Home Prices over Time

Historically, there was good reason to believe that homes represented stability, safety, and security. For more than half a century, home prices had marched steadily upward at a rate exceeding inflation by about one-half of 1 percent annually, with very little volatility, as shown in Figure 1.1.

Figure 1.1 Real Home Price Index, 1950-2000

Source: Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005.

Figure 1.1 Real Home Price Index, 1950-2000

Source: Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005.

Beginning around 2000, however, home prices started to rise at a rapid rate and became completely disconnected from their historical trend line (shown in Figure 1.2).

There were many reasons for the upward movement, as we'll explain in detail in Chapter 2, but the biggest driver of the housing bubble was the simple fact that the amount an average homeowner was able to borrow to buy a house tripled in a relatively short period of time, as shown in Figure 1.3 .

Prior to 2000, the typical borrower could borrow roughly three times his income to buy a house. Figure 1.3 shows that in January 2000, a person with pretax income of nearly $34,000 (the national average) could take out a mortgage of 3.3 times this amount, or $110,000. Of course, the borrower had to have a 20 percent down payment and a decent credit history, and banks were rigorous about evaluating the ability to repay. But all this began to unravel as the years passed.

By January 2004, average pretax income had risen 9 percent to $37,000, but the amount that could be borrowed rose 60 percent

Figure 1.2 Real Home Price Index, 1950-2008

Source: Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005, as updated by the author.

Figure 1.2 Real Home Price Index, 1950-2008

Source: Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005, as updated by the author.

  • 200,000 -
  • 100,000 -
  • Pretax Income
  • Borrowing Power

^^^^ 9.2X in January 2006

3.3 X in January 2000

Figure 1.3 Average Income and Borrowing Power

Source: Amherst Securities.

to $176,000, a 4.8X ratio. A year later, the figures were $38,000, $274,000, and 7.2X, and by January 2006, with income of only $39,600, the amount that could be borrowed to buy a house was an astonishing $363,000, a 9.2X ratio. This enormous borrowing power persisted for another year-and-a-half until the housing bubble began to burst in mid-2007.

There were a number of factors, including falling interest rates, driving this threefold increase in borrowing power in only six years, but by far the biggest was that lenders grew willing to lend up to the point that debt payments consumed 60 percent of a borrower's pretax income, whereas historically the permitted ratio didn 't exceed 33 percent. Worse, little or no down payment or documentation was necessary, and interest-only loans proliferated.

Suddenly throwing such a massive amount of capital at a relatively stable asset base caused prices to skyrocket, which led to a self-reinforcing cycle: In order to afford a home, prospective homeowners had to borrow more and take on risky, exotic mortgages instead of conservative 30-year, fixed-rate, fully amortizing mortgages. In turn, exotic mortgages and loose lending terms allowed homeowners to borrow much more money, thereby driving prices ever higher.

The bubble manifested itself in different ways in different parts of the country. As discussed later, in inner cities like Detroit, equity-stripping schemes were common; in Florida, Arizona, and Nevada, there was widespread speculation and overbuilding; and in California, which has 10 percent of the nation 's homes but is where 34 percent of the foreclosures are happening (44 percent by dollar value), the bubble was primarily an affordability problem. That's not to say there wasn 't equity stripping in California's inner cities nor an affordability problem in Florida, but these are the general characterizations.

Figure 1.4 shows what happened to housing affordability in three cities in southern California: Los Angeles, Riverside, and San Diego. One can see that the percentage of households that could afford the average home in these three cities, as measured by the National Association of Home Builders (NAHB)/Wells Fargo Housing Opportunity Index, plunged as this decade progressed, to the point that fewer than 10 percent of households could afford the average home using a standard mortgage.

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  • Los Angeles, CA
  • Riverside, CA
  • San Diego, CA

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Figure 1.4 Home Affordability in Three Cities

Source: Copyright © National Association of Home Builders 2009. All Rights Reserved. Used by permission. "NAHB" is a registered trademark of National Association of Home Builders. "Wells Fargo" is a registered trademark ofWells Fargo & Company.

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