California Real Estate Prices Back To Earth

The percentage of households that could afford to buy an entry-level home in California stood at 59 percent in the fourth quarter of 2008, compared with 33 percent for the same period a year ago, according to a report released Wednesday [February 18, 2009] by the California Association of Realtors.

The minimum household income needed to purchase an entry-level home at $248,030 in California in the fourth quarter of 2008 was $48,900, based on an adjustable interest rate of 6.02 percent and assuming a 10 percent down payment. The monthly payment including taxes and insurance was $1,630 for the fourth quarter of 2008.

At $48,900, the minimum qualifying income was 42 percent lower than a year earlier when households needed $83,700 to qualify for a loan on an entry-level home. Recent decreases in home prices and mortgage rates have brought affordability into better alignment with income levels of the typical California households, where the median household income is $59,160.

At 76 percent, the high desert region was the most affordable area in the state. The San Luis Obispo County region was the least affordable in the state at 44 percent, followed by the Los Angeles County region at 46 percent.

From here (emphasis added).

Nationally, about two-thirds of Americans are homeowners.

Not all of the fallout from the financial crisis has been bad news. California real estate prices had put home ownership out of reach for tens of millions of people in California and other markets experience housing bubble prices.

When entry level housing costs more than affluent home buyers can afford on terms that are themselves less than conventional, housing prices are higher than the market can bear and a disruptive collapse is inevitable sooner or later. Excessively high housing prices have been an important factor driving migration out of California and impairing its economic growth.

The powerful draw of the American Dream, which includes the notion that middle class families ought to be able to own their own homes, also helps explain the reckless financial arrangements that people entered into in order to cope with the bubble. People were willing to enter into adjustable rate loans that they knew they couldn't pay if the interest rates adjusted up from record low levels, skimp on down payments, and accept very long amortizations or even "interest only" loans, because without the lowest possible monthly payments they simply couldn't buy any home. Borrowers and lenders alike justified these risks, and stopped worrying about traditional underwriting tools like income documentation, because most of these loans were fundamentally "hard money" loans. In other words, the house that served as collateral seemed likely to increase in value so quickly, that foreclosure sales could easily cover the amount of the loan and the bank's foreclosure costs, as long as loan payments were kept current for even a year or two.

After the dramatic collapse in housing prices, would be California home buyers can buy the same home, with a similar or lower payment, with far more reasonable terms and down payment arrangements, from more traditional lenders like commercial banks, thrifts and credit unions, rather than mortgage companies financed with securitized loan sales.

Affordable housing is something that California hasn't had for a long time, and will once again make the state attractive for people wanting to start businesses and find work.

It would, of course, have been better if California hadn't seen a housing bubble in the first place. The collapse of a similar real estate bubble in Japan thrust that country into what was arguably the worst recession in the industrialized world since the Great Depression. Americans can't expect to be held harmless or nearly so from this real estate bubble collapse of comparable proportions.

The collapse of any real estate price bubble, particularly one with a drop of more than 20%, the cushion customarily provided to first mortgage lenders through some combination of a down payment, private mortgage insurance and a second mortgage at a higher rate, means that mortgage lenders lose some of the principal they lent, in addition to failing to earn the anticipated interest payments.

These losses, of course, hurt the financial institutions that are most leveraged, and made the least conservative loans, the worst. We've already seen the subprime and Alt-A lending industries virtually eliminated, banks with weak lending standards like Washington Mutual wiped out, and highly leveraged independent investment banks, which financed the nation's mortgage company based lending, cease to exist.

In the banking industry, the survivors seem to be commercial banks, thrifts and credit unions, particularly those with a local orientation disentangled from national financial markets more than major money center banks, that were conservative in their mortgage underwriting practices during the housing bubble.

Real estate construction is based upon assumptions about real estate prices in the year or two it takes from the time it takes to buy land, get zoning approvals and build new structures, until the time properties are sold, typically with third party financing. When real estate prices are unreasonably high, construction companies build too many buildings. So, the construction industry will probably remain anemic until all of the excess building inventory errected based upon unreasonably high prices is absorbed by economic and population growth. The temporary near demise of this industry, of course, will produce lots of job losses in the construction trades and related industries, and will in turn, weaking spending demand in the economy. It will also put pressure on wages in all industries that people who used to work in the construction trades are able to do, fields that have mostly seen declines in inflation adjusted wages since the 1970s already.

I expect that construction wages will plummet (ironically just as the proportion of the construction workforce that is composed as undocumented immigrations declines greatly as immigrant workers return to their countries of origin, discouraged by poor job prospects), as demand for construction work falls, and that in the face of a dearth of new construction work, that firms offering rennovation work at very competitive prices will spring up. Bids for government construction jobs, which may be the only game left in the industry in many cases, should also become more competitive, easing strained government capital budgets.

Who gets hurt, besides bankers, builders and merchants hurt by a generalized decline in economic demand? The people who bought property at real estate bubble prices and are now upside down on their real estate investments, and the parallel group of people who felt comfortable running up consumer debt based upon high real estate and financial investment values.

In California, which is one of the few places in the country where mortgages on owner-occupied homes are generally non-recourse (i.e. the owners can't be sued for the bank's losses net of the collateral after a foreclosure), homeowners who were swept up into the trend of taking out loans bigger than they could afford, may end up with battered credit records, but will typically lose only their down payments, which were often five percent or less of the purchase price. Some of these homeowners may even secure mortgage modifications in or out of bankrutpcy, and get to keep their homes with reduced loan amounts, lower interest, or more slowly amortized mortgage debts. Others may be able to buy different homes at the current more affordable prices.

For them, who on avearge and as a class were less thrifty than they probably should have been with debt financed consumer spending, a weakened credit rating may not even be a bad thing. Poor credit may discourage or prevent them from making purchases that they can't actually afford.

Real estate owners who made larger down payments who bought at bubble prices have been hurt more. Their large real estate investments will be gone, and neither the lenders nor the government will cushion their pain. They will be making the same big monthly mortgage payments that new buyers with almost no down payments make on their properties. And, falling real estate prices almost likely will lead to falling rental prices, so financial projections for investment properties may fall apart.

Investment real estate owners also aren't going to receive the mortgage modification benefits that were made available to owner occupied home owners, and typically don't have non-resource mortgage loans, so their other assets may have to be sold when their properties go upside down. Many will probably be forced into bankrutcy.

This whole class of once wealthy and influential investors will now be virtually wiped out, and will have to start over from scratch, something not easy for a group of investors who tend to be older and hence not as malliable when it comes to learning to start over in new endeavors, despite the fact that these investors tend to be smart, well educated individuals.

Real estate investors also make up a disproportionately large share of upper middle class black and Hispanic investors, so the black and Hispanic upper middle class may be particularly hard hit. Another area in which affluent black and middle class families have disproportionate investments is car dealerships, and General Motors has plans to cut a third of its dealerships, while other major car companies are also making some cuts to their dealership ranks. Members of the black and Hispanic middle classes were already asset poor compared to white family with comparable incomes. The crash leaves all people with substantial investments much less wealthy, but will probably widen rather than narrow this divide.

On the other hand, the financial crisis may bring to an end, for now, at least, the gross excessives of executive compensation in the financial sector, and for the first time in a very long time, will put a dent in the seemingly endless trend of the rich getting a larger and larger share of the nation's economic wealth. The link between productivity and wealth, which was very tight until a few decades ago, is beginning to be restored, over decades in which productivity growth was not shared with those who created it.

As previously noted, those who don't own businesses and vacation homes have seen their net worths fall by about 12%, while those who do have seen losses several times as large.

Who Owns America Revisited

Some points deserve to be repeated, like the highlights of this post from last summer, which relied on Federal Reserve research:

* The wealthiest 1 percent of Americans held 33.4 of the wealth in 2004. . . The top 5 percent collectively held 55.5 percent of the wealth in 2004.
* The poorest 50 percent of the American population collectively held 2.5 percent of the wealth . . . the very wealthiest 1 percent of Americans own a bigger piece of the pie (33.4 percent) than the poorest 90 percent put together (30.4 percent) . . . .
* The wealthiest 1 percent of Americans owned 62.3 percent of the business assets in 2004.
* The wealthiest 5 percent collectively owned 88.7 percent of business assets.
* The wealthiest 5 percent also owned 93.7 percent of the value of bonds, 71.7 percent of the nonresidential real estate, and 79.1 percent of the value of stock.

The family net worth cutoffs referenced above are:

99th percentile at $6,006,000
95th percentile at $1,393,000
90th percentile at $827,600
50th percentile at $92,900

. . . About 8% of Americans are millionaires. . . .

Unrealized, and hence, untaxed, capital gains make up 31% of the wealth of the top 1% and come mostly in investment assets for these families. . . .

Among African-Americans . . . the 75th percentile is $97,000, and the 90th percentile is $248,000. Among Hispanics . . . the 75th percentile is $103,200, and the 90th percentile is $304,100.

Last time I emphasized the fact that the distribution of wealth makes estate taxation, and tort reform damage caps relevant only to the a small percentage of Americans. This is still true. The forgiveness of tax liability on unrealized capital gains taxes at death is also a huge boon to the top 1% and of very little benefit to most people.

About Business Regulation

Today, I want to make a bigger point about business regulation and government efforts to secure social equality. As the facts above indicate, the vast majority of business assets in America are owned by 5% of the families in America, both big business which is owned through stocks and bonds, and privately held business (those referred to as "business assets" above).

Depending on how you count it, between 10% and 20% of Americans own privately held businesses or farms. But, most of those businesses aren't worth very much, and most of those businesses are either essentially one man or one woman shows that basically sell the services of the proprietor (whatever the form of business organization) or very small, single location, no middle manager, low capital investment type businesses like single location coffee shops or restaurants or food carts or tiny construction subcontractor operations, or "lifestyle" farms.

At the level of the economy as a whole, business regulation overwhelmingly impacts the rich and the near rich. Almost everyone who owns a business large enough to make worrying about unionization an issue (and clearly it is for business lobbies, who have made unprecedented efforts to oppose Colorado's HB 1072, a moderate pro-union bill this legislative session now awaiting a decision of the Governor), is in the top 5% of the wealth distribution in this country.

The Limits Of Soaking the Rich

This is not to say that liberals should overregulate or overtax business.

Republican style trickle down economics is largely a myth. Economic growth in the past thirty years has done far less to help "the rest of us" than would be expected. The United States is the only major developed country where the income of those at the top has risen greatly while the income of those at the bottom has fallen, in recent years.

But, while economic growth and prosperity for the nation as a whole is not a sufficient condition to make the majority of the population better off, it is a necessary condition. The only ways to make average people wealthier are to increase the size of the economic pie, or to seize wealth from the rich and to give it to the poor.

Seizing wealth from the rich, wholesale, may sound attractive. But, it doesn't work. Harsh efforts, in the alleged interests of the masses, to crack down on the well off produce the economic and social disasters of Stalin's Russia, Pol Pot's Cambodia, and China's Cultural Revolution. Traumatic effort to redistribute wealth are counterproductive.

This isn't simply a matter of history book communism. Zimbabwe, which in the year 2000 confiscated the wealth of a 3,500 ultra-wealthy white plantation owners whose wealth was a legacy of apartheid, however just or unjust the government's cause for doing so may have been, has paid dearly for this policy.

Since 2000, the national economy has contracted by as much as 40%; inflation has vaulted to over 1000%, and there have been persistent shortages of foreign exchange, local currency, fuel, and food.

In 2006 alone, the GDP contracted by 4.7%. And, while wealth was certainly concentrated in Zimbabwe before the land seizure, "whites made up less than 1% of the population but held 70% of the country's commercially viable arable land" in 1999, compared to the numbers above for the United States, it really wasn't so different when it comes to economic assets (60% of the population is engaged in agriculture, even after a collapse of the agricultural economy in Zimbabwe since the land seizure).

Examples Of Wealth With Greater Economic Equality

This isn't to say that the stark inequalities we see in the United States are necessary to prosperity either.

Japan and almost all of Europe has far smaller contrasts in wealth between the rich and the the rest of the population than the United States. Indeed, the United States distribution of wealth looks more like a Third World country than it does like a modern industrialized democracy.

Also, wealth distribution isn't terribly closely tied to usual suspects like tax policy and state regulation of the labor market. While Europe has largely chosen to organize its economy to work fewer hours than Americans do and impose higher taxes to support a stronger social safety net, Japan has taken a very different approach. Japan is neck and neck with the United States in both its high number of hours worked per person, and its low tax levels as a perecentage of GDP. Yet, the only country in the world with less income inequality than Japan is Denmark.

Government policy can foster an "ownership society" where the middle class has greater wealth, this wealth heightens social equality, and this shift fosters a sense of national solidarity because far more people have an economic stake in the system. But, the kinds of policies that the Bush Administration has fostered don't move us in that direction.

The most effective "ownership society" transitions in American history have been characterized by massive government largess for average people. The first was the Homestead era, when the government gave away tracts of land to anyone looking for a fresh start in the West.

The second was the post-World War II era whose signature policy was the G.I. Bill. The G.I. Bill provided government aid that allowed veterans (who made up a huge share of the adult male population) to get higher education and own homes. Federally sponsored corporations created the modern middle class mortgage market, also vastly expanding home ownership. Unions were strong which gave large numbers of working and middle class Americans jobs that paid a decent wage with benefits and relatively fair conditions of employment. Widespread employer provided health insurance and pensions (both, in part, creations of lingering war era wage controls) came into existence.

The benefits of the Social Security safety net, created in the Great Depression, became more noticable as more people lived to retirement age and people had fewer children. A massive reduction in poverty among the elderly had the side effect of allowing making some meaningful inheritance something most middle class families experienced, as opposed to something restricted to a privileged few.

Achieving progress now will take new efforts. But, we know from these experiences that it can be done.