Another Lesson to be Learned?

Implications: Our next lesson may be that homebuyers should carry some of the financial risk associated with owning a home.

Analysis: Mr. Wessel is right on, as he usually is, in the subject article.  “It is the hallmark of a credit bubble when lenders think that because collateral is going up in price they can ignore the borrower’s ability to pay,” Mr. Wessel quotes Peter Fisher of Blackrock Inc. as saying.  In other words, confirming someone’s ability to pay for a loan prior to giving them that loan is a good idea- an idea that sounds so simple but was largely ignored by some banks in 2004 and 2005.  

We have indeed, as Mr. Wessel points out, learned a lesson.  Today, lenders are documenting buyers’ income- verifying borrowers’ ability to make payments on their home loans.  Here in the Phoenix metro area, the financing tool of choice for entry-level and first move-up buyers is now the FHA loan.  Potential homebuyers like the low downpayment- just 3%- that accompanies FHA financing.  The FHA loan is built on the premise that people that can afford their homes will pay their mortgage, so verification of income is chief among lender underwriting priorities.  

Buyers unable to find the FHA-required 3% downpayment need not worry about getting into a home.  Homebuyer assistance programs exist and are heavily utilized by buyers.  In entry-level submarket areas like Avondale, Buckeye, and Maricopa, BREC estimates that more than 90% of all new home buyers are utilizing these programs.  Homebuilders simply “donate” the 3% downpayment to the assistance program, and the assistance program donates the 3% downpayment to the homebuyer.  

Closing costs aren’t even an issue for cash-poor buyers; the most common incentive currently provided to potential buyers is closing cost credits.  Buyers need only $500 to $1,000 to purchase a home today.  

One lesson we may not have fully learned from the downturn may haunt housing and finance markets in the future.  Today, some buyers that can afford their mortgage payments are forgoing payments and allowing homes to go into foreclosure.  These buyers owe more to the bank than their homes are worth.  As values continue to drop, these buyers are deciding to accept poor credit rather than pay for a depreciating asset.  

Conventional mortgages now account for the risk that values are dropping, and that buyers with little or no financial stake in a home may decide to stop paying monthly mortgage payments.  Many areas have been labeled “declining market areas”, and lenders require 10% to 20% downpayments on homes.  If values go down after the new homeowner takes possession of the home, the homeowner maintains a first loss position.  As long as the value declines do not substantially exceed the downpayment homeowners have put down on the home, the homeowners are unlikely to opt not to continue making payments.  

BREC’s forecast currently calls for slowing new home depreciation, as the number of purchasing opportunities continues to shrink.  Homebuilder price wars have driven metro Phoenix pricing down an average of 37% since the beginning of 2006.  On the outskirts, builders have written down their lot values and are now building homes at a loss.  Builders are discounting to sell-out, and leaving areas where money cannot be made.  This will allow for stabilization next year.  

The risk, though, of further significant depreciation exists.  Those contemplating this risk should also contemplate future foreclosure levels. Homebuyers purchasing homes today, with little or nothing down, could decide the value of their home has dropped more than they would like.  Despite being able to afford the mortgage payment they might decide- like those buyers walking from homes today- they will accept poor credit quality over a depreciating asset.  Our next lesson may be that homebuyers should carry some of the financial risk associated with owning a home.