Why Last Week's Interest Rate Based Selloff Was Overblown

Bill Gross is being blamed for dropping an enormous boulder on the road to leading up to a 30% year for the U.S. stock market.

Apparently Mr. Gross envisions 6.5% on the ten-year coming sooner than most people would like. This potentially hurts stocks and slows the economy as, quite obviously, accessing capital becomes more expensive.

While this is true, I think it calls for a little perspective. A $300,000 mortgage at 6% for 30 years will have a monthly payment of $1798.65.

At 7.5% the payment goes up to $2097.64. For a couple, each making $3000-$4000 per month I am not sure this is a deathblow to the dream of owning a home. It probably is an inconvenience that squeezes out the marginal buyer, or more likely, forces the marginal buyer to find a house that is a little cheaper. Here the context is people buying a home to serve as a primary residence.

For real estate that is intended to be an investment, speculative or otherwise, might not prices coming down a little bit result in a balancing out, or at least a partial balancing out? It seems plausible in some markets.

Regarding the portion of this rally that is attributable to private equity, and whatever the expectation might be about the future contribution to any further lift, it would probably have to be repriced if rates do start moving up that much.

I think the real thing here and now is that the ten-year, and Bill Gross, created an excuse for a sell-off of some sort. The move last week has been very fast, and while the move may have kept going for another day or two, it is very unlikely that the market can maintain the type of velocity we saw last week.

If this is the tipping point of the financial apocalypse (intentional hyperbole), you will have plenty of time to get out without succumbing to emotion. This is why, in the past, I have preached about making a simple plan for yourself as to when you would take defensive action, and what that action would look like, long before you need to. This removes some of the emotion for folks who are prone to emotion.

Comments

[Alan Brochs...:]

Roger,

I believe that the market is selling off not because what Bill Gross says but more about what the Fed is (or is not, in this case) going to do. The entire yield curve trading below short-term borrowing costs certainly reflected some optimism that the next move would be down for the Fed Funds. The weak Q1 GDP print wasn't what it appeared, with real consumer spending very high. A lot of the date coming through suggests that the Fed could justifiably discuss RAISING rates (I doubt that they do).

The market is in a tough spot, as the odds, seemingly, of sustaining economic growth are getting long, especially without a stimulative borrowing cost. You hit on a lot of areas that obviously could become troubling, including housing and the PE bid.

I am very bearish short-term - the market needs to shake out some of the complacency. I think, though, that we will have another run-up after a brief decline. As we move into the election year, I am not expecting the trend of the last few years (up) to be as pronounced.

2007 Jun 11 02:40 PM

[Dominick:]

I fail to be reassured by the comfort writing of this article.

To me, it is one more reminder of people’s behavior during the dot.com blow-out days. Even, as the dot.coms were getting slammed my investment banker friend acted like it was no big deal. The Dot.coms offered no real product and all you needed to do now was find a tech firm that offers real product like fiber optics.

No one bothered to question my investment banker friend’s salesmanship, no biggy, look on the bright side attitude. No one wanted to talk too negatively about the crumbling stock market, admit to all their friends how serious their losses were, or the acknowledgement that maybe they had been a bad investor.

Now, I see before me another example of, oh, you have additional expenses, you property value went down, no biggy. Maybe your understanding is distorted because most people do not care to discuss how cash strapped they really are.

2007 Jun 11 05:42 PM

[Roger Nusbaum:]

Interesting perspective you take. Are you saying that the market for primary residences bought by people that are not over leveraged is in trouble?

2007 Jun 11 09:57 PM

[Dominick:]

What I feel is that you are trying to refine the problem to a small circle of people, just like in the dot.com bust at first they tried to say that only a small circle of the most irresponsible companies where in trouble.

There was an effort to comfort investors by investment bankers. There were also investors who did not want to admit how difficult things had gotten for them. The result is we get a lot of people saying no biggy, when it really is a biggy.

Back in 2000, people with the old industry mentality felt like a dot.com downturn would have nothing to do with them.

It was a case of not understanding how big the circle of trouble really was and not acknowledging how much those irresponsible dot.coms could drag everything else down with them.

The answer is yes definitely, the difficulties of the most stretched buyers could drag everyone else down with them in a downward spiral.

I know that here in southern California real estate gets slammed, maybe other parts of the country won’t fair as bad.

I bought my first duplex in 1996 for $170,000. The previous owner purchased it in 1989 for $275,000. That’s a 38% drop in the value of that home. It would be enough to shake up even those who were not highly leveraged at the beginning.

2007 Jun 12 10:43 AM

[Roger Nusbaum:]

And what is it worth now? Was this duplex a primary residence for that person?

2007 Jun 12 11:40 AM

[williamjbond:]

Roger,

A couple of major points you are missing here. You use the example of a couple making $3k to $4k to buy a $300,000 house.

The biggest is that you can't find a decent house in the bubble markets for $300k. In California, NYC and Boston, $300k doesn't buy you much, especially here in California.

Moreseo, the couple you mention would have about $4,000 to $5,333 after taxes assuming typical tax rates and no contributions to retirement funds. So now you are talking about increase the percent of their take home income from 45% to 53%. And that's using $72k/year which is still above the median houshold income to buy that fictious house that doesn't exist in most bubble markets for $300k.

That's the problem with using averages. You take out the highs and the lows and and you are left with a number that often doesn't mean anything. The problem lies in the bubble markets like California where couples who are making $6k-$8k per month have gotten into $600,000 to $700,000 loans, often with higher rates, based on the assumption that prices will just go up. Any pullback and prices and the house of cards comes down.

Lets say a dumpy house in Los Angles costs $550k and a dumpy house in Buffalo, NY costs $50k (sadly I've lived in both places and its true) to give you the $300,000 average priced house you use in your example. If prices fall 10% in California and rise 10% in Buffalo in this example, the result is still an average drop in prices of 9.1%. The real problem here is that the rise of the bubble markets drives the median and the average much higher and when things pop at the higher end of the market due to subprime disappearing and interest rates rising, its not just the $300 extra in payments that become a problem, but the mechnism of price increases that let people perpetually refinance that become the problem. It works the same way but in reverse.

In closing, I just wanted to say you're comment about $300 not making a difference to an averge couple is a bit out of touch. With mortgages, credit cards, car payments and increasing gas and food prices, $300 extra a month is often more than most average people save in a month.

2007 Jun 12 01:45 PM

[wixeywaxy:]

I'm retired and don't owe a nickle to anybody and in addition I have a better income than your example and live in a relatively low cost area. From my own experience I don't see how a couple earning $4000/month can make it at all if they have children. Maybe if they live a lifestyle that is far below the standard. One thing I'm sure of $300/month would make a difference. $3600/yr will sure make life a little better for anyone struggling at the margin. Vic

2007 Jun 12 03:06 PM

[Roger Nusbaum:]

Guys if you look a littler closer I say <em>each</em&... making $3000-$4000 so $6000-$8000 for the household. Mr. Bond the example does not hold up for LA, SF, Boston etc but it work in a lot of other places.

2007 Jun 12 10:29 PM