Why The Real Estate Crash Will Continue

Housing affordability ratio irrelevant

The housing affordability ratio is the lowest since 1975 or 1965, so housing bulls tell people that this is a sign of a real estate bottom. I disagree because:

The qualitative nature of borrowers has degraded in terms of reliability of income and credit rating, and this change is not reflected in home ownership affordability statistics because they don’t adjust for credit rating or income verification problems. The index does not consider that underwriting rules have morphed into a very strict new paradigm in 2008, so the previous 25 years of mortgage lending is not comparable with today’s market because lender’s underwriting rules are perhaps the toughest in decades.

In the old days most people had a salaried job, there was less job hopping and less career changes and far less temporary work or independent contractor work. Lenders discriminate against people who are career changers, independent contractors or temp workers. With the lack of “Easy Qualifier” “stated income” loans many people who earned enough to afford a home but had an unreliable, short term self-employed independent contractor status won’t qualify because they lack the durability and stability of income that comes from having been in the same old salaried job for several years.

Further, there could have some buyers who used “Easy Qualifier” loans to exaggerate their incomes and now they can’t qualify for a loan. “Easy Qualifier” loans were first offered in 1984 and were outlawed in 2009. For 25 years they facilitated the funding of an extra source of homebuyers who were participating in bidding up the cost of housing. Now those potential buyers can’t buy.

Regarding credit ratings, roughly 10% of the homeowners (15% of the general population) have become delinquent or gone into foreclosure so that is a huge loss of potential borrowers who may earn adequate income but have ruined their credit rating and thus can’t get a loan.

So if you subtract the 15% of homeowners with bad credit and perhaps another 20% who need “Easy Qualifier” loans and then subtract those who lack a 20% or 10% down payment then there is a huge loss of potential buyers. This loss is far more important than merely comparing the ratio of income to payments. Even if you assume that most of the people who are disqualified have overlapping reasons for not qualifying (a combination of shaky income, bad credit, and inadequate down payment) and thus assume that only 15% to 20% less people can qualify that is still a huge loss of buyers. Then add to that the loss of motivation due to the perception that housing is a bad investment.

The metrics of affordability indexes are comparing apples to oranges. People paid more than they could afford for housing during the debt fueled bubble of the past four decades. This is because people desperately wanted to buy a home before the price rose out of reach to unaffordable levels. Just because people made a mistake and overpaid to participate in a bubble does not mean that those purchases are a benchmark on which to judge relative affordability.

Open the door to understanding the economics of home buying

Using the “real” inflation adjusted cost of money there were times in the 1970’s when mortgage interest was quite cheap and the perceived profit from appreciation very high. Today short term nominal interest rates need to be “negative” 1.65% in order for the economy to function properly according to the Taylor rule. Since interest rates can’t go below zero then this implies that the cost of mortgage interest is not that affordable compared to the 1970’s when nominal rates were high.

Underwriting standards have changed the qualitative nature of how income is used to qualify for a mortgage. See my essay “80% of loans were not safe” based on a news story that said only 20% of borrowers who bought a home in the past would qualify today.

I don’t think it is that bad, but it is very reasonable to assume a “casualty rate” from the mortgage bubble crash “wars” of at least 20% of would-be borrowers are MIA (Missing In Action) and thus the home buying army of consumers is understaffed and losing the war against deflation.

About the author

Don Martin, CFP®

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