In an article from today’s New York Times, the author David Leonhardt pointed to the major reason why residential real estate prices have eroded over the past few months. Moreover, Mr. Leonhardt points out that the cause of the problem will not be solved in the short term. Specifically, since 2000, house prices have risen dramatically faster than real disposable income.
To put the problem in a nutshell, for some forty years, from 1960-2000, house prices remained about three times higher than annual income. However, starting in 2000 house prices rose considerably faster than household income reaching a peak of 4.5x annual income. Stated differently, house prices would need to drop by 33% to get back to the historical ratio of three times annual income.
The mortgage industry and easy Federal Reserve policy fueled house inflation. That is, after September 11, 2001, the Federal Reserve dropped the federal funds level to 1% and kept it at that low level for several years. Thus, lenders could borrow at low interest rates and create very low historical mortgage borrowing rates. Furthermore, mortgage bankers encouraged purchasers by offering initially low variable rate mortgages instead of the traditionally more expensive fixed 30-year mortgages. Thus, purchasers could for initial periods afford to pay higher prices for their homes, because their monthly mortgage rates were artificially low. However, when the Federal Reserve began to raise the Federal Funds rate from 1% to 5.25%, then mortgage bankers could pass along these higher costs by charging more on variable cost mortgages. In a nutshell, home owners then faced financial crises because they had committed to mortgages significantly higher than their incomes and moreover the interest rate on these mortgages has risen considerably.
The problem was exacerbated by questionable practices such as lending 100% of the cost of the home, not requiring home owners to provide third party verification of their income, and encouraging home equity mortgages (second mortgages). Frequently, the value of the first mortgage plus the home equity mortgage exceeded the value of the house.
While housing prices will probably not decline by 33%, house prices could fall further from current levels. That is, in the long run the ability to finance a home purchase clearly correlates with family income. Although three times income might have been the norm for some forty years, maybe consumers can afford to pay a higher percentage of their disposable income on housing.
However, recent articles point out that many homeowners have become saddled with too expensive home costs. That is, in areas in the Northeast and in California, many people were paying more than 40% of their disposable income on homes. This is probably an unsupportable percentage.
Originally published in the Sarasota Herald-Tribune
