/ Home / The Home-Price Vise

Premise

There's been a lot of concern and discussion about home prices, and whether falling (or, to hear some tell it, "collapsing") home prices will trigger a national recession. In a May 9 item in American Banker, the National Association of Realtors forecast that home price would drop by 1% in 2007 -- that's not a typo -- to a median $219,800. Prices of new homes are expected to drop by a scant $100 over the same period, to $246,400. The most recent report from S&P/Case-Schiller said that home prices have slipped a little more than that, and are down by 1.4% in the first quarter of 2007 when compared against the first quarter of 2006.

While home prices are subject to the same laws of supply, demand, and speculation as are other assets, there are additional notable exceptions. The old real estate mantra -- "location, location, location" -- has a lot to do with how a particular property appreciates and depreciates in value. Just as certain properties appreciated more during the long housing boom, certain properties may suffer to a greater degree during the downturn in appreciation, however long it may last.

In this analysis, we focus on the home-price issue. We omitted issues with regards to two factors which, while salient, don't have anything to do with home prices: subprime mortgages, which are largely related to adjustable rate mortgage resets (which cause cash flow and payment affordability issues); and the effects of Option ARMs with minimum payments, which could serve to worsen the effects of a devaluation in prices to an unknown degree, depending upon the borrower's payment choices over time, LTV, actual payment rate and other factors. See this article for a discussion of Option ARMs.

Argument

That said, it's clear that some people will be more affected than others. You often see those persons subject to the market's whims described as "victims of the housing bust" or some similar description. Given a case of an owner-occupied home with an unlucky homeowner desperate to sell, you could theoretically find a "victim." What then, of the case of the many unoccupied properties, new or otherwise? Are investors and speculators "victims" too, even though they don't stand to lose home and hearth, but perhaps only money? To us the question is: How many actual "victims" of the market's whims will there be?

Although we know that the individual experience of a borrower will be quite different than any analysis might reveal, we thought it might be instructive to determine what would have happened to a hypothetical "median" borrower over the past few years.

To develop a sense of what might have happened, we used the median home price (from the Census Bureau) for a given year, starting in year 1999, 2000, 2001, and so forth.

Using that starting median price, we then applied the median percentage of appreciation (supplied by OFHEO) seen during the following year, and carried that forward for each year through 2006.

Then, we lowered the boom: we postulated that the median home price will fall by a full 5% in 2007 -- some five times the latest available forecast, and certainly an unprecedented fall.

If this should happen, what sort of catastrophe would it be?

The Numbers

Let's start with the earliest homebuyer. In 1999, the median priced home was $161,000. By the end of 2006, that home had an appreciated median value of $277,120, about 72% higher than its initial value. Subtracting 5% of that leaves a remaining value of $263,264. The big "collapse" in home prices has left this homeowner in quite comfortable straits.

That borrower's equity position would have been improved even further if he'd taken a fully-amortizing 30-year fixed-rate mortgage (FRM). Unlike recent times, fully-amortizing loans were very common practice in 1999, when the average interest rate for the year was 7.55%. With even just a 5% down payment, this borrower would have borrowed $152,950 and would have had a balance of $138,197 at the end of 2007.

As you would expect, the equity position is improved more with a large down payment. A purchase using a 10% down payment produces an initial loan amount of $144,900 and a 2007 balance of $130,920; this is improved further still with a 20% down payment (initial loan amount $128,800; 2007-ending balance of $116,376). Even net of a common 6% sales cost ($15,796), the homeowner retains net equity of at least $109,272, starting with just 5% down (and more, of course, with the larger down payments).

Similar, though somewhat less-profitable, experiences happened for borrowers in 2000, 2001, 2002, 2003 and 2004 (see the charts). These homeowners wouldn't have suffered any losses -- just a minor reduction in the final value of their home. It's important to remember that a reduction in profitability - a smaller gain -- is not a loss.

There are few issues to be expected with purchases made earlier than 2005, which is where the trouble begins. By this point, homes were very richly valued and borrowers were utilizing no-money-down piggybacks and interest-only vehicles to buy them. In the present market environment, surely all these borrowers are facing critical difficulties... aren't they?

Not exactly.

For the sake of ease of comparison of 2005 borrowers, we used a 30-year FRM at 6% as a fully-amortizing (FA) loan, and used the same interest rate as a basis for an interest-only (IO) mortgage (i.e. a 5/1 IO).

When purchasing a home, a two-year time window between purchase and sale would be a truly short horizon for a borrower; it would pose the risk of losing money even in a solid market, what with moving, financing, furnishing, and disposition cost (and moving costs again!). With up-front financing costs measured in the 2%-4% range, plus sales costs of up to 6% of the home's value, it would probably be hard to find any advisor who would recommend such a purchase if they suspected that the hold period for the loan and property was so short. It's just too difficult to be sure that all of those costs would be recovered or offset in only 24 months.

Regardless, we postulated a variety of borrower choices: a FA mortgage with no money down, and with 5%, 10% and even 20% down payments. Then, knowing that many homeowners opted for interest-only (IO) payment products in 2005 and later, we produced the same calculations where a non-amortizing mortgage was the choice.

Borrowers with FA mortgages would have managed to retire a little bit of their loan's principle during our analysis period, and as such, have generally fared better than their IO counterparts. The amount of principle retired in the early years of a mortgage is slight, and so too is the difference. However, the reduction of a percentage point or two of their mortgage's outstanding balance has served to trim the difference between the price they paid and the present value of their home, even without an initial equity stake (down payment).

In 2005, a borrower with no money down but using a fully-amortizing loan held $4,284 in equity at the close of 2007, but would fall $10,061 into the red after sales costs are paid.

A borrower with a no-down-payment IO mortgage is presently mildly underwater by about $1,815. However, should that homeowner be compelled to sell after only two years, the disposition cost would erode an additional $14,345, and that would put the homeowner deep ($16,160) in the hole.

Once there is an initial equity stake, the borrower is cushioned somewhat from any downturn in price. Borrowers with even a little money down were in better shape, overall. With a 5% down payment, only the IO borrower would be in a negative equity situation at the end of 2007, and that loss realized only if they are compelled to sell. All of their loss would come from sales charges.

Greater initial down payments would bring actual profits (net of sales charges), ranging from about $8,000 for a 10% down IO borrower to about $37,000 for a fully-amortizing borrower who had put 20% down.

Summary: Two Layers Of "Risk" Create Issues

Only the 2005 borrowers who put no money down and used an interest-only mortgage would be underwater at the end of 2007, and then by only about $1,815. Provided that the homeowner has no compelling need to sell, there's no reason for him or her to realize that loss. It is true, though, that there is insufficient equity in the home with which to refinance, but with a working 6% interest rate on their mortgage already, there aren't any comparable mortgage products available for refinancing which might improve the interest rate, regardless.

We've not seen any reliable estimates of the percentage of the 2005 market which was comprised of "no money down, interest-only borrowers" but it was probably a fair minority.

The Key Year: 2006

If "buy low, sell high" is the mantra for success in stocks, "buy high, sell low" -- and in this case, "sell soon" -- is certainly a way to incur losses. Low down payment borrowers who bought last year, particularly later in the year, face the biggest trouble, since there has been little if any property price appreciation to cushion our model's huge downturn in median prices.

As a result of that sharp price decline, borrowers who made a 5% down payment but held a FA loan have seen that slight bit of initial equity erode. With the downturn, the value of their home is equivalent to the value of their mortgage (100% LTV), but still, the loss of equity remains a "paper loss" unless the property must be sold.

What a Difference a Year Makes

By way of comparison, a 2005 borrower who put 5% down and used an IO product would have been about $4,115 in the red after sales cost; the 2006 borrower with a similar loan would have to pony up $14,022 as an exit fee. With a FA product, though, there was actually a little equity left over from the 2005 vintage loan ($1,679) after sales costs, but only a fairly deep hole for the 2006 borrower, who would be left $11,425 in the red, all told.

Down Payments Matter, Especially for 2006 Borrowers

For a 2006 borrower with a 10% down payment, the situation is considerably less dire. Despite the erosion of equity, a FA borrower retains a sizable portion of their down payment, so he isn't underwater. Even after sales costs (which will eat up the remainder) he is still left in the black, though barely, with a positive $739 remaining after all is said and done. The same 10% down borrower with an IO product does end up mildly in the red; all of the down payment is gone, plus an additional $1,722 out of pocket -- a (mildly) painful loss.

For 20% down borrowers, plenty of their down payment will remain, even after sales costs are subtracted. True, they will have suffered a loss, but with $25,065 (FA) and $22,878 (IO) remaining of their initial down payment, they need not worry about being underwater.

Who Are These Borrowers?

But a question remains: how many homeowners would purchase a home intending to live in it, only to decide otherwise only a short while after moving in? There probably aren't many borrowers who so enjoy the experience of moving that they'd want to do it again really soon, and that makes these kinds of 2006 vintage borrowers presumably a rather small number.

However, that leaves the homebuyer demographic who may have purchased homes not because they planned to live there, but because they intended to 'flip' it back onto the market at a profit as soon as practical.

Highest Leverage Borrowers at Greatest Risk

One of the most popular constructions of home lending over the past two years has been the "piggyback" mortgage structure. In it, a first mortgage is written for typically 80% of the value of the home, while a second mortgage can make up to the remaining 20%. In such an 80%/20% arrangement, the borrower can make no down payment at all; in such cases, the borrower is said to have no "skin in the game".

There are numerous reasons why a borrower might choose to not make a down payment on the purchase of their home. For example, a highly-levered transaction might be preferable to raiding a 401K account for a down payment, or disturbing other assets which could trigger tax implications. Increasingly, though, high-LTV offers became more appealing as home prices increased at rates well above incomes, let alone any ability to save money and hope to keep up with 10%+ increases in prices. Frankly, there was little chance for a typical borrower to manage to accumulate $10,000, $15,000, or even $25,000 in new liquid funds to be used for a down payment, and the availability of high-LTV loans meant there was no reason to even try.

High-LTV loans offered tremendous new opportunities for many borrowers to buy homes, which many did, which greatly fueled demand. Unfortunately, that additional demand (and demand from easy credit terms in general) also served to push home prices higher than they otherwise might have been, stretching the risks to an even greater degree.

Realizing Troubles

With no initial equity position, these high-loan-to-value borrowers were presented with incredible opportunity -- but with opportunity comes risk.

While borrowers who made some down payment may have seen their equity position erode due to market conditions, these high-leverage borrowers have not even lost any money "on paper," since they didn't put any in the transaction in the first place. In such a situation, much of the risk accrues to the lender.

All that said, how widespread is the damage?

A 2005 borrower with a 0% down payment and a FA loan has actually accumulated $4,283 in equity, due to amortization and appreciation of about 4.5% in 2006. Using an IO product, that borrower is about $1,815 in the hole at end-of-2007 assumed values.

What can cause trouble would be the $14,345 sales charge should the home need to be sold. This would produce actual losses to the FA borrower of $10,061, while the IO borrower will need to come up with $16,160 in cash to exit the home.

Some of these on-the-bubble borrowers will be "trapped" in their homes. They aren't underwater enough to want to mail the keys to the lender and ruin their credit (although some might), but there is no way to dispose of the home without realizing considerable personal loss. Staying put, happily or unhappily, while waiting for some return of market appreciation is probably the only solution.

Three Layers of "Risk" and You're Out!

We already identified two risk elements: High LTV loans and falling prices. By themselves, they serve to produce a loss situation, but an exacerbating factor can be a very short hold period. It's certainly possible that weak home pricing may persist for longer than a single year (unprecedented on a national scale in modern times, but certainly possible in localized markets), so it's reasonable to think that at least some price support may develop going forward, ameliorating the losses somewhat in the near term.

Keeping in mind the earlier paragraph's questions about 2006-vintage borrowers, we come to the crux of the risks, and those which concern lenders most gravely, prime borrower or not: The present value of the asset they lent money against may be substantially outweighed by the amount of the mortgage. Short of credit ruin, there's nothing to keep the homeowner from walking away from the property; in such a case, the lender's potential for loss is intensified, factoring the considerable costs of foreclosure, property acquisition, preparation and disposition.

2006 vintage borrowers with no money down are exposed to the greatest amount of risk. Regardless of the choice of full-amortizing or interest-only product, they are sharply in the red at the end of our analysis. The FA borrower will stand $9,566 below water, while the IO borrower is fully $12,300 in the red. Both numbers are before sales costs are factored in; that additional expense of $14,022 to dispose of the property on top of the losses above would leave those borrowers tens of thousands of dollars in trouble. Remembering the these owners may not have made a down payment because they had little savings to start with, they have no chance to cover the loss and little reason to want to.

Some of the recent rise in delinquencies and foreclosures is coming from speculator/investors, who can't (or don't wish to) manage the on-going property costs, have a desperate need to sell and little if any chance of recovering any value. Such a combination of trouble is the impetus for "mailing the keys back to the lender".

To Summarize:

There is no doubt that there will be some genuinely victimized homeowners -- as opposed to overextended and/or unwise investors -- from any downturn in property values. However, the dire headlines probably overstate the issue to varying degrees, and there are at least a few important points to keep in mind when you hear of "falling home prices" or "plummeting home values."

In no particular order, they are:

• The vast majority of homeowners will not lose any money.
• At most, they will see a reduction in their profit.

• Recent vintage, high-leverage property flippers are the most likely to realize losses, and/or to walk away from their "investments."
• Believe it or not, some of these may be sub-prime borrowers, so even the threat of credit ruin means little to them. With no 'skin' in the game and no credit risk, they see little reason to retain ownership of a devaluing property.

• This discussion posits a home price decline some five times the present expectation.
• This is a crucial consideration. Smaller median price declines means fewer and smaller losses will befall owners, occupied or not.

• Losses can be trimmed if sales commissions are cut.
• We've assumed a 6% sales cost in all situations. Sales commissions are negotiable, and "For Sale By Owner" (FSBO) is always a possibility. In our example cases above, lower sales commissions will mean smaller losses.

• We suspect that the actual number of owner-occupied borrowers is small, as any "losses" are only on paper until a sale is made.
• This is the case especially for those with shorter-than-normal time horizons or extenuating circumstances which force a sale, and then only those with no down payment or using non-amortizing loans.

• Product choices and combinations matter.
• With fully-amortizing loans and down payments, risks are minimized to the borrower and to the lender. Losses, if any, on the part of many owners will result only in some erosion of their initial equity stake.

• Buy and hold (e.g., traditional) borrowers should be unaffected.
• If history is any guide, any depreciation should be short-term in the grand scheme of things. There are markets enduring ongoing deterioration in underlying economic conditions which may continue to exhibit trouble, but most of those failed to join in the robust and outsized appreciation seen in many portions of the country, anyway. Markets which do go "bust" may do so a for a while, only to roar back again in time. Regardless, if a sale doesn't occur, losses won't be realized.

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