My many years of working in the mortgage business, especially during the lead up to the last housing bust, have given me a special interest in the current housing market. From where I sit, the housing bubble’s back. Don’t get me wrong, I’m glad to see that property values have come back, and bailed out a lot of homeowners who were underwater. But the current trend may be exceeding that objective, and setting up the next bust.
Please be very cautious about buying a house in this market. This is particularly true in the hot markets that have seen the biggest increases in property values in the past few years. The most basic rule in investing is to buy low and sell high. So be warned – if you’re going to buy in this market, you will be buying high – which is the exact opposite of what you should be doing. The current boom could be setting up the next round of underwater mortgages. Buying now could lock you in as a future victim.
Here are some of the recent developments that you need to be aware of.
The Down Payment Requirement has Been Done Away With – Again
As a veteran of many years in the mortgage business myself, one of the bedrock doctrines of the industry for decades was the own funds requirement. This rule held that a person applying for a mortgage had to have some of their own money in the transaction. This was usually a minimum of 5% of the purchase price.
Even if the buyer was going to use a gift for the down payment, he still had to satisfy the own funds requirement. For example, if the buyer was borrowing a mortgage equal to 90% of the purchase price, and using a gift for the down payment, at least 5% of the purchase price still had to come from the borrower. The remaining 5% could be a gift.
The lone exception to the own funds rule was if the gift was equal to 20% or more of the purchase price. In that case, with the mortgage representing only 80% of the purchase price, it was considered to be a lower risk loan. For that reason, and only for that reason, the own funds rule would be waived.
More recently, the own funds guideline has been relaxed. The new gift guidelines no longer enforce the own funds rule as long as the property being purchased will be used as a primary residence and is a one unit dwelling. That means that you can buy a property, take a 95% mortgage, and make the 5% down payment entirely as a gift from a third-party.
We don’t need 100% loans, like we had in the years leading up to the last housing bust. But you can still buy a house with no money down – at least no money of your own. It’s the zero down mortgage packaged in less obvious way.
Setting the Stage for Another Round of Strategic Defaults
How is effectively removing the down payment requirement a problem?
- No “skin in the game”. Lenders long ago recognized that unless the buyer has an actual investment in the purchase of the property, there is a much greater likelihood that they’ll walk away from the property, rather than trying to defend their investment. After all, if no own funds are required to buy the house, then there’s no investment to defend.
- A lack of demonstrated financial discipline. Owning a home is more expensive than renting, if only because an owner is responsible for major repairs and maintenance. If a buyer can’t save money before buying a home, it’s unlikely that they’ll do so later. That creates a wave of financially impaired households.
- If you can’t come up with any down payment at all do you really deserve to own a house? This is reminiscent of those blaring car sales ads that scream your job is your credit. Just show up and buy the house, no money required? Should buying something as large as a house really be that easy?
All three of these issues are contributing to a second housing bubble. But the last point is probably the most important. If no sacrifice is required to buy a house, then how much effort will be expended in order to keep it?
That’s more than a rhetorical question. The last housing bubble was characterized by strategic default. People were walking away from their houses simply because it no longer made financial sense to keep them. Aren’t we just feeding that dragon once again by enabling people to buy property with zero down?
The Real Reason for Relaxing Mortgage Regulations
Let’s get one thing straight right up front…the purpose of removing the down payment requirement is not to make homeownership more fair and accessible. The real purpose is to stimulate housing sales. Since the economy continues to be on life support even eight years after the last recession ended, stimulating housing sales is seen as a critical part of that support.
The overriding objective by the powers that be is to expand the homebuying customer base by removing as many obstacles as possible. The down payment requirement is widely seen as one of the biggest obstacles.
But the down payment requirement also serves as an important circuit breaker on the real estate industry. It limits the number of people who can buy a house right now, but it also ensures a steady flow of buyers in the future. Once those buyers have accumulated enough money for the down payment, they’ll be in line to be the future buyers who will support a stable housing market.
These efforts to relax guidelines serve primarily to move future consumption into the present. That contributes to a larger number of sales, which creates the kind of price spiral that we’re seeing right now. But just as was the case in the last housing boom, the dominoes are being set up for the next bust. Eventually, there won’t be enough new buyers, even with no down payment requirement.
Weakening of “Cash Reserve” Requirements
Allowing people to buy houses with no money down is a big enough problem in itself. But that’s not the end of the story. Another bedrock requirement of the mortgage industry was the cash reserve requirement. This held that the buyer needed to have an amount in liquid savings equal to at least two months of their new house payment after the purchase.
For example, if the new house payment – including mortgage principal and interest, property taxes, and monthly insurance allocations – was $1,500, then the borrowers were expected to have at least $3,000 in liquid reserves after closing.
The cash reserves were considered to act as a financial cushion in the critical first months after closing. That’s the time when new homeowners are often facing a barrage of new and unexpected expenses. The cash reserves were considered necessary to offset those expenses and prevent an early term default.
But the cash reserve requirements are being relaxed too. While the requirement is still there, there are now many mortgage types where cash reserves are no longer required.
Why is this a problem? A lack of savings almost dooms new homeowners to turn to credit.
Let’s say that a couple buy a house, and within weeks find that they have to replace the dishwasher and repair the central air-conditioning unit. They are looking at another $1,500 in expenses, but they have no liquid assets. Most likely, they’ll use credit cards, which will increase their monthly living expenses. In fact, unless they are able to get into the savings habit immediately after closing, they will increasingly turn to credit whenever they need extra cash.
This sets up new homeowners as entrenched members of the debtor class. Since there no requirement to establish a pattern of savings before closing, it’s unlikely to develop afterwards. Since savings are not a requirement, then credit becomes the default strategy whenever cash is short.
The Housing Bubble’s Back 101 – Incomes Aren’t Keeping Up with Increases in Property Values
So far we’ve been discussing changes within the mortgage industry designed primarily to artificially grease housing sales. But there’s a bigger picture development that can’t be ignored: incomes are not keeping up with increases in property values.
According to data from the Federal Reserve Bank of St. Louis real median wages were $57,423 in 2007, at the peak of the last housing bubble. For 2015, the latest year for which statistics are available, the median wage was $56,516, which is slightly below what it was during the last housing bubble.
Meanwhile, the median price of a house peaked at $262,600 in March of 2007 at the height of the last bubble. But in March of this year the median price has risen to $273,000, slightly higher than at the last peak.
So now we find ourselves in a situation in which house prices have reached or exceeded what they were in the last housing bubble. But incomes are no higher than what they were 10 years ago. If the economy couldn’t sustain that financial relationship 10 years ago, what makes us think that it will today? And what will happen if property values continue rising from where they are right now, but without equivalent increases in wages?
Will Relaxed Credit Standards and No Income Verification Be Next?
To be fair, mortgage guidelines have not yet been watered down to the levels that they were at in 2007. For example, mortgage lenders are still being tighter with credit guidelines than they were a decade ago. And perhaps more significantly, no income verification (NIV) loans are no longer permitted, at least not by the big mortgage agencies.
But that actually creates two potential problems. One is that house prices will become even more unsustainable, given the fact that the number of potential buyers is limited by credit and income restrictions.
But the other is even more ominous. In an attempt to prevent another collapse in house prices, the powers-that-be – who should know better from the last housing meltdown – might decide that they also need to relax credit and income standards in order to “save” the housing market once again.
If they do, we can see house prices rise to levels unimaginable just a few years ago, and even from where they are right now. Individually, they’ll climb so high that even people with NIV mortgages won’t be able to afford the monthly payments on their nonexistent incomes.
Despite all of the cheerleading by market optimists, we’re treading on very dangerous ground right now. And this is why I don’t think that now is a good time to buy a house.
Haven’t We Been Down this Road Before?
Logically, it would seem that since we’ve been down this road before, that we know better, and won’t repeat the same mistakes. But being human – and having a natural inclination toward optimism – we prefer to believe that the mistakes of the past were a one-time event and thoroughly unlikely to happen in the future. It’s even easier to make that assumption when everything seems to be going so well with housing, as it is right now.
But as the saying goes, those who can’t remember the past are doomed to repeat it. We seem to be on that exact and predictable trajectory right now. At a minimum, we are well on track for house prices to become so high that they become completely unaffordable. When we reach that point, house prices will have only one direction to go in – down.
Ironically, we haven’t even discussed the biggest potential nightmare for the current housing, which is higher interest rates. And we haven’t because that’s a discussion all its own. But suffice it to say that rising interest rates, when coupled with relaxed mortgage guidelines, is a recipe for another predictable disaster in housing.
What are your thoughts about the current housing boom? I know that it’s more pronounced in some markets than in others, particularly the coastal markets. But as we know from the last housing meltdown, the effects of another real estate crash will affect people living in both boom markets and more normal ones.