Some facts about the housing crash

I’m far from having a solid understanding of the current economic crisis, but I’ve been closely watching it for the past two years when it began to manifest itself in the housing crash, and I think at this point there are quite a few important facts about housing that are by now uncontroversial. I’ll list them here with minimal interpretation, saying only that I think the housing crash is still at the center of the overall crisis.

  • In the past ten years many, many people have bought homes which by any traditional standard were far more expensive than their incomes and savings could justify.

  • Buyers bought these homes with mortgages that were far larger than they could reasonably expect to repay.

  • Buyers were able to take out mortgages larger than they could repay because:

    • Lenders relaxed the traditional requirement of a 20% down payment from the borrower, accepting 10% or 5% or sometimes nothing at all.

    • Lenders offered mortgages with adjustable interest rates (ARMs) that were initially low but would rise later, making the loan more affordable up front.

    • Lenders offered mortgages where in the beginning the borrower could choose to pay only the interest on the loan, or even less (Option ARMs), meaning that the principal would stay the same or even grow over time, but further reducing the payments made early on.

    • Lenders often did not require documentation proving that the borrower had sufficient income and savings to pay off the mortgage (stated income or “liar’s” loans).

  • Buyers were encouraged to take out mortgages larger than they could repay because of intermediaries (real estate agents and mortgage brokers) who stood to make good money when the transaction took place and were at no risk if the buyer later defaulted.

  • Because of these lax lending practices, buyers were able to arrange for mortgages whose initially low payments they could barely manage to pay, and whose future larger payments were far beyond their ability to pay.

  • Buyers were willing to take out mortgages larger than they could repay because they did not intend to repay them, but planned to sell them at a profit before repayment became too difficult.

  • Because buyers were able to obtain so much leverage (i.e. ability to borrow with respect to their income), demand for houses grew and housing prices rose far higher than could be justified by average income in an area; at the peak houses cost about twice as much nationally as average income could justify, in some areas three times as much.

  • Because of the demand, far too many houses were built that were far too large, at least compared against the traditional needs of the population.

  • Because of the demand, the housing industry became an important component of the economy. Between 2000 and 2007, half of the new jobs created were connected to the housing market.

  • As prices rose, owners began to add further to their debt by borrowing against the increased value of their home (home equity loans, or second mortgages).

  • Many owners ended up with zero or even negative equity in their home (i.e. their loans were equal to or greater than the value of the home), either by never having paid a down payment or by taking out second mortgages.

  • As mortgages began to age, payments began to rise and borrowers found themselves needing to sell because they could no longer pay them. At the same time housing prices began to drop.

  • As housing prices began to drop, many owners found themselves “underwater,” owing more on the home than the home was worth. To sell their house, these folks would have to bring a check to the closing to pay off what they owed even after selling it. A recent report claims that 16% of all mortgage holders in the U.S. are currently underwater.

  • As housing prices began to drop, the market began to freeze up because buyers were mentally unable to accept (or financially unable to handle) selling for less than they had thought the house was worth.

  • As the market froze, new housing construction also ground to a halt, and jobs connected with housing began to disappear.

  • Many first mortgages in the U.S. are what are called “non-recourse” loans, that is, if the borrower defaults on the loan then the lender agrees to take possession of the house in lieu of further payments. This is unlike, say, a car loan, where if the borrower defaults the lender can repossess the car, sell it, and then require that the borrower pay the difference between the loan balance and what the car sold for.

  • When a borrower defaults, first mortgages holders are first in line for any proceeds from the sale of a foreclosed house, followed by second mortgage holders. However, second mortgage holders must agree to the sale. Many second mortgage holders are reluctant to agree to the sale of a house whose price has dropped, because there is little or no money left for them after the first mortgage holder has taken its share.

  • Buyers have become increasingly willing to “walk away” from their mortgages, turning the keys over to the lender; default has become socially acceptable, the effects on one’s credit record are erased after seven years, and many buyers feel that lenders bear much of the blame for enticing them into a bad deal.

  • Increasing default levels have made the mortgages owned by banks increasingly worthless. One early event in the credit crisis came in June 2007, when two Bear Stearns hedge funds that had heavily invested in subprime mortgages were forced to sell them; it turned out that the better fund was able to sell them for nine cents on the dollar, while the other fund discovered that their mortgages were worth nothing at all.

Strangely enough, all these things were true by mid-2007 and there has been nothing interesting to add to the list since then. All that has happened since is that these trends have picked up speed and made themselves increasingly felt. Housing prices continue to drop. Borrowers continue to default. Buyers are increasingly scarce. Mortgage pools held by banks continue to lose value. Housing-related businesses continue to lose sales.

I think what I’ve written so far is widely acknowledged to be true. What follows is speculation, but I think it is fairly well grounded in the facts:

  • Borrowers will continue to default in growing numbers for many years. This is in large part because the riskiest mortgages (Option ARMs) are just beginning to have their payments reset to higher amounts, a process that will continue for at least three years. Remember, these are the loans where grossly exaggerating one’s income was a common thing, and the buyer had the option of paying a payment that didn’t even cover the interest; these folks will now have to pay enough to cover interest and principal, at a new higher interest rate based on LIBOR, which is sky-high at the moment.

  • Because of increasing defaults, banks will fail in greater numbers and the survivors will continue to be unable to lend, not because the credit market is mysteriously “frozen” but because they are insolvent, i.e. broke. Their mortgage assets will become ever more worthless.

  • Housing prices will continue to drop for a long while, and will not rise for a very long while. One calculation claims that the relationships between housing prices and household income during the 20th century was steady and predictable until the mid-90s when all this nonsense began. If we take the steady trend that existed and apply it to current income levels, national housing prices at their peak were 2x what they should be, 3x in areas like California and Florida. A $600,000 California home will have to drop to $200,000 before things are normal again.

Finally, I think there is nothing that can be done to fix these problems:

  • Housing prices rose because people were willing to pay f
    ar more than a house was truly worth, because they thought that other people down the road would be willing to buy their house for far, far more than it was truly worth. Once that trend disintegrated, those people found themselves in possession of a financial obligation all out of proportion to the worth of what they had purchased. There is no way to re-interest buyers in buying those houses at inflated prices.

  • Borrowers went to extremes to be able to afford their loans, exaggerating their income, arranging for artificially low initial interest rates and artificially low initial payments that would rise greatly in just a few years. They took out loans far beyond their ability to repay because they expected never to have to repay them; they did not buy a $600,000 house in order to have a $600,000 house, but in order to sell that house at a profit later on.  No modification of the loan terms will make that buyer want to pay the rest of the $600,000 plus interest for a house that is now worth $200,000. The law will not force them to fulfill that obligation, and I doubt that a sense of honor will. So those loans will be defaulted in large numbers.

  • And if the borrowers default, the mortgages owned by the banks become worthless, and the banks edge closer to insolvency. Nothing short of giving them free money can change this.

13 thoughts on “Some facts about the housing crash

  1. Good synopsis. One more observation, if you’ll allow me. The frenzy of speculators buying new construction houses created a false demand. Here’s a story from the front lines.

    Mercedes Homes built 4000+ sf living space homes on zero lot lines with a toll road as the backyard in my hometown. There were several mistakes with this, and I’m sure the CEO’s think of these things, but they didn’t care. (If I made the observation, surely they did too.) First, there simply weren’t enough families moving to Merritt Island. I called the company when construction began and was told that there were 900+ on the waiting list. All the lots had been taken.

    Second, the lots–that’s another matter. These were zero-lot-line homes, which means there is no room for a pool or a yard for the kids to play. Remember, these are very large homes, which typically means children, since the homeowners association won’t allow you to run any kind of business out of this home. So you have these large homes going in on zero lot lines, and the place is sold out.

    Today, you can barely give the homes away. In order to build homes, you have to have families who are moving to the area who want to live in them and need a house that large. That doesn’t exist. Investors gambled on the idea that prices would always rise, as you already said. The lucky, early investors found more investors looking to buy and sell. But there were never any real buyers. Third (?), these families with 3+ children who don’t want a pool or a yard don’t exist in central Florida. Even if the prices were lowered, Mercedes built an entire development based on a ridiculous idea: large McMansions on zero lot lines. (I understand this happens all the time, but in FL, the majority of homes have pools.)

    Builders continued to build, but they were never building for real families who were going to plant a fruit tree and buy address stickers. I think this was a long way to say that there is an oversupply, but not only that, we will probably see a lot of houses that don’t last due to the hurry in which they were assembled and the fact that the buyer looking over the builder’s shoulder was not the homeowner.

  2. Amy,

    You’re certainly right. And worse, I think the craziness of the last ten years is that we all became speculators, coming to look at the home we live in as an investment that had the side benefit of providing us a place to live, rather than an expense. With expenses you try to keep the cost down, but with an investment you tend to go for as much leverage as you can get, so that the payoff will be that much bigger in the end. That also led to demand for more and bigger houses than reality dictated.

  3. In 1929, Bernard Baruch said that when he was given a stock tip by a shoeshine boy, he knew it was time to exit the market. This is the same problem we have had with housing. Rick you are right, we all have become speculators, and have been looking at our homes as investments instead of dwellings. One parenthetical outcome of this mindset, is that we never mentally OWN our homes. We are always worried about damaging our “resale value”: it seems most self-sufficiency activities hurt one’s resale value.

  4. My question that you never read about in all of this crisis, is what about PMI. What happened to this money that they all would have been spending and many still are. Is PMI really a scam? To me the only ones that should be failing are the PMI providers, which should not have been the same entities as provided the mortgages.

  5. First, I’m sure you’ve all read over at the Rural Missourian, great stuff. In my limited understanding (IE, what my wife tells me), PMI is useless because no one really knows who owns the mortgages, it has become this huge entanglement of selling and reselling mortgages between banks and other companies, so they are having a hard time figuring it out, if they are even trying. Another thing is that most of them don’t have PMI. When we bought our hovel-ish rodent zoo of a house, the lender told us we could use this adjustable rate business to take out a second mortgage right away and use that to do away with PMI. We opted for PMI, only so we could use 5% of our down payment to bring the place up to 19th century living standards, and so far have been able to keep our house. But I’m sure to many it sounded great, save that PMI money, and get a lower house payment at the same time–until the rate adjusts, then…oops. Problem is, it’s gonna “oops” everyone else, too.

  6. By the time they figure out who owns what, the “entities” (not people, as you’ve pointed out before!) responsible will all have taken the magic bankruptcy pill and disappeared back into the crevices from whence they came…

  7. So banks might not have the money to loan to people and corporations? Good. Folks got to start living within their means sometime, somehow.

    Maybe, if they really need the money, they’ll borrow from their neighbor or family member who actually has the money to loan.

  8. I’ve been lurking for a while now. I found you by way of Amy’s blog. I have nothing of greatness to share, only that I am blessed to learn from others who’ve “gone before” us. I appreciate your perspective on the economy, too. I’m learning a great deal by just reading..

    God’s best to you~

  9. I agree to most of what you said. However as a family caught up in the midst of all this, I’d like to put a face behind the crisis.

    In 2005 we sold our first home that needed quite a bit of work for a handsome profit. In purchasing a new home, house prices were obviously inflated. We invested in a foreclosed home thinking that was our best shot. We were shocked when the bank we were lending from told us our credit was bad and our only hope was a ARM that we could refinance in 2 years once our credit got better. We didn’t realize we had bad credit, but since we had a few problems when were first married the bank told us these things would “stay with us” We fell for it hook, line and sinker, and now have come to learn that is one of the banks tactics to get you into a high interest loan. In those two years my husband was injured in a serious accident, and out of work, and my son was diagnosed with pre lymphoma, and quite honestly we couldn’t afford our house anymore. We tried in vain to contact the bank and explain the situation, and they offered no help and actually began to refuse my phone calls. In this time frame, our house had already dropped well below what we paid for and had invested into it in fix up. We weren’t able to sell it for what we owed. Finally when I did talk to someone, they told us to go ahead and do a short sale. At this point, it looked like our only option. In the meantime, the bank continued to drag their feet on a short sale, we were unable to refinance, and our house has dropped about 75,000 below what we paid for it. Finally after a year we maybe, maybe have come to a light at the end of the tunnel as the bank looks as though they will finally take an offer.

    Yes there are irresponsible borrowers out there, but there are also those who did intend to build a life in these homes. It is the American dream! We do not have any other debt, no car loans, no credit cards etc. Our only debt was our home, a supposed investment. Don’t assume all people who have lost or are losing their homes had bad intentions. We didn’t. We got scammed by a greedy bank. Yes, we were uninformed about many things and should have been looking closer at what was going on. When our first home sold, it happened in 60 days and we were in a rush to find another home. We may have been foolish, but now we are a family of five with no home. There are faces behind these foreclosures.
    God Bless

  10. Anonymous,

    Thanks so much for telling your story. As far as the mortgage crisis goes, my sympathies are entirely with the borrowers. Whatever irresponsibility or unscrupulousness there might have been among borrowers fades into insignificance when compared to what the realtors, mortgage brokers, banks, and mortgage repackagers gleefully did to them. Invoking “buyer beware” is ridiculous; the average person has no defense against institutions whose “sound business practices” include playing on their credulity, their ignorance, or even their greed.

  11. First I want to say that I enjoy coming to your blog every so often. You have some great articles that I enjoy reading. Amy got me hooked on you in the first place!

    I have to disagree about borrowers vs lenders. I just wrote my local paper with my sentiments about this. I find it ridiculous that anyone would say that the bank made them take a loan out for whatever reason. I have been married 13 years now and we still have not bought a home. We have rented for the entire time we have been married. People have this idea that it is their right to own a home when it really is not a right but a privledge. If I can not afford a home then I have to rent. I would rather rent for the rest of my life and save my own money to help my children buy their homes than enter into a contract and then back out, only to have my fellow Americans pick up the tab. Now I am not saying that circumstances such as the lady above are not to be taken into consideration (her husband got hurt, her child became ill) because I have a very good friend who has been in a difficult situation like this. I am compassionate and I want to help those that are willing to help themselves but the greed among my fellow Americans needs to stop too. I find it a travesty that my children and grandchildren are going to have to pay for the ignorance people have today. I hope we learn our lessons before it is too late.

  12. I think home ownership has been pushed, and for those who are renting they are considered wasting their money each month. Also, for many, home ownership at one time was cheaper than renting. I agree with the statement that homes are looked as investments rather than being a home, a place to build a life. There are many greedy people, sure. But there are many who simply want to own a home because they DO want to build a life there. The American Government, greedy oil companies, and unfair lending have killed the dreams of these people. Naive people were taken advantage of. Were they being greedy because they wanted to own a home? I don’t think you could categorize them all as such. Were they being unwise, taking on more debt than they could afford? Probably. I think what most people hope is that their incomes will continue to increase as time goes on. Instead, prices of everything nearly doubled. How come more blame isn’t being put on these oil companies with ridiculous gas prices? They are the ones who drove us into a downward spiral.

  13. Here’s our housing scenario, and I’d be interested in yours and others opinions on what would be the best option for a family in lieu of the current economic and housing crisis:

    We bought a home with 25% down in California, coming from another state, at the height of the market 3 1/2 years ago, but bought very small, within our budget, and did some minor fixing-up. Currently, we might be able to sell for what we owe on the home and break even, losing our equity and having no down for another home. We aren’t in trouble financially, can afford our payments (which are fixed at a low rate), but are being wise to live extra-frugally in case things change. We have thought about a few options, but aren’t sure which would be the wisest.

    1. Stay where we are and risk being upside-down on our home in the near future if the prices continue to spiral downward.
    2. Sell now, break even and rent. Considering we’re not sure if we will stay in this area long-term, this isn’t a horrible option. Save for another down and buy again in the future when we decide where we would like to live long-term.
    3. Sell now and buy down, one of the many fixer-upper foreclosures on the market in our area, preferably with property so we could grow more of our own food and have some animals in order to be able to provide for more of our own needs if our income does end up dropping.

    Would love to hear your thoughts on what you would do in the same situation.

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