Despite all my years in Arcadia, I’ve never been to a race at the Santa Anita Race Track. I hear it’s fun and quite exciting to cheer on your horse all the way to the finish line. The thrill of a race and potential to strike it rich on a lucky bet is more than enough to get your heart pumping. For those trying to sell their home right now, that’s probably the same feeling they’re experiencing except there’s no more potential to make any money for years. With every lowball sales transaction that goes through, the comps in that neighborhood are pulled lower from the previous week and it’s making the sellers very, very nervous.

I made the usual Sunday rounds and saw this race in a cluster of condos within a mile of each other. Traditionally, condos feel the pinch of the market before single family homes and it’s the same this time around. Some of these homes are next to each other on the same street and some are even part of the same development complex.

35 Lucille St. #A – $644k, 3bed/2.5ba, 1551 sqft, $415/sqft, 82 days
33 Alice St. #B – $718k, 3bed/2.5ba, 2084 sqft, $345/sqft, 180 days
40 Alice St. – $488k, 3bed/2.5ba, 1241 sqft, $394/sqft, 32 days
45 Alice St. #J – $478,888, 2bed/2.5ba, 1483 sqft, $323/sqft, 172 days
50 Genoa St. #A – $758k, 3bed/2.5ba, 1865 sqft, $406/sqft, 87 days
42 Genoa St. #B – $758k, 3bed, 2.5ba, 1886 sqft, $402/sqft, 67 days
41 Genoa St. #C – $686k, 3bed/2.25ba, 2144 sqft, $320/sqft, 16 days
28 Fano St. #A – $689k, 3bed/3.5ba, 2350 sqft, $293/sqft, 74 days
153 Fano St. #A – $469k, 3bed/2.5ba, 1240 sqft, $378/sqft, 131 days
598 2nd Ave. #A – $849,950, 3bed/3.5ba, 2297sqft, $370/sqft, 33 days
600 2nd Ave. #A – $799,950, 3bed/2.5ba, 2185sqft, $366/sqft, 33 days
139 El Dorado #A – $858k, 3bed/3.75ba, 2126sqft, $404/sqft, 35 days
141 El Dorado #A – $838k, 3bed/3.5ba, 2034sqft, $412/sqft, 35 days

I’ve listed 13 properties above – which one will buckle and succumb to market forces first? The new construction, vacant homes are most susceptible because their carrying costs are killing them. Their investors’ money is going down the drain with each passing day and they do not have the luxury of holding out. Owner occupied units have more of an emotional factor compared to vacant ones and traditionally hold out longer before reducing prices.

This isn’t a new phenomenon. We’ve seen it in the past and we’ll see it again this time around. Owners do all that they can to keep the asking price as high as they think their house is worth regardless of what the current market is willing to pay for it. The naive action of lying to oneself continues until a comparable home in the neighborhood lowers the price to sell while their house is still sitting without an offer. Only then will the seller budge a little and lower the price to match the comps, except by that time, the comps have shifted even lower from recent sales as potential buyers expect even better deals.

This cycle repeats as the seller chases down the market as his asking price is reduced bit by bit late in the game. If he had only priced it right in the first place, the knife catchers that bought his neighbor’s house would have put an offer in on his place instead. Many make the mistake of listing their home at 2006 prices because they believe it’s worth that much. Well here’s news for them: it was worth that much when crazy people were willing and able to sign up for suicide mortgages. Lenders aren’t giving away free money anymore and buyers are starting to realize that real estate doesn’t always go up after all.

Remember, a house is only worth what buyers are willing to pay. With more and more listings flooding the market each day, the competition gets tougher. During the boom, buyers were racing to make offers in fear that they’ll be priced out forever and in turn drove prices up way beyond fundamental, sustainable means. The market will experience a similar phenomenon as it will soon become a race to the finish with sellers trying to sell their property as fast as they can by lowering prices, offering incentives and pushing for short sales. Whether the banks will approve those short sales is another issue, but one thing is clear – the longer a seller waits to drop the asking price, the longer it will stay on the market. With so much inventory and so few qualified buyers, sellers have to face the reality that their home may not sell for a very long time.

A financial bubble by definition is the unsustainable growth of a market due to deviations from certain market fundamentals. These bubbles, much like the ones your 5-yr old blows out in the backyard, will pop. That’s just the nature of the beast. Today we will examine several major contributing factors to the expansion of the recent US housing bubble. It’s unlikely any single factor could have fueled such a massive bubble, but the combination of such factors clearly illustrate that it is more than just the sum of its parts.

A) Lax Lending Standards

What lending standards? Oh, that’s right – I almost forgot about that part of the equation. During the past few years everyone and anyone could get a loan for a house. Even if you had a bad credit score, no down payment, no assets, credit card debts, low/non-documented income or a combination of any of the above, you could apply and be approved for a home loan in a snap.

A person’s credit score is a measurement of his or her financial responsibility. Albeit not a perfect system, it’s the system we have to work with. It does not take a rocket scientist to figure out that lending big wads of cash to financially reckless people is a huge risk. The lax lending standards dictated by the mortgage industry flooded the market with a huge (and new) sector of buyers – under qualified buyers. A person with a 590 credit score and $17,000 in credit card debts at 18% interest has no business in applying for any loan, let alone a large loan for a house. The Feds added fuel to flame when it tolerated this and quietly swept the issue under the carpet as their Wall Street cronies enjoyed the bull run.

An abnormally large influx of first time buyers created an opportunity for the market to expand and grow at an abnormally fast pace. Now that investors realize that these people cannot make their payments, as evident in widespread foreclosures across the nation, lending standards will tighten and rid the market of this buyer group. Reducing the buyer pool certainly tips the scales of supply and demand.

B) Innovative Loans

As an engineer and US patent holder, I revel at innovation. It stems from creativity and marks a new age in the way we live. Unfortunately for us, the innovative loans developed in the past few years only served to prop up over-valued properties and the paychecks of fraudulent brokers, real estate agents and lenders.

Adjustable rate mortgages are not new to the market. They’ve been around and used for years, but not to the extent that it was during this rally. About a third of all new or refinanced loans made in California during the last few years have some form of payment options. That’s astounding.

Since the vast majority of the general population cannot buy homes with cash, the purchasing power of the buyer is limited by the amount of money he can borrow. Low teaser rates loans at 1%-4% allowed buyers “buy” more home than they can afford because they are borrowing money at an artificially low interest rate for the first couple of years. This fueled a silly bidding frenzy as people can borrow more money than normal for a relatively low monthly payment until the loan resets. This is not just a subprime problem; there are plenty of Atl-A and prime ARMs as well.

The IO, or interest only, loans are self explanatory. Making payments on the interest only does nothing to reduce the principle amount borrowed. The delusional buyer is really just renting from the bank. So instead of renting a residence, the buyer has to pay HOA fees and be responsible for any maintenance work as well.

Another horrendous option loan is the negative amortization loan. In a traditional amortized mortgage, you’re paying a large percentage of interest to the lender, but still making a dent in the principle amount over the course of the loan. With neg-am loans, you actually owe the bank more money than you original loan amount because the monthly payment doesn’t even cover the interest on the loan! So the remaining amount gets added to the principle and the borrower owes more and more money each month. It’s like not paying off your credit card payments in full every month, but on a much bigger scale.

C) The Growth of the Secondary Mortgage Market

The above-mentioned loans only exist because there’s a market for it. Most banks don’t hold the mortgage in their portfolio, but turn their profit through fees and points and just sell the loan to another lender. Even with lax lending standards, the banks and their stockholders are only willing to risk so much. But the home prices keep increasing so what do they do? Welcome the birth of the second mortgage.

The conforming loan amount is $417,000. A borrower who needs a bigger loan is slapped with a higher interest rate because they represent a higher risk investment. To combat that, buyers turn to a different lender for the portion of the loan over $417k to keep the interest rate down. This too pushed home prices up because it gave buyers more borrowing/buying power than risk-adverse investors are willing to tolerate. The NAR is pushing for the Feds to increase the conforming loan amount. I am against that because it does nothing to fix the affordability problem we’re facing right now.

There’s a good reason why proven fundamentals exist to keep things in check. Unjustifiable risky investments are bad investments. When the market starts to deviate from market fundamentals, trouble brews and stupidity ensues.

D) No Down Payment, No Problem

Zero down loans is the crux of it all. A 20% down payment used to be the admission ticket to home ownership. It proved the borrower is financially responsible and prudent. It also gives confidence that they are willing and capable of making the mortgage payments.

With no money down, there is zero risk to the buyer because he has no stake in any of it. This is every flipper, speculator and shady investor’s wet dream. They can “buy” a house with hopes of double-digit appreciation without any risk whatsoever. If the market tanks like its happening now, they simply return the keys and walk away with nothing more than a dinged credit score. The lender is left holding the bag with an asset worth less than what they paid.

These were the big players that caused the rally in home prices and it will be the removal of these same factors that will result in the collapse of housing market. There are no more liar loans, secondary mortgage markets nor zero down home purchases. When it’s all said and done, the banks left standing will revert back to what they know works and that is verified, documented income with 20% downpayment required.

Everyone except those in denial knows that home prices are going to take a tumble crash until it’s back to fundamental normals. Great news for buyers on the sidelines right? Well, what about the offset effects of rising interest rates? Rates have been at historic lows the past few years and it looks like Bernanke and his cronies are going to continue dropping rates in hopes of preventing a full blown recession.

Realtors will try to spin this off and sell it to uninformed buyers that low interest rates is a great reason to buy right now. I hear this argument often and it’s simply not true. Even if the Feds continue to lower rates all the way down to 1% to keep the economy afloat, it doesn’t mean it’s a good time to buy just because you can land a low interest loan. Yes, interest rates won’t stay low forever and will eventually go up quite a bit. So what does that mean for potential buyers?

Let’s take a closer look at what’s more important when it comes to your monthly mortgage payment – interest rates or purchase price? Since there are no more liar loans nor secondary mortgage market, I have assumed the traditional 20% downpayment requirement and 30-yr fixed rates. No more nilly willy lending free money. Also, for the sake of simplicity I did not differentiate between jumbo and non-jumbo loans in this example – just assume a higher rate if your loan amount will be above $417k. For the income requirement column, I’ve assumed a purchase price-to-income ratio of 4X.

All monthly payment estimates were taken from this simple mortgage calculator. As shown below, it’s clear that purchase price is more important when it comes to saving you money.

Example 1: A $320k loan at 10.5% (10.5%!!!) still has a lower monthly payment than a $480k loan at 6.5%.

Example 2: A $480k loan at 8.5% still has a lower monthly payment than a $640k loan at 5.75%.

So when everyone says it’s the “worst time to buy” because home prices have been falling for several years straight and interest rates are high (perhaps much, much higher by 2012), it’s actually a GREAT time to buy. Interest rates and home prices are on opposite sides of the seesaw because interest rates dictate how much money buyers can borrow and by extension, what home prices will be.

I’ll be okay buying a home at say 10% fixed for 30 yrs because that will mean house prices have fallen considerably from their peak prices. You can always refinance to a lower rate because rates will change over the course of 30 yrs, but you cannot change the purchase price of your house after you sign papers.

Therefore, it’s better to buy when interest rates are high and prices are low than when interest rates are low and prices are high.