Future housing markets will be very interest rate sensitive

Economists who focus on larger trends, the so-called macro-economists, have rightly pointed out that housing markets in the past haven’t been very sensitive to fluctuations in interest rates. For example, during the 1970s, interest rates rose significantly, which should have caused house prices to drop, but instead California inflated a housing bubble. During the crash from the bubble in the 1990s, interest rates declined, and so did prices. The same has been true of the Great Housing Bubble.

With these significant periods when mortgage interest rates did not impact house prices the way the math would suggest, why would the housing market be more sensitive going forward? The new qualified mortgage rules take away the mechanisms lenders used to inflate prior bubbles. To understand how and why, we need to take a step back and evaluate how housing markets really work and what happened during previous periods.

What really determines market house prices?

Financing terms largely determine the equilibrium price for housing. Short term fluctuations in supply and demand cause gyrations, but over time the amount potential buyers can borrow will determine what houses cost. For example, the reason prices are going straight up right now is because potential buyers can borrow large sums due to very low interest rates. The activities of these buyers coupled with a depleted MLS inventory is causing prices to rise. Prices will continue to rise until potential buyers reach the limits of their borrowing power or new supply comes to the market. Banks are intent on the former outcome.

House prices rely on four things:

  • Interest Rates
  • Borrower Income
  • Allowable-Debt-to-Income Ratios
  • Amortization

Interest Rates

The impact of interest rates is obvious. The lower they are, the more someone can borrow, and the higher they are, the less someone can borrow. Mortgage balances are inversely related to mortgage interest rates.

One of the bad ideas utilized by lenders during the housing bubble was to provide a temporary “teaser” rate that was much lower than the market. This lower rate allowed them to underwrite much larger loans (with big fees), and everyone’s hope was that they could refinance before the rate reset higher and the payment recast to something the borrower could not afford. It didn’t work out. Fortunately, qualifying based on teaser rates was banned by the new regulations.

Debt-to-Income ratios

Borrower income and the allowable debt-to-income ratios work together to determine how much payment a borrower can afford. This assumes the borrower actually makes the amount stated on the loan application, and during the last bubble, this was often not verified. In order to calculate the maximum loan value someone could borrow, the lender needs an interest rate, borrower income, and the maximum DTI the bank will allow. For example, a borrower making $100,000 qualifying at a 31% allowable DTI can afford a $31,000 annual housing bill (includes interest, taxes, insurance, HOAs and other costs). That translates to a $2,583 monthly payment.

This assumes borrowers will max out their loan balances, and that isn’t always the case. Many areas of the country, but most notably in the Midwest, borrowers simply aren’t willing to leverage themselves to the max, and they accept lesser housing quality (and lower prices) as a consequence.

The new financial regulations capped back-end DTI ratios at 43% for all residential loans and banned low-doc and no-doc mortgages.


The type of loan program matters. Amortizing loans make for the smallest loan balances because a portion of the payment goes toward paying down principal. If the loan does not amortize, the entire payment can go toward interest, and the loan balance can be much larger. At it’s ultimate extreme, if the loan negatively amortizes (the balance gets bigger rather than smaller), and lenders use teaser rates, truly prodigious loan balances can be underwritten on very small payments. Buyers on the margins using these methods inflated the Great Housing Bubble.

Many of my cartoons are just for fun, but there is often a serious point behind them. The cartoon about housing market drag racing below illustrates the credit cycle that inflates housing bubbles.

In a “normal” market, prices are determined by the interaction of interest rates, borrower income, and debt-to-income ratios applied to a 30-year fixed-rate amortizing mortgage. In normal markets, the friction that limits the number of transactions is generally affordability. Needing to borrow more money to get their dream homes, desperate borrowers sometimes respond by financing with adjustable-rate mortgages. The first sign of an overheating market is an increase in ARMs.

ARMs generally carry a lower initial interest rate than fixed-rate mortgages because the lender is passing the interest rate risk to the borrower. Many people over the last 30 years of declining interest rates have come to believe ARMs are a safe loan product that can save them money and allow them to buy a bigger house. In the rising interest rate environment likely to be with us for the next 30 years, people who finance with ARMs will get burned.

The same forces that compels people to use ARMs further compels them to abandon amortization altogether. There is a slow but inexorable migration from amortizing ARMs to interest-only ARMs and finally to negatively amortizing loans. Unfortunately, interest-only and negatively amortizing loans are Ponzi loans, and once they proliferate, its like an iron core of a large star leading to a supernova. The market implodes. Fortunately, both interest-only and negatively amortizing loans were banned by the new regulations.

What caused the 1970s bubble?

During the 1970s, California inflated its first housing bubble. At the beginning of the decade, house prices were just as affordable in California as they were anywhere else — a truth forgotten by people who believe house prices have always been too high here. A growing number of development restrictions limited the ability of builders to respond to higher prices, the result was a sudden increase in prices that sparked a self-fueling rally that became a full-blown mania. As with any housing bubble, it wasn’t just the desire of homebuyers that pushed prices higher, their desires had to be enabled by foolish lenders.

With inflation running rampant in the 1970s, wages were also going up as the federal reserve kept interest rates too low for too long. Lenders realized that borrowers with rapidly inflating wages could handle larger debt-service burdens than during a period of tepid wage growth. For example, a 50% DTI becomes a 45% DTI if wages go up 10%. If they go up 10% every year for several years, even the most onerous DTIs become manageable as wage inflation bails the borrower out. Lenders responded to this reality of persistent inflation and permitted DTIs upward of 60% in the late 1970s. Of course, their response to inflation actually created more. Finally, it got so crazy that the US dollar collapsed, and Paul Volcker had to raise interest rates to 20% to save the dollar and get us out of the downward spiral. (Our distant future?)

What you need to take away from this history lesson is that the reason prices rose during a period of rising interest rates is because lenders allowed DTIs to grow even faster. If DTIs hadn’t gotten out of control, the housing bubble of the 1970s would not have occurred. With the new cap on overall DTIs at 43%, lenders won’t be able to inflate a bubble this way again.

Why did prices fall in a declining interest rate environment in the 90s and the 00s?

The last two housing bubbles were caused by the progression of riskier loans I outlined above. In each case, affordability products flourished, prices were driven up well beyond reasonable measures of affordability, and these toxic loans destabilized the market leading to a crash. Since the peak of the bubble was a point of disconnect between what people could afford and what prices actually were, a decline in prices was necessary for the market to rebalanced itself. In response, the federal reserve lowered interest rates to raise the point of market equilibrium so its member banks could recover their capital and minimize losses. In the 1990s, interest rates dropped nearly 30% while in the 00s, interest rates were cut in half.

(on a logarithmic scale, the bubbles are nearly proportional)

Why will the market be interest rate sensitive going forward?

When you look at the mechanisms used to inflate previous bubbles — using teaser rates, allowing excessive DTIs, and abandoning amortization — these were banned by the new residential mortgage rules. Lenders won’t be able to use these tools to soften the impact of interest rate fluctuations or provide “affordability” when the market reaches its friction point. This will be the cause of much weeping and gnashing of teeth in the real estate community. Most mortgage brokers and real estate agents are accustomed to a constant influx of affordability products to help save their deals. Since most of the tools they used in the past are now banned, everyone who depends on more transactions will constantly complain about tight lending standards and these “onerous” rules. The NAr will  lobby incessantly to relax these new regulations. Fortunately, since these rules are established by a bureaucracy somewhat insulated from political pressure, the NAr’s shrill cries will largely be ignored.

Without affordability products, the four variables I described above will work their magic in determining market prices. And since interest rates are by far the largest and most volatile component of the four, the housing market will be very interest rate sensitive going forward.