The Impending Mortgage Crisis: Part Two

Things are different this time. And, that is what I argued in my previous post on the coming mortgage crisis. Exploding option ARMs will lead to record foreclosures, which will cause house prices to further decline, which will cause many households to have negative equity. Rather than pay mortgages that are larger than house values, people will simply walk away.

One additional factor that will cause great harm to the housing market is that many stated income loans fraudulently overstated income ( I almost committed mortgage fraud myself). Bond insurers and buyers of RMBS and CDOs will force these back onto the balance sheets of investment banks and mortgage originators, leading to a further decrease in lending and an increase in lending standards. This will increase the cost of buying a house and put further downward pressure on house prices. The Market Ticker blog has a good discussion of this problem and the harm it will cause to banks.

Below are two more graphs to support my case that the bubble is nowhere near finished deflating. The first is the average house price to income ratio across the U.S. This comes courtesy of PIMCO.

click to enlarge

The second is a beautiful graph of home prices in every city in the Case/Shiller home price index. This comes courtesy of The Mess that Greenspan Made blog.

click to enlarge

You can see from this graph that home prices have a long way to go before they return to pre-bubble levels. Cleveland and Detroit are back to the 2000 price levels, but the fundamental deterioration in those cities means that prices should fall further. Detroit and Cleveland have had declining populations for a number of years, and that trend continues. Predictions are that Detroit's population will continue to decline and by 2035, it will only have 705,000 residents, down from 890,000 in 2005.

Disclosure: I own real estate in St. Louis and Chicago. I have a short position in a land development company.

Comments

[Lawrence York:]

Unfortunately this is true. What will also impact the US economy is the magnitude of defaulted GNMA loans no government official or politician is willing to talk about. All this means cutting spending and slowing growth. The Fed's actions merely bail out those responsible while little to abate the reality of too much leverage and too much debt.

2008 May 01 10:33 AM

[karchad:]

I trust the movement of the market more than all these seeking alpha wannabe financial experts, and the doomsday posters that follow them like Jim Jones groupies towards Koolaid. The market predicted this houding mess, homebuilders started falling in early 2006. Homebuilders stocks fell 70% or more. But IT'S DONE. I invested in ITB on 1/2/08, and have profited handsomely. Despite all your attempts to down the market with ridiculous columns like this, the stocks have stopped tanking, and in fact are rising. LISTEN TO THE MARKET. Homebuilders bottomed months ago. There's no disaster ahead.

2008 May 01 11:21 AM

[Analytica:]

Yeah, I listen to the market but is the market listening to the consumer?

I keep looking for even one Bull include a respectable evaluation of expected consumer behavior as part of a positive outlook assessment.

2008 May 01 11:30 AM

[karchad:]

Consumer sentiment is at its worst during every market bottom.

2008 May 01 11:36 AM

[User 143167:]

Karchad, that was becasue investor sentiment was usually highly correlated with consumer sentiment and ultra bearish investor sentiment peaks in the market bottom.
However, this time it is NOT the case. Investor sentiment is pretty good since mid March.

2008 May 01 11:47 AM

[jswede:]

We have a LONG way to go yet in home price declines, due to a plethora of reasons, but foremost is this:

the 20% downpayment is BACK.

...and Americans can't afford it. not even close.

We'll continue down slowly and and steadily until Americans' savings meet affordable 20% downpayments. I'd say approx. another 3yrs and 30%...

after that, home prices will continue to increase at about the rate of inflation, like they did the 100 years before 2000.

2008 May 01 12:03 PM

[Michael Goode:]

Karchad - so in 2000 did you listen to the market and buy tech stocks? Or in early 2007 did you listen to the market and buy Countrywide? The market is sometimes right, sometimes wrong.

2008 May 01 12:39 PM

[triznix:]

Consumer sentiment has not even come close to being it's worst. Even if house prices level out the consumer is tapped. Wages are not increasing and cost of living is jacking up oh so uncomfortably.

2008 May 01 01:42 PM

[triznix:]

....and no more heloc ATM

2008 May 01 01:43 PM

[Brian A. Davis:]

Mike,

Good post. I am curious to know whether you are in agreement with the trend that residential real estate markets will continue to deteriorate due to tighter lending standards, a tapped out consumer, and job loss. The other missing peice is the eventual rise of interest rates.

BD

2008 May 01 01:57 PM

[jcrash:]

Normalized your graph, once again to payments instead of price.

2007 1.397857594
2006 1.478314538
2005 1.432964409
2004 1.325094098
2003 1.232645673
2002 1.244852812
2001 1.240424748
2000 1.348800449
1999 1.285290782
1998 1.222953977
1997 1.297901204
1996 1.323260469
1995 1.336008158
1994 1.387439202
1993 1.260211257
1992 1.400404179
1991 1.497202082
1990 1.580267027
1989 1.583155393
1988 1.559526208
1987 1.546642267
1986 1.546642267
1985 1.808460137
1984 2.008946707
1983 1.973803225
1982 2.365982548
1981 2.487876013
1980 2.134449551
1979 1.702172503
1978 1.447718253
1977 1.340200308
1976 1.256437789
1975 1.279111413
1974 1.204463997
1973 1.059771781
1972 1


Not nearly so bad as your graph makes it look, and your graph actually doesn't even make it look awful.

2008 May 01 02:44 PM

[Pent up demand:]

jcrash,

Why do you keep rehashing your silly argument about "payment" vs. price? It makes no sense whatsoever to talk about payments (I assume computed against a traditional 80% fixed mortgage) when prices got so insane that very few first time buyers could come up with the down payment to afford the mortgage corresponding to the payment in your (dare I care it a) model?

That's the primary reason for the severity of this correction. Lenders again require serious skin in the game from borrowers, and few have the money to put 20% down on a $500,000 house if they didn't get it from their rich pappy.

2008 May 01 03:28 PM

[jcrash:]

Makes no sense? So, if I can buy something at 0%, do you think I might pay a bit more than if I can buy one at 20%?

At some point it makes a difference. Your SAYING it makes no sense, makes no sense.

At 0%, I personally can afford say a much nicer car than I could at say 20%. His whole argument is based on affordability. If you want to base an argument on affordability then don't throw up a graph that isn't based on what someone actually pays - not what they pay FOR.

If you instead, want to base an argument on the tightening of credit standards and increased downpayments, then gimme a graph on that.

Sure, you had a housing bubble in Schiller's 20 markets. But I don't live there, and many people don't. That's why his first graph is actually pretty tame compared to the second one.

A good house is more afforable now than at many times within the last 20 yrs, although he would have you not believe that.

2008 May 01 04:43 PM

[Adam Axler:]

Jswede, right on. Foreclosure glut and new lending standards correlated with abysmal credit scores will make it nearly impossible for most to get loans.

Jcrash and all other Schiller index bashers, irrelevant point on small market disconnect. The truth is that almost every major metropolitan area, you know, areas where most of us live, have been hit hard and that effects the economy, not housing prices in Walla Walla.

2008 May 01 05:29 PM

[popcorn:]

It is interesting that you posted a chart by PIMCO. Bill Gross, from
PIMPCO is now advocating that the government "support" housing prices by bailing out people and banks who borrowed or lended money recklessly.
Why not let the free market run it's course and decide on housing price in accordance with the law of supply and demand? For every speculator who took out a liars loan and lost their shirt, there is a young couple that can purchase a house at a bargain price and be financially strong to stimulate the economy in the near future.
I'm sure that Bill's call is self serving. He probably loaded up on distressed MBS at bargain basement pricees, which will rally significantly if a government bailout did happen.

2008 May 01 08:42 PM

[johngonole:]

Those who got rich promoting the speculative rise in home prices want to be bailed out. That is they want to stay rich. Those who bought more then they can afford think they should be bailed out cause its not fair to take away their house from them that they haven't paid for. The responsible portion of the middle class will have to pay for the above bailouts resulting in another round of downsizing the middle class. It wasn't until the last 1.5 years or so that I really came to understand how banking, the government, and the Federal reserve work to in concert to line their own pockets and manipulate the economy. When things go bad not their fault but they always seem to state they can help. Its sad that so many people are in the dark on this. I think if the majority of people understood how it all worked we'd round em up and kick them out of the country. Better to led someone else in to live here.

Get rid of the Fed!
Say no to the United Nations!

2008 May 01 11:42 PM

[ArnoldCountry:]

All of this talk of bailouts and write downs makes me ill. The government needs to make this market hit a bottom. They need to give people incentives to buy. All this bailout talk is just perpetuating the problem. A tax incentive to buy is needed. I have said it before, this is a complicated mess. What is clear, no buyers, no one is qualifying and prices are in a free fall. Dont throw good money after bad, give tax incentives to buy, make easier money to borrower for those transaction only and start to eat up inventory. Outside of that, why take your bailout? In 6 months the place is going to be worth less again and will need another bail out.

2008 May 02 12:12 AM

[sivere:]

I say,

TakeBackTheFed.com

2008 May 02 01:19 AM

[Pent up demand:]

"A good house is more afforable now than at many times within the last 20 yrs, although he would have you not believe that."

This statement is absolutely ludicrous. I'm curious what area you refer to jcrash? Where I'm sitting (NYC), price-to-rent is still out of whack by perhaps 50%.

2008 May 02 08:30 AM

[jcrash:]

I live in Tulsa, Oklahoma (actually a suburb of it, but close enough). Home prices here have not declined.

You can buy a NEW 3,000 sq. ft. house for less than $250,000. Given interest rates at 5.5 to 6%, that makes it pretty affordable.

But, in general I'm using the data provided by the author. Using his data, 2008 should be able a 1.35 on my normalized scale. That is about the same as most of the last 20 years, and much better than the late 80's and early 90's (not to mention orders of magnitude better than the early 80's).

I'm not a big believer in price to rent for several reasons, first of which is home sales are skewed to new homes and home rents are skewed to older homes thats like saying a 1970's VW bug is equivalent to a new Prius.

2008 May 02 10:55 AM

[Nick Gogerty:]

the average housing market correction lasts 2-4 years in terms of price.

2008 May 02 10:59 AM

[Pent up demand:]

So just tell me your "normalization" procedure then. It will be impossible to show you the error if you won't give the procedure that produces your data.

2008 May 02 11:38 AM

[vreporter:]

Price-to-rent in NYC is already correcting - just like the mid-80's! Believe it. Any borough outside Manhattan or NJ is tanking now. The job market on Wall St was the straw that broke the camel's back.

2008 May 03 06:50 PM

[jcrash:]

Use interest rates to calculate the payment on said houses. Normalize that to 1972. Very simple. Average annual home mortgage rates are readily available. You want unaffordable? Try the 16+% mortgage rates in the early 80's...that's why those years are above 2.0. See how big a deal that is compare to the paltry 30% difference between 3.5 and 4.5 on his chart? Even though ratio of price to income is higher in 2005, the ratio of PAYMENT to income would be lower...much lower in fact.

2008 May 03 08:48 PM

[Michael Goode:]

Hey jcrash, I appreciate your perspective. I'll work on a post to explain why I believe your argument is wrong.

2008 May 03 11:51 PM

[WSJevons:]

I am late to the game, but jcrash . . . what happens when interest rates go up? Does the value of the home go up, down or stay the same?


The Hypothesis:

I suspect higher interest rates depress affordability and consequently depress home values or curb appreciation. While lower interest rates increase affordability, inflate values and accelerate appreciation. This suggests that purchasing a home at the 'height' of affordability is a dumb move because there is no room for affordability to increase. (This smell like a differential equation . . . )

A quick correlation of the housing price data illustrates strong negatively correlation between home prices and interest rates: -.60 using Real Home Price Index and -0.75 Nominal HPI to 30y bond prices. (www.irrationalexuberan...)


The Sniff Test:

Your normalization suggests the late 1993 was a good time to be in property. It clearly wasn't.



Alternate Test:

If I differentiate the payment equation wrt interest rate and solve for the change in principal, I should approximate the effect of a change of interest rates to change in home prices, no? If no one has done this yet, I will get one of my internmonkeys busy . . .

2008 May 19 05:29 PM