11 October 2005

What Is Wrong With California?

California's real estate market has gone absolutely nuts.

For example, August median home prices were up 20.1% statewide from the previous year. Ten communities saw median home prices increase by 45% or more in a single year. If you received that rate of return that high on a promissory note in Colorado, you'd be breaking Colorado usury laws.

“California hit a new record median of $568,890 in August,” said [California Association of Realtors] President Jim Hamilton. “This was the second strongest August sales figure on record dating back to 1979, surpassed only by August 2003.

Five years ago, in 2000, prices were less than half of what they are now.

“The median price of a single-family home in California hit a new record in August, rising 14 percent to $255,580, ” said C.A.R. President Richard F. Gaylord. "August also was the 42nd consecutive month that the median price of a home posted an increase compared to the previous year."

Median single family home prices have increased an average of 17% per year since 2000. Many credit cards have lower interest rates. When it makes sense to borrow money on a credit card to invest in real estate, something is deeply wrong.

By comparison, inflation has been modest, 14% nationwide for urban consumers over the past five years from August to August. After inflation, California real estate prices have still gone up by about 14.7% per year for five straight years.

Where does the money come from? The numbers don't add up.

LOS ANGELES (Oct. 6) – The percentage of households in California able to afford a median-priced home stood at 14 percent in August, a 4 percentage-point decrease compared with the same period a year ago when the Index was at 18 percent, according to a report released today by the California Association of REALTORS® (C.A.R.). The August Housing Affordability Index (HAI) declined 2 percentage points compared with July, when it stood at 16 percent. . . .

The minimum household income needed to purchase a median-priced home at $568,890 in California in August was $133,800, based on an average effective mortgage interest rate of 5.87 percent and assuming a 20 percent downpayment. The minimum household income needed to purchase a median-priced home was up from $110,980 in August 2004, when the median price of a home was $473,520 and the prevailing interest rate was 5.83 percent.

The minimum household income needed to purchase a median-priced home at $220,000 in the U.S. in August 2005 was $51,740.

Five years earlier, the housing affordability index in California was at 29%.

What is going on?

California was the epicenter of the tech bust of 2001. Information technology employment in San Francisco fell 49% from the peak in March of 2001 to April of 2004.

The stock market is at almost exactly the place it was five years ago.

Incomes in California have not grown dramatically. Housing stocks in California are larger, not smaller than they were five years ago, in response to market forces.

Rents have gone down in much of California.

Money Magazine (not usually a leading indicator for insiders in the market) was bemoaning the California real estate bubble a year ago. A couple weeks ago, the call was that the market was overvalued by as much as 45%, despite an alleged "soft landing" on the way.

California markets have PMI risk indexes ranging from 339 to 487, meaning that their models predict a 33.9% to 48.7% change of a price slump within the next two years. The non-California high risk markets are mostly familiar: Boston, New York City and its suburbs, Cambridge, Providence, and oddly, Detroit. Denver hovers just about the national average (20.2%) with a 208 rating.

Patrick.net provides a detailed list of reasons why California (and more particularly the Bay Area) is a housing crash in progress. His evidence could be a bit better substantiated and his arguments could be slightly tighter, but fundamentally, I find little to argue with in his analysis. When rents are covering only half of mortgage payments something is deeply wrong.

Loose financing and tax policies like the mortgage interest deduction (which may now be reduced in size) and tax free treatment of most real estate market capital gains can explain part of the rise in real estate prices. Interest rates have been at record lows, interest only loans are abundant, and many people are financing their homes with adjustable rate loans. But, those factors have been more or less the same nationwide.

The only factor I can think of in the legal environment that may be particular to California is that lenders there are not permitted to pursue deficiency judgments against mortgage borrowers in the event of a residential real estate foreclosure. You can't get upside down on a California mortgage. If the market goes up, homeowners win, if it goes down, banks lose. Moreover, in the case of a low down payment loan, the upside gains from this extreme leverage may be immense for the homeowner, while the downside loss from a default on the mortgage may have a quite modest impact on the homeowner. The bank has relatively little incentive to closely police their loan underwriting, because they typically have a 20% equity cushion which is sufficient to sustain anything but a massive decline in real estate values (which may, admittedly, happen now). Most of the risk is born by a federal guarantor and/or a private mortgage insurer.

It isn't at all clear to me that PMI underwriting is anywhere close to the level of rigor needed to reflect the immense risk that these firms are undertaking, in large part because rising real estate prices have held these firms harmless from having to pay claims in California for many years. If one of those firms goes bankrupt in a declining market, however, the banks may suddenly find themselves facing far more risk than they had bargained for when they made the loans. Even sophisticated planners and lenders are usually poor judges of systemmic risk. If those losses are severe enough to break California banks, all of us could end up paying in the form of an FDIC bailout of the failed banks.

Prices can't go up at this rate forever, however, so we may very well end up finding out just what does happen when the California real estate bubble collapses.


Kyle said...

My father has the right idea. He's a coast guard doctor and just moved to a beautiful area outside San Fransisco. His monthly rent: 0$. Three cheers for (rather nice) government housing.

Andrew Oh-Willeke said...

The Nation thinks that the bubble is bursting right now.

Andrew Oh-Willeke said...

Lots of anecdotal evidence and references to local news stories in print that says that the Northern California bubble and New York bubble and others as well have burst.