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It's not (just) a credit crunch (Michael Goodfellow, October 1, 2007) I'm still reading plenty of articles in my news summaries that talk about housing and the credit crunch. These articles predict that the Fed will lower rates enough to make credit more available, and that this will help the housing market. From what I know of the situation, this is just plain wrong. So at the risk of restating the obvious, let's look at the numbers again. The situation is that Joe and Jill Average, living in the San Francisco Bay area, bought a house in 2005. They both worked and had a household income of $80,000/yr. They purchased an average house, costing $720,000. At 6%, their principle plus interest (using the Yahoo mortgage calculator), would be $51,801 per year. I'm not subtracting their mortgage interest deduction here, but I'm also not adding the property taxes, insurance or higher interest rate they got on the last 20% of the purchase price. I'm assuming that as typical subprime buyers, they haven't put much down. This is clearly an absurd purchase for them. With a house priced at nine times their annual income, the payments are 64.8% of their gross income. This is nearly all of their take-home income. They simply cannot afford this house. Instead of looking for something half as much (which doesn't exist), they get an ARM, with a 1% teaser rate. This gives them an annual payment of $27,790, which is 34.7% of their gross. It's still marginal, but they can barely make ends meet on this payment. Now it's 2007 and the ARM has reset. Reset to what percentage is anyone's guess. At best, it's going to approach the 30-year fixed rate of 6% in steps, but depending on the credit score of the buyer, I've seen reports of anything up to 11%. It hardly matters though. The buyers income may have gone up a bit in the last two years, but they still can't afford to pay the 30-year fixed rate, let alone anything higher. They were told they could refinance by now, when they had 20% equity in the house due to appreciation. However, at two years, they still owe $701K on the house, which they cannot afford at 6%. They would have had to refinance to another ARM. The thing is, the ARM has a prepayment penalty. When I first heard of these, I thought it was shocking -- to charge someone a fee for paying off a loan sounds immoral. Then I realized I was being stupid. The bank isn't giving them a 1% loan, after all. It's just restructuring the charges. Instead of 6% over the two years, it's 1%, with the rest of the payment at the back end as a prepayment penalty. This works if you are desperate to get into the loan, can't afford the payments, but assume you are going to refinance. It makes no sense otherwise. If they refinance, they are actually going to be increasing their loan balance to cover the prepayment penalty on the previous loan. By how much? Well, at 6%, they would have paid $85,373 in interest in the first two years. At 1%, they would have paid $14,003. For the bank to break even, the prepayment penalty has to be at least $71,370. So even if they get an ARM at the same interest rate as the old one, their loan will have increased to $773,141, with a new payment of $29,841, or $2051 more a year, just to tread water on this house they cannot afford. And that's assuming no other fees, and that the house has appreciated 10% to justify the higher loan amount. Without steady increases in their income, allowing them to pay down the loan faster, this is a losing game. But our couple can't refinance anyway. The price of the house has dropped and subprime loans are no longer available (more on that in a minute.) Without enough collatoral to cover the loan, they just don't qualify. If they do get a new loan, it will be with a higher interest rate that reflects the increased risk of default. They can't afford significantly higher payments. Since they've only paid off 2.5% of the balance in the last two years, they can't sell either, not without taking a loss. If the price has dropped 5%, and realtor fees are 5%, they need 7.5% of the purchase price to sell -- $54,000! Unless the bank takes a short sale, this couple is doomed to foreclosure. And they'll still have to pay income taxes on the amount the sale falls short. These numbers all sound ridiculous to people outside the high-cost coastal regions, but what really matters is the ratio of house price to income. Traditionally, the advice was to buy something three times your annual income. Our example was at nine times income, which was unfortunately more typical of subprime buyers during the bubble. Here's the table of payments as percentage of income at different multiples. These are figured for our example couple making $80,000/yr, but the relationship between multiple and percent of income is the same at any income.
The story we're being told by optimists is that this is a temporary glitch caused by uncertainty in the credit markets. Once that's cleared up, things can continue as usual. As you can see from these numbers, that's just not the case. Many of the subprime buyers simply cannot afford their houses, and never could. Counting the 5% selling cost, they were underwater on their mortgages the day they signed. They are much deeper underwater now. What happened is that as prices climbed through the roof since 1995 or so, people stretched farther and farther, borrowing higher and higher multiples of income, to try and afford a house. At some point (around 5x), they'd have given up and the boom would have ended. Unfortunately, easy money and loose regulation meant that the industry started to offer interest-only and ARM loans. These lowered the initial monthly payments enough that people could buy houses at even higher multiples. This continued until the clock ran out on the first big surge of ARM's in 2007. Then, as rates reset, people started to default. The much higher than expected default rates sent shock waves through the industry. The subprime credit mess is the result of this shock, not the cause of it. Think of it as the point where Wile E. Coyote has run out into thin air and realizes he's going to fall into the canyon. In this view, the tighter lending standards are a sensible reaction to what the industry knows is going to happen. You don't loan someone 100% of the value on a house that going to drop in price 20% in the next few years. You don't loan to people with bad credit, since they will walk away when they go underwater on the mortgage. And preferably, you don't exceed the government's jumbo mortgage limit, since the government is one of the few remaining purchasers of mortgages. The same is true on the market side. You don't buy CDO bundles of mortgages when you suspect that a huge percentage are going to default. You don't lend money to institutions that are exposed to subprime, since you know they are going to lose their shirts. Expecting disaster, you get cautious. None of this is irrational. What was irrational was paying nine times income for a house! The pattern of the housing bubble and the wreckage that comes after is similar to other bubbles. The damage is done during the boom, when people make stupid investments. The pain appears during the crash, when people wake up and realize the money is gone. Michael Goodfellow blogs at Free The Memes! For more on a wide array of other topics, please visit the oftwominds.com weblog. 
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