The Subprime and Affordable Mortgage Distortion

Affordable mortgage characteristics fundamentally altered the incentives of buyers and decoupled the relevance of house prices from fundamental value determinants.

On a macroeconomic scale the value of housing is determined by a large number of factors. Supply, demand, credit availability, mortgage terms, expectations for the future, perceived risk, cultural and social factors, tax treatment and recent performance trends to name a few.
At the individual level, the ability to purchase a home and the amount that a person can afford to pay for a home is restrained by access to credit, capital and cash flow. A potential buyer must have credit sufficient to be able to get a mortgage, must have sufficient capital to make a down payment and must have sufficient cash flow to service interest and capital repayment requirements.

Inappropriate government influence on GSEs and lenders artificially lowered the credit requirements necessary to access mortgages. Lenders were compelled to lend to individuals and in neighborhoods where they previously would not have operated. Once the Ponzi scheme developed self-sustaining momentum, no further government action was necessary as companies, eager to capitalize on this newly created profit opportunity, lowered the bar required to borrow money. When a reduced credit score ceased to be a competitive advantage in attracting borrowers, other mechanisms were adopted. Brokers ceased to verify the incomes of borrowers, issued mortgages that didn’t require such disclosure or in many cases committed fraud by overstating figures.

The larger pool of potential borrowers translated, as expected, into higher demand for houses. Increased demand started the steady acceleration of housing prices. Rising prices made subprime lending more profitable and lowered the perception of risk contributing to a further increase in the available supply of such loans.

Affordability Mortgages Were the Lynchpin of the Housing Bubble

Reduced credit requirements and access to mortgages were important to increasing demand, but the mortgage affordability characteristics which changed the capital and cash flow requirements necessary to buy a home were responsible for dramatically distorting economic incentives and home purchasing behavior.

House prices are restrained by the requirements of adequate credit, capital and cash flow.
The challenge facing private lenders was initially how to meet government mandates for subprime lending and, once a profitable subprime model was identified, how to structure mortgages so that they would be accessible to subprime borrowers with insufficient capital and cash flow. Thus were born affordability mortgages.

Down Payments

Low down payment mortgages reduced or eliminated the capital requirement of owning a home. Whereas a subprime borrower might have struggled to come up with a down payment to buy a modest home under traditional lending requirements, the same borrower could now “buy” a much more expensive home and put nothing down. Down payments are difficult to come by. They require a substantial effort to save. Accumulating such savings depends on deferred consumption. Once accumulated, there is a substantial opportunity cost involved with using the capital as a down payment to buy a house. The more expensive a house is, the higher the down payment must be. The higher the price of a house, the more savings, deferred spending and opportunity cost are required. When buyers invest their hard earned money to buy a house they are sensitive not only to price, but to value. As valuations increase relative to economic fundamentals, purchases become more risky and the potential for capital loss increases. Down payments regulate how high house prices can climb and correctly align the incentives and behavior of prospective buyers.

Low down payment and no down payment mortgages remove this fundamental impediment to rising prices. 100%-plus loan-to-value mortgages actually provided cash to people who bought houses, further distorting the incentives and behavior of buyers. These mechanisms incentivize buyers to purchase larger and more expensive homes. There is no marginal cost to the buyer in terms of capital required to buy a larger or more expensive house. In the case of 100%-plus mortgages there is a negative marginal cost. The buyer becomes disconnected to the fundamental value of the home. Price doesn’t matter as much when you can borrow all the money necessary to purchase an asset. For the first time in history, on a national basis buyers were not sensitive to the price or fundamental value of a home. Even stranger, rising house prices encouraged buyers instead of acting as a structural deterrent.

Transitioning from a down payment environment to a no-down payment environment will inevitably lead to increased demand, rising prices and decoupled valuations. This would be true for any asset class. Imagine if investors could put nothing down to buy stocks. What if private equity and hedge funds could buy companies with 100% borrowed funds. These 100% financing models effectively afford the buyer infinite leverage. In an environment of rising prices, optimistic expectations and low perceived risk, investors will access such leverage voraciously. Buyers no longer are sensitive to price or fundamental value. Based on expectation and perception, the elimination of down payments incentivized buyers to purchase as much house or as many houses as possible irrespective of price, thereby maximizing expected leveraged returns.

Introductory Adjustable Mortgage Rates

The other important characteristic that determines an individual’s ability to buy a house and regulates house prices is the cash flow requirement necessary to service a mortgage. Under the traditional mortgage model home buyers serviced market interest rates and typically repaid a percentage of borrowed capital. Buyers are restrained with respect to how much house they can purchase by their cash flow. It is for this reason that house values have typically had a steady relationship relative to income levels. The more house a person buys, the higher the cash flow required. Buying a more expensive house means allocating a higher percentage of one’s disposable income to servicing the purchase. Based on this model, overall housing prices are restrained by the income levels of individuals within a relevant market.

The innovation of adjustable rate mortgages reduced or functionally removed this important control on house prices. The marginal introductory rate of ARMs and Option ARMs dropped the effective interest rate to as low as 1%. For several years a buyer could service a mortgage for a small percentage of the traditional market rate. An important restraint on the price an individual could pay for a house was eliminated.

Beyond the ability to buy a high priced house, adjustable rates created another nefarious economic distortion. Renters were powerfully incentivized to buy houses irrespective of their financial circumstances. The security deposit necessary to rent an apartment represents a capital requirement that no longer existed when purchasing a home. Even more distorting was the reality that the cash flow requirements to service the introductory rates on adjustable mortgage were lower in many cases than the cost of renting an apartment. Many renters bought houses without regard to price because it made economic sense to do so for the duration of the introductory interest rate period.

Those buyers who considered that they would be financially worse off once the adjustable interest rates reset were assured that they would have the ability to refinance the mortgage based on rising equity or that the house could be sold at a higher price resulting from expected appreciation.

All things being equal, the lower the capital requirement necessary to buy an asset, the higher the asset’s price will appreciate. All things being equal, the lower the effective rate of interest on capital borrowed to buy an asset, the higher the asset’s price will appreciate. The only missing ingredients for such appreciation are confidence and greed.

Parallels with the 1920s and The Great Depression

Low down payments and interest rates were the conditions which precipitated the stock market bubble of the 1920s. Margin requirements to buy stocks were 10% and interest rates were as low as 1%. The ability of individuals to buy stocks in highly leveraged transactions with low maintenance cash flow requirements allowed for stocks to decouple from fundamentals and rise to unsustainable levels. Once these conditions existed, the only other ingredients necessary for an asset bubble were perception of risk and future expectations. A lack of material impediments to buying stocks at any price caused investors to become detached from their actual fundamental value. Speculators had the ability to leverage their capital dramatically, service the interest of this debt cheaply and had the expectation of receiving positive leveraged returns.

These conditions were duplicated by affordability mortgages and applied to the housing market to much greater effect. At the margin, the housing bubble was defined by 0% down payments and teaser rates as low as 1%. People with bad credit, could put nothing down and service a mortgage at a below market rate for years. It was these extraordinarily low effective interest rates and the absence of capital requirements that caused the Housing Bubble and sustained such lofty valuations.

Given the relatively larger size and greater rate of participation in the residential real estate market, the impact of these conditions was in many ways more widespread and pervasive than that experienced during the stock market bubble of the 1920s.

The Ponzi Scheme

Lenders and borrowers participated in the Ponzi scheme based on the assumption that prices would rise into perpetuity. As long as prices continued to appreciate both parties assumed that mortgages could always be refinanced and houses could always be sold for more than the value of the mortgage. Capital was assumed to be available and demand for houses was projected to continue. Competitive pressures and the pursuit of ever increasing profits sent this model to its logical extreme. Loans were extended to borrowers in amounts that could only be serviced at the teaser rates. Loans began to be made in excess of the value of the transaction. Option Arms were designed with the expectation that the value of the loan would continuously increase above the original transaction value. At the end of the bubble, defaults began to occur within months of loans being issued as borrowers were unable to service even the introductory rates.

Highly levered loans, on overvalued assets, serviced with introductory interest rates scheduled to reset much higher on a predetermined date are effectively economic time bombs. Neither lender nor buyer anticipated that these time bombs would explode. Both parties expected to be able to refinance the loan or sell the houses based on an assumption of continued price appreciation. And why not? Prices had been rising nationally for 60 years. Appreciation had been outpacing inflation since the mid-1990s. The federal government was using its resources and influence to expand access to mortgages, lower interest rates and manipulate homeownership higher.

Like all Ponzi schemes a collapse was inevitable. The supply of new construction far outstripped demand. Investors gobbled up theoretical condos, but once completed had no intention of closing on the purchases, much less living in them. At the end of the boom valuations had risen to heights that were straining even the mortgage affordability characteristics’ ability to support them. Defaults began to occur shortly after mortgages were issued. Homebuilders began to struggle to unload inventory. Price cuts began, initially in the form of material incentives such as free pools. Soon builders and home owners were slashing prices in the hope of eliminating the financial burden of continued ownership.

Once expectations of future appreciation vanished and the risk premium returned, the allure of infinite leverage attached to overvalued assets quickly evaporated. Without the rosy expectations of perpetual appreciation the whole scheme failed.

Price Reversion Driven by Dramatically Different Market Conditions

Now that the market has recognized the excesses of the real estate bubble, these affordability characteristics, which disguised dangerous leverage and distorted housing valuations, have disappeared. Homebuyers are faced with the prospect of putting capital at risk, committing to service a mortgage at higher interest rates in an environment where real estate values are high in historical terms and are faced with the prospect that those values may continue to decline. It is not difficult to see why prices are falling at record rates.

The structural market changes which drove price appreciation and homeownership gains have evaporated. Home prices are unsupportable given a reversion to the credit availability, capital requirements and effective interest rates of the pre-bubble environment.

Almost every fundamental determinant for the market value of houses today is less favorable than that which existed in the late 1990s, with the exception of population. The supply is higher as there are more vacant houses than at any time since the Census Bureau started keeping such data in 1960. The increase in housing stock has far outstripped the rate of population growth, more than offsetting any potential benefit from a larger pool of potential buyers. Demand is lower as a result of the decline in the availability of subprime and Alt-A mortgages. Credit is much tighter. The availability of highly leveraged and 100% loan-to-value mortgages, which had the effect of decoupling housing values from underlying fundamentals, are less prominent. Marginal effective interest rates are much higher. Houses are no longer perceived to be safe investments. Potential buyers no longer expect houses to appreciate rapidly and are increasingly worried that prices may continue to fall. Changing expectations have eliminated the home’s value as a leveraged investment opportunity. Cultural and social values attached to homeownership are being eroded.

One can reasonably expect homeownership rates to return to the 65% level which the U.S. economy structurally supported for 30 years prior to 1995. But the economic environment hasn’t simply reset to that of the mid-1990s. The terms and availability of mortgages have reverted, but credit is far tighter, the perception of real estate’s risk is different, the expectation of future performance has changed and the cultural value of homeownership has dramatically changed.

There are two discreet components to the value of a house which affect price. These include the value of a house as shelter and as an investment. The investment value is the component of housing prices which skyrocketed during the boom and is evaporating during the bust. The value of shelter is relatively static and related to income and relative rents. The investment value will continue to fall year after year until foreclosures are no longer happening in material numbers, credit isn’t restricted, buyers don’t expect real estate to continue to fall and inventories of houses for sale aren’t above historical norms. As long as expectations are negative and risk is high relative to fundamental value, prices are unlikely to stabilize until they approach the value of homes as shelter.