Risks from a Slowdown in Housing

Here's a little more on the risk of a crash in housing explained through an example. Suppose a person purchases a new house for $250,000 (in the "Flatlands") and signs loan papers promising to pay $1,500 per month for 30 years. If I did my math right, that works out to be an interest rate of 6.01%. There is no equity initially.

Now let there be a housing boom driving the value of the house up to $300,000 creating $50,000 in equity. The homeowner has kids in college and decides to borrow against this increase in value. However, the bank will only allow 80% of the difference to be borrowed (but offers a lower interest rate than banks who will lend up to 100%), so the homeowner borrows $40,000 again at 6.01%. Once more, assuming I did the calculations correctly, that amounts, for a 30 year home equity loan, to $240.08 per month. The equity is the bank's collateral.

Now the homeowner's monthly payment for the next 30 years is $1,500 + $240.08 = $1,740.08. Assume that under normal conditions, keeping a job, no unexpected contengencies etc., the household can comfortably pay this amount for housing each month.

What I want to ask is how risk changes if there is a housing crash. Let's suppose the market now "crashes" and the value of the house falls from $300,000 to $275,000.

Do the monthly payments change? Assuming that there is no call option on the home equity loan, the answer is no. The homeowner's monthly payments on the borrowed money won't change at all (to make it simple I'm assuming fixed interest rates). There is no change in risk in this sense. All that has happened is that the collateral has fallen - now, relative to the original loan, there is only $25,000 in collateral to cover the $40,000 loan instead of $50,000 that was there before the crash. This puts both the lender and borrower at increased risk since in the case of a contingency such as a sudden loss of job, full liquidation will not cover the loan. But the uncovered gap is not large and risks of this type ought to be capitalized into the price of the loan (that's why I assumed the bank only allowed 80% of the difference, that's one way to insure against a fall in the value of the house).

If you think of equity in a house as insurance against future unexpected expenditures, there is an increase in risk for the homeowner here as well. Assuming the equity had never been borrowed against, initially a homeowner would have $50,000 available to cover any contingencies, but after the crash that falls to $25,000, so the homeowner is more vulnerable to financial risks - any unexpected expenditure over (80%)($25,000) = $20,000 cannot be covered in this manner whereas previously the limit was (80%)($50,000) = $40,000. Think of this as an unexpected decline in a person's collateralized credit limit.

And of course, the fall in the value itself represents an overall decline in household wealth, and that can lower consumption. But the main point here is that while a housing crash does increase household risk since the insurance value falls and equity may be insufficient to cover borrowed money if the homeowner is forced to sell, it does not suddenly change the monthly commitments of households and in that sense does not represent a huge change in risk.

Here's another scenario. Suppose a second person got started house hunting a little later and bought when the value was $300,000 and took on a 6.01% loan for 30 years. The payments for this person are $1,800.58, a little more than $1,740.08 since the loan amount is $300,000 rather than $290,000 as in the previous case. When housing values crash, this person's monthly commitments do not change at all, but risk does increase as before since the collateral will not cover the loan value.

The main risk arises when people start losing jobs in a recession and are forced to liquidate because at that time they may not be able to cover commitments. This is the type of risk that is the most worrisome, the risk of an overall slowdown brought about by a slowing of the housing boom or other causes and the pressure that will put on households who find themselves unemployed and unable to meet their financial commitments. But so long as you have the same job and the same income you had before, and you live in the same house, a housing crash will not change your month to month financial picture (abstracting from property taxes, etc.).

I don't mean to downplay the business cycle risk from a housing slowdown, the type of risk that is the subject of Krugman's column for example (worth reading if you missed it) and I'm hesitant to post this out of worry it will leave that impression. The financial difficulties that could result from higher unemployment and falling income in a recession are real and need our attention. There are many on the margin who are vulnerable, and there are those who may have been induced to take on excessive risk. My point is different and directed narrowly at some of what I've read indicating that households with the same house, the same job(s), etc. will be put into financial jeopardy by a housing crash. As I hope is clear, that is not necessarily the case.

Comments

[Bruce Wilder]

Whether a home "owner" would be liable for a mortgage amount in excess of the house's market value in the event of foreclosure and liquidation, varies by State. In California, a home "owner", whose house is under water, metaphorically speaking, can walk away.

[barney]

Let's assume for a moment that the home's value decreases by 50% and that the home owner loses his job, his wife contracts cancer, his triplets are accepted at Harvard (just for the heck of it let's us assume Harvard offers a volume discount on triplets if they are females and their names begin with a J,L and/or a P). Now what would Paul Krugman suggest that we do?

[anne]

Though the comment has a thoroughly rotten tone, there is a point to be made. Send the kids to Harvard. I know of no student who is admitted who will not be supported when there is such need, while the education will be superbly inspirational and valuable.

[anne]

About losing a job and losing health care coverage and not being able to afford private coverage, there we have a critical problem that should be what Medicaid was designed for though Medicaid is under severe attack.

[anne]

http://select.nytimes.com/2006/01/02/opinion/02herbert.html

January 2, 2006

The Machete Budget
By BOB HERBERT

If Congress were merely useless, the country would be better off. But it's worse than useless. In the iron grip of a Republican Party that is almost slavishly devoted to the Bush administration, it's downright destructive, especially to the interests of poor and working people.

Consider the budget that will soon be sent to the president for his signature. Members of the House and Senate have agreed on legislation that achieves something approaching $40 billion in savings over five years primarily by hammering the sick, the poor, the elderly and college students and their families.

This is the same Congress that genuflects each time the president asks for yet another gift-wrapped tax cut for the wealthiest among us. The textbooks tell us that the U.S. is a representative democracy, but only the upper strata are truly represented.

The nearly 800-page budget bill would allow states to jack up the premiums and co-payments of millions of low-income Medicaid recipients. It would also allow some Medicaid benefits to be rolled back.

One of worst aspects of the Medicaid provisions is that large numbers of poor people, faced with the higher premiums and co-payments, will inevitably decide to take a pass on the health care they need. Some will die....

[ilsm]

1. A person I knew walked from a house in early 80's, owed much more than could sell for.

2. Another person did same in early 90's for same reason.

3. I know several people who 'held out' for 15 or 16 years to get back to mid 80's prices.

None had any major financial issue other than their price bubble burst.

It may not happen again, for too many people.

[dryfly]

Now what would Paul Krugman suggest that we do?

You can laugh at us worry warts but I've been through times like that and knew others who did too... it isn't funny... and if it gets severe enough it could rip this country apart.

Our situation was fairly minor compared to some - my father lost good jobs three times over about six years... it was 'rust belt'. After the last time he decided to start a business and ate our family savings to zero... we went 7 months without a house payment... before the business finally took off. We saved the home but barely. I was just starting college then... it wasn't a joy. My folks were mid-50s white collar throwaways in the middle of the stagflation era. It was not fun for them either.

In the mid-80s I met a 'refugee' from the Texas oil patch collapse. He had a great job as a mid-level exec at an oil company... bought a nice home in Houston for something like $250K with $50K down. Back then interest rates were very high - something like 12% - so the burden was high but his income higher so they didn't think much about it.

When the oil crash hit, he lost his job like thousands others in the region... No big deal he thought, he had great skills & experience, he'd find another. A year later he was still unemployed and had burned through a lot of his savings. So he decided to look outside the region and industry and landed a job in Chicago.

He tried to sell the Houston home to relocate and found the market had fallen A LOT... his $250K home couldn't pull in an offer greater than $150K... He didn't have savings after the long period of U/E so he didn't have the $50K in cash needed to buy off the remaining balance on the loan so he was stuck (BK wasn't something people did as quickly then).

So for three years he 'commuted' to Chicago where he rented an efficiency. He'd work three weeks a month (6 days - something like 10 hours a day) then take a week off in Houston with his family. He'd send the paycheck home to support the house payments. Eventually the economy got better and he got a comparable job in Houston and left Chicago. It was hell but at least he and his family survived a very difficult period - but it was close - they almost divorced a couple times over the stress & money arguments.

And he wasn't the only person I knew back then doing that sort of thing... I met many folks originally from rural America who lost good local jobs when the economy collapsed and also ended up commuting long distances to feed families. They too couldn't sell the properties for anything close to what they had invested in them. It is so damned hard to start over at 50 or 55 that they really had to hang in there.

I suspect we'll see similar times if RE implodes. Except this time the cities will be hit as hard as the boonies. The flow of bodies might actually reverse.

With luck we'll only see a slow down & not a crash. Crashes suck.

[save_the_rustbelt]

Hypothetical:

Two fifty somethings own an $85000 house in Ohio, with 40% equity. Both are manufacturing workers, say with Huffy or Ticonderoga or Hoover or Timken.

Their jobs are shipped overseas, they cannot find even lousy jobs, they lose their house through foreclosure and file personal bankruptcy.

Oh wait, this is not hypothetical, this is real and repeated over and over again.

The Bush administration, in an attempt to help, sends Treasury Secretary John Snow to Ohio to tell the workers that sending their jobs overseas is just another form of trade and trade is good.

So if people in Boston and San Diego and Florida are dumb enought to pay ridiculous prices on housing, well tough luck. The ones who buy three or four condos to "get rich quick" deserve whatever misery befalls them.

In terms of cash flow the professor is correct, if there are no other changes in circumstance and no need to sell changes in market value are meaningless. If something goes wrong, well ka-boom.

[meno]

Ha.

Some minor little details.

1) Consumer spending crashes because people who owe more than they own don't spend as much.

2) The construction industry is wiped out.

3) More bankrupt people walking away from their house. Which is Bad for any industry selling big ticket items that's being doing it on credit. Meanwhile spending on big ticket items is way down (see 1). So the US Auto industry hits problems.

4) The result of (1), (2) and (3) is a rise in unemployment.

5) Foreign investors bail. Two results: the US dollar slides, and interest rates go up. If it's a crashing end to the bubble, then investors bail fast as the US dollar crashes: and interest rates go WAY up as foreign central banks take their money and run.

Nope, I don't see this being benign. It's only a question of how bad it is.

[meno]

For your example family the fixed mortgage is a good thing (and given the way the US mortgage legal system is tilted in favour of the borrower, I'd sure as hell have a fixed mortgage if I was there). The secure job is a good thing.

But the lack of equity sucks. Because you don't know if you're going to suddenly end up one of the "vulnerable people on the margins" due to health, or unemployment, or whatever. So you're vulnerable: and you know it. Knowing that you're vulnerable is bad - it stresses people, it changes their behaviour. Especially in an economy gone bad. Even those for whom your financial maths is right, expect more ulcers, arguments and divorces.

[Mark Thoma]

Yes ... perhaps I should have gone into more detail on the business cycle risks - it was too long already:...I don't mean to downplay the business cycle risk from a housing slowdown, ... and I'm hesitant to post this out of worry it will leave that impression....