Written By:
Ingo Winzer,
President
Local Market Monitor
The traditional
calculation of risk in real estate -
the likelihood that a property will lose value or that a mortgage will default
- is similar to the experience-based methods used by the insurance industry. If
one percent of mortgages defaulted in the past, it's reasonable to assume that
one percent will default in the future.
This
approach works well as long as the context
of the real estate market - the larger economic circumstance - doesn't change.
But if the context changes, even the best experience-based calculations can be
overwhelmed by other forces.
During the
boom years of the mid-2000s, Fannie Mae, Freddie Mac, mortgage bankers,
investment bankers and the rating agencies all relied on traditional historical
data to tell them how much risk to assign to the large numbers of sub-prime
mortgages being packaged and sold to investors. And they all were wrong, spectacularly so, because they failed
to see that default data from periods of steadily rising home prices no longer
applied when home prices had become too high; they didn't see that the context
had changed.
The context
of risk can change for many reasons. The jump in oil prices in the 1970s led to
real estate bubbles in Texas and other energy states. The S&L crisis of the
1980s was largely caused by a doubling of government guarantees on deposits.
The recent crisis might not have happened if the Fed hadn't kept interest rates
artificially low, prompting investors to look for higher returns in sub-prime
mortgages.
Risk
Revealed in Home Prices
Even though a
change in context can't always be seen for what it is, the risk itself often shows up as an unsustainable increase in home prices. This happens when the demand
for homes - from just-hired oil workers, from speculators or from newly-qualified
sub-prime buyers - increases faster than the supply.
It's easy to
see in hind-sight when real estate
markets were over-priced. It's easy to say afterwards that the home price
increases were not sustainable. But can we see this beforehand, and therefore do
something about it?
The
steadiest anchor for home prices in the last 40 years has been income. Like home prices, income varies
from locality to locality - and although the ratio of price to income in a California market might be different
from the ratio in Iowa, the ratio in any local market is remarkably constant, changing only during those periods we're
trying to identify: when prices are unsustainably
high.
We calculate
an Equilibrium Home Price for each
of 316 markets in the US, based on the long-term ratio of local home price to
income. We consider a market over-priced
when the average local home price exceeds the Equilibrium Price by more
than 20 percent. Seen this way, in real time, some markets in Florida, Arizona
and California were already over-priced in 2004.
Combining
Context with Traditional Risk
The context
of risk doesn't directly translate into a mathematical formula of default
(which is why it's so often ignored). Even though we may know there is a higher
risk of default or of falling home values, we can't say exactly how much higher
the risk is.
But we can use
the context to take common sense management
steps that reduce the risk.
The first
step is to tighten underwriting standards. When business is brisk from strong
demand, lenders easily get careless with their underwriting process. Just
ensuring that no short-cuts are being taken is useful down the road.
1. We recommend that lenders review and tighten
their underwriting process when the average home price in a local market exceeds
the Equilibrium Price by more than 20 percent.
The next
step is to reduce exposure by writing fewer high LTV loans or by requiring
insurance on exposures above 80 percent LTV.
2. We recommend that lenders reduce their
exposure down to 80 percent LTV when the average home price exceeds the
Equilibrium Price by more than 40 percent.
The final
step is to stop all exposure to new loans, either by not writing any new ones
or by immediately reselling them.
3. We recommend that lenders stop their
expose altogether when the average home price exceeds the Equilibrium Price by
more than 60 percent.
This last is
a rare occurrence but was apparent in many Florida and California markets by
early 2006.
