Californians More Likely to Bite off
More than They can Chew

When it comes to housing, Californians are more likely than the average American to bite off more than they can chew.

There are two fundamental factors which determine a household’s ability to own a house: the price of the house and income.  The price of houses in California has always been among the highest in the nation.  Data from the California Association of Realtors (CAR) shows that in 2006, the median price of a single family home in the state was over $556K -  more than twice the national average of $221K.

In terms of income, average Californian households earn higher incomes than average American households.  Census data shows that median household income in California in 2005 was $53.6K, surpassing the nation’s median income of $46.2K.  While income is only 15% higher in the state, housing prices are 200% higher.  Thus, houses are less affordable in California than the rest of the nation.

A common measure of how affordable houses are in a certain region is called housing affordability index.  This measure contrasts the household income and housing price, and estimates the share of households who can afford median priced houses.  As shown in the figure below, the California affordability index fluctuates over time but has remained below the national index since 1990.  On paper, only 23% of Californian households could afford a house in 1990.  The index peaks at 40.0% in the late 1990s and fell badly to 15.9% in 2005 when the housing market and home prices were at their peak.  The national index, on the other hand, is more stable and significantly higher - above 50% during the same period. 

In an ideal world where all households have the same preference, people have the same attitude toward risks, and mortgage lending practices are uniform everywhere, the affordability index should closely represent the share of households who do own a house.  However, reality is always more complex than theory.  In practice, the number of owners is always greater than the number suggested by the affordability index.  As shown in the figure, the home-ownership rate, which represents the share of households occupying their own houses, always exists above the affordability index anytime in any of the three regions. 

In reality, there are other factors besides housing prices and household income that affect a decision to own a home.  Identifying and analyzing these factors require an independent study.  However, one important factor is the difference in mortgage lending practices.  The affordability index is

computed by assuming that houses are purchased under the same standards.  Examples of the standard practice are: monthly payment being at least 30% of income; 20% down payment, and a 30-year fixed mortgage rate.  In reality, plenty of households and lending companies can agree to deviate from these standard practices and move on with riskier loans.   The standard lending practice yields safer loans, which represent most of the so-called prime mortgage loans in the housing market.  Any deviations from this practice yield riskier loans, which represent most of the so-called sub-prime mortgage loans.

In general, the difference between housing affordability index and home-ownership rate represents the gap between the number of households who can afford a house and the number who actually buy a house.  The larger the gap suggests that relatively more households, knowingly or unknowingly, are willing to live beyond their normal means.  The larger the gap also suggests the higher likelihood that more households are involved in riskier mortgage loans.

As shown, the gap in California is much larger than the nation over time.  The gap narrowed in the mid 1990s and then continued to widen starting in 2000 when the housing market started booming.  The gap in all regions peaked in 2005, when the housing market reached its peak.

Prior to 2000, the gap in San Joaquin County was not as bad as in the state as a whole.  This was because housing prices in the county were much lower at that time.  After the housing market started booming in the late 1990s, San Joaquin County received an influx of people migrating from the Bay Area and East-Bay regions.  Housing prices in the county then skyrocketed, significantly dropping the affordability index in the regions.  This didn’t stop people from buying a house, however.  In 2005, the gap in San Joaquin County was 44 percentage points, surpassing the gap in the state (42 percentage points), and was well above the nation (17 percentage points).

Such large gaps in California and San Joaquin County represent the occurrence of excessive demand for housing in the two regions, which tend to make housing highly over-priced.  When the market cools down to get back to normal, more market correction is needed in the regions. This partly explains why in the summer 2007 the state of California and San Joaquin County are among those with the largest proportion of sub-prime mortgage loans and the highest number of foreclosures in the nation.

Graph of the Week, August 17, 2007, Business Forecasting Center, University of the Pacific