Even though the recent financial crisis is barely in the rearview mirror, risk is starting to build once again in both the U.S. mortgage and housing markets.
Contrary to the prevailing view that only borrowers with pristine credit records can get a mortgage these days, many risky loans are still being made. A new index published by the International Center on Housing Risk at the American Enterprise Institute measures this risk month by month, based on about three-quarters of all home-purchase loans extended across the country. And the index clearly shows that many of today's mortgages would not perform well under stressful conditions. This conclusion holds for the nation as a whole and for nearly every state individually, California included.
Here's why. In recent months, fully half of all the home loans covered by the risk index had a down payment of 5% or less. With so little money down, those borrowers would be underwater with only a modest decline in housing prices. In addition, for nearly half of the recent loans, borrowers' monthly payments on their mortgage and other debt exceeded 38% of their pretax income, the traditional threshold for acceptable payment burdens. Such borrowers could find it difficult to make their monthly payments if they came under even moderate economic stress, such as a temporary layoff or a reduction in work hours.
The Federal Housing Administration is the prime source of this risk. It now guarantees more than a quarter of the newly originated home loans, and it does so with little regard for risk. Under the banner of expanding homeownership, the FHA provides risky loans to households that often lack the resources to make the payments if anything goes wrong.
Home prices are also rising at an unsustainable pace. For the nation as a whole, prices increased 11% last year, according to the S&P; Case-Shiller index. The jump was even larger in the major California markets: 21% in Los Angeles, 23% in San Francisco and 19% in San Diego.
The Fed's easy monetary policy, which has kept mortgage rates very low, has been a key factor behind the rise in house prices. Another factor has been strong investor demand for distressed properties. At the same time, the supply of available homes has been limited. Housing starts, while up from their lowest point, remain well below normal, in part because builders shed capacity during and after the recession. Reflecting these factors, house prices in the hotter markets around the country may already be above the levels warranted by household income, rents and other economic conditions.
Does this mean we are likely to see another housing bubble? That's hard to say. Nonetheless, the risk of a price overshoot of some magnitude is especially high in California. According to Fitch Ratings homes in Los Angeles, San Francisco, Oakland and San Diego are overvalued by 20% or more. Other analysts see California markets as fully valued rather than overvalued. But even if this is correct, it is worth noting that historically, many areas of California have had extremely volatile home prices.
Given that risk is rising, how should a prospective California home buyer decide whether to jump into the market? Start by comparing the price of a home you are considering to what it would cost to rent. Go to Zillow.com look up the home's "Rent Zestimate," and then divide the annual rent estimate by the home price to calculate the home's gross yield.
For example, a $500,000 home with a rent estimate of $3,000 a month ($36,000 a year), would have a yield of 7.2% before accounting for maintenance, utilities, taxes and other costs of homeownership. As a rough rule of thumb, a yield of 8% or more means the home is a relative bargain, while a yield below 5% means the home is likely overpriced. For yields between 5% and 8%, the rule of thumb doesn't produce a clear conclusion about valuation. In this situation, a buyer should plan to stay in the home for at least five years to spread the costs of buying and selling the house over a longer period, which will reduce the odds of losing money on the purchase.
For a more in-depth analysis, try using an online calculator that assesses the merits of buying versus renting, such as the New York Times' buy-rent calculator. It allows you to input many variables for buying and renting, and calculates whether you will be up or down after six years. Although this is a useful tool, keep in mind that the result will depend on your assumed outlook for home prices.
Even if a house appears to be a good deal, the more important question is whether it's something you can comfortably afford. To gauge whether the mortgage you would be taking on is affordable, you can go to the Table of Risk at HousingRisk.org. The table estimates the risk of defaulting on the mortgage in a severe real estate correction.
You will need three pieces of information to use the table: the ratio of your proposed loan amount to the purchase price of the house (the loan-to-value ratio), your FICO credit score and the ratio of your total debt payments for the mortgage and other loans to your pretax income. If you don't know your FICO score, you can get a free estimate at http://www.myfico.com/Fico-Credit-Score-Range-Estimator.
With house prices already up substantially from their lows, today's home buyers need to pay close attention to risk. Prospective buyers can protect themselves by using newly available tools to analyze local market conditions, and by realistically assessing their own financial situations before making such an important decision.
Edward J. Pinto and Stephen D. Oliner are co-directors of the International Center on Housing Risk at the American Enterprise Institute. Oliner is also a senior fellow at the UCLA Ziman Center for Real Estate.