who sold homes due to job relocation were unable to buy back into the market when they returned a few years later. Most of this was speculation but, when you are in the middle of it, it may be hard to detect. California had all the characteristics of a real estate bubble for about five years now. A few people saw it. We had a similar situation in 1991 but five years later, the rise in residential real estate had resumed. Obama may make enough mistakes to end this cycle.

    10. Chris Says:

      “..Oh yeah, speaking of financial models that don’t always work, how about dollar-cost averaging in a bear market?…”

      Jonathan,

      I have been given this advice over and over by people with alot more investing experience than me, but I did precisely this during every major market downturn during my adult life and made out great. I admit I do not fully understand all of the reasons and statistics why this is a bad idea, I only know that it has worked extremely well for me. I would agree that doing it in companies/funds that you would normally invest in as a matter of routing during a regular steadily growing market is not wise, but there has always appeared to me to be systemic opportunities in the market anytime *everything* goes down. I would concede that statistically they are probably right to tell me this, but it alwasy amazes me how vehemently my “in the know” investor friends tell me this…it is inversely proportional to how well it has actually served me.

      Oh and one more important point, I ususally start buying after a bit of downward activity. I guess if people are warning against doing it immediately when a downward trend starts then I would agree. Perhaps someone who is savvy and not just lucky like myself on here can explain in detail why I shouldn’t be doing this any more?

    11. Chris Says:

      Living in Hawaii sucks as far as buying a home. If you are an upper middle class earner, even with a spouse who is the same, you will never ever be able to afford your dream home or property. Everything here is a riduculous compromise on space, neighbors, traffic, or price or all of the above. Now I know people will say, “yeah, but you live in Hawaii..boo hoo”, but unless you are well off enough to not really have to work, then you are still stuck in the day to day of it all. Coming from the midwest as I did (Lenexa, KS) I have had to seriously refine what I expect out of a home property/space wise here. My wife and I own a townhome and a 3 bedroom home which we rent out and we are just waiting…waiting to pounce on the next market crash here(it has begun somewhat in Hawaii, but we lag the mainland in those regards) so we can finally buy somethign that I consider has enough space to raise my young children in the manner I would like. Oh yeah, and I want an inline hockey rink on my property, so an acre would be good…

    12. Jonathan Says:

      Chris,

      It’s averaging a loss. It works as long as the market recovers in a reasonable amount of time, where “reasonable” is a function of your patience, leverage and risk tolerance. Stocks tend to go up in value over time, but there have been long periods when it was not profitable to hold stocks. If, per typical dollar-cost-averaging advice, you regularly buy stock all the way down in what turns out to be a major bear market, you may have to hold it for years to get back to even. It doesn’t sound like this is what you are doing, since per your description you are basing your stock purchases on market conditions rather than the calendar. Also, I am not giving you or anyone else trading advice. I am not a good trader myself. I am merely pointing out that the DCA investment model falls apart under some market conditions, much as the real-estate investment model Carl is discussing does.

    13. Tyouth Says:

      DCA seems to me pretty foolish in bull market but makes more sense to me in a declining or declined, beat up market (like this one). Hopefully much of the value not based upon the intrinsic worth of a company stock has been dissipated. One doesn’t know where the bottom is, however, and so protects oneself by the gradual investing of DCA.

      (Note here that my record as an investor is not particularly good.)

    14. toad Says:

      The housing Mortgage crisis is not only about the leverage working against home owner but the fact that this is hitting at one of those technological slumps. At the moment the developed world has wrong about all the productivity it can out of the current technologies. The technologies that could cause another productivity spurt like the rail roads, automotive and road growth, the computer, and the internet, are pretty speculative and rather far down the road. We could be looking wring out deflationary period of five years but things could just sit there.

      The demographics aren’t good on top of that. The baby boomers will not be consuming nearly as much and they won’t be producing either. We are all ready starting to see an increase in growth of the multi-generation house. The US could become like Europe. College graduates in there thirties living with their parents because the don’t make enough to live on their own. Grandparents in the house because the money is too tight for the fancy assisted living places.

      The money for research will also get tight. There is some argument if a rational energy policy or a breakthrough on fusion power would help, since we’ll be short on intelligent productive people. The products from our public schools and way too many universities are turning out to be dumb an lazy…….Want fries with that.

    15. Real Life Bundler Says:

      Right now we are in a major (unprecedented since the depression) deflation. However, many wise economists believe in a long term inflation. Certainly the policies of the TARP and Obama’s future plans point to this, as do the actions of every US administration since Nixon abandoned the gold standard. Owning a house, even a highly leveraged one (assuming you can pay the mortgage) is one of the best hedges against inflation you can have. This is because your mortgage payments, if fixed, become repudiated by the inflation which makes your 6% payment effectively lower than market, and your house, which is just a pile of arranged commodities, appreciates in breakdown value as the price of wood, copper and gypsum rise along with inflation.

      Consider this book for some good ideas:

      http://www.amazon.com/Coming-Generational-Storm-Americas-Economic/dp/0262112868

      The remark that it is ‘a lot like gold’ is apt. It appreciates a lot like gold (parallel to inflation) but you can live in it.

      The remark that property taxes are passed to the tenant except in new york is incorrect. Tenants always pay the market price for the housing, irrespective of the Landlord’s costs of operating it. High operating costs over time my result in a slow increase in additional supply, but this will only increase rents if the value of labor in that region goes up faster than inflation.

    16. Tyouth Says:

      “The technologies that could cause another productivity spurt like the rail roads,….” said Toad.

      (Apologies to Carl for wandering from his post.) Now that you mention the railroads, Toad, it seems to me that now would be an excellent time to go back to the future and create a rail system would benefit the country immensely (inexpensive travel and shipping – pennies vs trucking-dollars per mile we’re told; employment in construction and maintenance). Expansion and modernization of an existing system would provide some economies in construction and would, in the end,I imagine, provide benefits similar to the interstate highway system work of the 1950s.

    17. Tyouth Says:

      I wonder what could be done with an investment in a project such as railway modernization (or some other area) with the funds that will be used to bailout financiers.

    18. Cousin Dave Says:

      Carl, interesting writeup. I think there is an implicit assumption in your analysis that property values are already high. But this is not true in all parts of the country. Where I live, in northern Alabama, it is possible to purchase a 3-bedroom house with a 10% down, 30-year conventional, and the payments will end up about the same as what it costs to rent a 2-bedroom apartment. At this point, the considerations become:

      1. How long do you plan to stay in the property? Renters in this area, by and large, are people who are in transient situations where they don’t plan to stay in the property more than a year or two.

      2. Do you have enough income to itemize deductions, in order to get the mortgage interest deduction?

      3. How important are the ameneties of living in a rental property (having maintenance taken care of, the swimming pool and party room of the typical apartment complex, etc.) vs. the conveniences and freedom of owning (having yard space, no upstairs/downstairs neighbors, having a garage or other parking of your own, being able to modify the property to suit yourself)?

      I’m not sure how the current deflation is effecting the local market. Construction of new housing has slowed, but looking at the Sunday morning real-estate shows, I don’t see prices for existing properties coming down very much.

    19. Ellen K Says:

      When we were buying a new home, our good credit rating would have allowed us to buy 50% more home. Thank God we refused. I see people in these overly large minimansions and they can’t afford to run the air-conditioner in summer or the heat in winter. They are white elephants on the market because NOBODY wants them. We became a middle class society that was mesmerized by the trappings of the elite thanks to Oprah and her ilk.

      I would also like to know at what point the many real estate flippers are going to come under scrutiny. It’s no secret that the centers of the burst bubbles are in California, Florida, Las Vegas and North Carolina-all markets that has their housing costs driven by ever increasing, or at least the perception of increasing, demand. Many of the defaulted loans were ones written for just this type of transaction. While I don’t want families out starving in the cold, I have a problems with funding someone who used a loophole in the system to fund what amounts to some sort of get rich quick scheme.

    20. toad Says:

      Bonus points for not buying a house that the lowest paid income spouse couldn’t keep up the payments on.
      Back in the ’80s we had “peanut butter millionaires.” A couple would buy a big house and then have to sit at home on crates eating peanut butter and crackers because of the monthly payment.”

      What might happen is in an effort to fight the deflation ( measured in 10 to the 12ths) the governments get to the point where they are obviously printing money and then inflation or hyper inflation starts.

      I finally got the guts to take a look at the Baltic Dry Index and the sea shipping costs for raw materials has dropped by about a third.

      I’ve looked and talked to some people and owners of large houses have gone from say Granny Cottages add ons to putting in “wet bars” that are in effect mini-kitchens. You’ll have many more houses with rental rooms defying restrictions and the multi-generation in one house is going to include not only grandparents but children in their late twenties and thirties that can’t afford to live on their own or get married in a lot of cases. So called starter homes are just to damn expensive in relation to pay these days. It will get like Italy.
      I’m afraid that it is going to get real nasty for small children and we are going to see and increase in throw away kids.

      Lord how I hope I’m wrong.

    21. Real Life Bundler Says:

      [i]Back in the ’80s we had “peanut butter millionaires.” A couple would buy a big house and then have to sit at home on crates eating peanut butter and crackers because of the monthly payment.”[/i]

      This would be a good outcome – it lowers the expected default rate.

      [i]What might happen is in an effort to fight the deflation ( measured in 10 to the 12ths) the governments get to the point where they are obviously printing money and then inflation or hyper inflation starts.[/i]

      We are obviously printing money already. We subtracted $3.5 trillion from the (m x v) money supply via the credit contraction and the consequential fall in v.. Hyperinflation will not occur until either the rest of the G-7 stop printing, which they won’t because of same problem or until V starts to come back, which will take years before creditors forget the pain of their burned fingers which won’t happen until a generation of executives retire.

      [i]I finally got the guts to take a look at the Baltic Dry Index and the sea shipping costs for raw materials has dropped by about a third.[/i]

      To the extent businesses can stay in business and individuals can keep jobs, lower commodity and energy/oil price helps increase the savings (aka Investment) rate which will eventually recapitalize lenders (who use savings to lend) and restore V. Key word: EVENTUALLY.

      [i]I’ve looked and talked to some people and owners of large houses have gone from say Granny Cottages add ons to putting in “wet bars” that are in effect mini-kitchens. You’ll have many more houses with rental rooms defying restrictions and the multi-generation in one house is going to include not only grandparents but children in their late twenties and thirties that can’t afford to live on their own or get married in a lot of cases. So called starter homes are just to damn expensive in relation to pay these days. It will get like Italy.[/i]

      This is a normal and also positive outcome. Good thing they have the extra kitchen area. Having the family support the housing needs of the non-working members means they are not on public assistance.

      [i]I’m afraid that it is going to get real nasty for small children and we are going to see and increase in throw away kids.[/i]

      Free abortions for all (people who can’t afford to take care of their kids or get a rich family to adopt them)!

    22. Tyouth Says:

      Bundler, be kind enough to define m and v? Thanks in advance.

      ” Having the family support the housing needs of the non-working members means they are not on public assistance.”

      True enough for WRT homeless shelters and the like, but assistance which comes in the form of a check in the mail won’t be much different.

    23. toad Says:

      The Baltic Dry Index is an index of mostly raw manufacturing materials; ores, coal, steel, and etc. Liquid and gas transport are a different index.) Since the number of ships doesn’t vary all that much (on average about two years to build a ship) shipping price is a pretty good indicator of manufacturing demand.

      Oil prices are dropping and that’s beneficial, but if the value added by manufacturing doesn’t pick up……

      There is a considerable social stress involved in multi-generation housing. Especially since the US populace isn’t used to it as much anymore. I’m afraid the birth rate will drop even more.

    24. toad Says:

      3.5 trillion for the US portion of the loss. European loss reportedly may be as high as 7 trillion if the “sub-prime” loans they have reportedly to “developing” economies hit. That’s maybe 10.5 trillion maybe. I don’t know how much countries in Asia have lost but it makes me semi-nervous.

      I’m just hoping for some tech discovery that will offer a good ROI.

    25. Real Life Bundler Says:

      “Bundler, be kind enough to define m and v? Thanks in advance.”

      m and v represent the entire philosophy of the Chicago School of Economics from whence the “Chicago Boys” came (to fix the economy in Pinochet’s Chile).

      http://en.wikipedia.org/wiki/Monetarism

      http://en.wikipedia.org/wiki/Chicago_school_(economics)

      http://www.econweb.com/MacroWelcome/monetarism/notes.html

    26. Anonymous Says:

      I must first say that I am a mortgage broker, and have been for almost 10 years. So my view may be skewed (*wink*)

      As such, I’ve been able to see this crisis unfold from the inside.

      Here is how it happened from my POV:

      1. 2000 – 8-9 percent rates, relatively low house prices, conventional financing is most common but there were “BCD” lenders that were financiall responsible. They required 20% equity, time since delinquiency to pass before issuing mortgages, documented income, 6 months worth of payments in the bank, etc.

      2. September 11 happens. The stock market is hit and the panic results in interest rates in the 4% range. People can suddenly afford more house for their money, or see this as an opportunity to cash out their equity and keep their payments similar. Demand for homes increase, increasing the price of homes. Rates are steadily low for years, and prices steadily increas. Investors are buying properties, making huge gains, repeat.

      3. After about 4 yrs of large and steady value increase (5-20% per year), mortgage lenders get aggressive. In an inclining market, it’s easy to lend as much/more than the house is worth because the value will catch up later. This may seem like a short term view, but when 95% of homeowners sell or refinance every 2-3 years, that’s all these lenders needed.

      4. Enter: Interest Only and Minimum Payment loans. Now, not only are the rates low, you don’t even have to pay principal on the first, or most of your interest on the latter! Minimum payment loans defer the interest yearly that is not being paid back onto the loan balance. It’s like making a minimum payment on your credit card and your montly balance increases.

      At this point the situation looks like this:
      -Increasing house values
      -Low interest rates
      -Low documentation loans
      -Loans with increasing principal
      -Lower credit score, asset, income requirements

      This provides us with the perfect storm for buyers who can get into a huge house with little credit, income, assets or equity and make minimum payments. And as home prices more than double in some areas over a 5 year period – there’s no end in sight!

      But alas, we here in the US have a thing called Free Market. When the supply of items exceeds the demand for the same, price corrections are bound to happen. The first to go were the most agressive (Minimum payment “option arm” loans). Then people’s adjustable mortgage payments increase. Foreclosures hit the market further decreasing the value of property, resulting in more foreclosure. Banks close by the hundreds, making it difficult for people to qualify to buy. Fewer buyers further punish the house prices. Mortgage insurance companies go out of business. And since they’re the ones that insure any mortgage over 80%, only the perfect buyer can get away with 0-10% down. FHA loans are the wave of the future, requiring only 3%. More mortgage companies go out of business for lack of new responsible loans, and a large default on their bad loans.

      So here we are.

      Which brings me to the point of this post. You say that Rent vs. Own is perhaps not worthwile in a time like this. Consider this:

      -New loan guidelines are as strict as they should have been this whole time. You must prove that you are absolutely capable to buy a home and pay the mortgage to purchase right now, keeping the sneaky agents and brokers (those devils) from steering a client into a bad loan. Any incling of risk will get you turned down these days.
      -By not purchasing more fuel is added to the housing crisis fire. The fewer the buyers, the more the price will fall, the stricter the lender guidelines will be. At some point the price must fall to a point where people will buy homes at bargain prices, again stimulating housing prices to grow.
      -Buyers, lenders, investors need to stop looking at homes as short-term investments. Over time, prices of homes increase. They’re a necessity. You have to live somewhere. Even if you rent, the guy you rent from has bought the house.

      That’s my two cents, anyway.

    27. Real Life Bundler Says:

      This was one of the underlying problems. Low interest rates put in place to stimulate the economy post-tech bubble bursting (sep 11 was more of a coincidence than a cause) were simply left in place too long. One could argue that this was done to keep us busy shopping to keep our minds off the Iraq War. Or one could argue that ‘easy money’ policy is the serpent’s apple of every US administration with an upcoming election. Nixon learned this the hard way too.

      In any case, what you describe is a nice micro-economic way to look at one facet of the consequences of easy money policy and how it played out in the $ billions of losses for the housing market. Now if you want to understand what this did to Wall Street and why there are no longer investment banks, and how this played out to $3 trillion of losses, Michael Lewis’ article IS a good one.

      http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom#page1

      By the way, anyone who claims Wall Street was ‘bailed out’ doesn’t have a clue. Wall Street was left to die. All 5 major I-banks either went under and evaporated overnight (Bear, Lehman), were bought for nothing (Merrill) or converted themselves to regular banks (Goldman, Morgan) and are in the process of de-levering froim 30:1 to 10:1, and unloading most of their non-fee-based staff in the process. The ‘bailout’ was designed to keep main street banks like Citi, B of A and National City from going under and losing ma and pa’s accounts in the process.

    28. Carl from Chicago Says:

      I am always trying to stay “on” thread but the last comment about the bailout is true.

      The only element I never understood was WHY anyone would lever themselves 30-1. As a finance person, any slip up anywhere and you are underwater. Those assets all had a downside, few of them had an upside.

      They were all just waiting to die.

      To top it off, their funding models had them running to the markets every 5 minutes for cash. If you are going to lever up like that, just take out the cash in a big lump and hold on until you die. No one wants to loan more to a stone loser.

    29. e1b8497ef3cf5cc6a3931548da0f4f5c Says:

      “Join me at $500 and I will get you in for the $3500 level!”