The debt-to-income ratio is a measure of how far buyers are "stretching" to buy real estate. Buyers have historically committed larger sums to purchase real estate when prices are rising in order to capture the appreciation of rising prices. Conversely, buyers have historically committed smaller and smaller percentages of their income toward buying real estate when prices are declining because there is little incentive to overpay. Some may look at this phenomenon as a passive effect of the rise and fall of prices, but since buying is a choice, the fluctuation in debt-to-income ratios is an active force on prices in the market.



This change in buyer behavior based on the trend in house prices is apparent in the national mortgage origination ratio. This statistic kept by the Federal Reserve Board is a measure of the total national mortgage debt service as a percentage of gross income. In the coastal bubble rally of the late 80s, people took on larger debts to buy homes, and when prices began their decline, people did not stretch to buy. If people had continued to put a high percentage of their income toward housing, prices would not have fallen as far as they did. The Great Housing Bubble witnessed a 30% increase in the average mortgage debt ratio on a national basis as people bought out of fear and greed in order not to be priced out forever and capture the capital gains of home price appreciation. If history repeats itself, this ratio will decline as house prices decline.

House prices are sensitive to small changes in debt-to-income ratios when interest rates are very low as they were during the Great Housing Bubble. For instance, a 2% increase in the debt-to-income ratio can finance a loan that is 10% larger. Each borrower deciding to put a little more of their income toward housing can bid up prices very quickly. Prior to the bubble rally, lenders would limit DTIs to 28%, but during the bubble rally the only limit to DTIs were the degree to which borrowers were willing to exaggerate their income on their stated-income loan application.

The debt-to-income ratio in Irvine, California, in 2007, was 64.4%. Even if it is assumed every buyer was putting 20% down (which they were not), the DTI ratio is 50.1%. This is gross income; as a percentage of take-home pay, the number is much higher. Most financed these sums through some combination of “liar loans" and negative amortization loan terms. Since these two “innovations" have likely been eliminated forever, bubble buyers who used these techniques are not going to be bought out by a future buyer using the same financing methods and thereby using the same debt-to-income ratio. In short, prices in these markets are going to crash very hard.

Homeowners during the Great Housing Bubble utilized debt-to-income ratios higher than ever witnessed previously. Default rates were low while prices were rising and Ponzi Scheme financing allowed homeowners to pay their mortgage with borrowed money. When prices began to drop, default rates began to rise quickly, and lenders responded by cutting off the Ponzi Scheme financing in a massive credit crunch. This caused prices to drop further and defaults to skyrocket. A downward spiral ensued. Projections are for this downward spiral to continue through 2011 when prices bottom at fundamental valuations.