Higher priced houses are affordable to many families with high incomes, but many families lack the hefty down payments necessary to close the deal.

Last year I reported that Housing inventory is abundant at prices buyers can’t afford. The constant refrain in the financial media is that home sales are weak because sellers refuse to list and sell their homes. This is only partially true.

Sellers’ reluctance to list at reasonable prices constrained sales, but not for the reasons commonly stated in the financial media. Sellers list their properties in sufficient numbers, but not at prices affordable to buyers. Since sellers must net enough at closing to pay off their supersized bubble-era loans, they ask too much money, and they resist lowering their price. Most would rather not sell if selling means writing the bank a check for the shortfall.

Imagine a market like Orange County in 2012 where comparables for a certain property sell for $400,000. Now further imagine about 25% or more of the houses in this market have mortgages well in excess of $400,000, so they either don’t list their homes, or they list them for $50,000 to $100,000 over recent comparable sales. Are those homes listed well above comparable sales really for sale? I think not.

When houses get priced based on outstanding loan balances rather than the market, it’s a recipe for stale listings. Thus we have a market where the few reasonably priced listings go quickly with multiple offers and the overpriced listings just sit there.

This phenomenon will continue until incomes applied to mortgage rates elevate market prices above peak housing bubble levels all across the country, and in some markets, that’s another decade or more away.

The great down payment barrier

The problem with affordability is not merely that prices are high. Families with high wages could finance mortgages large enough to buy more expensive properties, but they run into another roadblock: the down payment barrier.

Ordinarily, the conforming loan limit or the FHA loan limit is not a barrier to first-time homebuyers. But with record low mortgage rates, many potential buyers could finance sums well in excess of the conforming loan limit, but they lack the 20% down payment required on a jumbo loan.

During the housing bubble, the conforming limit rose as high as $417,000, but when the housing bubble burst, this limit was raised to $729,750 in markets like Coastal California that needed the most government support to maintain peak prices. In 2011, the conforming limit was lowered from $729,750 to $625,000 ($546,250 in San Diego).

The conforming loan limit demonstrates the tug-of-war between two conflicting desires of policymakers.

On one side, they want to lower the limit to restore the prior mandate of insuring loans only for lower- and middle-income Americans and reduce the potential liability for the US taxpayer, who would currently cover all the losses if the market crashes again. If the conforming loan limit were reduced, it would reduce the size of the GSE operations and make it easier to someday dismantle them; however, the last time the conforming limit was dropped, Irvine, CA witnessed an 84% decline in sales volume in the price range no longer financeable with GSE loans.

Right now the low conforming loan limits inhibit sales and the relentless push for higher home prices.

A few months ago, I published a Story of a self-reliant Gen-Xer’s first time home purchase. That story reveals something very important about how the housing market functions today.

In the story, the protagonist relayed his experience looking for homes both below and above the conforming limit. He found that competition was fierce for those properties within reach of the conforming limit, but this competition dropped off considerably if he looked just above. Why is that?

The hard cap on FHA and GSE loans means borrowers must use a jumbo loan. Lenders who originate jumbo loans have stricter standards than the FHA or the GSEs, and most importantly, they required at least 10% and most often 20% down; most buyers lack the down payments.

Many potential homebuyers who have the income to qualify for loans much larger than the conforming limit don’t get these loans because they fail to meet the down payment requirements.

This problem is illustrated below. In Orange County, the conforming loan limit on GSE loans and the FHA loan limit is set at $625,500. For purposes of this illustration, I used the 3.5% down required on FHA loans because the 3% down program at the GSEs isn’t widely used.

The increase in housing inventory on the MLS starts just above the conforming limit. An FHA borrower in Orange County can buy a home for $647,392.50 and use exactly 3.5% down, or $21,892.50, a paltry sum given the purchase price. However, every dollar of the next $134,482.50 must come out of the buyer’s savings. In order to borrow $625,501, the borrower must use a jumbo loan, and that generally means 20% down, which translates to a $781,875 purchase price.

Needless to say, many more people have $21,892.50 than have $156,375, the down payment at a $781,875 purchase price. This makes the market for properties priced above the conforming limit very thin and mostly unavailable to first-time homebuyers.

This barrier is a particular problem to homebuilders in the Inland Empire where the FHA loan limit is only $356,500. It’s nearly impossible to build a house profitably out there given the high fees and other costs. Even if the land residual were near zero, it would still be a challenge to build and sell for less than $370,000.

September 19, 2016, Kelsey Ramírez

In the second quarter of 2016, the Federal Housing Finance Agency’s house price index was almost identical to the level of the index in the third quarter of 2007, according to theMortgage Bankers Association. So why is this so important? Once the HPI reaches pre-crisis levels, Fannie Mae andFreddie Mac can raise the conforming loan limits — the maximum mortgage origination balance the GSEs are permitted to buy. Loans above the limit are known as jumbo loans. The FHFA restricted the GSEs from raising the conforming loan limit until prices exceeded pre-crisis levels of one of the three HPIs, the expanded-data HPI.

Because of the price levels during the second quarter of this year, the FHFA could raise the conforming loan limit for 2017, the first such increase since 2006.

This would be welcome news for homebuilders, but perhaps not for taxpayers. Lawmakers failed to reform housing finance and created a new system that reduces taxpayer risk. Congress needs to act or homebuilders won’t provide entry-level product for the Millennial generation, at least not in California.

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