By Ramsey Su
The website Mortgage-x.com provides a number of historical charts of mortgage rates. Here is the one that I would like to discuss. It is a chart of mortgage rates over the last 50 years.
[Click to enlarge]
Via Mortgage-X.com – 50 years of mortgage rates in the US.
What a beautiful chart. If this were the only data I had, it would be logical to conclude that for the twenty years starting in the early 1960s, this country suffered from increasing housing costs, probably accompanied by a long period of inflation. In 1983 it finally got its finances in order and the next thirty years were a long period of prosperity. Its citizens enjoyed home ownership at very reasonable cost.
How is it possible with such accommodating mortgage rates such as we enjoy at the moment, to suffer a real estate crisis with record defaults, foreclosures and many mortgages exceeding the value of homes? Even more puzzling is that mortgage giants like Freddie (OTCQB:FMCC) and Fannie (OTCQB:FNMA) had to be taken over by the government.
For the record, Paul Volcker was Federal Reserve Chairman from 1979 to 1987, exactly the period of the 'Matterhorn' on the chart. It appears that he came in when rates were around 9%, did a big battle with inflation and left when mortgage rates were back down at 9% after peaking at almost 15%.
Greenspan took over in 1987, initiating a period of almost 20 years of easy credit, taking rates from 9% to 6% when he exited in 2006. Not to be outdone, Helicopter Ben took these rates even lower and did it even faster, to around 4.5% today.
But let's forget the past, where is all this leading us?
Not a day goes by without some guru on CNBC complaining about how difficult it is to qualify for a mortgage these days. That is total baloney. The documentation and verification may be cumbersome, but loans have never been easier to qualify for.
The national median home price is only $184,000 according to NAR (National Association of Realtors, ed.). At 4.5%, the monthly payment for a mortgage is only $900 per month and some change. Household income of about $2,700 per month should be sufficient to qualify for such a loan. How low is household income of $2,700 per month? In California, the minimum wage is $8 per hour or $1,387 per month. A household of two making just minimum wage ($2,774) would qualify. How much easier can it get?
Where are mortgage rates going from here? The current low rate is the result of the combined monumental efforts by Heli-Ben via his 'QE' operations and the costly guarantee of the Treasury for all GSE loans, which represented the bulk of mortgage financing over the last few years. It is difficult to imagine how rates could go much lower and terms more favorable.
What if mortgage rates were to go up? It would be a total disaster, even if they rose just by one percent.
If market participants are complaining about the difficulty in qualifying now, an extra percent should slam the door shut on a lot of first time buyers. Trade up buyers would have to give up a lower rate loan on their existing home in exchange for a higher rate loan when they trade up, which wouldn't make economic sense. Most damaging would be the effect on refinancing activity. Today, according to the Mortgage Bankers Association, 70% of all loan applications are refinancings.
Just from looking at the mortgage rate chart above, this behavior is obviously very logical. Every borrower who has the ability and sufficient equity should be refinancing every time rates ratchet down further. The contribution of refinancings to economic activity has likely been under-appreciated in recent years. Not only are they providing the banks with revenues and fees, each refinancing benefits borrowers, if only in the form of a reduced mortgage payment, leaving them with more disposable income to pay for the next i-Pad. If mortgage interest rates were to reverse trend and move up, refinancing activity would not merely slow down, it would come to an abrupt stop.
What about real estate prices? There is no valid measurement of costs, nor do I know of any meaningful method of measuring costs being available. As sophisticated as the Case-Shiller house price index may appear, it has a major flaw – it contains no adjustment for prevailing mortgage rates.
If a property sells for $200,000 (inflation adjusted) today, and the same house sold for $200,000 ten years ago, does that mean the price has not changed in ten years? Not really, at least not from the point of view of mortgagors. Ten years ago, the mortgage rate was around 7% compared to 4.5% today. For a mortgagor (the vast bulk of homeowners), the same $200k house is much cheaper to own today than it was 10 years ago. My point is that with artificially low mortgage rates today, real estate prices have in reality declined substantially more for mortgage borrowers than it would appear from the reported price statistics alone, be it the Case-Shiller index, or NAR's or the FHFA's (Federal Housing Finance Agency, ed.).
In this respect, real estate is normally similar to the bond market. If rates go up, real estate prices should come down and vice versa. That mortgage rates declined so rapidly during the Bernanke years and that this could still not halt the decline in real estate prices is very disturbing. The real estate market appears like the proverbial camel waiting for the last straw.
We have reached the end of an era of the real estate market as we have known it. What eventually emerges from the other side is anyone's guess.
I believe GSE reform will be decisive in shaping the future of the US real estate market, but at the moment I don't know if anyone else is even thinking about the topic.
By Pater Tenebrarum
Ramsey is quite correct – in times past, residential real estate happened to trade almost like a bond – prices would move inversely to interest rates, reflecting the change in the cost of ownership to mortgagors. Obviously the fact that this is no longer happening shows that something has seriously gone wrong. From an analytical standpoint, real estate can be treated as akin to a capital good due to the long time period during which it renders its services.
What happened in real estate during the 'bubble years' was a case of malinvestment on an unprecedented scale. Greenspan was widely hailed as the 'maestro' for ending the slump that followed the collapse of the technology boom by lowering interest rates to rock bottom and goosing the money supply (at one point in the recession, the growth of broad money TMS-2 went to over 20% year-on-year, a record not even matched by the Bernanke Fed yet).
Alas, as we can now see, the boom's prosperity was an illusion – it made no-one richer in the end. On the contrary, it dealt a deadly structural blow to the economy, ultimately extracting a high price from a broad range of economic actors, not only those directly involved in the housing boom.
'MEW' (mortgage equity withdrawal) via home equity loans to be spent for current consumption was in fact a glaring example for what Austrians refer to as capital consumption. Today not even rock-bottom interest rates can stop the bust from unfolding – too many houses were built, and more importantly, too much capital was consumed during the boom.
It is indeed an illuminating illustration of the process and what it leads to in the end. We would note to Ramsey's question of what will eventually happen, this sector of the economy needs to reach market clearing prices before one can begin to think about a sustainable recovery, something the administration and the central bank are desperate to avoid. And yet, trying to uphold the fiction that the capital losses are somehow not 'real' in order to protect the solvency of banks does not alter the fact that the capital was really consumed.
By means of sufficient money supply inflation, the price decline in the real estate collateral backing nearly $3 trillion in mortgage loans that are still on the banks' books could conceivably be halted or reversed – but society would invariably pay an even bigger price for such a policy down the road.