The Republicans under George Bush passed a series of tax cuts that are due to expire at the end of 2012. Republicans are making this a campaign issue by scaring voters with the specter of a “fiscal cliff.” Economists have stepped forward with varying but dire predictions of the end of the US economy. Republicans hope they can scare enough people to win the upcoming election. They just might.
Lost in the campaign rhetoric is a careful examination of what the expiration of the various tax cuts really means. Will expiring tax cuts cause housing to fall off a fiscal cliff? It might, but not in the way most pundits imagine. The real danger is not from a damaged economy. That’s a red herring. The real danger is from higher personal tax rates resulting in a lower affordable debt-to-income ratio.
There are three variables that determine how much a borrower can finance to buy a home: (1) interest rates, (2) income, (3) debt-to-income ratio.
Interest rates are inversely related to loan balance. At low interest rates, loan balances are very large, and at high interest rates, loan balances are very small. The federal reserve has drastically reduced interest rates to make bubble-era prices financeable to give borrowers the ability to bail out the banks with large, affordable loan balances.
Income is necessary to make payments, so obviously it’s part of the borrowing equation. That’s why lenders ask potential borrowers to prove they have income to service the loan. However, there is a limit as to how much income a borrower can reasonably set aside each month to pay a mortgage. Lenders forget this occasionally and inflate massive housing bubbles.
When prices began to crash in 2007, the government worked to develop the first loan modification programs. Since the government was working to save the banks, they set the debt-to-income ratio they considered “affordable” at 38% of a borrower’s gross income. A debt-to-income ratio of 38% is not reasonably sustainable, so nearly everyone who got those loan modifications failed. Later loan modification programs were set to the GSE underwriting guideline of 31% of disposable income. More recent loan modification efforts have been marginally more successful, although these efforts are still mostly can-kicking by the banks.
Prior to the housing bubble, bank underwriting standards and financial planner’s advice was to keep the debt-to-income ratio at 28%. So how did a 31% debt-to-income ratio become affordable?
The same tax cuts that are due to expire at the end of 2012.
Of course, it will take a few years for underwriting standards to reflect this fact. If personal income taxes do go up, it will take some time for the new defaults to become widespread enough to force lenders to tighten debt-to-income ratios. Lenders will be “surprised” by the increasing delinquency rates because they don’t want to acknowledge the connections between higher tax rates and the need to lower debt-to-income ratios to keep disposable income available to live a life. Banks don’t want to admit anything which would serve to limit lending and reduce their profits.
If the personal income tax cuts are allowed to expire at the end of 2012, the housing market will suffer. It won’t crash, but the pressure on borrowers will cause higher default rates which will inhibit lending. Eventually, this will lead to even more conservative debt-to-income ratios and smaller overall loan balances. Perhaps incomes will rise to compensate, but it’s still one more factor serving to limit future appreciation. And we all know how popular that is.
Morgan Brennan — 8/30/2012 @ 11:21AM
Fiscal cliff fears are here. With nearly $500 billion in simultaneous tax hikes and spending cuts set to take effect in January, economists have been forewarning the devastating consequences the so-called “fiscal cliff” could cause if Congress fails to come to a budget agreement before the end of the year. The latest report hails from the Congressional Budget Office (CBO), warning that inaction could plunge the U.S. into a “significant” recession in the first half of 2013.
“Most consumers aren’t paying attention to the fiscal cliff. If the [local] housing affordability condition is good and they can get a mortgage, they are in the market,” says Lawrence Yun, chief economist of the National Association of Realtors (NAR). “However if the cliff was to be realized come January 1st and we do go into a recession, job losses could hamper the housing recovery.”
An outright recession and associated job losses would force the banks to rebuild shadow inventory as more borrowers go delinquent and fewer buyers step forward to mop up the mess. I don’t think this is very likely.
And housing has arguably begun to recover (albeit unevenly, with some markets still suffering losses). On Wednesday, July pending home sales were at their highest level in more than two years, according to NAR, and inventory continues to contract. The association projects home prices will increase 10% cumulatively over the next two years.
The NAr has no shame. Ten percent cumulative? I guess 5% a year — which is still optimistic bullshit — isn’t good enough, so they need to find a more exciting way to dress up their ridiculous predictions.
… the CBO projects a fiscal cliff could cost the U.S. two million jobs next year and cause the unemployment rate to stay stubbornly stuck above 8% through 2014. Fewer jobs could translate into less demand for new homes, possibly even a new wave of foreclosure filings as newly unemployed workers struggle to make mortgage payments.
While Yun asserts that buyers of U.S. homes currently pay little attention to what’s coming … . If 2010’s Bush Tax cut debate was any indicator, mounting economic and financial uncertainty could cause Americans — particularly Americans with higher levels of discretionary income — to pull back on consumer spending, holding off on major purchases like homes. At least until a resolution is realized.
… “The stability of people’s jobs does impact their confidence to spend moving forward,” adds Mark Cole. … Cole says average American families have been cautious about taking on new debt (if they can even qualify), choosing rentals over home purchases, according to the organization’s data.
The greatest fear of homebuilders is that potential futures buyers may chose to rent instead. California kool aid will make that unlikely here, but in the rest of the country, the bitter taste of the housing bubble may prompt many not to buy homes in the future. Many in the masses who are underwater regret their decision.
Indeed the one area of housing that could gain from mounting economic uncertainty is the already-booming rental market. “Renting is the cautious alternative and I think that trend will be exaggerated a little bit more if there is a fiscal cliff — or even if we come close to one,” says Barry Hersh, a professor at New York University’s Schack Institute of Real Estate. Rents are already expected to increase an average of 4% nationally this year and 4% in 2013, according to NAR. …
New home building will be hit hard if a recession is realized, too. “It will reverse the small gains we have made in home building thus far,” says David Crowe, chief economist of the National Association of Home Builders (NAHB). … New home starts remain about 50% down from the rate required in a healthy housing market. The lack of new supply is already causing an inventory crunch in some areas; a reversal could lead to larger inventory shortages in the coming years.
Despite the speculative doom and gloom, economists believe a fiscal cliff-spurred recession would not spark the kind of home price-hemorrhaging witnessed when the housing bubble burst five years ago. “Markets have already corrected from the bubble, and in some places, over-corrected,” asserts Yun. “Even if there is a fiscal cliff, I suspect Congress will rectify that situation within a few months so it will be a very short term negative before the problem gets resolved.” Here’s hoping the realtor’s right.
Given the dismal failures of our centrally planned economy over the last several years, I don’t hold out much hope for future success of government or federal reserve policy.
The fiscal cliff may cause disruptions in the housing market, but how would we tell? Banks have already completely manipulated the market by creating a massive shadow inventory and endlessly can-kicking. Even if we do fall off the fiscal cliff, the banks will continue just as they have before, and our housing market will exist in a surreal never-land of bank and government manipulation just like it does today.
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Proprietary Irvine Housing News home purchase analysis
$989,000 …….. Asking Price
$482,000 ………. Purchase Price
10/20/2000 ………. Purchase Date
$507,000 ………. Gross Gain (Loss)
($38,560) ………… Commissions and Costs at 8%
$468,440 ………. Net Gain (Loss)
105.2% ………. Gross Percent Change
97.2% ………. Net Percent Change
6.0% ………… Annual Appreciation
Cost of Home Ownership
$989,000 …….. Asking Price
$197,800 ………… 20% Down Conventional
3.51% …………. Mortgage Interest Rate
30 ……………… Number of Years
$791,200 …….. Mortgage
$198,696 ………. Income Requirement
$3,557 ………… Monthly Mortgage Payment
$857 ………… Property Tax at 1.04%
$233 ………… Mello Roos & Special Taxes
$247 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$238 ………… Homeowners Association Fees
$5,133 ………. Monthly Cash Outlays
($793) ………. Tax Savings
($1,243) ………. Equity Hidden in Payment
$221 ………….. Lost Income to Down Payment
$144 ………….. Maintenance and Replacement Reserves
$3,462 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$11,390 ………… Furnishing and Move In at 1% + $1,500
$11,390 ………… Closing Costs at 1% + $1,500
$7,912 ………… Interest Points
$197,800 ………… Down Payment
$228,492 ………. Total Cash Costs
$53,000 ………. Emergency Cash Reserves
$281,492 ………. Total Savings Needed
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