Are low rates an adequate substitute for low prices?

For the last several years I have written in favor of low prices as the best option for putting the country back of firm economic footing. The argument is simple: Low prices make for a lower cost of ownership which translates to more disposable income for homeowners to use to purchase goods and services to drive the broader economy. Disposable monthly income is a superior economic stimulus because it’s sustainable. The savings each month are consistent and reliable. Contrast that to HELOC money that comes in a lump sum and once spent requires larger payments which reduces disposable income. Lower monthly cost of ownership is a sustainable source of disposable income to stimulate an economy. HELOC money is not.

So that opens the larger question about which is better, lower prices or lower interest rates? Both lower the monthly cost of ownership and result in more disposable income. Obviously, the banks prefer higher prices to recoup their capital from their bad bubble-era loans, so they are offering 3.5% interest rates to prevent prices from going any lower. I think most buyers would prefer lower prices, but since the banks make the rules which determine market prices, low interest rates and high prices are what we get. And as I pointed out last week, the cost of ownership is back to 1980s levels in Orange County.

Ben Bernanke’s Mortgage-Refi Nation

By Karen Weise on October 09, 2012

Well, that didn’t take long. It’s been less than a month since the Federal Reserve announced plans to buy $40 billion of mortgage-backed securities a month for as long as necessary to spur lending and boost employment. Since then, mortgage interest rates have fallen to the lowest level on record—the average 30-year loan stood at 3.53 percent as of Sept. 28—driving refinance applications to jump to their highest level since 2009, according to the Mortgage Bankers Association.

$40 billion a month for as long as necessary. It still shocks me to read that. It’s the ultimate housing market bazooka, and he pulled the trigger.

Borrowers are refinancing at an annualized rate of 22 percent, according to Lender Processing Services (LPS). At this rate, more than one in five borrowers will refinance over the next year. Borrowers who have at least 20 percent equity in their homes are even more likely to refinance. Among those homeowners, one in three will refinance in the next year if the current pace continues.

Even those who overpaid in the false rally of 2009-2010 will end up getting bailed out by the low interest rates. Apparently, Bernanke intends to keep lenders alive with refinance fees until owner-occupant lending comes back.

Refinancing is normally not an option for borrowers who owe more than their home is worth. But they have been getting into the act this year, thanks to the Obama administration’s Home Affordable Refinance Program, which rewards banks for working with underwater homeowners. Since the start of 2012, there’s been a 65 percent increase in refis for borrowers who owe at least 20 percent more than their homes are worth; HARP now accounts for about a quarter of all refis.

This is where the shadow inventory is going. It’s clear that any declines in shadow inventory are not coming from foreclosures since they are processing them so slowly. The big headlines on shadow inventory reduction are from the can-kicking cures from underwater loan modifications. Many if not most of these will fail. According to the latest data, 31.8% of HAMP loan modifications have failed since the third quarter of 2009. That’s nearly a third in two and a half years. And HAMP is the more successful program. Other loan modifications fail 46.6% of the time. Loan modifications are clearly not the solution, and they are barely passable as can-kicking.

With rates so low, some borrowers are taking out shorter-term loans that let them pay down their debt quicker.

This is a great solution. Perspective, one of the regular astute observers on this blog, recently completed a cash-in refinance, and if rates move lower and prices move high, he may refinance with a 15-year mortgage. This would greatly accelerate how quickly he builds equity in the property.

Gone are the days people take out cash when they refinance. In almost a quarter of all refinancings in the second quarter of 2012, homeowners ponied up cash to reduce the principal on their loans, according to Freddie Mac (FMCC). A further 59 percent kept their loan balance the same—the most ever on record.

I rejoice the lack of HELOC abuse. It will sadden me greatly as this increases over the next several years.

Lower interest rates free up real monthly cash flow for homeowners. In the second quarter—before the Bernanke-induced drop in rates—the average refinancing cut the homeowner’s interest rate by 28 percent, the biggest reduction in the 27 years since Freddie Mac began tracking the data. That means a homeowner with a $200,000 loan would save about $2,900 in their first year, Freddie Mac says.

For every $100,000 in loan balance, the refinance activities are lowering monthly costs by about $100 per month. This seems small compared to the bonanza from mortgage equity withdrawal, but as I pointed out earlier, this is a sustainable stimulus.

All this refinancing activity is fine for the economy—lower monthly costs could help boost consumer spending–but it’s not Bernanke’s real target. He said (PDF) at a press conference last month: “You get more benefit when people buy homes. … It’s the purchases of new homes that generate the construction activity, the furnishing, all those things that help the economy grow.” Though home sales are starting to rebound slowly, it’s still hard for people with less-than-stellar credit to get mortgages. So for now, while low interest rates may be relieving the consumer debt burden for some, their boost to the overall economy is limited.

As someone who used to work in the construction and development industry (and I’m looking for opportunity to work there again), I am happy to see this dormant sector of our economy come back to life. I would feel better about it if it weren’t’ the result of constant market manipulation by lenders and our government, but I have to live in the world we have, not the one I would prefer to live in.

I don’t think low rates are as desirable as low prices, but they do serve as an adequate substitute. Low rates lower monthly costs and stimulate consumer spending. That is what will ultimately make the economy recover.