Jul112013

Mortgage rates move higher, housing less affordable

The recent sudden spike in mortgage interest rates shows no signs of abating; in fact, it is getting much worse. The yield on a 10-year Treasury has moved up from about 1.7% in May to 2.7% today. Since mortgage interest rates and 10-year Treasury rates correspond strongly (they are competing investment alternatives subject to substitution), mortgage rates are also expected to move up a full 1% from their May levels. That translates to a jump from about 3.5% to 4.5%. Yesterday, there was another huge selloff of the 10-year Treasury. Mortgage interest rates may hit 4.75% shortly.

… on Friday, the 10-year Treasury yield posted a large jump, signaling that mortgage rates may see yet another jolt higher in coming days. The 10-year Treasury yield rose almost one-quarter of a percentage point to 2.74% on Friday. … But given Friday’s yield surge, this Thursday’s weekly mortgage-rate report from federally controlled mortgage buyer Freddie Mac could show a large gain. …

Obviously, this makes houses less affordable. Sellers don’t adjust their expectations quickly (if at all), and buyers usually don’t have an extra $100,000 lying around to increase their down payments if rising rates makes their loan balances smaller. The result is many deals that fall out of escrow due to financing problems, and the sellers are unable to find a buyer who is willing and able to pay the previous escrow price.

If rates had risen slowly, even the full 1% increase from 3.5% to 4.5% could have been absorbed by the market. Prices in most markets are still undervalued, and the increased borrowing costs wouldn’t have the effect of killing many deals. Both buyers and sellers would have time to adjust their budgets and expectations to the realities of a rising rate environment. It’s the sudden rate shocks that really cause problems.

Rising mortgage rates will make home-buying more expensive, and some buyers will have to scale back purchase plans. Goldman Sachs analysts estimated that recent mortgage-rate gains mean that for a median-priced single-family home, which costs about $200,000, borrowers who put down 20% face an increase of about $100 in their monthly mortgage payments.

Mortgage News Daily, which closely tracks the market, described Friday as “among the worst days in mortgage rate history,” and said some lenders’ rates rose as high as 4.875%.

This can’t be good for housing, but you wouldn’t know that if you focused on the bullish spin. We’ve witnessed a proliferation of articles in the mainstream media providing assurance to a weary public over the fate of interest rates and house prices. The focus of nearly all these articles is that rising interest rates won’t stall the housing recovery. Most come to the conclusion that home prices and mortgage rates don’t correlate, so there’s nothing to worry about. Further, “other factors (like a stronger economy) have a bigger impact on house prices than changes in mortgage rates.”

This is thoughtless nonsense. It reflects a lack of understanding on how housing prices are determined. It screams out for an answer to why house prices may have gone up when interest rates did too. The why matters. It’s only in understanding why that we can reasonably determine if history will repeat itself or go another path.

House prices are largely determined by how much borrowers can finance. Cash buyers are 15% of the market in normal times, and a record 30% today. This leaves between 70% and 85% of the market determined by financed buyers. They set the prices.

To evaluate whether or not rising interest rates will be good or bad for house prices, we need to examine a period when mortgage rates rose steadily and see what that can tell us about house prices.

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. This is an important point. Rising interest rates won’t necessarily impact house prices if wages move up even faster. In mortgage rates move up a small amount, and borrowing power is reduced by 5%, this won’t make house prices go down if wages go up 10%. It’s how the combination of wages and interest rates impact loan balances that matter. Looking forward, do any of you think wages will start rising rapidly in a high-unemployment environment?

Rising wages can also lead to another tipping point. 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 wages where increasing, and lenders allowed DTIs to grow even faster. If wages hadn’t been rising rapidly, house prices wouldn’t have gone up, and 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.

If a period of rising interest rates corresponds to a period of high wage growth, rising rates are not necessarily bad for housing. Also, if rising rates corresponds to a period of inflation and relaxed debt-to-income ratio standards, house prices may also go up. However, looking forward, it doesn’t seem likely we will see either high wage growth or relaxed DTI standards. For those reasons, rising mortgage interest rates will cause problems with housing, and future housing markets will be very interest rate sensitive.

A $134,000 purchase price and a $557,600 mortgage debt

Today’s featured property was purchased for $134,000 on 6/23/1992. Over the course of the 14 years that followed, rather than paying down the mortgage and owing about $60,000 on their original mortgage, the former owners of today’s featured property ended up borrowing $557,600 with a $400,000 first mortgage and a $157,600 stand-alone second. It’s unclear exactly how much they extracted because I don’t have their original first mortgage, but suffice to say it was a lot of money.

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2226 South TOWNER St Santa Ana, CA 92707

$469,900    ……..    Asking Price
$134,000    ……….    Purchase Price
6/23/1992    ……….    Purchase Date

$335,900    ……….    Gross Gain (Loss)
($37,592)    …………    Commissions and Costs at 8%
============================================
$298,308    ……….    Net Gain (Loss)
============================================
250.7%    ……….    Gross Percent Change
222.6%    ……….    Net Percent Change
5.9%    …………    Annual Appreciation

Cost of Home Ownership
——————————————————————————
$469,900    ……..    Asking Price
$16,447    …………    3.5% Down FHA Financing
4.40%    ………….    Mortgage Interest Rate
30    ………………    Number of Years
$453,454    ……..    Mortgage
$127,200    ……….    Income Requirement

$2,271    …………    Monthly Mortgage Payment
$407    …………    Property Tax at 1.04%
$0    …………    Mello Roos & Special Taxes
$98    …………    Homeowners Insurance at 0.25%
$510    …………    Private Mortgage Insurance
$0    …………    Homeowners Association Fees
============================================
$3,286    ……….    Monthly Cash Outlays

($571)    ……….    Tax Savings
($608)    ……….    Principal Amortization
$26    …………..    Opportunity Cost of Down Payment
$137    …………..    Maintenance and Replacement Reserves
============================================
$2,271    ……….    Monthly Cost of Ownership

Cash Acquisition Demands
——————————————————————————
$6,199    …………    Furnishing and Move-In Costs at 1% + $1,500
$6,199    …………    Closing Costs at 1% + $1,500
$4,535    …………    Interest Points at 1%
$16,447    …………    Down Payment
============================================
$33,379    ……….    Total Cash Costs
$34,800    ……….    Emergency Cash Reserves
============================================
$68,179    ……….    Total Savings Needed
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