I have a huge pile of housing articles from the past three months. Instead of blogging all of them, I thought I would write a summary of the picture I am seeing. A picture that is becoming more and more clear each day as major lenders like New Century Financial file for bankruptcy and details about the "rise" become more clear.

The housing market is unravelling because the two reasons the market boomed in the first place are unravelling: unwise consumer spending and a bottomless supply of cheap loans. Both of these factors were unsound, and most importantly unsustainable, reasons for a housing boom.

Consumers

How much home can you afford?

How much is that home worth?

In order to make sound decisions, consumers need to have some basic financial training and they need to be willing to say no when they reach their limits. Unfortunately, public schools do not teach any financial training so most people make housing (and other investment decisions) based on emotion. Two particularly strong emotions today: "I deserve it", "Real estate is always a safe investment!", are particularly troublesome. These two emotions are hard to resist and they lead to very bad decisions.

What most people dont know is that the best way to value a house is to look at rent. What would someone pay to rent this condo or house? If comparable properties are renting for $1,700/mo and the mortgage alone is $2,000/mo, the home is overpriced. You need to say no.

But saying no is hard to do. Especially when lenders are waving money in your face and realtors are telling you that you deserve it and that you can find a loan to get it.

For many consumers, the answer to how much a home is worth is how much they can possibly borrow. And the answer to how much they can afford is whether they can make those interest-only ARM payments or whether they can cash out more home equity.

Banks

Banks are money professionals. They are the traditional brake for unrealistic home buyers. But banks have changed.

In the past, banks would loan their own money (money collected from savings deposits in the bank) and that money was limited so they were conservative about who they lent to. Moreover, any defaults were their problem so they were doubly conservative.

In the distant past, banks barely lent money at all which meant few people could buy a home. (No home loan; no home). This was a problem and the federal government stepped in to encourage banks to lend more so that home ownership would increaes. It worked but this is an example of a tight money supply.

The past few years have been the opposite example: a limitless money supply. When there is too little money in the system, no one can buy; when there is too much money in the system, prices inflate. If you have $10, that $6 beer at the ballpark seems expensive; when you have $100, who cares if the beer is $6? Everything seems cheaper when you have the money and that has been the case for homes recently.

Home prices have not been going up because household incomes have been rising 10% or 20% a year. Prices have been going up because banks have been lending ever increasing amounts to an ever increasing number of people. Why have banks become such eager lenders?

Banks have changed their behavior because the loan industry has changed. Banks no longer keep those loans they make. Instead investment firms buy their loans and repackage them as mortgage-backed bonds for investors, largely investors from other countries. When the banks get their money back from selling the loan, they make another loan.

Instead of making money from the monthly interest you pay over 30 years, the banks have been making immediate profit by selling your loan to investors and that profit proved too tempting for them. In order to keep the money train going, they had to keep making new loans. That means loosening loan standards in every conceivable way.

Borrowers could borrow ever increasing amounts, even if their income levels could not afford it.
Borrowers could get 100% financing for a home, ie no collateral or money down.
Borrowers could get a loan without any proof of income or paperwork at all.

Anyone with half a brain can see that practically giving loans away would lead to abuses. And we are talking about trillions of dollars here. As things start to unravel, the newspapers stories about these abuses will continue to come to light.

What happened?

What happens when banks need to make loans and consumers cannot say no? Prices go up.

The price of a home is set by a negotiation between a buyer and a seller. There is no mathematical way of proving what a home is worth. It is worth whatever someone is willing to pay for it - whether that is $50,000 or $5,000,000. You may have a list of things you like or maybe you just get a "good feeling", either way home prices are not an exact science.

Are home prices overpriced? There are two things to look at: the buying power of households and the rental prices.

Rule #1: buying power

The rule of thumb is 28/36.

No more than 28% of your gross (pre-tax) income should be spent on home debt. Home debt = (mortgage, property tax, homeowners insurance) + second mortgage + home equity line of credit.

No more than 36% of your gross income should be spent on all debt payments. Total debt = the home portion above + car loans, student loans, and credit cards.

If you look at the borrowing capacity of 28% of different incomes as shown in the table, you will begin to wonder who can afford all these $400K, $500K, $600K homes. Especially when you look at median incomes in the $50-60K range for most cities. (Note that the bottom number is the size of mortgage that the 28% payment could afford assuming you spent it all on mortgage. In other words, it does not include other home expenses, which would mean an even lower mortgage or a higher percentage of income spent on housing.)

Periodically there are articles that show the % of home debt in different cities. San Francisco residents, for instance, typically pay 50% of their income for housing not 28%. These numbers confirm that prices have been rising faster than incomes, making homes less affordable.

Rule #2: comparable rentals or positive cashflow

The other measure of price inflation is comparable rents, which I mentioned at the beginning. Spend some time looking for rental prices in the area of interest. What does it cost to rent a comparable 2BR/2BTH condo or a 4BR home? How does that rent compare to the cost of buying the home yourself?

This analysis is what real investors use because it a home must rent for more than the cost. If your monthly rental income is greater than your monthly costs, you have positive cashflow and you have an investment. If you have negative cashflow, you have a money pit.

This cashflow analysis is another traditional check & balance on rising prices but very few home owners ever look at it. They assume they will always be in the house so who cares what it costs to rent. And recently, even investors have counted on rising home prices to flip a property more than they thought about monthly expenses to rent it.

The ratio of rent to buy confirms price inflation in many cities. Seattle for instance is one of the worst. It rent in Seattle is almost 1/2 the cost of buying a comparable home here.

big hills; no brakes

When buying power and comparable rent ratios get out of whack, it is a sign that something is broken and eventually things have to change.

These two rules were supposed to be a brake on borrowing for both consumers and lenders but the brakes fell off the go-cart. What we have seen instead is borrowers who (I think unwittingly) looked only at the monthly payments and borrowed as much as they possibly could. At the same time, we have seen lenders willing and able to loan any amount to anyone with a pulse.

The flood of money from investment firms created a huge pool of cash for banks to lend. That supply of easy money allowed people to pay for ever increasing home prices because all the checks & balances stopped. The result was ever increasing home sale prices which kept the whole thing going. Instead of looking at monthly costs, people looked at sale prices and felt like they were making money.

But home prices were inflating because of the supply of loan money not because of increasing incomes. The process was unstable and doomed to end sometime.

Now what?

The big question now is what will happen next.

the loan supply dries up

The first thing we are seeing is the implosion of subprime lending and CDO's (those mortgage-backed bonds). Investors are freaking out and the whole supply-side of the loan industry is suddenly a train wreck. AS a result, one can expect the easy loans to dry up fast. One can also expect to see large if not massive loses at banks that invested in subprime CDO's which should effect stock prices.

borrowers wise up

If the revolving door of home loans stops revolving, what about the borrowers? Banks are freely admitting that a lot of people who did not qualify for loans got them. How will the market clear that up?

There seems to be very little information on who these "stated income" borrowers are but my guess is that they werent just poor people and unwitting seniors. I suspect there were plenty of eager investors and "no money down" folks.

I also suspect that there were a lot of regular people who bought homes that were much too expensive for their income to support, even people with large incomes. People that gambled on the idea that a home is a safe investment and that rising home values would bail them out.

I also think there are a lot of people out there who just plain live beyond their means and they have been using home equity to pay their bills for a few years. People that just didnt take the time to understand their spending and their limits.

If housing prices just flatten and dont fall, the music stops for a lot of people and there arent enough chairs in the room for all of them. Those people who over spent are going to be in trouble as they learn hard lessons about the 28/36 rule.

The people at the edge will just have to stop spending as much. This will slow consumer spending overall. And they will dip into their savings. The changes will be painful, maybe even embarrassing, but manageable.

Other people will find that they bought "investment" property that costs more to own than they can get for rent. They wont be able to refinance and no one will want to buy the property at a price they want to sell it. These people are in trouble. They will sell for a loss or walk away completely. The people that sell for a loss will lose savings. The people that walk away or declare bankruptcy will create a large supply of foreclosures

And I suspect the damage wont all be in bad neighborhoods. If the home equity gravy train ends, plenty of prime (not just subprime) borrowers are going to face problems.

consumer spending and a period of "correction"

If a lot of people over-extended themselves, consumer spending will slow down and so will the economy. Consumer spending is the main determinant of our GDP. If you have ever wondered how so many people can afford those new cars and plasma TV's, we may soon find out that they really couldn't and that will hurt retail and other non-essentials.

If a lot of people overpaid for investment properties that are too expensive to be investments and the introductory period on ARM's expire, there may be a big supply of homes "priced to sell". If home supplies rise because people need to sell or banks have foreclosures, prices are bound to fall until more conservative buyers (the ones using our two rules) are willing to step in. This is the falling home price scenario.

One thing to remember is that it could take years and years to see the impact of this brief "home rush". Property prices in Japan fell or stayed flat for ten years. If home prices are out of touch with incomes, we could see a prolonged flat period at best or even falling prices. No one wants falling home prices so expect every other source of cash to be exhausted first.

One factor to consider in all this is our national saving rate which is now zero. Most people will spend their savings before declaring bankruptcy. Much like refinancing, this is simply another way of postponing the problem until another day. In order to continue their lifestyle, people have completely stopped saving for retirement. People have also been using home equity to fund their lifestyle and will have less home equity for retirement. In fact, many people have given up on the idea of ever paying off their home (or car) - another fundamental change.

Exciting times. Business cycles do exist. We saw a stock market boom followed by a bust. We have just seen a housing boom. Now what?