house house of cards?
I've long been bemused by housing prices and the mortgage industry. I make a pretty good living but would have trouble affording, say, a $513,000 house without taking on an unacceptable amount of debt. But that's the average price of a home in the Seattle neighborhoods north of the Ship Canal that I'd most like to live in. So I've often wondered who's buying these houses, and how do *they* afford them? Well the answer is probably the obvious one--people who are willing to take on what to me are unacceptable amounts of debt. During the first half of this decade money was cheap and loans were easy to get, so for the debt-tolerant (or the naive) houses were affordable even at 20% year-over-year price inflation. And Seattle's run up is by no means the most spectacular--California's Bay Area started earlier and rose faster. In San Mateo county for example the average home is "valued" over $820,000. In objective terms, that's a lot of money. How is this affordable?
Lets assume that you have managed to save, say $164,000 to use as a down payment. That leaves a mortgage of $656,000. Let's assume a 6% interest rate and a 30 year term your housing payment would be $4,000 per month. That means somewhere over $50,000 worth of pre-tax income per year is going to your housing payment. In a typical loan scenario the lender would limit you to a "front-end ratio" of about 1/3, meaning no more than 1/3 of your total income could be going to housing payments. You'd need an income of over $150,000 per year to afford this mortgage! Well the good news is that San Mateo has one of the highest average household incomes in the country, the bad news is that it's still only $70,000, or less than half of what's needed to afford the mortgage on the average home (and that's assuming you've saved $164,000 on your $70,000 income, no small feat).
It doesn't take a degree in economics to realize this situation isn't sustainable. Eventually something has to give, and since it would be completely unprecendented for salaries to instantly more than double the answer is undoubtably, prices are going to fall. Yet the numbers so far have been steady, at least on the surface. But I'm increasingly convinced that the stability is an illusion, deliberately propped up by developers, who are in effect jamming their fingers in the dike holding back a flood of falling prices. In fact I think they may be inflating home "values" as much as one third through weird discount schemes.
Here's just one of several posts that caught my eye on a mortgage industry bulletin board:
This is a property in California. Owner needs $175-200K in a stand-alone second for home improvements. Loan to be funded immediately after purchase closes at 25% discount off of production builder's regular price with ultimate CLTV based on appraisal (not purchase price) = 80%. Owner-occupied, SIVA and 700+ FICO. Very stable borrower.
CLTV is "combined loan to value", which is the ratio of the principal amount of all outstanding loans (what you "owe") to the amount of money the home is worth. Of course what a home is worth is kind of fuzzy. The most common measure is "what you could sell it for", but short of actually selling it how do you figure that out? Well the standard approach is to look at "comps", which are similar homes that sold recently in the same area. One way of looking at this is that your house is worth what your neighbor's house is worth, plus or minus intrinsic differences in value such as size, quality, view, etc. In modern subdevelopments there's often a lot of nearly perfect comps, since there's likely a home with the exact same floor plan a block away, and in new construction developers often set a price for each model and don't negotiate. But here's a case where the developer is selling the house for 25% off of "regular price", but the "appraisal" is 33% higher than the sale price? How's that work? Well the only way it can work is if the appraisal is based on comps that sold at "regular price", and this is some special one-off deal on the part of the developer. I guess that's possible, but here's another post on that same board:
Customer bought @ purchase price of $1.1 Million, and the sales manager at the new home community told them that the new place should be worth when we walk in about $1.5 to 1.6 Million, based on sales that he has done and closed in the same community and other homes that have sold in the area. An appraiser that he knows has apparently confirmed that orally.
Amazing coincidence another person buying a home in a new development at (over) 25% off what the sales manager says the house is worth? Consider the next line of that same post:
In addition, the borrower had to sign an agreement stating that they could not disclose the purchase price under certain circumstances - can for refi.
WTF? Why would a borrower have to never tell anyone what they paid for their house? Well part of the answer is because then it would be used in appraisals of other houses in the neighborhood. And that means the "V" part of everyone's LTV would go down. Assuming that LTVs for new purchases are nominally at 80% (20% down against the sales price) what would happen if the real sales price was used insted of the "regular price"? It goes to 105%--meaning the amount of the mortgage is 5% more than the value of the home. No lender, even at the height of the sub-prime craziness last year, would approve such a thing if they knew about it. So perhaps I've stumbled across the only two instances of this ever heard of? Since I'm not a mortgage industry insider I seriously doubt that. In fact I'm guessing it's rapidly becoming the rule rather than the exception, and since everyone is sworn to secrecy (and is gleefully smug about the "great deal" they got) it's hard for the news to spread. The situation is much like a Ponzi scheme however, and only works as long as no one is forced to publicly sell at true market prices. The minute one house in the neighborhood sells for 25% below what people think it's worth appraisers will be forced to take that into consideration on new appraisals, and everyone will look at their mortgages and say to themselves "holy crap, I don't have $200,000 in equity, I OWE $50,000!". And I expect that many of those people, who were struggling to make those obscene mortgage payments anyway, will either sell "before things get worse", or simply walk away and let the bank take the thing back. Which in turn puts more houses on the market, and the law of supply and demand kicks in and market prices begin to fall, say back to the point where people can actually afford them, which as we established above is ultimately over 50%.
I recommend the Mortgage Lender Implode-o-Meter for further reading on any of these subject.