Economist's Commentary: April 30, 2008

Rates May lmprove, but Higher Standards Should Stay

By Ken Fears, Manager, Regional Economics

Although the crisis in the credit market has created substantial problems for buyers and consternation for sellers and owners, it has produced some necessary changes. Many of the practices within the mortgage market at the latter part of the recent housing boom were risky and unsustainable. One pattern that signaled a loss of appreciation for risk by mortgage writers was the significant decrease in the loan-to-value ratio (LTV) on mortgages.

The LTV ratio is a measure of how much the owner of a home has invested in the purchase. A higher LTV indicates that the person has a smaller down payment in the home (assuming no second loan is used to finance the down payment). So, the lower this ratio is, the better it is from a market standpoint as the owner will be less likely to walk away from the home in case the price were to fall or payments become unsustainable.

Some interesting points can be made by examining the LTVs for all mortgages versus just those for ARM loans:

1. The LTVs on total loans fell sharply from 2000 through the middle of 2003. This decline was in lock-step with the sharp drop in rates. As monthly payments fell, buyers could use more of their reserves to reduce the principle up front because a smaller reserve was needed to buffer future payments.
2. LTVs on ARM loans dropped by nearly 2 percentage points from January of 2005 through January of 2006 and accelerated by an additional 4 percentage points in the middle of 2006 alone. This drop coincides with the period of increased usage of ARMs in response to higher interest rates, record home prices, and reduced affordability. This pattern would suggest that ARM users had larger down payments, but it is also likely that they might have been using piggy-back mortgages…one cannot discern between the two possibilities with this data.
3. After 2005, LTVs on ARMs rose quickly back to the 20% level. This pattern suggests that the initial of ARM users were trade-up buyers with large down payments. Since this data sample from the Federal Housing Finance Board (FHFB) only looks at fully amortized loans (e.g. no interest only loans), this assertion bares merit.
4. Since the share of ARMs was falling as early as 2006 in this sample, it is likely that this sample does not capture the risky, ARM loans that precipitated the surge in foreclosures and the credit crisis. In addition, the FHFB sample excludes the condo and coop sector where many investors took part. This pattern shows recognition on the part of users that rates are likely to rise, thus, the decline in the share of ARMs.
5. From the middle of 2005, LTVs rose rapidly through mid-2007, reflection of trade-up equity withering in the face of rising prices, when LTVs on all products moderated in line with credit tightening and more stringent down payment requirements. The decline was stronger in ARMs where market shell fell by half in 13 months.
6. Finally, there is a spike in LTVs for all products in December of 2007 and a sharp decline in 2008. The jump in LTVs in stronger for ARMs than long-term rates. This pattern suggests that buyers might have scrambled to exercise the last of the hay-day financing available from banks prior to banks eliminating them at year end or their terms expiring.

What this exercise shows it that a large component of the buyer population was behaving rationally and choosing to use ARMs without the interest only or negative amortization constraints. In addition, the mortgage users in the FHFB sample appear to understand interest rate risk and avoid it. This behavior suggests a rational choice on the part of core demand.

Today, conforming mortgage rates are near historic lows and jumbo loan rates are likely to ease in the months ahead. Given the right circumstances, this core component of housing demand is likely to improvement in affordability witnessed since 2005, stimulating housing demand in the later part of 2008.

This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >

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