That being said, while the coming two years will be a very bad time to own bank stocks or bonds or to have uninsured deposits at banks (over the $100,000 FDIC limit), the economy will not completely collapse (though we should have a decent recession) and the world will move on.

The main thing to do is make sure that you and any friends and relatives never have more than $100,000 at any bank. If you wish to keep more, you may want to visit the FDIC website to see if your type of account is protected for more money (some are). You can search for your bank here and find out if it is insured by the FDIC and you can view financial information on your bank, even if it is private. For example, try searcing for “Home State Bank NA” in zip code 60014* (see random note at bottom of post). Then click on “Last Financial Information”, and on the next page click on “generate report”. This brings you to the bank’s balance sheet. If you click on the link towards the bottom for “past due and nonaccrual assets”, you will be taken to the good stuff. You can see that past-due loans have more than doubled over the last year. Unsurprisingly, much of the increase ($2.5m) was from “construction and land development loans”. It also pays to note that this big increase in past-due loans was solely in the 30 to 89 days late category. A more agressive bank might still be accruing interest on those loans. However, this is a conservative community bank and as you can see towards the bottom of the page, all loans that are more than 30 days late are non-accrual. (An interesting discussion of regulatory vs. tax requirements for deciding which loans are non-accruing can be found here.)

If you go back to the main balance sheet page and click on “net loans and leases” you can find the breakdown of loans. This is a good place to find out how risky your bank’s loan portfolio is. Unfortunately for Home State Bank, 20% of their loans are construction and land development loans. This bank is based in the far northwest exurbs of Chicago, so I think it likely that the bank will take a huge hit here. If you click on “1-4 family residential” you can see the breakdown of these loans. Luckily, most of these are first mortgages. Overall, Home State Bank looks okay. What about your bank?

If you have accounts as a credit union, visit NCUA to see details on insurance of your deposits. You can find your credit union and then request that a financial report be emailed to you. As an example I uploaded the report on my credit union. You can download the Excel Spreadsheet here. When analyzing credit unions, be aware that they will generally have more real estate exposure than similar commercial banks. Important things to examine are delinquent loans as a percent of assets (sheet 2, line 21 in the spreadsheet), asset mix including the amount of REO (sheet 4). If you are afraid of a bank run sparked by articles similar to this, take a look at the amount of uninsured deposits (sheet 5, lines 46-50). Delinquent loan info is always interesting (sheet7). For most of the data in the spreadsheet, an average of peer group credit unions is provided as well, making comparison easy. Overall, I think West Community looks quite safe.

What should you do if your bank doesn’t look safe (such as National City, where I have multiple accounts)? First thing that you should do is make sure your deposits are insured. Then make sure that you have enough cash in safer banks so that you can last awhile if you temporarily lose access to your money. Up until now the FDIC has been very good at getting depositors quick access to their insured deposits at a failed bank, but if things get really bad and big banks go down the FDIC could become backed up and take weeks or months to grant depositors access to their money. It pays to be prepared for such a scenario, even if it is unlikely.

*This bank, by the way, provided me with my first mortgage. Easiest mortgage I ever got — my father and I ran into Steve Slack, the bank president, while dining at the local country club, and I mentioned that I was buying a house in St. Louie. Slack gave me his card and told me to give him a call when I get close to finding a house. There are benefits to relationship banking–my extended family has banked there for three generations and uses the bank for a family company.

Disclosure: I am short several regional and local banks. 

But the current mortgage crisis is only the pinnacle of the problems with our debt-accepting culture. See the new report by the American Interest, a think tank. They fault credit cards, payday lenders, and especially state lotteries for encouraging spending and debt and discouraging savings. It is amazing to me how much low income households spend on lottery tickets. It is galling how the states take from the poorest and then give it back in welfare, food stamps, and section 8 housing assistance. In the taking the government discourages savings and in the giving it discourages work.

It is time for Americans to learn that it is good to save. Having a nice car is not going to bring you happiness. Having a 4,000 square foot house isn’t going to bring you contentment. But I can assure you that being debt-free and having enough money saved up to not worry will make for less stress, a lower risk of divorce, and more happiness and satisfaction.

A: One is a scum-sucking bottom feeder and the other is a fish.

I have recently made the acquaintance of a law firm that appears to use the above joke as its guiding principle. That firm is Friedman & Wexler. I recently got a new cell phone number and it just so happens to be the old phone number of someone who didn’t pay her bills. Friedman & Wexler has been playing the part of the collection agency and has been harassing me with automated phone calls to try to get me (actually, the former user of the phone number, Jasmin) to pay them. I sent them an email and asked them to stop harassing me and yet they keep calling me. Unlike with real collection agencies, no one comes on the phone if I pick up; the message simply says to call them. I am not about to waste my precious time trying to reach someone there and tell them that my name is not Jasmin and that I don’t owe their client money, so I’ll just ignore their calls for the next month and then I will get a new phone number with my shiny new 3G iPhone.

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Total Debt Matters

Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (ie, money not spent on necessities). Total household debt is at an all-time high. The savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition, “Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”

Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.

These are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about 4 percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.

Inflation Matters

Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.

Inflation in the US is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.

See Also

Option ARMageddon take on this issue

The Coming Mortgage Crisis: Part 1
The Coming Mortgage Crisis: Part 2

Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.

The Cataclysmic Shift

The problem with the housing market bulls is that they are thinking within the framework of past housing downturns. The current downturn is unlike any other since the Great Depression. No other downturn has started with houses so overpriced relative to rents. Few downturns started with such reasonable interest rates. No other downturn saw double digit house price declines across the country. This downturn is different, and it is going to lead homeowners (or homedebtors, as the Irvine Housing Blog calls those who have little equity) to change their behavior in ways that only the pessimists such as myself anticipate.

The problem with most predictions is that they are linear extrapolations of the past into the future. Have global temperatures been rising? They will continue to rise at the same rate. Has crime been increasing? It will continue to increase at a similar rate. The problem is that significant change often comes suddenly. That is why no one who knows anything is worried about the gradual increases in the Earth’s temperature that will occur if global warming continues. What really scares people is the possibility (however remote) that the changes could accelerate or could cause something unexpected to happen (such as the jet stream moving or the ocean currents changing). A thorough review of the history of global temperatures reveals that such cataclysmic change is not unusual.

In the case of housing, the cataclysm will come within the next couple years. It will be fueled by two factors: option ARM mortgage recasts and house price declines. (Slate has a worthwhile take on what will happen, but its analysis is less detailed than mine.)

Why House Prices will Continue to Decline

House prices are elevated relative to rents and relative to incomes, especially in the hottest markets, such as California, Nevada, Florida, and Arizona. However, price increases in middle America have been no less astonishing. One example with which I am all too familiar is the house I just sold in the Saint Louis suburb of Maplewood. Zillow has a decent graph of the house’s value, although it is not completely correct. If you look at the county assessor’s website (and search by the address) you can see that the house sold for $100k back in 1997 and then for $188k in 2004. I just sold it for $165k. Over this period of time few renovations of note were done on the property and the neighborhood did not improve significantly. The employment situation in the area has not changed. So from 1997 to 2004 the house appreciated by 88%, while between 1990 and 1997, during great economic times, the house appreciated by only 25%. In relation to both rents and area incomes, the house is still probably 20% overvalued.

Moving from the anecdotal to the statistical, we can see that this is not an isolated situation. The chart above shows housing starts and permits for the last 30 years. Over this period the population has increased at a fairly steady rate. Since 2003 there have been too many houses built. This will lead inevitably to falling prices.

If you look at the ratio of income to house prices in the above graph (from Piggington’s Econo-Almanac), you will see that house prices are way higher than they should be relative to incomes (while this graph is for one area of California, prices are elevated relative to incomes across most of the country). While creative financing can lead to a bubble in prices, there is no way for house prices to remain unaffordable indefinitely.

Another thing to consider is that house prices remain tethered to rental prices over the long term. If renting is cheaper than buying, people will choose to rent rather than buy and house prices will fall. House prices have never been so much higher than rental prices than they are now. Above is a chart of the ratio of the OFHEO house price index to the CPI-Owner’s equivalent rent.

Another factor weighing on prices is the increase in foreclosures. Banks that own foreclosed houses are motivated sellers and they will cut the prices so that they can sell their inventory. Increasing foreclosures will increase supply and decrease prices of transactions. Why pay $200k for a house when your neighbor but his out of foreclosure for $140k? Foreclosures are actually understated because banks often don’t have the manpower necessary to foreclose and sell delinquent properties.

The foreclosure problem will soon get much worse. Considering that it often takes over half a year (and can take much longer) between when a homedebtor falls behind on a mortgage and when the house is repossessed, the current wave of foreclosures began before house prices had fallen significantly. With prices now down 20% in many areas and 30% or more in some areas, the rate of foreclosures will increase drastically over the next year. Those that need to sell and who have little equity will be unable to sell for more than they owe. Short sales are difficult, so foreclosure will be the last resort for many who need to move.

Even though asking prices for houses have fallen dramatically already, they have not fallen nearly enough: witness the low volume of house sales relative to prior years. In the graph below we can see that the spring selling season in San Diego has been a bust, as it has elsewhere (image from the Bubble Markets Inventory Tracker blog).

Option ARM Recasts

Besides falling house prices, another factor in the coming mortgage crisis is the coming recasts of millions of option ARM mortgages. Most of you will be familiar with the problem of interest rate resets on ARMs (adjustable rate mortgages). This problem is well-known. Almost all ARMs have fixed rates for the first couple years and then the rates reset to market rates. Considering the current low interest rate environment, this problem is likely overblown.

The greater problem, however, is recasts. Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.

Option ARMs are highly prevalent, especially in the most bubbly markets. See the following map and click on it for a larger version (courtesy of the Irvine Housing Blog):

The Coming Crisis

The coming crisis will be caused by option ARM recasts, falling prices, and banks’ increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. Economy.com currently estimates that 9 million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.

The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.

The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.

I like Vanguard’s target-date funds because of their low costs. While they tend to be more conservative than other company’s target-date funds, an investor willing to take on more risk could easily do so by investing only in the longest-date fund, no matter when that investor plans to retire, or by supplementing the target-date fund with a pure-stock index fund.

Most credit cards offer downloading into Quicken. I like using my Discover card because it will download the most easily into Quicken. Most other cards (such as those by Chase) require a visit to the website to download transactions.

A number of brokerages offer automatic downloading into Quicken of transactions, including E*trade, Scottrade, and Ameritrade. My main broker, Interactive Brokers, requires a visit to its website to download trades to Quicken. Of course, buy-and-hold investors should not use IB; the only reason I use it is because it has a good platform for short selling.

A few hints:

• Track depreciation of assets such as cars. I track all my large assets in Quicken. Each year I have depreciated my car, a 2003 Mazda Protege, using a straight-line 8-year depreciation schedule. This tracks the real loss of value of the car.
• Use mark-to-market accounting. I own a rental property, a house, and a chunk of land. I anticipate selling the rental property sooner rather than later and have reduced its value in Quicken by the 6% commission I will likely pay. I have also reduced its value by an extra $10,000 in market-value losses I have suffered. I have likewise reduced the value of my house by about $30,000 in market value that it has lost since I bought in 2003. I have increased the value of the land by a couple percent a year. I am still carrying it at a price below what I could get by selling it.
• Capitalize home improvements. Home improvements (not repairs) increase the value of your home. Capitalize them by transferring the money you pay (in the program) to the asset account of your house. Do not do this for improvements that will not increase the value of the house.
• Track your net worth. This can be a good motivator. My financial goal is to grow my net worth by over 10% per year. For those with significant debt, seeing a large negative net worth can be a good incentive to save.

Doing all the above lets me track my net worth very closely so that I can see if I am making progress towards my financial goals. If you wish to improve your financial performance it pays to track it. Tracking your finances closely will help you know how you are doing and it will motivate you to do better.

In comparison, buying a superior computer for $500 and then paying 30% on credit cards for one year would cost $650. Of course, my favorite method, saving the money in a bank account, would cost only $500. It would only take 17 weeks of saving at $30 per week to be able to pay cash for a superior computer than the one issued by Guaranteed Consumer Funding.

Some people wonder why many poor people are poor. Medical problems and job problems are often reasons, but the largest single reason is an unwillingness to delay gratification and save. While income matters, avoiding spending matters even more. I know a man who makes $200,000 per year as a financial adviser who has saved less for retirement than a woman who never made more than $30,000 per year (and who put a kid through college as a single mother).

The best way to save is to make sure you are not tempted to spend. If you get a raise or a better-paying job, increase the proportion of your income that you put into your 401(k) and IRA. You do not need a fancy house or a new car. As for myself and my dear wife, we are taking my advice. My wife will be putting 50% of her income at her new job into her 401(k) and I am putting 100% of my eligible income into a solo 401(k). We will also contribute the maximum to our IRAs. From income that we are not eligible to stick in a tax-deferred account we will have just enough left over for living expenses. That way we will not be tempted to buy unnecessary things such as my next car.

How can we afford that? We have a modest home, drive a 4.5 year old compact car, and because I work from home, we only need one car (that saves us about $5,000 per year). We still have plenty of money left for the good things in life, such as a 7-year old $60 bottle of Tokaji wine I just opened today (which is rated 95 by Wine Spectator; I find it to be marvelous).