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It is remarkable to me to watch the level of bullishness surrounding housing today. From homebuilders to home furnishing stores, the euphoria continues to reach a fever pitch. However lurking beneath this endless torrent of positive news is a reality many are either blind to, or just not willing to believe. By artificially suppressing interest rates by way of its quantitative easing program, the Federal Reserve is sowing the seeds of the next housing correction.

There are multiple reasons why this is the case, however, one in particular stands out. The low interest rates today are fueling housing demand that would not otherwise exist. This dynamic is multifaceted. Demand is fueled both by investors rushing into housing, in search of yield in the form of rental income, in addition to actual home buyers, convinced that home prices have bottomed, and interest rates are bound to rise. Unfortunately, the dynamic of rising interest rates and rising home prices will at some point diverge. Historically, rising interest rates have corresponded with rising inflation, reflective of an environment where home prices as a real asset also rose correspondingly. Unfortunately, the current experiment in monetary intervention in place at the Federal Reserve has the potential to backfire dramatically when mortgage rates begin to rise, but home prices no longer follow suit.

Why This Housing Recovery Is Different

Housing is a cyclical industry that, over the course of U.S. history, has sloped gently upward in terms of both home prices and new home starts. The housing bubble that popped in the mid 2000s was the exception, not the norm. Historically, homeowners in the United States could expect to see the value of their home slowly increase over time.

The housing crash, followed by the collapse of mortgage interest rates, has set the table for a new housing market that is in uncharted waters. If you look back at the last 40-year history of mortgage rates, you will notice that rates moved sharply up and down over a wide range every few years as seen below:

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Now look at a chart showing interest rates from 2000 through present day:

(click to enlarge)

There is no comparison of how mortgage rates acted over the last 40 years, compared with the last 15 years. Since 2000, rates have moved steadily downward, with any uptick in rates being no more than a blip on the chart. Further, mortgage rates have now spent the better part of the last three years under 5%, dropping under 4% under the last year. The implications of these historically low interest rates are what makes this housing recovery different than any other, and ultimately why the housing market is setting up for another correction.

Implications Of Historically Low Mortgage Rates

While most applaud the government for its efforts to create programs allowing a significant portion of U.S. homeowners to take advantage of historically low interest rates, the real story is these same homeowners are potentially being locked into their current homes forever. As of 2010, government sponsored entities such as Fannie Mae and Freddie Mac, backed over 50% of all mortgages in the United States. Since that time, the amount of new mortgages issued through government controlled entities has only increased as a percent of the total mortgage market. Thus, it can be assumed that well over 50% of all mortgages today are backed by the government. Thanks to the generous government refinancing programs, it can also be assumed that over 50% of all mortgages outstanding today are at close to record low interest rates. Considering that in order to refinance your mortgage if it is owned by an entity such as Fannie Mae, it does not matter how far underwater you are on your home. Just about any person planning on keeping their mortgage has refinanced it at the record low rates by now as well.

Looking back at the chart showing the last 40 years of mortgage rates you notice two things very quickly. Rates would rise and fall, sometimes dramatically, every few years. You also notice that rates were never close to being as low as they are today. Taken in context, consider the population of homeowners today that have record low interest rates. What reason will they have to purchase a new home as mortgage rates rise from ashes? Further, will they even have the financial ability to qualify for a new mortgage as rates rise? The answer is no, barring material changes to the employment and wage outlook for the average American.

Can Wages Keep Up With Rising Mortgage Rates?

As of February 2013, the median household income in the United States was just over $51,000. At about the same time, the median home price in the United States was about $189,000. These are important statistics to understand when considering the impact of mortgage rates. As rates begin to rise, coupled with home prices that have bounced significantly from the bottom, the population of people eligible to purchase a home will diminish significantly. The caveat to that statement would be if household income were to rise as well. However, the chart below shows that even at the peak of the housing bubble, household income was only about 10% greater than it is today:

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Others have opined recently that small mortgage rate increases, less than 10 basis points as an example, have potentially impacted housing. A small increase in rates is again, just a blip on the radar. The real concern comes when interest rates rise from the range of about 3.5% where they are today, to say 5% sometime in the next few years. To illustrate how this would impact the housing market, see the table below:

(click to enlarge)

The table above shows various mortgage amounts, and the impact of mortgage rates increasing from 3.5% to 5.0%. The most important takeaway of this entire article is the bottom line, showing annual compensation required. At the median home price in the U.S., of about $190,000, a 1.5% increase to mortgage rates would require a corresponding $7,000 increase in compensation to qualify for that mortgage. Let me reiterate that comment. If the median household income is $51,000 today, it would have to increase by over $7,000, to be able to afford the same mortgage payment that it can at today's record-low rates. Look back above at the graph of median household income shown. At no time in the last 15 years has the median household income been $7,000 more than it is today.

This is the conundrum that the Federal Reserve faces. Wind down quantitative easing, allowing mortgage rates to rise, and without question the housing recovery will end because the population of qualified buyers will drop with every tick higher in mortgage rates. Conversely, continue quantitative easing, and artificially push home prices higher and lock more and more people into their current homes. The pitfalls of continuing the easy money policy are just as severe. With this policy comes the potential for home prices to continue rising too quickly, combined with a significant portion of today's homeowners unwilling and unable to buy a new home in the future with significantly higher mortgage rates.

Ultimately, whichever path the Federal Reserve chooses is fraught with risk. The easy money has been made in housing and housing-related stocks over the last few years. As the drumbeat grows louder for the end of quantitative easing, it would be prudent for investors to step back and watch the fireworks that accompany it from the sidelines.

Source: Housing: The Risk Of Rising Home Prices And Mortgage Rates