Arnold Kling  

Housing Market Uncertainties

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From an analysis by J.P. Morgan:

We expect that home prices, as measured by the Case-Shiller 10-city composite index, will decline as much as 15-20% from the June 2006 peak before this cycle hits bottom, potentially two or three years from now. As of April 2007, the index was down 3% from the peak, suggesting there is another 12-15% decline to go. While a total price decline of 15-20% sounds large, many markets saw prices double between 2000 and 2006, making a retreat in prices less extraordinary. Moreover, subprime heavy areas are expected to perform worse than higher end housing markets.

Back in the days of 20 percent down payments, a 15-20 percent decline of home prices would still leave the borrower with positive equity. When borrowers have positive equity, defaults are rare--you're better off selling the house than letting the lender have the house.

But 20 percent down payments are so-o-o-o last century.

The pointer is from David Leonhardt, who also points out that adjustable-rate mortgages are about to reset (i.e, have their monthly payments jump) in large numbers.

In all, the interest rates on about $1 trillion worth of mortgages, or 12 percent of the nation’s total, will reset for the first time this year or next. A couple of years ago, by comparison, only a marginal amount of mortgage debt — a few billion dollars — was resetting each month.

This Leonhardt paragraph puzzles me:

From 1994 to 2005, some 3.2 million households were able to buy homes thanks to subprime mortgages or other such loans, according to an analysis by Moody’s About 1.7 million of them will probably lose their homes to foreclosure when all is said and done.

I would assume that most of the borrowers who purchased between 1994 and 2004 are safe, because of subsequent price appreciation. Obviously, someone who bought in 1998 and refinanced in 2006, taking out all their equity, might be in trouble. But that should not be huge numbers of people.

In fact, according to the Office of Housing Enterprise Oversight, house prices are still going up. (Their index is based on the same calculation techniques as Case-Shiller, but uses a different sample of homes.) In the first quarter of 2007, their index was 4.25 percent above the same quarter a year ago, which was 12.61 percent above Q1 of 2005. Homeowners who bought in the first half of 2005 or earlier should have built up a pretty fair equity cushion.

Given all this, I wonder how many borrowers out there do not have positive equity in their homes. Until somebody does that calculation, I am not sure whether to predict a trickle of mortgage defaults or a flood.

Comments and Sharing

COMMENTS (7 to date)
Steve writes:

I bought by house four years ago with 5% down, and I think my equity is about equal to the brokerage fee.

But I live in Michigan, home of the one state depression.

Also, default isn't just caused by negative equity, right? It could be caused by illiquidity, too. If I have 10% equity in my house, and suddenly lose my job or rates reset and can't make the mortgage payment, what are the chances I can avoid forclosure? How long does it take? Could you sell the house before it was foreclosed? I doubt you could get a HELOC for the extra 10%

Arnold Kling writes:

If you have 10 percent equity, and you foresee not being able to make payments, then sell the house. If you can indeed get the market value, then compared with foreclosure (a) your credit will look better and (b) you will have some money (the difference between the sales price minus commissions and the loan balance)

Matthew C. writes:

If you have 10 percent equity, and you foresee not being able to make payments, then sell the house.

You've forgotten the 6% listing fee, the 1-3% spent getting the house fixed up for sale, and the difficulty and time getting a buyer in a down market.

awoolf writes:

There are some differences between the OFHEO and Case/Shiller indices. It's not just the geographic sample that differs. The OFHEO index includes only conforming mortgages, which means less than about $400,000. Case/Shiller does not restrict itself to under $400,000. Given that a large number of homes in major metro areas sell for more than $400K and many of these are in California, Florida, and other cities where appreciation has been high, the negative equity problem may be more severe than the OFHEO numbers would predict.

Ranjit Mathoda writes:

I wrote an analysis some time ago about a possible housing bubble that you may find of interest:

Dan writes:

Don't forget the growing credit rates and how they affect home sales...people are crediting their payments at an all time high, just take a look at this report i found...

Sean writes:

I'm a mortgage loan officer for a large national bank in San Diego. About one third of the clients I've spoken with over the last three months currently have ARMs that are adjusting or are about to adjust, and they owe more on their homes than the homes are worth. There is nothing I can do for these people. Usually they are facing a 2.25% increase in rate annually, which translates to hundreds of dollars in additional monthly payment. They cannot sell their homes. Most prime customers simply retrench and deal with it, but I've had several conversations with subprime customers who know they are going to lose the house. Here in San Diego, it certainly feels like the foreclosure rate is going to get much worse before it gets better. If housing prices continue to shrink for another 12 months and prime borrowers face an additional 2.25% increase next year they are going to be in serious trouble (the rates are usually capped at 5-6% above the intitial offer). And everybody I know in the business has seen the lenders they work for or broker for tighten lending rules significantly over the last three weeks. I know it's anecdotal, but it seems like the lenders are girding for worse to come.

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