Housing affordability set to plummet as interest rates spike again

The gyrations in most financial markets have little or no impact on housing. However, price fluctuations in the market for 10-year Treasury Bills has a strong impact on how much people can borrow to bid on houses. The 10-year Treasury is a close proxy for mortgage bonds as their durations are very similar. Price movements in either of these markets will impact the others as investors move back and forth for the best possible deal.

When prices for 10-year Treasuries fall, so do prices on mortgage-backed securities. When prices on mortgage backed securities fall, interest rates go up (yield is an inverse function of price on bonds). When interest rates go up, house affordability goes down because borrowers can’t finance large mortgage balances. So in an indirect, yet very strong way, prices in the Treasury bond market directly impact house affordability. When bond prices go down, affordability goes down with it.

There has been a great deal of volatility in the bond market since the federal reserve announced they were going to slow down and eventually stop their bond purchases. The so-called “taper” scared bond investors who didn’t want to be the bagholder when the largest buyer of these securities stopped buying. The result was a massive selloff in government bonds which triggered a selloff in mortgage-backed securities that sent interest rates soaring from 3.5% in May to over 4.5% now. This has obviously hurt house affordability.

The fact that concerns analysts who closely watch these markets is that this massive selloff was caused by only the rumor of a slowdown in federal reserve buying. There has been no actual slowdown to date. When the federal reserve actually does slow it’s purchases, and the market sees this occurring, the urgency to exit the market will become even greater. And since the entire market has been on federal reserve support for such a long time, nobody knows what the real price should be. When a manipulated market is turned back over to free-market forces, there is generally a great deal of price volatility as both buyers and sellers struggle to discover fair-market value. In short, interest rates will rise, but the flight will be turbulent.

Get ready for a ‘massive interest rate shock’ soon

By: Michael Pento — Published: Tuesday, 27 Aug 2013 | 11:26 AM ET

Wall Street and Washington love to spread fables that facilitate feelings of bliss among the investing public.

The value of blogs like this one is that I cut through the nonsense and spin put out by the MSM and provide a more accurate view of what’s really going on.

For example, recall in 2005 when they inculcated to consumers the notion that home prices have never, and will never, fall on a national basis.

We all know how that story turned out.

The latest happy-talk mantra is that rising interest rates will not impact the housing market. Article after article oozed from the bowels of housing analysts and reporters from May through August. Only in recent weeks when it’s become obvious that mantra is no longer operative has anyone commented on the impact everyone was denying for months.

Along with their belief that real estate prices couldn’t fall, one of their favorite conciliatory mantras that still exists today. Namely, that foreign investors have no choice but to perpetually support the U.S. debt market at any price and at any yield.

But, unlike what their mantra claims, the latest data show weakening demand in overseas purchases of Treasurys.

According to the U.S. Treasury Department, there was a record $40.8 billion of net foreign selling of Treasurys in June. That was the fifth straight month of outflows in long-term U.S. securities. China and Japan accounted for $40 billion of those net Treasury sales.

Those two nations are important because China is our largest foreign creditor ($1.27 trillion), and Japan is close with $1.08 trillion in holdings.

This shouldn’t be a surprise to those who are able to accurately assess the ramifications from the Federal Reserve removing its massive bid for U.S. debt.

China and Japan know they are bagholders. They want to get out of these assets they know will decline in value before the carnage gets worse. With the US federal reserve pulling back, and the two biggest soverign nations who hold Treasuries actively selling, the price should go nowhere but down.

In truth, yields currently do not at all reflect the credit, currency or inflation risks associated with owning Treasurys.

There is no price discovery. As market participants figure this out, prices will be very volatile.

If the Fed were not buying $45 billion each month of our government bonds, investors both foreign and domestic would require a much higher rate of return.

If investors demand a higher rate of return (which they will), then interest rates must rise. The interest rate on a mortgage is the investor’s rate of return on that investment. If investors demand higher returns, they are in effect demanding higher interest rates on mortgages or they simply won’t fund them.

Investors have to be concerned about the record $17 trillion government debt (107 percent of gross domestic product), which is growing $750 billion this year alone.

In addition, holders of U.S. debt must discount the inflation potential associated with a record $3.6 trillion Fed balance sheet, which is still growing at $85 billion each month. Also, foreign investors have to factor into their calculation the potential wealth-destroying effects of owning debt backed by a weakening U.S. dollar. …

Right now, the US dollar is the least bad place to park money, but if we keep printing, we can manage to destroy the dollar’s safe-haven status.

If the free market were allowed to set interest rates and not held down by the promise of endless Fed manipulation, borrowing costs would be close to 7 percent on the 10-year note. Let’s face it, the only reason why anyone would loan money to the U.S. government at these levels is because of a belief that our central bank would be there to consistently push prices up and yields down after their purchases were made.
Seven percent yields on 10-year Treasury Notes would translate to 9% mortgage interest rates. That would be a catastrophe for banks who need to reflate the housing bubble.

Our central bank has now adopted an entirely new paradigm.

Fed intervention used to be about small changes in the overnight interbank lending rate, which has averaged well above 5 percent for decades. However, not only has the Fed funds rate been near zero percent for the last five years, but also long term rates have been pushed lower by four iterations of quantitative easing.

The latest version is record setting, open-ended and massive in nature.

Prior to 2008, the GSEs were private entities, mortgage rates hadn’t been below 6% for 50 years, and the federal reserve had never purchased anything other than a short-term Treasury. All that changed in 2008. People became accustomed to these emergency measures and forget that this is nothing like the “normal” that existed prior to the 2008 meltdown.

Since QE is mostly about lowering long-term rates, it shouldn’t be hard to understand that its tapering would send rates soaring on the long end.

When the Fed stops buying Treasurys, foreign and domestic investors will do so as well. This means for a period of time there won’t be anyone left to buy Treasurys unless prices first plunge.

The effects of rising rates will be profound on currencies, equity prices, real estate values and economies across the globe.

It would be wise to prepare your portfolio for a massive interest rate shock in the near future.

I know I repeat this often, but buyers need to temper their expectations of future appreciation. The only reasons prices went up so abruptly over the last 18 months is because inventory was restricted and mortgage interest rates were artificially pushed down to record lows. Both of those conditions are changing. As prices near the peak, more and more underwater borrowers who cannot afford their houses will try to get out. Further, the huge interest rate stimulus is being quickly removed from the market. In the face of these two changes, and the likelihood of further interest rate increases, buyers should focus on getting a property they like and can afford because the dreams of soaring house prices and rapid appreciation probably won’t come to pass.

Why did the bank sit on this house for four years?

The former owner of today’s featured property was a Ponzi. He took his debt from $314,450 to $595,000 in four years. I imagine that extra $70,000 per year in spending money came in handy, but when the home ATM was shut off, he imploded, and the bank foreclosed back in 2009.

What’ strange about this property is the long bank holding time. They bought this at auction on 8/26/2009, and here we are four years later, and it’s just now coming to the market. Based on the current asking price, the banks stands to make a good profit on the deal.

How many more properties like this are out there waiting for higher prices?

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[idx-listing mlsnumber=”OC13173186″ showpricehistory=”true”]

25 SKYWOOD St Ladera Ranch, CA 92694

$707,700 …….. Asking Price
$331,500 ………. Purchase Price
9/14/2000 ………. Purchase Date

$376,200 ………. Gross Gain (Loss)
($56,616) ………… Commissions and Costs at 8%
$319,584 ………. Net Gain (Loss)
113.5% ………. Gross Percent Change
96.4% ………. Net Percent Change
5.9% ………… Annual Appreciation

Cost of Home Ownership
$707,700 …….. Asking Price
$141,540 ………… 20% Down Conventional
4.47% …………. Mortgage Interest Rate
30 ……………… Number of Years
$566,160 …….. Mortgage
$146,413 ………. Income Requirement

$2,859 ………… Monthly Mortgage Payment
$613 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$147 ………… Homeowners Insurance at 0.25%
$0 ………… Private Mortgage Insurance
$163 ………… Homeowners Association Fees
$3,782 ………. Monthly Cash Outlays

($671) ………. Tax Savings
($750) ………. Principal Amortization
$234 ………….. Opportunity Cost of Down Payment
$108 ………….. Maintenance and Replacement Reserves
$2,704 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$8,577 ………… Furnishing and Move-In Costs at 1% + $1,500
$8,577 ………… Closing Costs at 1% + $1,500
$5,662 ………… Interest Points at 1%
$141,540 ………… Down Payment
$164,356 ………. Total Cash Costs
$41,400 ………. Emergency Cash Reserves
$205,756 ………. Total Savings Needed
[raw_html_snippet id=”property”]