Last September in the post Another Reason Real Estate Prices Will Drop Further, I outlined how the banks that got burned by easy lending would be forced to tighten their lending. At the time of the post, Fannie and Freddie were moving to a 10% down payment requirement.
It has only been a few months since then and the new guidelines have gotten tougher. Much tougher. From the article Home buyers to be dinged with new fees:
Under Fannie’s and Freddie’s new guidelines, even applicants who assumed their FICO scores would get them favorable rates will be charged more unless they can come up with down payments of 30 percent or higher. For example, a buyer with a 699 FICO score who can make a down payment of 25 percent will now get hit with a 1.5 percent “delivery” fee at closing under the new guidelines.
A buyer with a Fair Isaac Corp. FICO score between 700 and 720 will pay an extra three-quarters of a point. Even someone with a 739 FICO will get dinged with a quarter-point add-on.
30% down payment! I knew lending would move back to the 20% down model. Never did I think it would overshoot to 30% down. The point of a down payment is to protect the lender should the borrower walk away. A 20% down payment assures the lender feels some pain if they stop making payments.
With a 20% down payment, the lender has enough insurance that should they be forced to foreclose and resell the property that they don’t lose money. The only reason to go beyond 20% is because the lender feels the underlying asset (the home) will drop in value as much or almost as much as the down payment.
The new guidelines tell us that Fannie and Freddie are projecting a large housing price decline.
The article continues:
Applicants who seek to buy a condominium and cannot come up with a 25 percent down payment will be hit with a three-quarter point add-on penalty, no matter how high their credit score – simply because they are not purchasing a traditional detached, stand-alone home.
Condos are often purchased by first time home buyers. How are they going to come up with a 25% down payment to avoid the penalty? Prices have to fall. Even if they assume the 3/4 point penalty, that hit will be taken by the seller in the form of further price cuts. This will put even more condos underwater and cause more owners to walk away. This is going to crush the Downtown Miami.
What percent of home buyers will be affected by these fees? I tried to find updated FICO averages, but couldn’t. An average of sites that cited scores from 2006-2007, stated 42% are below 700 and only 18% are above 800. In other words, the new guidelines aren’t targeted at deadbeats. They target the majority of potential home buyers. It is Fannie and Freddie’s response to lending while housing prices are in free fall.
I have to say that I disagree that the 25-30% down payment and extra fee requirements are because Fannie and Freddie are projecting a further decline. Lenders in some other countries (my sister had to do this in Australia) require a 50% down payment. It seems more to me like they are finally enforcing stricter lending standards and forcing people to have a higher stake in home purchase and ownership as well as showing that they know how to use credit wisely. It’s much harder to walk away from a home in which you have 25-30% equity.
I do agree that there will be some impact on the home prices (though not even close to as extreme as your prediction) because supply will outweigh demand with a lot of homes on the market and some buyers just unable to come up with the funds. Would you say that that is a problem? I don’t think so, it’s about time something was done about people who want what they cannot afford and make other people and businesses pay for it. For the record, I don’t buy the “bank lied to me” statement, no one put a gun to their head to make them buy anything. It’s greed, pure and simple.
The only reason someone walks away from 20% down is because they are in a desperate situation. Raising it to 25% or 30% changes little from a buyers ethics prospective. IMO, it is an admission by Fannie and Freddie that they see big price declines coming.
Ironically, these new guidelines will ensure that those price declines occur. Especially with condos.
When you mix huge inventories with higher than historical norm down payments, you will end up with an over correction in prices.
Is that good?
Not for the people that need to move and can’t sell their property without taking a huge loss. I sympathize with them. It only benefits renters on the sidelines with excellent credit scores and sizable savings.
If these people are selling in a depressed market and then will probably buy again in the same depressed market someplace else, are they really in a worse situation than if they had held on to their homes till the market recovers?
It means the person that bought a conforming loan with 5-10% down between 2003-2007 will very likely need to bring money to the table to sell their own place. Let us assume they can. Now they need to cough up 20-30% down for their next home. Most people aren’t that cash rich.
Very specific case, MAS. There are too many variables (location of homes, original loan, new loan, etc) in this equation to say that they will be worse off.
My question was a general one since as a seller in this market, they would be at a disadvantage but would have the upper hand as a buyer. They could, in fact, come out even or even better off.
According to ZILLOW, 41.2% of all mortgages bought in the last 5 years are now underwater. If these people want to leave their home, they need to bring cash to the closing.
So if you aren’t part of that group AND you have enough savings to put 20-30% down – then sure it balances out.
Home sellers also incur a 5-6% fee for selling, so my guess is the ZILLOW number is low. And that number is growing.
I’m not saying everyone will be worse off, but enough people will be to depress home prices at an accelerated rate.
Until median home prices are no higher than 3% of total household income for the given submarket, valuation is not ‘correct’. Where I live, the median home price has come down quite a bit from the 2005 prices, but it’s still way too high (~$450k). Very few people have a total household income of over $125k/yr. If you read media reports, you hear words like “free fall” or “biggest decline in decades”. All is happening is that prices are (very slowly) getting closer to ‘normal’. IMHO, we are simply seeing a pricing correction that has long been over due. Unfortunately, many good people are getting creamed in the process (I empathize with a lot of them). So, once prices get closer to ‘normal’ and the banks get back to ‘normal’ (20% down, little to no fees for strong borrowers), we will reach stabilization in the housing market. But by then, we humans will probably find something else to create a bubble with (hopefully it will be more of a sustainable, cross sector modest growth versus a bubble — ‘green collar’??).
If you follow this link it will take you to the Case-Shiller Index for Seattle:
http://seattlebubble.com/blog/wp-content/uploads/2009/01/case-shiller_seatiers_2008-11.png
The current level is about 165 (peak at ~ 190). If you do some calculations you will find:
80% (or 20% down) = 132
70% (or 30% down) = 115
So 20% down takes you back to about 2005.
30% down takes you back to about 2003 …which appears to be where prices first went parabolic.
It appears that the banks think we will not go lower than 2003 prices, but will go below 2005 prices. They are obviously not good at predicting such things or most would not be technically insolvent …but I think that is what they think regardless.
Finally, if you honestly don’t think this is the reason banks are suddenly demanding 30% down, then provide a better reason. No offense, but what they do in Australia is not a better reason.
And just as an exercise, take a look at:
1) The DOW – 1929 – 1933
2) The NASDAQ 1995 – 2003
3) Oil – 2007 to Present
4) The Case-Shiller link above.
The common thread here is that all four examples are economic bubbles that burst.
Further, the steepest monthly house price decline yet was just last month …and Seattle UE just kicked into 5th gear!
Seattle house prices are headed waaaay lower folks… sad, but true.
Jim,
Just so you know..I am very aware of the Case-Shiller index. I have 2 statistics degrees, have done more simulations and forecasting than most people and have even worked through how the C-S is constructed. BTW, I disagree with some of the assumptions made in developing the index which I choose not to get into on this blog.
Incidentally, I cited Australia as an example of countries with better lending practices and not as a reason. I don’t think anyone in their right mind disputes that stricter lending practices are needed in this country.
And here is my last comment on this topic:
We are all providing opinions on the change in Freddie and Fannie requirements, and at this time there is no way to know for sure. If anyone wants to go down the data path, that would require quite a bit of causation (and not correlation!) modeling. I’m totally willing to change my opinion if provided with a conclusion that is supported by defensible data but I have not seen that from any of the information here.
Al –
- Either the Banks think housing prices will drop >20% more or they don’t.
- If they don’t, I would expect them to try to sell as many loans as they can to increase profit (or more likely reduce losses).
- Raising requirements to 30% down doesn’t do that.
So in your model, the banks don’t seem to be acting in their own best interest …that’s all I’m saying.
I’m not sure Freddie and Fannie Mae are changing the lending standards because they predict a decline in prices, mostly because at this point, while it’s probably true, I don’t trust them to make accurate predictions anymore.
Even if it’s just an arm jerk reaction to the lax standards we had over the past few years, the effect will be the same. It will be much harder for people to come up with 30% down, so prices will need to drop for people to be able to afford the down payment on the property.
Not sure why no one has mentioned FHA. With FHA around there really isn’t a huge need to go Fannie or Freddie unless you plan to borrow more than 625k.
You don’t need to be a clairvoyant let alone the Doyen of All Things Economic to recognize basic patterns in the market. It boils down to common sense/street smarts; the charts and indexes tell us our collective tit is in the wringer and Fannie and Freddie pretty clearly want a little more CYA in what will be a majorly flagging economy for many years to come.
BTW, it is hardly any secret that Australia is one of the hardest hit countries in this national economic downturn, but ESPecially in the housing sector; referring to their superior lending practices needs more citation.
Look until prices collapse to mid-1975 levels when they were in line across the board and realistic, and you HAD to put 20% down which gives the lender a reason to trust you – you have a valid stake in the property and its value – honest value not Wizard of Oz crap that we have seen lately. Real estate especially in the states of CA and FL is still way out of wack – the owners are still delusional that their shack is worth ten times value, sorry it isn’t. Let the foreclosures continue, the banks have to eat it they were stupid or greedy enough to make loans knowing damn well there was NO underlying value, let the people lose their houses they were stupid enough to buy them to be part of the crowd again knowing damn well they weren’t worth what they were paying. Just do not look to me – who kept renting, and paid down credit debt – to pay for their stupidity.
I can’t agree more wholeheartedly with the observations made in this article. I am seeing Florida house prices drop in earnest since just after the 1st Quarter of 2008. The decline has definitely picked up since October. Thanks for the good article!
I agree John. I see FL is collapsing but frankly, what are most average Florida houses anyway but cinder blocks on a concrete slab? Come on, yes location is location but what goes into a structure comes into it too. Cinder blocks on a slab? That is a garage in most parts of the country. The Florida economy cannot sustain very high prices in 99.9% of the state. Florida wages are very low, you have to run air conditioning year, food prices are sky high, crime is out of control and reality is that there is NOT a lot of money there, contrary to what “some” would like the the public to believe – The Town of Palm Beach is part of but NOT the same as Palm Beach County in general – that is a perfect example.
Well, to add to it in California what about Santa Monica or Culver City those two Westside “Leave It To Beaver” type areas, or in terms of Culver City “Twilight Zone” most of that series WAS filmed there as it is home to MGM, what made anyone think that houses of an average ideallic American nature were worth 750K? Who was fooling who? Those houses were averaging 75K a pop around 1977 sorry they ain’t worth ten times the money – not to my wallet. Let’s be real and get out of the fog. That is an example of how far these places have to fall in my view. Come on, time for REALITY CHECK – yes, perfect, where is MADtv I think they could do a show on this lunacy.
Bullfinch,
Remember what I said about correlation not being the same as causation? Here is a press release that has some interesting information even though it is from Oct 2008:
http://www.bankers.asn.au/Australian-banks–sound-lending-practices-have-protected-customers-from-a-US-style-sub-prime-crisis/default.aspx
Also, I have not seen any “health checks” done like this in the US (and this release is from 2003): http://www.apra.gov.au/media-releases/03_22.cfm
Please note that I’m definitely not saying that Australian lending practices are perfect by any means but they do seem to be somewhat more regulated and stringent than we are.
I wanted to agree with Edward, and also add that property taxes and homeowners insurance are HUGE factors that are going to accelerate the fall in property values. With tourism down, not many people are going to step up to pay inflated mortgages, insurances and property taxes.
I like what Jack is saying. Most companies are valued based on an earnings multiplier (as well as commercial real estate – cap rate). So, too, should residential real estate. I think that multiplier should be household income. The problem (opportunity?) is that residential real estate operates in an imperfect market so there will always be ‘irrational’ price fluctuations because people make emotional decisions about their ‘home’ (i.e. American Dream). Until it settles into a 3x household income generally, it (being wherever ‘it’ is) is over-inflated. When I see homes starting to trade in my area in the $200k median range more often, I’ll feel that we’re back to ‘corrected’ valuations (about where they were in the late 1990s, which is where wages still are generally). Then, if wages increase so too shall appreciation (assuming supply stays constant and demand does not suddenly increase dramatically). Supply/demand dynamics and absorption is another topic obviously.
According to the US Census Bureau, the median US household income was $50,233 in 2007. So, the median house price should be in the $150k range (that’s about $30k down @ 80% and a mortgage in the $900/mo range @6% if you’re escrowing taxes and insurance). If your gross is $4200/mo minus, let’s say, 30% in total taxes, your net take home is roughly $3,000/mo. So, that $900 is about right if you want to keep your total mortgage as close to 30% of take home pay as possible (a good rule of thumb in my opinion). The latest median home price data I could find shows that the median US home price right now is $180,100. I’d say that’s about right based on this analysis. So, nationally, we’re getting back to normal (still a bit out of whack in many areas though).
Matt
Big Picture had a good article on this yesterday:
http://www.ritholtz.com/blog/2009/02/homes-still-too-pricey-to-stabilize/
Even good chart porn!