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.

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.”