Archive for 2008

Our new President will need help to address the problems in the residential real estate financing system that resulted in The Great Housing Bubble. My full proposal is here: Preventing the Next Housing Bubble.pdf. The following is an exerpt from this proposal: bernanke_forever_blowing_bubblesThe secondary mortgage market was created in the 1970s by the government sponsored entities, Freddie Mac, Fannie Mae, and Ginnie Mae. This market was expanded by the creation of asset-backed securities where mortgage loans are packed together into collateralized debt obligations (CDOs). This flow of capital into the mortgage market is a necessary and efficient tool for delivering money to borrowers for home mortgages. This market must remain viable for the continued health of residential real estate markets. The problem during the Great Housing Bubble was that the buyers of CDOs did not properly evaluate the risk of loss[READ MORE]

There has been plenty of conjecture about the impact of adjustable-rate mortgages (ARMs) on the future of our housing market. Some people believe that if interest rates remain low that the upcoming ARM resets will not cause many foreclosures. This is wrong. Today's post examines what will happen when these resets occur, and it will demonstrate why this problem is so big. Adjustable Rate Mortgage Reset Chart   By now, most of you have seen the ARM reset schedule shown above. But what does it really mean, and why is this a problem? ARMs became very popular in the bubble rally because they allowed people to finance huge sums of money with smaller payments. In time, it became the only viable alternative for financing. There are two types of ARMs: interest-only and negative amortization (Option ARMs). A typical ARM has a fixed interest rate[READ MORE]

All methods of predicting future price action rely on the same basic premise: prices are tethered to some fundamental value, and although prices may deviate from this value for extended periods of time, prices eventually return to fundamental valuations. This premise has been reinforced by market observation; in fact, many estimates of fundamental value are based on market action. Since many market participants believe in buying and selling based on fundamental values, there is also an element of self-fulfilling prophecy contained therein. The efficient markets theory is based on this idea, and although the behavioral finance theory is needed to explain the wide deviations from fundamentals real-world prices exhibit, both theories share the same notion of an underlying fundamental valuation on which prices are ultimately based. The challenge to market prognosticators is to select a fundamental valuation to which prices will return, and then extrapolate a period of time in[READ MORE]

Regulatory Solutions

The regulatory solution proposed herein is simple, yet far reaching. It comes in two parts, the first is to limit the amount lenders can loan to borrowers with a rather unique enforcement mechanism, and the second is to increase the penalties for borrowers who commit mortgage fraud. The following is not in legalese, but it contains the conceptual framework of potential legislation that could be enacted on the state and/or federal level. A detailed discussion of the text follows:Home Page Image Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
  1. 1. All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing[READ MORE]

Preventing the Next Housing Bubble

The pain of the deflation of a housing bubble cannot be avoided by trying to keep the bubble inflated, or by trying to deflate it slowly. The only way to avoid these problems is to prevent the bubble from inflating in the first place through some form of intervention in the mortgage market. Intervention can take the form of a market-based intervention demanded by investors and ratings agencies, and it can also come about through direct government regulation.Home Page Image

Necessary Intervention

The regulated free-market system in place at the turn of the millennium allowed the creation of the Great Housing Bubble. Some combination of market-based and regulatory reforms is necessary to prevent the same circumstances that created the bubble from creating another one; it is imperative to prevent the next bubble in order to avoid the problems from the bubble’s[READ MORE]

Buying and Selling During a Decline

Home Page ImageDuring the bubble price rally, sellers and realtors, the agents of sellers, had everything going their way. It was easy to price and sell a house. A realtor would look at recent comparable sales, and set an asking price 5% to 10% higher and wait for multiple bids on the property–some of which would come in over asking. The quality of the property did not matter, and the techniques used to market and sell the property did not matter either. As far as buyers and sellers were concerned house prices always went up, so the sellers were thought to be giving away free money; obviously, the product was in high demand. As the financial mania ran its course, buyers became scarcer; all the ones who could buy did buy. The buyer pool was seriously[READ MORE]

Price Decline Influences

There are a number of factors that will influence the timing and the depth of the price decline. There are a number of psychological factors and technical factors in play. [1] These include:
  • Smaller Debt-to-Income Ratios
  • Increasing Interest Rates and Tightening Credit
  • Higher Unemployment
  • Foreclosures
  • Decrease in Ownership Rates
  • Government Intervention
Smaller debt-to-income ratios impact the market because buyers tend to put a smaller percentage of income toward housing payments during price declines. Increasing interest rates decrease the amount borrowers can finance and use to bid on real estate, and tightening credit decreases the size of the borrower pool and thereby lowers demand. A deteriorating economy and higher rates of unemployment means there are fewer buyers with the income to purchase homes, and more homeowners are put in financial distress. High rates of financial distress caused by unemployment or the resetting of adjustable rate mortgages in a higher interest rate environment leads to more foreclosures. Large numbers[READ MORE]

Price-to-Income Ratio

Since incomes and rents are closely related, evidence for the Great Housing Bubble that appears in the price-to-rent ratio also appears in the price-to-income ratio. National price-to-income ratios are quite stable. There has been a slight upward drift with the decline of interest rates since the early 1980s peak, but from the period from 1987 to 2001, this ratio remained in a tight range from 3.9 to 4.2. The increase from 4.1 to 4.5 witnessed from 2001 to 2003 can be explained by the lowering of interest rates; however, the increase from 4.5 to 5.2 from 2003 to 2006 can only be explained by exotic financing and irrational exuberance. Figure 46: Projected National Price-to-Income Ratio, 1988-2015 Projected National Price-to-Income Ratio 1988-2015     If national price-to-income ratios decline to their historic norm of 4.0, prices nationally will fall 9% peak-to-trough, bottom in 2011 and return to peak pricing in[READ MORE]

Future House Prices

For all our wisdom and collective experience, none of us knows what the markets will do next. Like an ocean current or a raging river, a financial market charts its own course. It is fickle and feckless and flows without regard to our hopes and dreams. The ebbs and flows of financial markets are meaningful to us, but in reality they are just movements in price; nothing more. Price rallies make homeowners blissful and renters bitter, while price declines make homeowners gloomy and renters gleeful. These feelings and emotions are independent of movements in price. The market just moves, that is all it does. It is benign, yet dangerous; it is indifferent, yet demonstrative; the market is a paradox which we must simply accept. During the rally of the Great Housing Bubble, buyers did not concern themselves with the day they were going to become sellers. Why would they?[READ MORE]

Bailouts and False Hopes

Home Page ImageOne of the more interesting phenomena observed during the bubble was the perpetuation of denial with rumors of homeowner bailouts. Many homeowners held out hope that if they could just keep current on their mortgage long enough, the government would come to their rescue in the form of a mandated bailout program. Part of this fantasy was not just that people could keep their homes, but that they could keep living their lifestyle as they did during the bubble. What few seemed to realize was any government bailout program would be designed to benefit the lenders by keeping borrowers in a perpetual state of indentured servitude. With all their money going toward debt service payments, little was going to be left over for living a life. All of these plans had benefits and drawbacks. One of the[READ MORE]

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