Arnold Kling  

Leveraged to the Eyeballs

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Subprime Daily Briefing, Dec. ... Tolstoy on Disagreement...

Herb Greenberg quotes from Mark Hanson, who works in the mortgage industry.


75% of Option ARM borrowers make the minimum monthly payment. Eighty percent-plus are stated income/asset. Average combined loan-to-value are at or above 90%. The majority done in the past few years have second mortgages behind them.

Option ARMs were invented relatively recently, so I may have this wrong, but I think that the borrower has the option of making a sufficiently small payment that the outstanding balance on the loan can go up. This is called negative amortization. When you combine that feature with declining home values, you can easily get to a point where the home value exceeds the loan balance loan balance exceeds the home value. Meanwhile, the borrower may not be able to afford the payments, particularly after they hit the limit on the loan balance.

Anyway, read the whole thing. Mark Hanson seems pessimistic. He paints a picture of home "owners" (I use the term loosely, given how little equity they have--or ever had) leveraged to the eyeballs. Ordinarily, I disagree with doomsayers, but he may be right, particularly for California. I could be suffering from availability bias. I don't see this phenomenon among people I know. They've been in their houses a long time, and they are not living the type of lifestyles that require tapping into housing equity to be sustained.

My impression was that Americans as a whole actually have a lot of equity in their homes--something like 50 percent or more in the aggregate. But I can't find any recent numbers. There is some quasi-relevant information in a speech by Alan Greenspan. There are lots of interesting numbers, but not exactly what I was looking for, in this paper, by Greenspan and Fed economist Jim Kennedy.

I remember Kennedy from when I was there. One day, I was very tired after finishing (I thought) a difficult round co-ordinating the staff economic forecast. Jim walked in to my office and said that he needed to make a change. He apologized, and said it was his fault. I lost it. "I don't care whose f--ing fault it is...etc. etc."

There are not many times in my life when I have gotten so angry with so little justification. As I said, I was tired...

Thanks to Felix Salmon for the pointer.

UPDATE: An alert commenter finds this story.


The amount of equity homeowners hold in their homes slipped in the third quarter to the lowest level on record, just above 50 percent, according to a report from the Federal Reserve Thursday.

In its quarterly U.S. Flow of Funds Accounts, the central bank reported that homeowners' percentage of equity dipped to 50.4 percent from 51.1 percent from the previous quarter. On average, housing is Americans' single largest asset.

Economists expect this figure, equal to the percentage of a home's market value minus mortgage-related debt, to tumble even further as falling home prices eat into equity. It could easily drop below 50 percent by the end of next year, some experts say, marking the first time homeowners will owe more than they own since the Fed started recording the data in 1945.

Home equity has steadily decreased even as home prices jumped earlier this decade due to a surge in cash-out refinances, home equity loans and lines of credit and an increase in 100 percent or more home financing.


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COMMENTS (12 to date)
ksh writes:

Timing is everything.

This article from today states that the Fed is reporting that the amount of equity is at a record low 50.4%.

http://www.fxstreet.com/news/central-banks/article.aspx?StoryId=820e68cb-5a7c-4152-9109-3fbcfe04189b

jb writes:

I think in this sentence you got the two parties reversed:

you can easily get to a point where the home value exceeds the loan balance

It should read:
you can easily get to a point where the loan balance exceeds the home value

No?

As an aside, I'm 37. I lived in my house for 10 years, fixed mortgage, originally 30year, refied to a 15 year about 7 years ago. I have 50% equity now, and every payment was half to principle. I paid $176k for it, and it is scheduled to close on the 13th at $270k

I just recently moved to DC. I'm looking at the equivalent house for roughly $500k. I can't justify buying that, under any circumstances. And for my age, I appear to be in the top 1/2 of one percent of earners.

The only way I could justify buying a $500k house is if I thought it would go up to $700k in a few years, and I could sell it again. That's clearly not the case now. So I am sitting in a rental for the time being. I will not be the bigger fool :)

So the question is - if _I_ can't buy that $500k house, who the &*#$ can? Realistically, I wouldn't even touch it unless it falls to $300, maybe $350. It's just not worth it.

I predict a significant drop in house prices in the expensive towns over the next year or two. It won't just be California. Every "hot" metro area is going to go through the same pain. There's not enough money to make a difference.

jb writes:

I think in this sentence you got the two parties reversed:

you can easily get to a point where the home value exceeds the loan balance

It should read:
you can easily get to a point where the loan balance exceeds the home value

No?

As an aside, I'm 37. I lived in my house for 10 years, fixed mortgage, originally 30year, refied to a 15 year about 7 years ago. I have 50% equity now, and every payment was half to principle. I paid $176k for it, and it is scheduled to close on the 13th at $270k

I just recently moved to DC. I'm looking at the equivalent house for roughly $500k. I can't justify buying that, under any circumstances. And for my age, I appear to be in the top 1/2 of one percent of earners.

The only way I could justify buying a $500k house is if I thought it would go up to $700k in a few years, and I could sell it again. That's clearly not the case now. So I am sitting in a rental for the time being. I will not be the bigger fool :)

So the question is - if _I_ can't buy that $500k house, who the &*#$ can? Realistically, I wouldn't even touch it unless it falls to $300, maybe $350. It's just not worth it.

I predict a significant drop in house prices in the expensive towns over the next year or two. It won't just be California. Every "hot" metro area is going to go through the same pain. There's not enough money in salary out there to make those expensive houses affordable in a flat market.

jb writes:

sorry for the double post. It bailed on me the first time.

Dwight writes:

I have two charts from Calculated Risk that might help everyone focus. The first chart is monthly mortgage resets (option arm, subprime, Alt-A, prime, & agency) provided by IMF/Credit Suisse the majority of such resets substantially coming due mostly by 2011.

The second chart also from Calculated Risk is the number of homeowners with no equity (2006, 2007, 2008, and with projected home price drops at 20% & 30%).

Keep up the great insight!

John Fast writes:

Mark Hanson, eh? Any relation?

Tony Aldrich writes:

For homeowner equity, look in the FRB's funds flow tables, I think table B100. Your question will be how well they calculate the market value of homes.

Lord writes:
Patri Friedman writes:

Why do people assume that high LTV and low payments mean buyers are leveraged? I have a high LTV, and an interest-only loan, and I pay the minimum, because I would rather have my money in the stock market. If I ever had equity in a home, I would tap it and buy index funds. So anyone who assumes that my low equity and payments mean I am overspending is wrong.

To my mind, anyone with equity in their house is crazy. They are the ones being financially imprudent. Why wouldn't you get a loan at 6%, with tax benefits that make it effectively 4%, and put it in the stock market and earn 10%-12%?

Arnold Kling writes:

Patri,
There are many other ways to own stock in a leveraged manner. You could buy call options on the S&P 500, for example. My guess is that paying high mortgage rates in order to own stock is relatively inefficient. In the end, you will have less wealth than if you took out a lower-cost mortgage and got your high-leverage stock portfolio by using derivatives.

I also think that people tend to over-rate the value of tax deductibility of mortgage payments. But that's another post altogether.

spencer writes:

Patti -- you are already leveraged to the eyeballs with you mortgage. And you think you are being smart to increase your leverage in the stock market.

Obviously, you have no idea of the real risk you are taking on.

John Thacker writes:

And yet, household net worth increased.

Here's a question: Does it make sense for people to "diversify out of housing" by getting home equity loans and lines of credit and investing in other assets?

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