Soft Market

The coming of fall roughly marks the one-year anniversary of the housing market's slip into its current slump. And according to the most optimistic predictions of the last few months, it was also supposed to mark the beginning of the road to recovery. Most prognosticators now say, however, that the housing market is not yet done softening. Nearly every week, it seems, a news story points to another key indicator that foresees a further downturn in the market, and predictions of when we'll start to see a recovery keep getting nudged back. The latest put the bounceback beginning closer to the end of 2008.

One of the more recent additions to the pile of bad news — on top of declining home sales and stagnating home values — is reduced affordability in housing. On the most basic level, this may seem counterintuitive; after all, houses were flying off the market just a few years ago even as prices skyrocketed, so why are they less affordable now that prices are less inflated?

This is especially puzzling when the current market is put into historical perspective. True, 30-year mortgage interest rates were, at 6.7%, a point higher in June 2007 than they were two years ago, but “they aren't that bad,” says Bruce Christensen, general manager of GE Money's Home Improvement Division, headquartered in St. Paul, Minn. Indeed, that rate compares favorably to the years leading up to the most recent housing boom.

Additionally, the most telling part of the National Association of Realtors' (NAR) Housing Affordability Index (HAI) still looks relatively good. Revised numbers show that the average mortgage payment as a percentage of income in May was 22.6%. This is lower than the annual rate in 2006, and this indicator has been trending positively downward since last fall. Overall, the HAI has dropped in each of the first six months of 2007. (The HAI comes with two qualifications, according to Walter Molony of NAR. First, it is not seasonally adjusted, and has historically shown seasonal bias, rising each fall and dropping each spring. Secondly, Molony says that due to lending standards being different today than when the index was created in 1981, the HAI is a rather conservative measure of housing affordability.)

*Data is for Q2 2007 Housing affordability is down, but the situation isn't dire. This chart compares current conditions with a recent peak (2003) and a recent valley (1991) in the remodeling and new-construction industries.

Photo Credit: National Associate of Realtors, Office of Federal Housing Enterprise Oversight, National Association of Home Builders

If traditional measures of affordability are still relatively good, what then is the source of the current crisis? To find the answer we must rewind several years to the peak of the recent boom. Homeownership rates were at an all-time high, and while many new homeowners took out standard mortgages, a substantial number opted for adjustable-rate mortgages (ARMs). These loans offer an initially low interest rate that increases incrementally after a set time — usually a few years — until it reaches a fixed maximum. While there are strategic reasons for investors to consider an ARM, they're popular because they allow people who wouldn't otherwise be able to afford a mortgage the opportunity to own a home. The low interest rate during the early stages of the loan makes the monthly payment more tenable.

Of course, there is some risk involved. Homeowners entering into an ARM because it's the only way they can afford a home are banking on being able to make larger monthly payments within a few years. Quite often — and this was particularly true during the housing boom — people rely on their ability to make up the difference by borrowing against their growing equity in a home that they assume will continue to increase in value.

At the time, that seemed like a pretty safe gamble. “Home values were escalating at such a rapid pace,” notes Bill Simone, chairman of the board of HomePlus Finance, a Los Angeles-based lender that concentrates on the “subprime” market. “[People thought] that by the time that first adjustment came around, they'd be able to refinance for a fixed loan or another ARM. They were betting on the economy to keep them in their housing.”

Now that the housing market has cooled, those who bought their homes toward the end of the boom — when value increases were at their peak — have not yet built up the equity that they anticipated. It now appears that the potential consequences will become very real for a significant number of homeowners.

In July, there was a flurry of news reports focusing on the repercussions of the largest ARM reset in history — more than $50 billion in October alone, according to Mark Zandi, at Moody's Economy.com. A CNNMoney.com story said that in the most extreme circumstances, monthly mortgage payments would increase by more than one-third, and that perhaps as many as 300,000 homeowners could end up losing their homes.

For his part, Simone doesn't think the fallout will be that drastic. “The majority of these loans are going to remain current,” he says. “This won't be the crisis people think it will be,” he continues, noting that the increases in loan payments will be incremental and therefore easier for households to handle.

As far as remodeling goes, it's hard to say what kind of effect the decline in housing affordability will have. “This won't lead to a glut of available homes,” says Kermit Baker, director of the Remodeling Futures Program at Harvard's Joint Center for Housing Studies. “The household that was foreclosed has to live somewhere.” However, that household may not undertake remodeling projects typically associated with homeowners moving into a new home. “This is not the typical churn of homeowners trading up,” Baker says.

In addition to his role as a lender, Simone is also president of Custom Design & Construction, a Los Angeles remodeling firm. He says that homeowners in his area are not necessarily wary of doing home improvement projects, but that his average job size has gone from $500,000 a few years ago to around $300,000 today. He says that homeowners are less willing to pump larger sums of money into home improvements without knowing if the house will support the investment. While less upscale markets may not support half-million-dollar remodels under any conditions, the principle remains the same, so remodelers in all areas should be prepared to see their average job size drop.

Calculations by the National Association of Home Builders Housing Policy Department, based on income distribution from the Census of Population and Housing, U.S. Census Bureau

Photo Credit: National Association of Home Builders

However, Simone does think that the lending landscape will change slightly as a result of what some have termed the “subprime catastrophe.” In fact, his company has already changed some of its policies. “If we see a recent refinance [on a credit report], we now just naturally assume that it's an adjustable,” he says. “So when we calculate income-to-debt ratio, we assume that there will be an adjustment in the next year. We want to make sure that people can handle that payment, and ours.”

Christensen also predicts changes in the lending marketplace as a result of affordability problems. “We're going to see lenders looking for more proof of income, and they will look closer at the actual value of the house,” he says. “There will be more scrutiny, more appraisals, and a tightening of underwriting standards.”

Christensen adds that this isn't necessarily a bad thing. “A lot of consumers got in over their heads.” He's careful not to offer a prediction, but concedes that he “wouldn't be surprised if we see the same frenzy going on 10 years from now.” Simone seems to agree, noting that “this isn't the first time that subprime loans have been looked at under the microscope.”