Ten Percent of the Home Owners… Now and Potential… Gone

I used to have a few co-workers who lived in Boston in the 80’s. In the 80’s Boston had a massive real estate boom that ended in a bust. Two stories stood out in my mind:

1) when the first guy sold his condo, he had to bring actual cash to the closing because the sales price wasn’t enough to cover the mortgage debt
2) the second story was more complex. A woman’s parents lived in a small house in an affluent area near Boston. The couple was up to date on their mortgage payments. However, the value of the house plummeted to a point where the mortgage was significantly higher than the value of the underlying house. As such, the bank had the right to “call” in the mortgage even though her parents were current on their payments. Since they didn’t have enough money to refinance, they lost their home

Now the real estate boom is collapsing, but not due to plummeting housing values (like the Boston crisis, above) but due to a liquidity crisis. Existing buyers who put little or no equity into their homes are going to find that they can’t refinance – per this article (which is consistent with what I have seen elsewhere) deals aren’t getting done unless the buyer has a solid credit score and is willing to put down 10% of the value in a down payment. New buyers also face this 10% down hurdle which will effectively shut them out of the market for more expensive homes.

The liquidity bust will have some initial impact, and then a much longer term “tail”. Initially, those who did a two year interest only deal and can’t make the new payments when the rate ratchets upward will likely lose their homes, and these homes will be put back on the market by mortgage companies who want to get rid of them quickly. These repossessed homes will put a chill on the market and add to the already bloated inventory (the SUPPLY side).

On the DEMAND side, there is a whole class of people who simply won’t be able to buy homes anymore. 10% down payments and solid credit scores will put more expensive homes out of reach to buyers in many markets. These individuals will have to rent, instead, or move somewhere cheaper where 10% isn’t that much money. Another impact to DEMAND is that “jumbo” loans of more than $417,000 which can’t be bought by Fannie Mae (the quasi-Federal agency that buys up mortgages) are now selling for a significant premium, which will make it even harder to qualify for these more expensive homes.

The likely “end state” of this is that there will be a significant dent in the pool of home owners in the next two to five years. The ex-owners will consist of those with poor credit, those who lost their homes and now have that on their record, and those who can’t save up 10% for a down payment. Realistically, many of these people should never have been shopping for a home in the first place.

Eventually the markets will come back into balance, as prices are reduced to a more manageable level. Prices for assets like homes cannot always keep increasing above the rate of wage increases; it isn’t sustainable. The rent / buy equilibrium will get back in balance; that is to say that the value of a home should be some reasonable multiple of its rental value; if you start buying relatively modest homes in places like NY or California for above $500,000 – try to do the math on what you’d have to rent the home for in order to cover your mortgage and costs; it is very daunting.

A couple of wild cards are property taxes and the AMT; it is unlikely that state and local governments, addicted to increasing revenues, will reduce property taxes; they will just raise the rate to come up with the same dollars (as the assessed value decreases). Under the AMT these dollars are not deductible, so the pain of property taxes will be even more pronounced, as asset values fall or are stagnant.

It is interesting that the prick in the asset bubble was caused by a liquidity crunch due to the fact that securitized mortgages weren’t selling rather than the traditional fall (which takes much longer) in property values, such as occurred in Boston in the 80’s. The disinflation will be much faster than in previous busts. There isn’t really an historical framework for this type of fast correction, so think hard before making any moves or predictions.

Cross posted at LITGM

9 thoughts on “Ten Percent of the Home Owners… Now and Potential… Gone”

  1. Something similar is happening in Britain just now, as well. People cannot sell their homes because lending institutions will no longer finance properties that have been sold at fanasy values over the past 10 years. There are some streets in the south of England with For Sale signs in every other garden.

  2. So the source of the bubble is overly generously lending practices? It sounds like collection of financial instruments intended to distribute the risk of giving mortgages to more marginal borrowers got used far beyond the scale it was safe to do so.

    It is interesting to see how so many people see these bubbles coming but so few can predict when they will pop. I think I’ve been reading about the threat of housing bubble for the last five years or so. We saw the same thing in the high tech bubble.

    We seem to be able to understand the basic relationships involved in the creation and popping of a bubble but we lack the ability to make the crucial real-world, real-time measurements that lets us assign scale and intensity to those relationships. Without that information, we face a situation similar to a physicist who has Newton’s laws of motion but doesn’t have any concrete astronomical measurements and consequently cannot actually predict the motions of the planets.

  3. I wonder how similar this is to our tendency to think the schools in this country suck generally but the ones our kids go to are fine or that Congress sucks generally but our local congressman is fine – etc. We all think that our practices (loaning, getting a loan, etc. ) are solid but others aren’t.

  4. Ginny,

    You might have a point. I think the problem maybe that the distribution of risk might be to wide. Its like people who say, “i think our school gives an education to 80% of the students but 20% of students get a sucky education,” adding up all that 20% of suck across the entire country represents a significant problem.

    Likewise, if a large number of institutions have each taken on a small percentage of their assets in risky loans then collectively, that problem becomes very large. If all the institutions experience a significant, but non-fatal, loss at the same time they will all become risk adverse at the same time. That means high risk borrowers will not be able to get loans anywhere.

  5. I don’t claim to understand the source of the bubble, although I would guess that it is artificially low interest rates combined with the ability to “package” high risk loans into AAA paper through securitization and “tranches”. I am always interested in comments on this blog because there are a lot of academic views that try to understand “why” things happen… I am usually more interested in “what” is going on and what are the best courses of action to take given the circumstances.

    I do think that this one will “pop” a lot faster than the other bubbles because it starts with liquidity which “gums up” the system instantly; falling home values take a lot longer to take hold because you have to wait for people to get desperate enough to sell for a loss. Also, I don’t think that there has been a time when these high risk products like interest only mortgages were sold in such large numbers; there are now a whole class of borrowers that NEED to refinance (even if they are staying in place)and can’t – in the past generally the cause of trouble for borrowers happened when they had to move and were unable to sell their homes for more than the mortgage balance.

  6. I skeptical about the second story. First, contrary to urban legend, no lender has an incentive to foreclose on a performing mortgage. Changing an asset from performing to REO, hurts its performance ratios and draws attention from regulators. Second, Fannie Mae’s forms and most other consumer mortgage documents do not permit foreclosure, except in cases of non-payment, and a few other bad acts, such as lying on the application documents.

    My guess is that the owners were embarrassed to admit that they could not make the payments and made up the story about the lender to save face.

    “Now the real estate boom is collapsing, but not due to plummeting housing values (like the Boston crisis, above) but due to a liquidity crisis.”

    I think that the housing market was going south before the current market crisis. Housing permits and housing starts fell through out 2006. The liquidity crisis is occurring 20 months after other housing indicators began to soften.

    “deals aren’t getting done unless the buyer has a solid credit score and is willing to put down 10% of the value in a down payment.”

    What ever happened to the 20% down payment?

  7. I had a conversation with a woman where I’m currently assigned, and it was a bit of an eye-opener. She bought her condo with a piggyback mortgage: 80% first mortgage, 10% second mortgage (in ancient times, a “home improvement” loan), 10% cash (optional; she could have financed the whole thing). The arrangement means she can avoid primary mortgage insurance (PMI). She also carries about $30,000 in credit card debt. In her current industry, personal bankruptcy is not a good thing for one’s career, either.

    Nobody asked me, but I would never have advised her to gamble so much on future asset appreciation, favorable interest rates, and uncontrollable costs (condo fees, taxes, etc.). Neither would I have recommended approval of this set of loans, nor would I invest in a portfolio backed by similar loans.

    Lots of people saw this coming. I can’t claim any gift of prescience, but this market gave me the collywobbles, similar to the queasy feeling I had in 1998-9. Probably the smartest money manager in the world is Ken Heebner. He has always liked real estate. In 2001, he was long on builders’ stocks and REITs. In 2003, he was showing caution. In 2005, he cashed out. He may have been early, but not by much.

    Right up until the last minute, there was a lot of uneasiness. Mark Kiesel of PIMCO famously sold his house in 2006 and started renting. If you have a subscription to the WSJ, this Heard on the Street column lists some hedge funds that saw the iceberg and started buying lifeboat seats. Note that they were not relying on some quant magic, just common sense. One of my favorite investing websites, Seeking Alpha, has been running a column called “Housing Bubble and Real Estate Market Tracker” by Judy Weil since at least last year.

    Too many money managers just can’t stand to cash out while others are making money, even though they know it will end soon and suddenly.

  8. I think one of the primary reasons that people have felt impelled to buy houses is that fear that if they don’t, they will be left behind by rising prices. Yes, in many cases people have practical and psychological reasons for home ownership, but there are also many–particularly among the fairly young–who have felt that if they don’t get on the price escalator NOW then they’ll never have another chance. If the consensus changes to “housing prices will be flat to down for years” then many people will feel less impelled toward home ownership because of the expectation that prices will still be reasonable at some later date.

    On the other hand, here’s a WSJ article arguing that housing is in fact undervalued by a significant amount. I’m not convinced, but his argument is worth reading.

  9. “You can’t eliminate risk, you can only redistribute it” says the wise man. Unfortunately, unwise men seem lately to have invented ways of redistributing risk that mean that no-one knows exactly where it’s gone.

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