Why? 1. Prices still disconnected from fundamentals. House prices are still far beyond any historically known relationship to rents or salaries. Rents are still less than half of mortgage payments. Salaries cannot cover mortgages except in the very short term, by using adjustable interest-only loans. Anyone who buys now will suffer losses immediately, and for the next several years at least.
2. Buyers borrowed more than they can ever repay. Now there are mass foreclosures. Banks happily loaned whatever amount borrowers wanted as long as the banks could then sell the loan, pushing the risk onto Fannie Mae (ultimately taxpayers) or onto buyers of mortgage backed securities (MBS’s). Now that it has become clear that a trillion dollars in mortgage loans will not be repaid, Fannie Mae is under pressure not to buy risky loans and investors do not want MBS’s. This means that the money available for mortgages is falling, and house prices will keep falling, probably for 5 years or more.
A return to traditional lending standards will mean a return to traditional prices, which are far below current prices.
3. Interest rates increases. When rates go from 5% to 7%, that’s a 40% increase in the amount of interest a buyer has to pay. House prices must drop proportionately to compensate.
For example, if interest rates are 5%, then $1000 per month ($12,000 per year) pays for a loan of $240,000. If interest rates rise to 7%, then that same $1000 per month pays for a loan of only $171,428.
Even if the Fed does not raise rates any more, all those adjustable mortgages will go up anyway, because they will adjust upward from the low initial rate to the current rate.
4. Extreme use of leverage. Leverage means using debt to amplify gain. Most people forget that losses get amplified as well. If a buyer puts 10% down and the house goes down 10%, he has lost 100% of his money on paper. If he has to sell due to job loss or an interest rate hike, he’s bankrupt in the real world.
It’s worse than that. House prices do not even have to fall to cause big losses. The cost of selling a house is 6%. On a $300,000 house, that’s $18,000 lost even if prices just stay flat. So a 4% decline in housing prices bankrupts all those with 10% equity or less.
