The option-ARM crunch and the housing crunch

Homeowners with option-ARMs may not be able to wait out a housing-price “correction.” If they start selling in large numbers, we could see a chain-reaction crunch.

Note that the option ARM crunch (see previous post) has the potential to make the housing-price landing a good deal harder.

Usually, when house prices go down, sellers pull back; you could describe this as speculative holding or as loss aversion, but either way transaction volume drops because homeowners don’t want to sell their places for less than they think them to be worth.

But people who can’t make their suddenly “adjusted” option-ARM payments and don’t have any equity to refinance may have no alternative to a distress sale except foreclosure, and the banks aren’t going to want to sit on piles of houses either. So we might see the sort of “selling climax” that characterizes the end of a stock-market dive.

The difference is that big institutions don’t generally buy individual houses as investments, so it’s hard for big pools of speculative money to come in if a selling panic leaves houses underpriced compared to some external standard of value such as the capitalized value of the rent. Being ready to step up and buy in the face of that sort of crisis is an excellent way to get either rich or broke in a hurry.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: Markarkleiman-at-gmail.com

5 thoughts on “The option-ARM crunch and the housing crunch”

  1. "The difference is that big institutions don't generally buy individual houses as investments, so it's hard for big pools of speculative money to come in if a selling panic leaves houses underpriced compared to some external standard of value such as the capitalized value of the rent. "
    So far…
    Is there a good reason for this? Is there a reason why the market in rental *apartments* is (at least in the places in CA where I have lived) dominated by companies, but the market in rental *houses* is dominated by individuals? My guess is that there is some tax scam that makes it work out this way, but, especially with GWB in the White House, tax scams can always be extended (cf agribusiness and family farms).
    I'm not convinced this would even be a bad thing. It is conceivable to me that, with the US population as mobile as it is, a population that owned fewer houses, but could easily and fairly rent might be better for everyone. For a start, if the two halves of LA that each seem to work an hour from where they bought their house each swapped places we'd all be better off.
    Like many political fetishes, I suspect that the idea of every family owning their own home is one of those ideas that may, perhaps, have made sense in 1930, and perhaps not even then, but may well not be especially relevant to the society of 2006.

  2. A simpler explanation. There is a lot of O(# of properties) costs in the rental business, which is a lot of overhead. Thus companies are interested in properties with lots of units (apartments).
    With individuals, its either their old house after they upgraded, or a collection of houses that were purchased over the years, with a lot of sweat equity for the O(# of properties) houses.
    Also, not only is there no institutional savior, but prices have to drop 30% (or more!) in real terms in the bubbled areas (eg, California) before it even starts to make sense as rental property.

  3. > Is there a reason why the market
    > in rental *apartments* is (at least
    > in the places in CA where I have lived)
    > dominated by companies, but the market
    > in rental *houses* is dominated by
    > individuals?
    I suspect that west of the Mississippi the culture and laws have strongly favored large apartement complex development over the last 50 years; such developments require too much capital and management time for an individual or small partnership to handle. East of the Mississippi there are still a fair number of 3-, 4-, and 6-flats that are owned by individuals, families, and backyard partnerships. The same would apply to houses: the individual can afford to own and manage 1 or 2 rental houses, and there isn't a huge economy of scale in owning more as there is with a large rental complex.
    Cranky

  4. I've got a friend who bought a house, was renovating the basement and was hoping to flip the house before the interest-only ARM switches to a "principle + interest" ARM this winter. As rates have also gone up in the past 5 years, he's looking at a 50-100% increase in his mortgage. He was hoping to find "a greater sucker" to buy his place and get into another interest-only place, but instead, it looks to him like he's going to be living there for another decade.
    A point I was making in the previous post was that the mid 80s burst in real estate was further driven by the S&Ls and banks owning large quantities of foreclosed properties ending up themselves in liquidation and all their properties dumped onto the market at once, rather than dribbled out in a measured pace to keep prices from collapsing.
    I think most of the home mortgages are nowadays repackaged as "MBS" and sold off to investors and mutual fund companies in large packages. When the bubble does burst, it might end up wiping out a lot of IRA and 401ks.
    >Is there a reason why the market in rental *apartments* is (at least in the places in CA where I have lived) dominated by companies, but the market in rental *houses* is dominated by individuals?
    Individuals can afford to purchase a house to rent out (frequently, they lived in it before they moved). Here in Denver, the "second job" of most bus drivers is owning homes they rent out. Apartment buildings tend to sell for 7-8 digit prices which isn't something that individuals can swing. Many books on getting rich reference purchasing a house, renting it out, then moving up from there. One can find those in some of Robert Allen's books: Nothing Down, Creating Wealth, Multiple Streams of Wealth. An individual can take care of the maintainence needs of a couple of houses, but once one ends up running more than say 8-10 apartments, it can become an almost full time job.
    As for the tax-scam feature, you can thank Proposition 13 for that. As you know, with Prop 13, one's tax basis changes when the property changes ownership. Business oriented properties (office buildings and apartment complexes) are usually owned by a shell company. You don't sell the property, you sell the company *owning* the property, therefore the sale of property never happens and the taxes never go up. You don't see this in other states because they lack Grover Norquist's Prop 13.
    Before Prop 13, if you got a job on the other side of LA, you'd move, after Prop 13, you can't afford to do so, because tax rates go up to counter the effect of all those frozen tax bases. The effect of the screwy real estate games/scams/cons in CA will vanish when they get rid of Prop 13.

  5. Peter
    Great analysis. I would add to this:
    – 40% of US MBS securities are held by overseas investors, primarily the Asian central banks
    If the US MBS market gets in severe trouble, then the Chinese and Japanese and Koreans are going to take a bath.
    *however* there is the question of the Fannie Mae, Ginnie Mae, Freddie Mac 'implicit' guarantee by the Federal government (these things are priced as if the US government guarantees them– in fact the Treasury has a very limited authority to do so).
    If the US dollar were plunging, US interest rates skyrocketing because these things suddenly became toxic waste with the overseas investor, would the US government (read: taxpayer) have to step in? The problem could be several times that of the Resolution Trust/ FSLIC debacle of the Bush I Administration.
    Add to that: many of these MBSs are held in leveraged portfolios by hedge funds. that leverage comes from banks lending money to the HFs. So an MBS crash could force the hedge funds to sell (downward price spiral) and the banks to cut credit across the economy.
    On such scenarios you can get a very painful set of outcomes.

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