28/36- Why House Prices Must Fall

Now 28/36 may not ring a bell with most homeowners, but for 99% of people who applied for a mortgage loan during the second half of the 20th century, they were measured against that standard, or one very similar. And if they were approved for a mortgage during those years, then most likely they met the 28/36 standard. The problem is that many who took out mortgages during more recent times did not really meet that standard, nor can they currently. And that is at the heart of why house prices must fall. It is also why the bailout plans will ultimately fail.

To mortgage lenders, 28/36 is the ratio of a borrower’s debts to their gross income, meaning their monthly house payment (including loan principal & interest, real estate taxes, homeowners insurance and private mortgage insurance, if applicable) must not exceed 28% of their monthly income. The 36% refers to a similar ratio, but in addition to the house payment includes all other loans and the minimum payment due on credit cards. In the old days- like prior to the Millinium, if a borrower exceeded those ratios then there was no mortgage. And that formula worked pretty darn well for a whole lot of years. It was only in the last 5-10 years that lenders quit taking the time to calculate that ratio, or took the borrower’s word for what they made without requiring so much as a quick glance at a paystub. So, it’s little wonder that borrowers have been defaulting on loans almost before the ink is dry. There has been a lot made of the harsh reality brought on by hundreds of billions of dollars of ARM loans re-setting, but an even harsher reality is the number of borrowers that are running delinquent on ARM loans prior to re-set. And if they can’t make the payment at the teaser rate, well- fixing the rate “ain’t gonna help matters any”.

Consider this…according to the US Census Bureau, the median household income in 2006 was $48,201. That translates to a monthly gross of $4,017. Okay, let’s take the median sales price for existing homes as reported by the National Association of Realtors just last month- $201,100. Assuming no down payment, as was the case with approximately one-third of homebuyers a year ago- you’re looking at a monthly house payment of about $1,741. I dunno’ about you but I don’t need a calculator to see that $1,741 is a heckuva’ lot more than 28% of our $4,017. In fact, it’s 43%. So let’s see…for the median US household, the monthly house payment needed to buy the nation’s median priced home not only exceeds the 28% standard but the 36% standard for all payments as well.

Hmmm… what’s wrong with that picture? Add a couple car payments and credit cards, and our median household would have to spend over half their gross earnings to pay contractual debt. And we all know that we don’t get to spend gross dollars, so grab a calculator and quick-like, figure what’s left over in this scenario after taxes and debt payments. It’s not a pretty sight.

Unlike other investments, real estate (as in housing) is first and foremost “shelter”. At least that’s how it’s been viewed throughout most of the history of mankind. Then during the past 50 years or so, it increasingly became a source of esteem and social standing, even among the middle class. Next, somewhere along the way, it came to be viewed as an investment, and during the “go-go” days of the past decade that concept got pushed way out in front of all other concerns. And those two forces would at least partially explain the mania on the part of buyers purchasing ever more expensive homes. Of course they were enabled by the easy money policies of the Fed, and then encouraged by realtors, lenders and the mainstream media as well. And of course, without the constraints of 28/36 to hold things in check, people bought or financed more than they could afford.

Why? Because they could. And because it seemed like a great idea at the time- “a no brainer”, “a sure thing” that nobody in their right mind would want to miss out on. Heck, it even seemed like the “right” thing to do- living the American Dream and all. Unfortunately, it fooled a whole lot of homeowners- many of whom should’ve known better. But it also fooled a whole lot of the smartest guys in the room. I mean, how did mortgage lenders, investment bankers, the ratings agencies, investors worldwide, and the media all not think to check for 28/36? How did they look at those swiftly escalating home prices and not ask- just how were people going to make their payments?

Now, we have millions of people living in homes they cannot afford and unable to make their payments. The Fed can lower interest rates, teaser rates can be fixed, loan limits can be increased, banks can be force fed liquidity, etc, etc, etc- but how does that change the fact that the average household cannot begin to afford the average home? Before this is over, wages will rise or home prices will fall, or some combination of the two- until the median household can make the payment on the median house each and every month. Do the math, at 28/36… $4,017 gets you a home with a price tag of $129,000. That’s a long unwind from $201,100…

Another way to approach the same issue is to look at the relationship between annual income and home prices. Historically, home prices tracked annual income at the rate of about 3x, or at least until ten years ago they did. From that point forward, they skyrocketed til they reached a peak of 4.5x in 2005. So, if 28/36 is too much math- then simply multiply the median annual income 3x and you can quickly see whether home prices are out of whack or not. Btw, to bring that multiplier back to 3x, home prices would need to fall to $144,630. That’s still a lot of water to flow over the dam…

To be sure, Bear Stearns (BSC) and the many others holding significant quantities of Mortgage Backed Securities (“MBS’s”) collateralized by sub-prime mortgages face the severest risks. But what of Fannie Mae (FNM) and Freddie Mac (FRE), with very sizeable recent loan portfolios based not on 28/36 but rather on such ratios as 35/50, and even worse, way too many “Prime” loans at 50/67?

Comments

[Jack K:]

Great points but the median income may be skewered. A lot of people are retired and aren't working. They often own their home without a mortgage. What is more important is what is the median income of people who buy homes, who use a mortgage, compared to the price that this same group pays. Perhaps one can not get that data,but one has to be careful with medians that one is using the correct denominator.

2008 Mar 17 06:34 AM

[zenalgorithm:]

One thing that will really suffer by the decline in housing prices is the taxes cities and counties reap from new home building. In Seattle, one needs $200,000 just to pay for building permits and other various fees, before anything is built. These fees have been skyrocketing this past decade.

Property taxes certainly will drop as well.

Now that there will be a decline in this property tax base, cities are going to start scrambling for new tax revenues.

2008 Mar 17 06:52 AM

[User 164597:]

This was written perfectly. I do not like to say this, but I have been saying this for over 2 years now! I have friends that make 40K year and they bought $350,000 homes with no money down and no verafication of income. Now they are screwed. Or should I sya we are screwed. This is just the tip of the iceburg and we are the Titanic

2008 Mar 17 09:08 AM

[Danial Magid:]

Bob,

Very good summary of the citizens situation. The numbers may not reflect the entire US population, and the "local economies', but it definitely puts the picture in perspective.

-Danial

2008 Mar 17 10:57 AM

[Fabien Hug:]

Good article. I looks for factual data to grab the problem. Of course median are what they are but it is a start. Where I live, LA San Fernando Valley, the median income is lower ca. $ 35k and the median home price is much higher, ca. $ 425k. There are some places in this country where the situation is more dire.
I think that those who own their homes in full are in no better shape; the "equity" that was building in those days was supposed to finance their retirement. Thus they used cash flow for consumption (see the drop in savings' rate).
Re. the municipalities, they are effectively in trouble. Less tax income in the pipeline. I read an interview of the boss of Blackstone in the last Business Week where he says that the last place he wants to be is in Treasuries. I would also add Munibonds.

2008 Mar 17 11:42 AM

[Hyman:]

This excellent article totally hits the nail on the head. We have been game playing with "creative" mortgages for the last ten years, and now economic reality has finally crashed through the illusion. The credit pendulum will soon swing past what we had 10 years ago, and all these old mortgage loan formulas will be back. The result? Prices will plunge down to what the local wage earners can actually afford to pay. We are looking at 35%+ drops in home values, back to around 2001 levels or even lower. The situation could be much worse for California, Florida, Arizona and Nevada home owners, who have seen the maximum real estate bubble effect over the last decade.

2008 Mar 17 03:04 PM

[User 164904:]

I think there is more to it than is noted. In 1995, the Median Household Income was 34,100, and the median Home Price was 133,900...a ratio of .24. Pretty much the same as the ration for the 2006 number 48,201/201,100 or .24.

2008 Mar 17 05:36 PM

[buyitcheap:]

Would be very interesting if people had to raid (those that could) their 401ks, IRA's etc, sell stock? to cover the mortgage? which is ironic given that those vehicles are protected in bankruptcy and the house isn't. It makes more sense to walk away and start over.

Why aren't we seeing any perp walks yet?

2008 Mar 18 08:30 AM

[Augustus:]

In earlier times the ratios were 25/33. And it worked pretty well. Maybe a slight bit of favorable skew for the first time homebuyer using a Govt program for a lesser priced commodity house. The idea of $1,000,000 houses with nothing down financing is nonsense.

2008 Mar 20 06:23 AM

[Tarjan-B:]

Interesting article, but what to make of the Fed FOR report that claims all is well in the ratio department?

2008 Mar 25 03:54 AM