Thursday, January 17, 2008

Wealthy People Can Be Stupid Too

This is a perfect story illustrating why the housing market problems are not a "subprime" problem as is commonly argued in the media. This is a poor interpretation of the problems that are occuring. The correct thesis is that homes were overvalued and lenders were far too willing to lend way above traditional multiples of incomes or property values. This is, unfortunately coming soon to a neighbourhood near you. This story rings so true of the Vancouver area - a facade of wealth and a chronic over-extension of family and personal finances.

From Reuters (emphasis mine):

By Nick Carey HINSDALE, Illinois (Reuters) - A house in this wealthy Chicago suburb is far beyond the reach of most Americans. Unfortunately, Hinsdale may also now be too expensive for some of the people who already live here.

"There is a section of the population here that over-extended themselves to buy here and then keep up the facade of wealth," said Sharon Sodikoff, a broker associate at local real estate agency Prudential Homelife Realty. " In the next year or so they'll be forced out in dribs and drabs."

With a picturesque little downtown area and large, expensive houses -- according to the Headrick-Wagner Consulting Group, the average home sale price here in the 12 months to September 30, 2007, was around $1.15 million -- Hinsdale seems a world away from the housing slowdown that may have brought the U.S. economy to the brink of a recession.

But even here, far from the housing crisis' epicenter, high earners with good credit may be heading for trouble as their adjustable rate mortgages (ARMs) adjust beyond their means, local real estate agents and others say. In a normal housing market they'd be able to sell, but now they are stuck.

"The next wave of problems will come from prime borrowers who bought too much house or borrowed too much against it," said Michael van Zalingen, director of home ownership services at Neighborhood Housing Services of Chicago. A "prime" borrower is one with good credit.
Real estate agents warn that some high-income borrowers have already been forced to sell or leave their homes and more will follow. Especially those who used their homes as ATMs, withdrawing cash via home equity loans.

"For those who utilized home equity loans for five to ten years to finance their lifestyle, the chickens are coming home to roost," said Chicago-based real estate agent Marki Lemons.

There are also signs some lenders are warily eyeing "prime" borrowers. Tom Kelly, spokesman for Chase Home Lending, a unit of JPMorgan Chase & Co, said the company raised its reserves for possible home equity loan loss for subprime and prime borrowers by $635 million in the second and third quarters last year.

"The concern is people who have borrowed a large percentage of the equity (in their homes)," Kelly said. "Now the value of their homes is falling and they can't refinance."
"Some just stop paying and walk away," he added.


Getting into property during the boom was easy, with mortgages freely available for no money down.

Then came the subprime crisis and the credit crunch, slowing the market, pushing prices down and home inventories up. In Hinsdale, for instance, the supply of homes on the market rose to more than 17 months in early October from less than 6 months in January 2006. While it's apparently a buyers' market, Lawrence Yun, chief economist at trade group the National Association of REALTORS, says high-end borrowers are put off by the high interest rates now applied to so-called "jumbo" mortgages, those for $417,000 or more.

"Potential buyers say 'no way am I buying at that price,'" Yun said. "If people can't enter the market, this slows everything down and puts pressure on foreclosures."

If some borrowers can't get into the market, there are others who can't sell to get out. Home owners who bought recently with no money down are the ones most likely to abandon a property when they fall behind on the mortgage.

"I've seen people who bought less than a year ago and have no equity in their homes simply walking away with no regard for the consequences," said Genie Birch, a real estate agent at Chicago-based Koenig & Strey GMAC who covers the city's wealthier districts.

Real estate agents say speculative investors who bought to make a profit are also walking away as the rents they charge fall behind the mortgage payments as their adjustable-rate mortgages readjust.

The home owners who find it harder to walk away are those who took out large home equity loans before prices started falling and now owe far more than their home is worth.

"It's difficult for home owners in that situation to sell as they'll still be left owing money," said Dave Hanna, managing partner of Prudential Preferred CRE, which owns Prudential Homelife Realty in Hindsale.

Unlike subprime borrowers, however, wealthy home owners are more likely to try to cut a deal with their lender, rather than end up in foreclosure. The alternative solution available to them is to opt for a short sale.

Under a short sale agreement, the borrower sells below the mortgage value and the lender writes off the difference. The lender gets less than originally anticipated, but is not stuck with a foreclosed property. The borrower's credit rating is damaged, but not as badly as if they had lost the home.

"You won't see many foreclosed homes here because that would involve public embarrassment," Prudential Homelife Realty's Sodikoff said. "But they will call their realtor and get them to quietly broker a deal to get out of their homes."


jesse said...

Does anybody know how cap gains tax works on primary residences in the US? I heard that it can be deferred but I don't know in what situations.

solipsist said...

Ouch, ouch, ouch.

"Subprime" has a much greater depth and breadth than we can appreciate.

This time (2001-Now) has been our "Roaring 20's", and there is no place for those chickens to roost. There must be a cull.

patriotz said...

I think in the US if you have lived in your house for 2 years all gains are tax free. Don't know about deferrals.

The old rule was that it was tax free only if you used the money to buy another house of equal or greater value.

Of course in Canada all gains on your principal residence are unconditionally tax free, and there is no 2 year requirement as in the US. But you can have only one principal residence at a time.

The correct thesis is that homes were overvalued and lenders were far too willing to lend way above traditional multiples of incomes or property values.

Absolutely right, and this is what I have been pointing out myself. "Suprime" is just a label and means nothing. And of course I'm sure you've all head the refrain "there's no subprime in Canada and we can't crash". Well of course that's just another variation on "it's different here".

What matters is - surprise - fundamentals, i.e. the carrying costs of the property versus the market rent and local incomes. And we all know that the fundamentals here are just as ugly as anywhere in the US.

Radley77 said...

Excellent blog. I think I'm from the same school of thought. I've started up a blog of Calgary real estate market analysis. Just did up the price to rent ratios, and it's roughly double historical valuations:

Calgary Real Estate Market Blog

patriotz said...

The housing market has a new problem: ageing Americans

" America should be bracing itself for the end of the “generational housing bubble”, according to a new study by Dowell Myers and SungHo Ryu of the University of Southern California. As the country's 78m baby-boomers retire, the report argues, the housing market will change dramatically."

But of course it's different in Canada because we don't have any aging boomers.

mohican said...

Good work radley. I'll put a link up to your blog.

Patriotz - I wrote a post about the demographic impacts on housing back in the day. Check it out here. It references a study done by the federal reserve that says that baby boomers have driven down long term bond yields because of their pensions and investment behaviour and this, combined with their consumption patterns has caused the off-kilter environment we find ourselves in today.

Sam said...

Indeed - it seems a key investment mistake made today is to assume that the past 20 years of boomer-influenced economic activity is the new norm, rather than an aberration. People who assume that the next 20 years are going to proceed for them just like their boomer parents had it are likely to be unpleasantly surprised. Perhaps the last generation of North Americans are the most mollycoddled, rich, and complacent of all time? Or does it just seem that way.

Drachen said...



Mollycoddled? Honestly? Isn't that just about as archaic as codpieces and merkins (notice the only two words I could come up with that are no longer in common use are dirty words...)

Aleks said...

Mollycoddled is a perfectly cromulent word.

Siobhan said...

Very interesting report on demographics.

I would think that some one born in the year 2000 will have their pick of housing and only be paying 2 or 3 times their annual income for a home.

Of course by 2030, the big chain fast food restaurants may be be paying their part time workers a $100,000 a year.

The problem by 2030, will not be the price of homes - but paying the property taxes.

Alan said...

re: “generational housing bubble”

I am getting the impression that a lot of buyers are getting their 50% down payments from their boomer parents.

Kind of funny, actually. The boomers sell, to the kids of other boomers, who are financed by their boomer parents, who sold to the kids of other boomers, financed by boomer parents, at nauseum ...

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