The Marginal Home Buyer

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economic theory rests on the insight that what takes place between
a buyer and a seller at the margin — one of these in exchange
for two of that — is the central economic fact of pricing.
The price of some item at the margin is imputed to all other goods
of the same class.

mania is therefore an imputed-price mania. It cannot be sustained
beyond the ability and willingness of the last marginal buyer to
pay an equity-raising price to the last marginal seller.


the tail end of any asset bubble, people who have watched the bubble
grow from its inception kick themselves for having missed out. While
it may be true that for them, they stayed on the sidelines too long
in a truly once-in-a-lifetime opportunity, they don’t shrug it off
and say, "Lots of other people missed out, too. So what? Something
else will come along." Instead, they climb aboard on what they
think is the last train out.

manias, a few people buy in at the top. They buy an asset that will
fall like a stone from astronomical levels. People who would not
normally have been willing to roll the dice on such a high-risk
venture buy in and gratefully sign the mortgage papers. Normally,
no lender would have loaned to them. But the mania affects lenders,
too. Both participants make a once-in-a-lifetime contract. Both
will pay a heavy price when the mania ends. It is a once-in-a-lifetime
opportunity to lose money.

is true of all housing manias. We see these manias from time to
time. The sign that the end is near is when people line up to bid,
auction fashion, on properties that, five years earlier, would have
been on the market for six months. The mania is revealed by the
presence of above-asking-price prices. People bid frantically against
each other to buy a property that they would not have considered
buying two years before, or even a year earlier.

are never many of these people. At the top or the bottom of any
asset market’s big move, there are few participants. Every mania
ends when the last remaining group of potential buyers is finally
unable to afford to buy. Then the market turns down.

people who were the last ones to buy are left holding the bag. They
committed themselves to huge monthly payments. They bought in at
no money down or close to it. A month later, they are owners of
a depreciating asset that may be worth 20% less after the sales
commission than the day they bought it. But they owe full sticker
price to the mortgage company.

once-in-a-lifetime boom was not used by most owners as a way to
sell at a huge profit. Why not? Because most families don’t want
to move out of the mania region. Also, wives don’t want to rent.
The nesting instinct is ownership-biased among humans. So, most
people hang onto their homes. Then come the property tax hikes,
which are based loosely on market value, which has risen. The mania
giveth. The tax man taketh away.


prices have been driven up to manic levels in California, Las Vegas,
and east coast urban centers. Where brains congregate, where the
division of labor is high, and where businesses pay for talent,
housing prices are astronomical. I define "astronomical"
as follows:

the monthly payments on a no-money-down home are twice or more than
the rental price of a comparable home."

these markets come the Johnny-come-latelies — the people who
thought they could not afford to buy when prices were merely stratospheric.
They see the last train out leaving the station. "I’ll never
be able to buy a home!" they wail. This cry of despair has
unstated qualifiers:

  1. In this
  2. In my present
  3. At today’s
    interest rates
  4. At today’s
    property tax rates

can move. They can find lots of places to live where home prices
are half as high, and wages are only 25% less.

can invest in occupational skills improvement the money that the
mortgage/tax/upkeep will cost them. They can capitalize themselves
rather than paying off the lender for 30 years. Within a decade,
they could double their income. Then they could afford a home.

don’t. They buy the house.

interest rates will rise. But when they do, selling prices will
fall and home equity will disappear.

taxes will rise, which will force late-comers to sell at a loss.
Wait. Be patient. Shop.

people in the last stage of a mania are impatient.

is what they wish they had not done earlier.

the lenders are offering them deals.

want to become owners.

Because they want to be part of a never-ending boom. Because they
forget about rising property taxes. Because they want to know that
they will not suffer rent increases — as if property tax hikes
were not rent increases.

in the Middle Ages were locked into their family’s land. They could
not leave. They were immobile. They owned their land, but the land-owner
owned their services. They were owners, but, in effect, the land
owned them.

person who lives in a mortgaged home that he cannot afford to sell
because he owes too much on the loan is like that serf. The home
owns him. The mortgage company owns him.

unlike the serf, he can lose the home. He can be evicted if he misses
payments. He can lose his property if he cannot pay his taxes. Yet
he thinks of himself as way ahead of renters, who can shop for lower
rents, and move at any time, and do not have their credit rating
at risk for mortgage payments.

the recent first-time buyer in mania regions is now at great risk.
He stayed out of the market. He may have bought in at the top —
way above rental costs. He is locked into the loan contract. He
is stuck. The equity in his home — if any — is dependent
on a stream of buyers: other late-comers whose credit ratings are
so low that they would not have been eligible for mortgage loans
five years ago. But credit standards have dropped as long-term rates
have fallen.

short, late-comers’ net worth is dependent on even poorer credit
risks than they are. This is not the basis of long-term capital


interest-only loans with variable interest rates are available to
middle-income people. People can buy for no money down. All they
need to do is sign on the once-dotted line. These people have spent
their adult lives as renters. As renters, they have been unaware
of the following:

  1. Mortgage
    rates can (and probably will) rise.
  2. Property
    taxes can (and probably will) rise.
  3. Equity can
    (and probably will) become negative.
  4. Maintenance
    costs are born by owners.

people have had such low credit ratings that the lowering of their
credit rating for non-payment poses no immediate threat to them.
They can walk. They can leave an empty house behind. They can become
renters again.

a story run in the Los Angeles Times and picked up by other
, the situation of one woman is described in considerable
detail. The lady consented to be interviewed by a reporter. He,
in turn, offered an assessment of her seemingly precarious financial

is a police dispatcher. She just paid $211,000 for a one-bedroom
condo in Oakland, California. If you have ever been to Oakland,
the thought of paying $211,000 for a condo may come as a shock.

had sat on the sidelines for years. But then a mortgage company
offered her a chance to buy for no money down. It is an adjustable-rate
mortgage (ARM). If mortgage rates rise, her monthly payments will

Nov. 1, 2007, she will have to start paying off principal. "I
don’t know what I’ll do," she said. "I’m already working
overtime to pay my bills."

reporter got the story correct. He has assessed the risk to lenders
and borrowers. What happens when mortgage/tax/maintenance costs
rise faster than wages, which are not rising at anything approaching
the rising cost of homes?

the most dire scenario, if they owe more on the home than it’s
worth, they’ll walk away. Abundant foreclosures could spark a
downturn in the entire housing market, leading to the long-feared
bursting of what some call a housing bubble.

loans, and other forms of so-called creative financing that are
far riskier than the traditional 30-year fixed-rate mortgages,
have allowed more people to afford homes even as prices skyrocketed.

normal, non-mania conditions, as home prices rise, fewer people
buy. But in housing manias, the reverse is true, assuming lenders
can be found to finance the purchases.

the price of houses in California soared 17 percent in 2003 and
22 percent in 2004, a curious thing happened: Instead of home
ownership decreasing because fewer people could afford houses,
it rose to record levels.

the last two years, according to U.S. Census Bureau data, home
ownership in the state rose to 59.7 percent from 57.7 percent.
The previous record was 58.4 percent, measured during the 1960

home ownership in California traditionally lags behind the rest
of the nation, the 2-point increase during the last two years
was greater than in all but a dozen states.

mania is being funded. The buyers must have lenders to make the
market boom. We can readily understand buyer’s motivation in a housing
mania. What is not easily understood is the lender’s motivation.

than closing the door, lenders have apparently been opening it
wider, inviting in people . . . who would not have qualified for
a mortgage under the more rigorous standards of an earlier generation.
"If you can fog a mirror, you can get a home loan,"
said mortgage analyst Ralph DeFranco.

interest-only loan offers the ability to defer for three, five
or seven years any payment for the house itself. That allows a
potential buyer to stretch to afford a place that would be otherwise
out of reach.

course, everyone else using an interest-only loan can stretch
too. The result is that prices keep rising. That encourages still
more people to use interest-only mortgages, which fuels still
more appreciation.

extensive is mortgage lending based on interest-only contracts?
This is where things get dicey.

2001, as the current housing boom got under way, fewer than 2
percent of California homes were bought with interest-only loans,
according to an analysis done for the Los Angeles Times
by LoanPerformance, a San Francisco mortgage research firm.

last year, the level had risen to 48 percent. Nationally, interest-only
loans were used in about a third of all purchases.

things get tight, a percentage of these people will default. Nobody
knows what this percentage will be. Remember this: These people
have been renters. They have no equity. They have walked away from
housing in the past. What is to keep them from doing it again?

new federal law on bankruptcy is tighter, but it is not so tight
that lenders will be able to squeeze blood out of turnips.


think of buyers as participants in a mania. But it takes two to
tango. Lenders are equally maniacal.

seem reluctant to turn away any potential borrowers, no matter how
few their qualifications. At the moment, at least, this is a profitable
venture, although by their own admission it is becoming a riskier
one too.

the midst of what is a mania in certain large, influential real
estate markets, the voice of Alan Greenspan calms mortgage lenders.

Federal Reserve
Chairman Alan Greenspan has a different point of view. "I
do believe it is conceivable we will get some reduction in prices,
as we’ve had in the past," he said in February. But he added
this wouldn’t be a problem because housing prices have gone up
so much, providing homeowners with "a fairly large buffer."

which the reporter — who gets my vote for economic rationality
— responds:

who buy at the peak, however, aren’t going to have that buffer
— or, if they have an interest-only loan, much room to maneuver.

reporter understands the fundamental principle of economics: decisions
made at the margin. Today, as always, it is the marginal buyer who
determines the price of housing. Today’s buyers are more marginal
than at any time in history.

cannot get the words of Groucho Marx out of my mind. In "The
Coconuts," the first Marx Brothers movie, Groucho is selling
Florida real estate. He tells a crowd of mania-driven buyers about
the homes available. "You can have any kind of home you want.
You can even get stucco. Oh, how you can get stucco."

keeps getting worse. We would expect lenders to come to their senses.
They don’t.

Federal Reserve regularly queries banks whether they’re tightening
or loosening credit standards for home mortgages. In four of the
last five quarters, standards were loosened. The combined drop
was the biggest in more than a decade.

the range of home mortgage products keeps expanding. Some lenders
offer mortgages that are spread over four decades rather than
three. Others extend the interest-only period to 10 or 15 years.

few years ago, you would have had to go to an infomercial to get
the kind of deals we’re offering now," Wells Fargo home mortgage
consultant Jimmy Kang recently told a group of new real estate

interest-only loan is being matched by the adjustable rate loan.

California, the traditional fixed-rate loan is in danger of becoming
extinct. According to recent LoanPerformance data, the percentage
of new loans that are adjustable in Santa Rosa was 85 percent;
in Oakland, 84 percent; in San Diego and Santa Cruz, 83 percent;
in Los Angeles, 74 percent.

two-thirds of these loans are also interest-only, compounding
borrowers’ risk of "payment shock."

at the margin want to buy. They are emotionally committed to buying.
So, they seek rational justification in the musical chairs aspect
of the mania.

Matz and her fianc, Chris, a restaurant manager, are closing
this month on their first house, a three-bedroom in Palm Springs
that cost $495,000. They’re borrowing $60,000 from their parents
for a down payment, and financing the rest with an adjustable-rate
loan that is interest-only for the first three years.

will be extremely nervous if we decide to stay longer than three
years in that house and interest rates skyrocket," Matz said.
"We are just banking on the hope that the home will gain
enough equity by the time we sell."

every mania, there are late-comers who buy in at the top. Manias
end when the late-comers cannot afford to buy in. That marks the

ratings will fall with equity. How much money would you loan to
a person with an interest-only ARM who lives in a $400,000 home
for which he owes $465,000? This is the median price of a home in
California today: $465,000.


is nothing wrong with renting. It is wiser to buy with a fixed-rate
loan than an ARM. It is wiser to buy where rental income will pay
for mortgage/taxes/upkeep. But there is nothing wrong with renting.
In a mania, it is the wise thing to do.

mortgage loans are made by local lending institutions and short-term
national mortgage brokers. These mortgages are immediately re-packaged
and sold to investors in Fannie Mae and Freddy Mac.

homes are abandoned, there will be no local lender to take care
of them, or price them rationally, and get them sold. They will
sit there, empty — the target of vandals.

day is coming. There will be motivated sellers. When you are an
investor, always buy from a motivated seller.

the other guy’s disaster. I refer to the foreclosing lender. The
overextended buyer is long gone. There is nothing like a house sitting
empty for six months to motivate a lending institution.

23, 2005

North [send him mail] is the
author of Mises
on Money
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