The Marginal Home Buyer

Modern 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.

Every 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.


At 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.

In 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.

This 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.

There 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.

The 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.

The 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.


Housing 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:

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

Into 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:

In this regionIn my present jobAt today’s interest ratesAt today’s property tax rates

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

They 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.

They don’t. They buy the house.

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

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

But people in the last stage of a mania are impatient.

Waiting is what they wish they had not done earlier.

Meanwhile, the lenders are offering them deals.

Renters want to become owners.

Why? 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.

Serfs 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.

A 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.

Yet, 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.

Today, 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.

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


Today, 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:

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

These 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.

In a story run in the Los Angeles Times and picked up by other papers, 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 situation.

She 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.

She 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 rise.

On 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.”

The 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?

In 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.

Interest-only 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.

Under 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.

When 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.

During 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 Census.

While 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.

The 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.

Rather 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.

An 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.

Of 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.

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

In 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.

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

When 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?

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


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

Lenders 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.

In 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.”

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

People 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.

The 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.

I 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.”

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

The 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.

Meanwhile, 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.

“A 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 agents.

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

In 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.

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

Those 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.

Amy Matz and her fiancé, 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.

“We 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.”

In 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 top.

Credit 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.


There 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.

Today, 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.

When 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.

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

Buy 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.

April 23, 2005

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

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