If your personal financial household was experiencing a rough time, and you dipped into your savings or used credit cards to shore up your finances, make purchases or take trips, would you feel good about your newfound economic recovery? Probably not. But if you were the U.S. Bureau of Labor and Statistics you would be touting recovery.
How does this relate to the housing market? Home prices seemed to have bottomed. Inventory is low and demand is high. Last year, I wrote an article titled “The Coming Bottom in Real Estate”, and prices this year do seem up from last fall, confirming my hypothesis. But this recovery has partly (not entirely) been goosed by the catalyst of easy money. Making the stability of a future recovery feel somewhat less stable.
The question I pose is how much of this recovery and its stability is a function of easy money policies? If we didn’t have easy money policies, how much more might prices have fallen? Looking forward, what if easy money policies are reversed? Then what kind of head wind will this somewhat fragile recovery face?
There are three issues to consider. First, we have an interest rate environment, courtesy of the Fed, that provides below market interest rates. Second, the FHA has stepped in to provide very low down payment loan programs at much higher purchase prices than were ever available before. Thirdly, we have a fragile housing market as a result of many owners with no equity, which could create a snowballing affect. If owners with no equity start walking from their properties at a increasing rate, it causes lower prices and then even more homeowners are likely to walk from their homes, creating a self reinforcing cycle.
1) Interest Rates
While it isn’t clear what is the correct interest rate, as the Fed has obliterated normal market mechanisms, it is fair to say that a 30 year mortgage should be at a rate greater than 4%. I can’t define what would be the right interest rate. In fact I don’t believe any one person, even Ben Bernanke (Federal Reserve Chairman) is smart enough to set rates for an entire market. That is the job of the “Market”. The idea of a collective group of individually motivated investors (ie. the “Market”) being smarter than the government is what I believe makes us American versus a socialist or communist centrally planned government. Yes I feel that strongly.
So while I can’t define the right “Market” rate, I can define how much of a difference a higher rate would create in terms of price. In most instances, buyers purchase a home based upon the payment, so the interest rate they pay directly affects what they can pay for a home.
If Bernanke wasn’t propping up the housing market with a low 4% rate, what might happen to prices?
Let us assume that a buyer puts down 10% on a $500,000 home with a 4% mortgage. Their total payment (PITI)would be $2,742.
Making some quick calculations shows how the interest rate affects the price a buyer can pay if payments remained constant. Below are some examples.
Home Price . . . . .%Down . . . . Int Rate . . . . . Total Payment
$500,000 . . . . . . . . 10% . . . . . . . 4% . . . . . . . . . $2,742
$450,000 . . . . . . . . 10% . . . . . . . 5% . . . . . . . . . $2,718
$400,000 . . . . . . . . 10% . . . . . . . 6% . . . . . . . . .$2,650
Looking at the above numbers, one can see that each 1% drop in interest rate allows a buyer to pay almost 10% more for a home with no increase in home payment.
Last year at this time 30 year mortgages were about 5%. Yet this year they are around 4%. Has this helped put a floor in the market? Certainly, and maybe it has even caused a small pop in prices.
What will happen if rates go back up to a more reasonable figure? If a fixed rate mortgage was 6% today, might prices be 10% – 20% lower? Keep in mind that just 5 years ago, an interest rate of 6% was considered amazingly low.
2) Availability of Money and Lending Underwriting Guidelines
The lending landscape is certainly different today than pre-crash (2007). Scrutiny is pretty much over the top, with lenders requiring paperwork that doesn’t necessarily reduce risk. They are more concerned with meaningless details, rather than real world risk factors, like larger down payments. So while scrutiny is high, the emphasis is largely misplaced. If banks restricted buyers to a minimum of 10% or 20% down, it would solve most risk issues in the first place, as it had prior to the low money down programs that only started as recently as 1995 and to a great extent fueled this last and very long boom that lasted from 1997 – 2006.
As a brief anecdotal history – In 1986, when I bought my first property, I struggled to find a lender that would allow 10% down on a duplex. I called EVERYWHERE, and after over 50 calls, I finally found a 10% down product with Glendale Federal. So in the 80’s, 10% down was not very common.
In 1993 at the bottom of the market, lenders started to offer 5% down loan programs. Listing agents didn’t trust opening escrow when a buyer had only 5% down because the scrutiny was so great that many fell out of escrow. But by 1995, if a buyer had 5% down, it was NO problem. Let’s go buy a house!
After the credit crunch hit (2007), lenders in the jumbo market (loans larger than $417,000) fled and have yet to return. Fannie Mae and Freddie Mac have stepped in to provide low down (only 3.5% down) loans on homes up to $625,500, and duplexes up to $800,000. Imagine buying a $600,000 home with only $21,000, down. That’s not much skin in the game!
From a market value perspective, the question I pose is “How many more buyers exist for a given home, when 3.5% down is possible, versus if 10% or 20% down were the standard?
It is impossible for me to calculate exactly how many more buyers there are as a result of having the government step in to provide easier money in terms of low down payments at higher jumbo prices. And it is also just as difficult to assess how this possible doubling of the number of buyers might boost or shore up home prices. But it is certainly fair to say that it helps, significantly.
Depending on the price range, I would say approximately 30% to 50% of buyers are utilizing the FHA minimum down loans. When I got into the business the FHA loan limits were so low that they could only be used in the most affordable parts of town, hence FHA low down loans were rarely used.
Today, in an entry level market like a starter home in Lakewood, more than 50% of offers utilize FHA minimum down loans. As the price point rises to the mid price point of Los Altos, buyers will often come in with more down. And trade up markets like Alamitos Heights and Park Estates usually see buyers with 20% down. So government low down programs certainly bolster the housing market in the lower price points. But we don’t live in a bubble and buyers for the mid and upper levels come from price points below. So it is likely that removing a good portion of the buyers at the low end and a significant portion of the buyers in the middle would have a very large rippling effect through the entire market.
Government sponsored entities (Fannie Mae, Freddie Mac, FHA) are responsible for 80% of mortgage originations. This is basically because banks don’t want to be loaning their money at 4% for 30 years, with low collateral. Borrowing “short” and lending “long”, has traditionally been a recipe for disaster. An example of borrowing “short” and lending “long” would be where banks borrow “short” term money at 1% and lend it out for a “long” term (30 years) at 4%. All is good, for now, as the bank makes the 3% difference, but this is based upon a future supply of short term capital which can be borrowed at 1%. What happens if in 5 years short term rates are above 4%, then the bank becomes insolvent. This is why banks, if they do originate a loan at 4%, sell it to Fannie/Freddie like a hot potato.
The government, while having stepped in to save the day by taking over Fannie and Freddie and providing low down loans for pricier homes, has also created a potential time bomb as they are now on the hook should this debt go bad. We are no longer in a market economy for interest rates or even the credit risk associated with underwriting guidelines.
If the government didn’t step in, how much lower might home prices be?
Finally, the Snowballing Effect
We can calculate the effect of interest rates on home payments. We can see how more buyers exist when down payments are reduced. But the momentum from a snowballing effect is pure speculation. We do know that financial markets tend to go to extremes. This is because the act of an asset going up actually causes it to go up more. Just as the act of an asset going down actually encourages more price drops.
Think like a buyer for a moment. If the cost of renting a home is the same as the cost of purchasing the same home, it would be fair to say that the home is at fair market value. However lets take this “fair market value” scenario and add the expectation that the home will go up 10% in value, versus the expectation that the home would drop 10% in value after one years time.
How a buyer values property depends greatly upon expectations of appreciation. In the example from the previous page, a $500,000 home has a payment of around $2,700. Rent on this home might be a little less, but with tax breaks, owning the home would be about the same as rent and maybe even a little cheaper, on an after tax basis. With this Payment vs. Rent comparison, we are just splitting hairs of a couple of hundred dollars difference between the cost of ownership versus the cost of renting.
Appreciation (or depreciation) of the homes value, is what really makes the difference between the rent vs. buy comparison. What if you thought that the home was going to increase $50,000 next year. That is over $4,000 per month in appreciation! In this case buying wins hands down. If this type of appreciation is expected, then buyers are often willing to pay a premium versus the rental cost of the home.
This same principle works in reverse. This is why markets tend to move to extremes, either above or below fair market value. Psychological momentum, and the tendency of humans to weight recent history with greater emphasis, makes trends often times move well beyond fair market value.
In a normal market, prices dropping wouldn’t be a big deal. As property gets cheap, buyers start snatching up the deals, rewarding the disciplined investor that kept some cash on the sidelines. But when nearly 1/3 of mortgages are under water, you have the makings of another financial meltdown. Where simple liquidity isn’t enough to stem the tide of homeowners walking away.
When a good portion of homeowners have no skin in the game, have mortgage payments they can’t afford, and no equity as incentive to make their payments, the market is fragile. If prices drop more, then more homeowners are underwater, and the lack of willingness to hold on. More owners then dump their property, prices drop more and more mortgages are then underwater. This is the snowball effect that Bernanke wants to avoid.
Whether a self reinforcing Snowball effect would take hold if Bernake and the government didn’t step in is pure speculation. Interest rates are definable, a reduction in the number of buyers if larger down payment are required could have negative impacts. But complete financial Armageddon, from a snowballing affect of mass foreclosures, is just completely undefinable, but a real possibility.
Final Assessment
While the market has bottomed, this recovery doesn’t feel completely organic. Let me explain an organic recovery. Business owners liquidate their unprofitable businesses. These unprofitable assets are sold off at a price point where new businesses can put them back into service profitably. Very similar to a worker that is in a dying industry and gets retrained to earn a greater wage in a growth industry.
The real estate analogy is when a home or apartment is owned by somebody that can’t afford it, or make the apartment profitable because their debt service is too great, and the property goes into foreclosure. It subsequently resells at a lower price with less debt service and is either an affordable home, or a apartment that makes money for its new owner. This new owner then has a stable asset free from the risk of loss, because the property makes financial sense.
A very good portion of this recovery has been organic or earned, possibly at least 50% or more. After all, home prices are 25% to 30 % off peak values, and we are 5+ years into this correction where foreclosures and short sales have been the norm. This is the type of time and liquidation that sets the ground work for a stable recovery. But there has been a portion of the recovery that has been engineered with artificially low interest rates and government sponsored (not free market) money.
For a real recovery to take place we want homes to change to strong hands. But even a new buyer with only 3.5% skin in the game may not be a strong hand. This new low down buyer might be more stable than the previous owner that is upside down, but it isn’t a true bottom, it is an engineered bottom. Not quite as robust.
While I see a bottoming in the market, it is for these reasons that I am not ready to jump up and down, proclaiming “all is again right with the world”. Moving forward from here the market will likely have to face a headwind of increasing mortgage rates. And if Fannie Mae and Freddie Mac start bleeding the government dry with Billions in losses, low down programs may disappear.
My gut feel is that about 70% of this correction has been earned through the liquidation of over encumbered properties and over extended home owners. It is the other 30% that feels engineered by politicians and the puppeteers at the fed. It is this 30% that gives me reason to believe that this recovery, while firmly in place, won’t be a barn burner.
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