Tuesday, January 25, 2011
Tuesday, January 4, 2011
The iron grip of ARMs on California real estate
The iron grip of ARMs on California real estate | first tuesday journal online
This article discusses how the ratio of adjustable rate mortgages (ARMs) to all loans originated in California can be used to determine the health and direction of California’s near-term real estate market.
Data Courtesy of MDA Dataquick, the US Federal Reserve, and Standard and Poor’s
The above charts present two real estate market perspectives on adjustable rate mortgage loan (ARM) volume in California. Both charts track ARM loans as a percentage of all mortgages recorded in California (the blue line), called the arms-to-loans (ATL) ratio. The first chart juxtaposes California’s ATL ratio with the fixed rate mortgage (FRM) rate for the Western Census Region (the green line), while the second chart joins the ATL ratio with the combined monthly tri-city average of low-tier home pricing in San Diego, Los Angeles and San Francisco (the red line).
The ATL ratio is a crucial measure of the relationship between ARMs and FRMs, and can be used to determine probable sales volume and price movements for 12 and 24 months forward (respectively). [For a more detailed look at home pricing in California, see the first tuesday Market Chart, California Tiered Home Pricing.]
ARMs depend on FRM Rates
The availability of purchase-assist money is the single most powerful engine driving price movement in California real estate transactions, as shown by the boom in sales volume and pricing caused by excess funding in the mid-2000s; a phenomenon called the financial accelerator effect. Purchase-assist money is delivered almost exclusively by either ARMs or FRMs (except for the very few buyers who pay cash). [For more information about the financial accelerator, see the May 2010 first tuesday article, Cleaning up after the ruptured housing bubble.]
Because mortgage financing is so dominant in sales transactions, the friction in the movement between the 30-year FRM Rate and the ATL ratio is essential to the understanding of brokers who wish to hazard a prediction of what lies ahead for their real estate market.
Combined in analysis, these two factors – the FRM rate and the ATL ratio – have the power to predict California’s future home sales volume and price movement. Local market conditions, on the other hand, seem to have little influence on sales volume and pricing, since both are controlled by financing trends, which are moved only by the bond market and federal monetary policies. [For a more global review and critique of ARMs, see the March 2010 first tuesday article, The Danger of an ARMs Buildup.]
The FRM-ATL Connection
30-year FRMs are the most basic and essential form of financing for homebuyers in the real estate market. If FRMs are available at comparatively low rates, and the homebuyer is well-informed (and somewhat rational), the homebuyer will almost always choose the FRM over the much riskier ARM loan.
In a normally functioning purchase-assist and refinancing mortgage market, the percentage of ARMs – the ATL ratio – rises and falls only in direct response to changes in FRM rates, in sympathy until friction develops and leads to a deviation in movement between the ATL ratio and FRM rates. Such a deviation is a clear warning of an impending distortion in real estate sales volume and pricing.
As the top chart vividly indicates, observed rises in FRM rates tend to lead to increases in ARM volume, the normal situation. The reasons are intuitive, since ARMs allow borrowers to obtain more funding when the FRM rate increases (sellers refuse to lower their prices in response to FRM rates, so buyers are forced to either lower their standard of living or obtain a higher amount of funding).
For instance, the number of ARMs jumped dramatically when FRM rates were raised in 1988, 1994 and 1999. Prices never moved down, as the ARM supported sellers’ demands by delivering more money than the buyers would otherwise be qualified to borrow.
It is useful to think of ARMs as bridge loans, spanning gaps in the availability of purchase money when FRM rates rise. Any rise in FRM rates immediately reduces the buyer’s purchasing power, since lenders do not permit buyers to make loan payments higher than 31% of their income. Higher interest rates always mean lower principal amounts are available to borrow. [For more on the influence of rates upon the buyer’s ability to get financing, see the first tuesday Market Chart, Buyer Purchasing Power.]
When FRM rates rise, ARMs tend to keep prices from falling. Unfortunately, ARMs originated in excess will quickly cause prices to rise during periods of flat or declining FRM rates. ARM financing permits sellers to raise prices beyond what buyers would otherwise be able to pay. Increased availability of funds from ARMs help stabilize the market in a time of temporarily high FRM rates, but they can just as quickly lead to a home pricing bubble and a potential market crash when the ATL ratio is running contrary to the FRM rate movement as occurred in 1993 and 2002.
In the past, ARMs in healthy markets have generally made up approximately 20% to 40% of the home loan market, while the remainder is made up of FRM loans. If the ATL ratio exceeds 40%, which normally happens when FRM rates rise too high, it is a sign of instability in the financing market, and forebodes potential problems for homeowners and homebuyers in the near future – weaker sales volume and home prices.
Forecasting the future
With FRM rate movements in mind, it is possible to forecast the future of sales volume and sales price trends by comparing FRM rates with movement in the ATL ratio. To do so, take a close look at the correlation from year to year between FRM rates and the ATL ratio on the first chart above.
Ordinarily, the ATL ratio rises and falls in tandem with FRM rates, roughly following it in a stable and nearly parallel relationship. However, this stable relationship can and does sometimes fail when external factors cause the ATL to move contrary the FRM rate. Such external factors may include:
increases in jumbo loan demand;
rapid shifts in demographic demands to buy or sell;
too much or too little construction activity; or
changes in government regulations on homeownership or mortgage financing.
You can develop an understanding of what will be the real estate sales volume for the next 12 months, and sales price movement for a full 24 months by following any failure in ATL/FRM relationship.
To predict home sales volume and pricing in California, the only figures you need are the ATL ratio and the FRM rate for the past 12 months.
In the real estate market, home sales volume tends to rise and fall in a cyclical fashion corresponding to economic recessions (represented above by gray vertical bars on the charts) and booms. Home prices change primarily due to prior changes in sales volume, although the pricing inertia generated by rising sales volume tends to continue for 8 to 12 months after home sales volume reaches its apex (this delayed change in pricing, which is particular to SFR property, is referred to as the sticky pricing phenomenon). [For a more thorough analysis of sticky pricing, see the first tuesday December 2009 article, The Flat Line Recovery: A Side-Effect of Sticky Housing Prices.]
To make an accurate and well-informed prediction of home sales volume and pricing in California, the only figures you need are the ATL ratio and the FRM rate for the past 12 months. When these two figures fail to move in tandem during the prior 12 months, the friction between them is predictive of the extent of the change in sales volume and pricing trends in future months. Which direction the trend will take depends upon whether the two rates become more closely aligned or more distant.
It is unnecessary to look to any information other than the correlation between the ATL ratio and the FRM rate for forecasting the next 12 months of sales volume and 24 months of pricing. All other factors either reflect the ATL and FRM rates, or are directly caused by the fluctuations in those rates. For instance, while the volume of notices of default (NODs) and trustee’s deeds (TDs) may appear to have an influence on price movement at the moment of analysis, in fact NOD/TD volume is merely a manifestation of prior price movements which are dictated by FRM and ATL frictions. [For more information on NODs in the current market, see the first tuesday Market Chart, NODs and Trustee’s Deeds.]
When the ATL ratio parallels the movement of FRM rates, both sales volume and prices will remain fairly constant in the future. This is the definition of a normal market: looking forward, readers can safely predict that neither a measurable boom in pricing nor a recession will take place in the two years following such conditions.
Instead, sales volume will continue much the same as at present for at least 12 months, and prices will remain reasonably steady, adjusting upward at approximately the rate of inflation in the consumer price index (CPI) for a longer period, another 6 to 12 months. [For the most current CPI figures, see the first tuesday Rates Page.]
However, any sustained period (12 months or more) in which the two factors are at odds with one another, as demonstrated by a widening or narrowing of the space between the two lines on the ATL/FRM chart, discloses a hazardous abnormality in the home financing market. Any such abnormality establishes a divergent trend going forward in real estate sales and pricing. Examples of such divergences are elucidated below.
Copyright © 2010 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.
This article discusses how the ratio of adjustable rate mortgages (ARMs) to all loans originated in California can be used to determine the health and direction of California’s near-term real estate market.
Data Courtesy of MDA Dataquick, the US Federal Reserve, and Standard and Poor’s
The above charts present two real estate market perspectives on adjustable rate mortgage loan (ARM) volume in California. Both charts track ARM loans as a percentage of all mortgages recorded in California (the blue line), called the arms-to-loans (ATL) ratio. The first chart juxtaposes California’s ATL ratio with the fixed rate mortgage (FRM) rate for the Western Census Region (the green line), while the second chart joins the ATL ratio with the combined monthly tri-city average of low-tier home pricing in San Diego, Los Angeles and San Francisco (the red line).
The ATL ratio is a crucial measure of the relationship between ARMs and FRMs, and can be used to determine probable sales volume and price movements for 12 and 24 months forward (respectively). [For a more detailed look at home pricing in California, see the first tuesday Market Chart, California Tiered Home Pricing.]
ARMs depend on FRM Rates
The availability of purchase-assist money is the single most powerful engine driving price movement in California real estate transactions, as shown by the boom in sales volume and pricing caused by excess funding in the mid-2000s; a phenomenon called the financial accelerator effect. Purchase-assist money is delivered almost exclusively by either ARMs or FRMs (except for the very few buyers who pay cash). [For more information about the financial accelerator, see the May 2010 first tuesday article, Cleaning up after the ruptured housing bubble.]
Because mortgage financing is so dominant in sales transactions, the friction in the movement between the 30-year FRM Rate and the ATL ratio is essential to the understanding of brokers who wish to hazard a prediction of what lies ahead for their real estate market.
Combined in analysis, these two factors – the FRM rate and the ATL ratio – have the power to predict California’s future home sales volume and price movement. Local market conditions, on the other hand, seem to have little influence on sales volume and pricing, since both are controlled by financing trends, which are moved only by the bond market and federal monetary policies. [For a more global review and critique of ARMs, see the March 2010 first tuesday article, The Danger of an ARMs Buildup.]
The FRM-ATL Connection
30-year FRMs are the most basic and essential form of financing for homebuyers in the real estate market. If FRMs are available at comparatively low rates, and the homebuyer is well-informed (and somewhat rational), the homebuyer will almost always choose the FRM over the much riskier ARM loan.
In a normally functioning purchase-assist and refinancing mortgage market, the percentage of ARMs – the ATL ratio – rises and falls only in direct response to changes in FRM rates, in sympathy until friction develops and leads to a deviation in movement between the ATL ratio and FRM rates. Such a deviation is a clear warning of an impending distortion in real estate sales volume and pricing.
As the top chart vividly indicates, observed rises in FRM rates tend to lead to increases in ARM volume, the normal situation. The reasons are intuitive, since ARMs allow borrowers to obtain more funding when the FRM rate increases (sellers refuse to lower their prices in response to FRM rates, so buyers are forced to either lower their standard of living or obtain a higher amount of funding).
For instance, the number of ARMs jumped dramatically when FRM rates were raised in 1988, 1994 and 1999. Prices never moved down, as the ARM supported sellers’ demands by delivering more money than the buyers would otherwise be qualified to borrow.
It is useful to think of ARMs as bridge loans, spanning gaps in the availability of purchase money when FRM rates rise. Any rise in FRM rates immediately reduces the buyer’s purchasing power, since lenders do not permit buyers to make loan payments higher than 31% of their income. Higher interest rates always mean lower principal amounts are available to borrow. [For more on the influence of rates upon the buyer’s ability to get financing, see the first tuesday Market Chart, Buyer Purchasing Power.]
When FRM rates rise, ARMs tend to keep prices from falling. Unfortunately, ARMs originated in excess will quickly cause prices to rise during periods of flat or declining FRM rates. ARM financing permits sellers to raise prices beyond what buyers would otherwise be able to pay. Increased availability of funds from ARMs help stabilize the market in a time of temporarily high FRM rates, but they can just as quickly lead to a home pricing bubble and a potential market crash when the ATL ratio is running contrary to the FRM rate movement as occurred in 1993 and 2002.
In the past, ARMs in healthy markets have generally made up approximately 20% to 40% of the home loan market, while the remainder is made up of FRM loans. If the ATL ratio exceeds 40%, which normally happens when FRM rates rise too high, it is a sign of instability in the financing market, and forebodes potential problems for homeowners and homebuyers in the near future – weaker sales volume and home prices.
Forecasting the future
With FRM rate movements in mind, it is possible to forecast the future of sales volume and sales price trends by comparing FRM rates with movement in the ATL ratio. To do so, take a close look at the correlation from year to year between FRM rates and the ATL ratio on the first chart above.
Ordinarily, the ATL ratio rises and falls in tandem with FRM rates, roughly following it in a stable and nearly parallel relationship. However, this stable relationship can and does sometimes fail when external factors cause the ATL to move contrary the FRM rate. Such external factors may include:
increases in jumbo loan demand;
rapid shifts in demographic demands to buy or sell;
too much or too little construction activity; or
changes in government regulations on homeownership or mortgage financing.
You can develop an understanding of what will be the real estate sales volume for the next 12 months, and sales price movement for a full 24 months by following any failure in ATL/FRM relationship.
To predict home sales volume and pricing in California, the only figures you need are the ATL ratio and the FRM rate for the past 12 months.
In the real estate market, home sales volume tends to rise and fall in a cyclical fashion corresponding to economic recessions (represented above by gray vertical bars on the charts) and booms. Home prices change primarily due to prior changes in sales volume, although the pricing inertia generated by rising sales volume tends to continue for 8 to 12 months after home sales volume reaches its apex (this delayed change in pricing, which is particular to SFR property, is referred to as the sticky pricing phenomenon). [For a more thorough analysis of sticky pricing, see the first tuesday December 2009 article, The Flat Line Recovery: A Side-Effect of Sticky Housing Prices.]
To make an accurate and well-informed prediction of home sales volume and pricing in California, the only figures you need are the ATL ratio and the FRM rate for the past 12 months. When these two figures fail to move in tandem during the prior 12 months, the friction between them is predictive of the extent of the change in sales volume and pricing trends in future months. Which direction the trend will take depends upon whether the two rates become more closely aligned or more distant.
It is unnecessary to look to any information other than the correlation between the ATL ratio and the FRM rate for forecasting the next 12 months of sales volume and 24 months of pricing. All other factors either reflect the ATL and FRM rates, or are directly caused by the fluctuations in those rates. For instance, while the volume of notices of default (NODs) and trustee’s deeds (TDs) may appear to have an influence on price movement at the moment of analysis, in fact NOD/TD volume is merely a manifestation of prior price movements which are dictated by FRM and ATL frictions. [For more information on NODs in the current market, see the first tuesday Market Chart, NODs and Trustee’s Deeds.]
When the ATL ratio parallels the movement of FRM rates, both sales volume and prices will remain fairly constant in the future. This is the definition of a normal market: looking forward, readers can safely predict that neither a measurable boom in pricing nor a recession will take place in the two years following such conditions.
Instead, sales volume will continue much the same as at present for at least 12 months, and prices will remain reasonably steady, adjusting upward at approximately the rate of inflation in the consumer price index (CPI) for a longer period, another 6 to 12 months. [For the most current CPI figures, see the first tuesday Rates Page.]
However, any sustained period (12 months or more) in which the two factors are at odds with one another, as demonstrated by a widening or narrowing of the space between the two lines on the ATL/FRM chart, discloses a hazardous abnormality in the home financing market. Any such abnormality establishes a divergent trend going forward in real estate sales and pricing. Examples of such divergences are elucidated below.
Copyright © 2010 by first tuesday Realty Publications, Inc. Readers are encouraged to reprint or distribute this information with credit given to the first tuesday Journal Online — P.O. Box 20069, Riverside, CA 92516.
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