Can mortgage interest rates inflate a housing bubble?

As mortgage rates rise, home sales will decline, and if it goes on long enough, prices will fall.

home_price_appreciation_fairyIn rocketry, escape velocity is the speed required to propel an object into a stable orbit. In a housing market, escape velocity is a rate of price and sales volume increase necessary to sustain an increase in demand required to push prices higher for the long term. Escape velocity is the elusive dream of real estate pundits, a group who doesn’t understand what it was or why it disappeared (probably forever).

In previous real estate cycles (pre Dodd-Frank), as prices went up and buyers were priced out of the market, lenders responded by offering affordability products toxic mortgage financing terms. As affordability products proliferated, prices kept rising, and many buyers accelerated their buying plans out of fear of being priced out and out of greed to capture appreciation. This unsustainable and self-reinforcing buying activity is escape velocity. All that was required to start the cycle was a period of rising prices — and a heavy dose of realtor bullshit.


For a housing market to embark on a long bull rally, it needs rising prices predicated on rising incomes and increasing household formation built on a stable foundation of steady interest rates and conventionally amortizing mortgages. For the last ten years, the market has bounded from one unstable prop to another in the hopes fundamentals would improve. The main reason prices rose is because inventories were so restricted by bank policy that the few active buyers in the market were forced to pay more.

Today, sales momentum is clearly slowing down, a troubling sign considering mortgage rates are near record lows.

We’re in a new housing bubble: Why it’s less scary this time

Diana Olick, August 29, 2016housing_martyr

A decade ago, the U.S. housing market swelled to a bubble of epic proportions. Too many homes were built, and too many people were willing to pay top dollar for them with the help of faulty mortgage products.

When the bubble burst, millions lost their homes and their savings. Home prices dropped for six years, finally hitting bottom in 2012; today, home prices are about 1 percent shy of that 2006 bubble peak.

Which is a testament to the effectiveness of can-kicking bad loans instead of foreclosing on them.

The difference today from a decade ago is that these prices are not being driven by faulty mortgage products that people can’t afford. They are being driven by a severe lack of supply of homes for sale, as well as near record low mortgage rates.

“If you look at the percent of the median income required to buy the median household, we’re at 21 percent, which is very healthy,” said Ben Graboske, senior vice president of data and analytics for Black Knight. “In the bubble years it was 36 percent. Rates are super low, and that is a big impact on affordability.”

The concern, however, is if those rates start to move up. Then affordability would weaken and home prices could move lower.

Assuming a consistent payment, higher mortgage rates decrease the size of the loan and reduce the amount borrowers can bid on real estate. While it is possible the federal reserve may print enough money to spark wage inflation, given the high levels of residual unemployment and a low labor participation rate, wage inflation is elusive and almost certain to come later than rising mortgage rates. Therefore, if rising mortgage rates results in smaller loan balances, then either sales volumes will go down, or house prices will go down, or perhaps some combination of both. This isn’t speculation; it’s basic math.


(See: Fewer home sales or lower prices sure to follow higher mortgage interest rates)

Also, low rates may make homes affordable, but a sizable number of potential buyers still can’t qualify for those low rates and/or cannot meet the down payment requirements. As home prices rise, so too does the down payment.

“It’s the credit box. There are a lot of people that cannot qualify because they don’t have the credit or the equity,” said Graboske, adding,

The huge down payment barrier prevents many people from buying, particularly at price points above the conforming limit where 20% down is a must.

“A portion is not buying because housing had a reputation for depreciating for five years, and people don’t like buying depreciating assets.”

I don’t see this attitude much anymore. People are cautious — and they should be — but unlike ten years ago when the mania was in full force, the kool-aid intoxicated ignored the signs, but more rational people saw the bubble for what it was and chose not to participate. The debates in forums like this one were epic.

The headline of the article is catchy, but it fails to make the case that today’s house prices are a bubble.

We’re not in a housing bubble, Redfin economist says

Michelle Fox, August 29, 2016going_down

Despite sky-high real estate prices, there is no housing bubble, Redfin’s chief economist, Nela Richardson, told CNBC on Monday.

“We just have really high prices and shrinking number of transactions. In fact, I think the market is contracting instead of expanding into a bubble,” she said in an interview with “Power Lunch.”

I have no idea what she is talking about when she talks about expanding into a bubble.

Nela Richardson fails to understand that a decline in transaction volume is the first sign of a market top. At a market top, sellers expect buyers to raise their bids, and buyers don’t cooperate, so transaction volume declines. If sales remain sluggish the following year, prices begin dropping as motivated sellers decide to get out.

I’m not saying today’s prices are a bubble, but Nela Richardson’s argument against a bubble is completely incoherent.

Richardson said a bubble is usually marked by speculative building and buying, neither of which is happening right now.

“New construction is short of historical norms. We need more inventory, not less,” she said.

flesh_woundThere is plenty of speculative buying in coastal markets, and if there is a bubble anywhere right now, it’s in those markets where people are buying because they believe home price appreciation will provide them a windfall.

Meanwhile, the investor share of existing homebuyers has also been really low, making up about 10 percent of the market, and it’s been a difficult environment for homeowners who want to trade up.

In fact, sales dropped last month due to chronically low inventory, she said.

“A lot of them are staying put, choosing to renovate and stay in their existing homes instead of speculate on a growing market and get something bigger.”

The problem with housing is and always was affordability, and the long-term decline in mortgage rates has artificially improved affordability. (See: Housing market impact of 25 years of falling mortgage interest rates)keep_us_flying

For example, the average monthly interest rate from 1993 to 1999 was 7.63%. The average monthly cost of ownership was $1,538 in Orange County. That combination would finance a loan of $223,011. Add a 20% down payment, and the home price would be about $275,000 ($278,763 to be exact). Over the last 12 months, the median monthly cost of ownership in OC was $2,102. If you plug in that number in place of the $1,538 from 1993-1999, the resulting home price would be $380,089. The last reported median home price for OC was well over $500,000. House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.

So now let’s assume mortgage rates will revert to the mean. What will a long-term rise in interest rates do to home prices? Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.

In the absence of rising wages, when mortgage interest rates go up, one of two things will happen: either sales will fall, or prices will fall. Since we don’t have a free market, it seems more likely to me that sales will fall and remain depressed for a long time.

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