"In Northern California, a household income of $90,000 per year could legitimately pay the minimum monthly payment on an Option ARM on a million [dollar] home for the past several years. Most Option ARMs allowed zero to 5% down. Therefore, given the average income of the Bay Area, most families could buy that million dollar home. A home seller had a vast pool of available buyers.
Now, with all the exotic programs gone, a household income of $175,000 is needed to buy that same home, which is about 10% of the Bay Area households."
--A Mortgage Industry Insider
Over the past few years, the housing market became riddled with bogus lenders funneling mortgage money to bogus owners of houses with bogus prices. Attempting to prop up this phony baloney is a pointless exercise. What the housing market needs in order to get back to normal is a strong dose of reality.
When we bought our house 25 years ago, we paid $130,000. I think our income at the time was around $35,000, so we paid a little less than four times our income for the house. If we had thought we could have afforded more, we would have gotten a similar house with a garage for another $10,000. Over the years, we've often regretted not having a garage.
What the "mortgage industry insider" suggested to columnist-blogger Herb Greenberg is that it became commonplace in some parts of California for people to buy houses at prices more than ten times their incomes. It's hard for me to have a whole lot of sympathy for those people today, considering that we didn't think we could afford four times our income when we passed up a house with a garage.
Balancing Supply and Demand
In my opinion, the number one priority in resolving today's mortgage crisis is to bring the housing market back to equilibrium. Equilibrium means prices that are in line with incomes, with supply and demand in balance. With equilibrium prices, houses could be readily bought and sold. When houses can be readily bought and sold, mortgage loans are backed by valid collateral. When mortgage loans are backed by valid collateral, investors will once again be able to trust securities backed by pools of mortgages. Only when we reach that point will the "subprime crisis" be behind us.
The alternative to bringing the housing market back to equilibrium as soon as possible is to kick the problem down the road by keeping people in homes that they cannot afford. Keeping people in their homes at artificially low interest rates will only serve to perpetuate a distorted structure of home prices, ensuring that the crisis stays with us for years.
Determining the Right Price
I believe that the maximum ratio of the house price to income should be six. I calculate that figure as follows.
First, assume that it is reasonable for a household to pay 25 percent of its gross income on rent. So if you have a $48,000 household income, you can afford $12,000 a year in rent, or $1000 a month.
Next, assume that you make a rent vs. buy calculation by figuring that you need an inflation-adjusted return on housing investment of 4 percent per year. The price/rent ratio is 100 divided by the required return. 100/4 = 25, suggesting that the price/rent ratio should be 25.
Historically, price/rent ratios in the housing market have been lower--closer to 15. I am not sure why it has been so low. Perhaps it reflects high transaction costs in the housing market--real estate commissions and all of the "junk fees" that afflict home buyers.
If my figure for the price/rent ratio of 25 is correct, then a household that would spend $12,000 a year on rent should buy a house for 25 times that amount, or $300,000. If the price/rent ratio should be 15, then that household should spend no more than $180,000 on a house. Those are the sorts of house prices that make sense for a household with an income of $48,000.
Mark them down, move them out
When we bought our house, we put down 20 percent of the value of the home. Many of today's home "owners" have put nothing down. They have no equity in their homes, which is why I put the term "owner" in quotes. This makes it particularly difficult for me to understand why I should want to keep these people in their homes. If you have no equity in the home, and the home is more than you can afford on your income, then what gives you the right to live in that home?
It is not clear to me what purpose is served by encouraging people to stay in expensive houses at artificially low interest rates. The way I see it, if you're living in a house that cost more than six times your income, and you have no equity in the house, then the logical thing is for you to sell that house and move to a place that you can afford. That's better for the family, and it's better for the health of the housing market.
If we feel sorry for the family, then let's give them a $10,000 tax credit for their troubles. Preferably paid for by confiscating the Rolexes and Lexuses of the real estate agents and mortgage brokers who garnered rich fees for getting families in over their heads. But let's get the bogus homeowners moved out of the houses that are more expensive than what they can afford.
It is possible that although the loan balance is more than 6 times the borrower's income, the true value of the house is now less than that. It is possible that the borrower can afford the house at the true market price, just not at its original inflated value. In that case, it might make sense in theory for mortgage lenders to mark the loan balance down to a level that is no greater than the realistic value of the house.
In practice, it is fairly difficult to tell the mortgage "lenders" how to handle borrowers who are in over their heads. I put "lender" in quotes, because the loan was originated by a broker who took his fee and ran. The loan is now owned by some type of financial institution or pension fund which had nothing to do with the original terms and conditions of the loan. But the solution is certainly not to have the lender string the borrower along with an impossibly large loan balance, even at a subsidized interest rate.
The concept of people owning homes worth ten times their income is a fantasy. Politicians may want to cater to that fantasy, but to do so harms more people than it helps. The people that it harms the most are those who want to buy homes that cost four to six times their incomes. They are the ones that would be best served by a real housing market, not a bogus one.