## Monday, January 02, 2006

### 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.

Posted by on Monday, January 2, 2006 at 03:05 PM in Economics, Housing | Permalink  TrackBack (1)  Comments (11)