The Credit Crunch
I’m a big fan of financial sayings. “It’s only when the tide goes out that you discover who’s been swimming naked – Warren Buffett, is one of my favorites. In August of this year, that is exactly what happened to many sub prime lenders and the loans they made. See page 34 of document referenced in sidebar to left for timeline of credit crunch.
Our 2nd quarter 2003 Newsletter was titled “Creative Financing, A Sign of Trouble? We expressed concern over bad loan quality. It wasn’t too hard to spot a bad business practice, lending to buyers unable to repay. But as long as the tide of home prices was rising, no one knew who was headed for foreclosure.
The credit crunch created an immediate repricing of mortgage risk. Interest rates on Jumbo loans (greater than $417,000) went up, while exotic loans disappeared. The housing market lost the cheap & easy money which helped propel it dramatically higher. During the last three years of the boom market 03’-05’, many lenders said that the majority of the loans they were originating were for marginal buyers, either 100% loans, bad credit and/ or “stated income” (buyers unable to document income), now referred to as liar loans. Post credit crunch, lenders have tightened up all around, some loan programs are gone and other loan programs with higher loan to values or “stated income” loans are more restrictive.
Loosing these loan products means loosing buyers. Less buyers means less sales, and it has shown up as a big drop in the number of sales. The charts of SFR sales in Long Beach (as seen on the front cover), shows the number of sales chugging along at about 170 sales per month for the first half of 07’ and in the last two months (August & September) sales dropped to about 110 per months, a whopping 35% decrease. The date that I track is the opening escrow date, not the escrow close date that is typically reported, so we are usually ahead of the curve in reporting a trend.
Taken in a positive way, if this is possible, we only lost the loan programs lenders shouldn’t have offered in the first place. Loans are still readily available to qualified buyers at great interest rates.
The negative spin is that we have lost a significant portion of buyers, so the demand for housing at current prices has diminished. Availability of marginal loans helped prices on the way up. Their loss will hurt prices as these loan programs disappear.
Short Sales
Moving forward the housing market will be saddled with the baggage of these bad loans. Which leads us to the topic of “short pays”. A short pay is a home sale in which the seller owes more than the net proceeds from the sale of the home. For those fiscally responsible, having your home loan in excess of your homes value might seem like rare case. But keep in mind that any home purchased with 100% financing is immediately underwater. Even a home purchased with 5% down is immediately a potential short pay, since 5% equity doesn’t quite cover the typical closing costs in a sale. Then add a small price decline like 10%, which we have already seen and then anybody with less than 20% down who bought at the market’s peak is a potential short sale.
While LTV (loan to value) is an issue, the real issue is whether the buyer can afford the property or not. The best case scenario is a buyer obtained a full doc loan (the income was verified) and qualified for a fixed rate loan, and has not had any financial hardship. But this was often not the case with many exotic loans. Many loans that were 0% or 5% down were stated income loans (income was never verified) or buyers qualified at an unrealistically low teaser rate, made possible by Alan Greenspan’s lowering short term interest rates below the rate of inflation. With a low teaser rate of 1-2% and lure of rapid price appreciation, even a prudent buyer might be seduced into buying more home than they could afford.
While the unwinding of these loans will affect the market, it is too hard to tell how much prices will be affected and how long it will take for the market to digest these loans. Certainly the supply will increase as many of these marginal buyers that purchased in 03’-06’ find it difficult to hold on to a home that they can’t afford.
While homes that go into foreclosure will affect the entire market, some neighborhoods will see more visible signs than others. For example, in many of the well established neighborhoods of Long Beach, there are a lot of original owners. In addition, recent buyers of these properties were more likely to put 20% down and qualifying with no “shenanigans”.
While entry level neighborhoods, condos, and newer tracts in the Inland Empire will be more likely to have a significant number of buyers that obtained marginal loans and are struggling to hang on. Last week I was pricing out homes in Anaheim under $425,000. Out of 30 active listings, 20 were listed as “short pays”. The likely reason the home is on the market is because the owners can’t afford the payment. They won’t get any proceeds from the sale, so there is no other reason to sell. With no equity in the property and little incentive or ability to continue to make a high payment there is little reason to hold on. My guess is that a majority of these 20 homes will be REO’s in the next 6 months if the short sales don’t get approved by the lender. Even if these short sale do get approved, short sales sell for prices similar to or less than foreclosures, putting downward pressure on prices.
Similarly, I was just pricing out a home in the Los Altos area. Out of 75 competing homes on the market, only 5 were short pays, showing East Long Beach homeowners are more stable. So while better neighborhoods will see less foreclosures and short pays, no market exists in a vacuum.
For buyers in the jumbo loan category (loans greater than $417,000), the credit crunch has raised interest rates significantly. The usual spread between conforming (
Prices
The new year saw the number of unsold homes drop significantly from 1200 homes for sale to 800 homes for sale in January (See chart on outside cover). This re-energized the market for the first half of 07’, but inventory kept climbing and now stands at 1375 unsold homes. During the first part of 07, it felt like we were in a sideways market. Where many list prices remained optimistic and buyers only snatched up the well priced listings. This kept prices level. With 170 homes selling per month, there was an 8 month supply of homes. Not too much above historical averages. (See pages 13,14,15 of CAR 2008 Economic Outlook – www.LBRE.com). But like the last two years, the fall season has seen a slow down in activity, and the credit crunch has dramatically slowed the pace of sales. So if the last two months sales, around 110 units, becomes the activity going forward, our inventory of 1375 homes becomes a 12.5 month supply of homes.
As for the current state of the market, we are seeing a possible addition to current 10% give back in prices. Again if you bought your home more than 4 years ago and watched it double or triple in price, giving back a little is no big deal. But if you are selling your home now, you may be faced with downward price revisions.
As a side note to prices. Statistics are a funny thing. They can lie. While prices have dropped from peak values, CAR hasn’t reported any significant drop in prices. This is because the mix of sales has favored more expensive homes. The number of sales for homes below $500,000 has dropped 24.6%YTD, while homes from $500,000 – $999,999 have dropped 24.2% YTD, sales of homes $1 million and above are only down 0.5% YTD (See page 7 of CAR report). So while home prices have dropped, CAR reports that the median priced home is almost the same as last year. Think of a class of students. If you reduce the number of small students by removing 25% of the shortest students and 25% of the medium sized students, but leave all of the tall students, the median height of the class would increase. But did any of the students grow? Certainly not.
Affordability still remains low
Affordability is still very low. Only 28% of California households can afford the median home. Compared to nationwide the affordability index is over 60% and in Q1 of 2003 the California affordability index was around 50%. For affordability to increase, either one or all of these three factors have to change: Incomes need to go up, interest rates need to come down, or prices need to come down. Incomes usually only see a 3%-4% annual gain, this takes time. Interest rates may come down a little but the Fed has to keep foreign investors in treasuries happy with higher rates, so Bernake has a difficult balancing act. This leaves prices to do some of the heavy lifting.
Housing Slowdown with No Economic Slowdown
On the plus side this is a housing slowdown without an economic slowdown. During the last SoCal housing crunch 1990-1995, people were concerned about loosing their job, and during one of those years, there was a net outflow of people from Southern California for the first time ever. Now the economy is still strong and there are prospective buyers with cash in hand just waiting for the right property at the right price.
While 1990 -1995 was a very long malaise that seemed like it took forever to work out, it is possible that this correction will be quicker. I say this for several reasons. Last cycles marginal buyers, bought homes with 20% down. That was the easy qualifier of the time. 5% down loans weren’t yet available and 10% down required full income documentation. It takes a lot longer for a buyer with a 20% downpayment to fold. But today’s marginal buyer has nothing at stake, and will more likely toss in the towel quicker. The economy is also healthier, which will provide a quicker rebound as we work off some excesses.
On the plus side those with income property will likely see rents stable. A healthy economy will increase demand, and tighter credit standards will reduce home ownership opportunities for those renting. So the pool of renters is likely to remain strong or even increase.
California Outpaces the Nation
California Real Estate prices far outpaced the nation for appreciation. (See page 107). From the bottom of the market in 1995, the median home in the US was a little over $100,000 while California’s median home was just under $200,000. Now rather than less than 2 times the national average we are almost 3 times the national average. Just a worthwhile chart to note. It seems like California has a greater propensity to booms and busts.
Summary of 2008 CAR Report – Not that bad
While the overall statistic coming from CAR showed that the housing market has slowed very significantly. It has slowed from an unsustainable pace, making year over year comparisons look pretty bleak. But when these benchmarks are contrasted to the long term averages, the market is only slightly weaker than average. However it is interesting to note that CAR’s forecast for the Median price of a home is a 4% drop in 2008. This is the statistic that recently made the front page of many newspapers.(see page 105 of 2008 CAR Economic Forcast).
Finally, I would like to conclude with another one of my favorite economic quotes which may sum up the future outcome of this market. “It’s a recession when your neighbor loses his job: it’s a depression when you lose your own.” – Harry S. Truman
This quote seems apropos, since those with conservative or no loans and manageable payments will not be affected, while those who over extended themselves or gambled on more price appreciation may face hardship. The current housing downturn will likely be very selective. The smart money will start stepping in to buy when the price is right. Till next time. – John