Arnold Kling  

Subprime Daily Briefing, Dec. 14

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Just a couple of remarks on housing market equilibrium.

First, Paul Krugman.


To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

...Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.


Second, I am coming a bit late to this chart from 'toro'.

The chart shows that the ratio of median house prices to median family incomes rose from 2.3 in the 1970's to 3.0 in 1981, then dipped back to around 2.7 or 2.8 through 2001, from which point it rose to 4.0 at the recent peak. In the latest point in the chart, it is at 3.8.

Recall that I said that for a homebuyer, this ratio should be no higher than 6. The median ratio perhaps ought to be lower, because the bottom end of the income distribution should include a lot of people who are not home owners, and rental housing ought to have a lower price/rent ratio.

Anyway, I don't think we should take 2.8 as some absolutely correct ratio of median home prices to median income. It's hard to know the right number. I don't recall thinking that the housing market was out of balance in 2003 or 2004, when the ratio was at 3.25 or so. My guess is that if you were to get everybody who has a house price more than 6 times income out of their houses, we would be back in balance today. I don't think that requires a 30 percent drop in home prices overall--just in a few spots where people went nuts.

My guess is that the near-term loan losses are going to be larger than people are expecting, because of fraud. But the longer-term scenario might not be so dire, because I don't think balance in the housing market is as far away as the doomsayers believe. Keep in mind that the Paul Krugmans and Steve Roaches of the world are always on the pessimistic side, and I tend to err in the other direction.


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COMMENTS (6 to date)
Phil writes:

Answer to the first paragraph in Krugman quote, as well as to the chart and to Arnold's argument is "Interest Rates" - with low interest rates, borrowers can support monthly payments on much more expensive houses. The measures such as "median house prices to median family incomes" are largly meaningless, as most of the monthly mortgage payment consists of interest, not principal repayment.

Dan Weber writes:

It does seem scary to me that the price of such a significant asset could rest on something so variable as interest rates.

I'm frightened; someone calm me.

Arnold Kling writes:

The nominal interest rate affects the monthly payment. But what affects the economic value of the house is the real interest rate (the interest rate adjusted for inflation).

Part of the point of my essay on "your income and your house" was to tie income and house prices together on the basis of the real interest rate, not the monthly payment.

Jim M writes:

You can use http://www.housingtracker.net/affordability/
to follow the median house prices to median family incomes" for many markets around the country. There is a lot of variability in that ratio.
Jim

Gary Rogers writes:

Two things that drove housing prices up while also driving families to buy as much house as they can possibly afford are easy mortgage credit and the expectation that house prices will always increase. The HPI has never gone down. What other investment do you know of that you can always depend on to increase in value? Historically it has been the person who buys a big house that makes big money through real estate appreciation. Those who bought small ended up with much smaller gains. The housing market has been that way since the end of the second world war.

As far as seeing the end of this problem, I would agree that a 30% drop in real estate values is a reasonable estimate, and it is badly needed to correct for years of artificial stimulation. It is hard to predict where this will actually end, though. I also expect a pretty significant round of inflation that will ease the problem for the homeowner but make things more difficult for the lenders. One thing that worries me is that I heard on the radio on my way home from work today that the Senate is working on a bill that will guarantee homeowners financing at a low fixed interest rates with only a one and a half percent down payment. Some people still have a lot to learn.

Mark Seecof writes:

Prof, I don't think your 6:1 is realistic.

Consider a simple illustration: Mr. and Mrs. Buyer have two kids and make $120,000/year. They buy house for $720,000, downpayment $144,000(! inheritance?). They borrow $576,000 at 7% (30 year fixed): payment $3,832/month. They must pay property tax (~1% ad valorem in CA) of $500/month. Total monthly payment $4,332.

But the Buyers only take home $7,000/month after taxes. So you want them to pay way more than 50% of their cash income for housing? How will they pay for their kids?

It might be one thing if that $420,000 represented a big (say, 3500sf) house. But in bubblicious Orange County, Calif. at the moment, that's the asking price on a 1000sf condo in a building that is already falling down. Now, of course, such prices are absurd and no one is buying-- but that supports my view.

Your "six to one" won't serve unless people can get something reasonable for their families for less than that.

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