Fear and greed: why the American housing credit crisis is worse than you think

International Economy, The, Spring, 2007 by Lawrence B. Lindsey

HOW DOWNCYCLES BECOME SELF-REINFORCING

While credit market up cycles have their self-reinforcing trends, so do down cycles. We are beginning to see this already in both the real estate market and the mortgage market. With credit availability made as easy as possible in order to make as many mortgages available as possible, there does come a point when there literally is no one else who conceivably could be a homebuyer. With houses bid up to historically high prices, sellers often decide that now is the time to take profits. As in any market, whenever there is an excess of supply over demand, the only way the market can clear is for prices to fall.

But the high level of credit in housing makes the price cutting process more painful. For example, consider what would happen if you borrow money to buy a stock in the stock market using the maximum amount of borrowing allowed--50 percent. On a $100 stock, you put down $50 and borrow $50. If the price drops by 10 percent to $90, then you are forced to sell (it's termed a margin call) and pay back what you have borrowed. You end up seeing your initial investment drop by 20 percent, from $50 to the $40 you have left after you sell the stock for $90 and pay back the $50 you borrowed.

Now consider what happens when you buy a house putting only 2 percent down like the median first-time homebuyer in 2006. Let's say it is a $200,000 house and you put down $4,000. If the house goes down in price by 10 percent and you sell it for $180,000, you lose all of your $4,000 down payment, plus you still owe the bank $16,000 at the closing. You have no down payment left to buy another house and your credit rating is ruined by your $16,000 debt. Essentially you cannot get a mortgage to buy another house. Your response: don't sell.

So the first thing that happens when the real estate market softens is that volume drops sharply. In 2006, for example, 9 percent fewer homes were sold than in 2005. By contrast, prices have only softened a little, with the price of the median home that was sold in January 2007 just 3 percent lower than a year earlier.

Now consider the attitude of the lenders. When house prices were going up it was easy to give someone a loan with a 2 percent down payment. After all, if home prices rose 10 percent, that 2 percent down payment became as good as a 12 percent down payment in just one year. The chances of the homeowner not being able to repay with that much of a cushion in the house was very small. But when prices begin dropping by 3 percent a year, a 2 percent down payment gets wiped out. Your loan is in the classic position of being "under water" just a year later.

Then the role of the appraiser becomes very important. Appraisers give their assessment of what the house is "really" worth by comparing it to similar houses that were sold in the area. It is a reality check by the bank on what the buyer is paying, most of which is, after all, the bank's money. When the market was going up and there were plenty of houses sold this was easy. Not only were there lots of comparable houses, but the likelihood that the appraiser would err a little on the high side would be offset by the overall rise in prices. This goes into reverse on the downside. First, there is a big decline in sales, and so fewer houses to compare to. Second, the consequences of erring a little on the high side are large because they will be magnified by the price decline. The result is that appraisers tend to be extra cautious in their appraisal of the "fair market value" of the house.