Housing market is NOT strong enough to handle higher mortgage rates
The housing market can’t absorb a sudden or large increase in mortgage rates without major declines in sales and perhaps even decreases in prices.
In response to the housing bubble and bust, Congress passed the Dodd-Frank financial reform. These new mortgage regulations will prevent future housing bubbles by effectively banning destabilizing loan products with interest-only and negative amortization features because those loan programs enabled buyers to greatly inflate house prices from stable levels set by wages and mortgage rates.
The toxic loan products banned by Dodd-Frank were invented to solve the problem of affordability. In a stable housing market, the equilibrium price is the highest price consumers can finance, so under pressure to complete more deals, lenders seek ways to increase the size of the loans lenders provide borrowers. Unstable affordability products were born out of this constant market pressure.
Since affordability products were designed and used to solve affordability problems, when interest rates would spike higher, lenders had a way to close deals and sustain sales momentum. After Dodd-Frank, this was no longer the case. In February 2013, before the taper tantrum of May 2013, I wrote that Future housing markets will be very interest rate sensitive due to the lack of affordability products. This was dramatically confirmed when rising rates abruptly ended the reflation rally and again in April 2015 when home sales were pummeled by rising mortgage rates.
Historically, house prices and mortgage rates haven’t correlated well; thus the prevailing view among economists is that the housing market would respond positively regardless of what happens with mortgage rates. Since the market went through significant periods when prices moved in opposition to mortgage rates, and since macro-economists aren’t skilled in deciphering the reasons behind their models, they failed to recognize that the new mortgage rules changed the way housing markets work.
According to the theory I postulated back in early 2013 — prior to the rate surge from 3.5% to 4.5% — rising mortgage rates should cause sales volumes to fall, and falling mortgage rates should cause sales volumes to rise. The restricted inventory may cause prices to go up, but the changes in affordability caused by mortgage rate fluctuations would necessarily impact sales volumes by pricing out (or pricing in) marginal buyers.
In October of 2013 after the sudden mortgage rate spike pummeled sales, I wrote about the mounting evidence of the market’s sensitivity to mortgage rates. 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 can’t soften the impact of interest rate fluctuations or provide “affordability” when the market reaches its friction point. This is the main reason the market changed so dramatically and so suddenly when mortgage rates surged.
The sensitivity of the housing market to changes in rates is remarkable, and it’s one of the many reasons I don’t believe the federal reserve will raise interest rates (more than 1/4) in 2015 because if mortgage rates rise in 2015, house prices might drop.
Despite the groundbreaking change to real estate markets caused by this recent legislation, most housing market analysts and real estate economists fail to recognize the impact of these changes on the market, and they continue to make predictions based on previous history and their previous understanding of how housing markets work.
The U.S. housing market is probably strong enough to stand up against an interest rate hike by the Federal Reserve this year, with stabilizing home prices supporting sales, a Reuters poll of top economists showed on Wednesday.
Of 22 economists surveyed, all but two said the market could withstand the Fed’s expected rate hikes. They pointed to job creation and growing demand for houses from millennials as factors contributing to the market’s resilience.
Specifically, what does it mean to withstand rate hikes? The earth could withstand a direct hit from a giant comet, but that doesn’t mean it would be pleasant. If by “withstand” they mean that sales volumes and prices will continue to increase at historic rates, which is what they imply, I think they will be mistaken.
“Rates are very reasonable now, and the signal the Fed will give when they begin raising their key lending rate will push more people into the market,” said Rajeev Dhawan, director of the economic forecasting center at Georgia State University. …
Again, this behavior may have been true in the past, but buyers are no longer frightened into action by the specter of rising rates. People know real estate prices can go down, and if prices become unaffordable, they will fall back to levels buyers can afford. Buyers can’t be pushed into the market like in years past.
Economists say home price increases of about 5 percent are just strong enough to raise equity for homeowners to encourage some to put their properties on the market and help address a persistent shortage of houses available for sale.The increase is also not big enough to price out first-time home buyers, economists say.
“The recent strength of housing activity suggests the market is well placed to cope with a gradual rise in interest rates,” said Capital Economics economist Matthew Pointon. “Rising rates will also be accompanied by an improving labor market and gradually loosening of credit conditions.” …
If the increase in rates is gradual, if wages go up, and if credit standards loosen up slightly, then the housing market can cope with the changes, but the impact will be apparent in lower sales and lower rates of appreciation. There is no free lunch.
“There are no bargains in the market now,” said FAO Economics economist Robert Brusca. “Maybe high rents will drive people to buy. But it seems the opposite is true. High house prices make high rents look cheaper.“
Our government, federal reserve, and a cartel of too-big-too-fail lenders are manipulating the housing market in an effort to drive up house prices. Since must-sell shadow inventory morphed into can’t-sell cloud inventory, I think it likely that home sales will be depressed for several years as mortgage rates rise.
If we had cleared the market of distressed loans, hedge funds and other investors would have purchased millions of homes, and sales volumes would have been much higher. Of course, this would have bankrupted the banks, so another path was taken, but this path has consequences. If the plan is to sell these homes to owner-occupants and higher prices — a group struggling with high unemployment, low savings, high debt levels, and poor credit scores — then it’s going to be a long, slow slog.
If interest rates go on a sustained rise, financing home purchases will become more expensive. The real question then is whether or not these rising costs due to rising interest rates are compensated for by rising wages. In order to increase sales and increase prices by 4%, we need an economy that produces aggregate wage growth of 16.4% to offset a 1% increase in mortgage rates. If mortgage rates go up to 5% next year, will wages rise 16.4% to compensate? I doubt it.
If wages rise as fast as interest rates do, then borrowers will still be able to finance large sums, and house prices can remain stable or even rise. However, if wages do not rise as interest rates go up, then loan balances will decline, and house prices will fall again.
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 very long time.