The Impending Mortgage Crisis: Part Three 11 comments
-
Font Size:
-
Print
- TweetThis
Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous articles on the coming mortgage crisis at SeekingAlpha).
To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.
Total Debt Matters
Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (i.e., money not spent on necessities). Total household debt is at an all-time high, and the savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition:
Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.
Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.
These are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about four percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.
Inflation Matters
Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.
Inflation in the U.S. is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.
Additional Reading:
Option ARMageddon take on this issue
Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.
Related Articles
|
Find People on SA
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largest
increase in followers
in the last 7 days-
1
David Fry
-
2
Bill Gross
-
3
Philip Davis
-
4
Tyler Durden
-
5
TraderMark
Fastest Climbers » -
1
-
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 11 comments:
- it allows people to adjust to the reality of lower real estate prices
- it gives banks time to shore up their balance sheets
- it prevents big market swings in both the real estate and the stock market
- it allows inflation to actually work in his favor. Two years of inflation is roughly 6%. That's $15,000 on a 250k home.
The downside is it's at the expense of the American public in the form of higher prices and anemic growth.
It would be much better to raise interest rates to a level sufficient to encourage even diehard hyperconsumers to save (10% would have me interested again but the shoe and plasma TV addicts will probably need more). This will make housing cheaper, forcing all the marginal "owners" out of the market and making it clear that many banks are insolvent. There will be blood. But a few years on, higher savings, lower prices, and the promise of lower rates in the future will fuel a recovery as daring buyers with enough capital to withstand calling the bottom a few years early start jumping in. It will also make oil and food cheaper by strengthening the dollar, further boosting Americans' ability to save and invest. It's no panacea - job destruction will be substantial. But corporations are generally in much better shape financially than consumers; many are sitting on accumulated cash from years of record earnings, and the wise have taken the opportunity to clean up their balance sheets, refinancing risky short-term debt with long-term debt at lower rates, buying back shares, and selling or closing loss-making operations. The damage there will be less than one might assume, and while financing costs would rise, energy and materials costs would fall (a major drag on earnings recently), and those companies with plenty of cash would actually find themselves motivated to invest some of their interest and earnings in cheap assets they can use to grow their business. In short, the process of creative destruction would proceed at all levels instead of being hindered by a Fed policy determined to keep everyone, no matter how weak, limping along with slow growth, high costs, and rapidly rising prices. Amazing that they didn't learn anything from the 1970s. Maybe they think "it's different this time"?
It is highly unfortunate that a housing bubble occurred just before this slide in consumption started. It is possible that the excess housing will not disappear for a decade.
Our best bet - though I do not see any politician picking up this ball, is to create an economic union with Mexico. The flood of young and willing workers would revive the sagging demographics of the 20 to 35 year olds and simultaneously reduce our National Security problem. Mexico's southern border is much smaller and could be well-controlled if desired.
I have sold as much residential rental housing and purchased as much student housing as I could- 2 1/2 years ago. As the economy declines, and people have difficulty finding jobs - they return to school - to gain new skills or to delay that day when they need to get a regular job.
I also shifted from regular equities to Canadian Royalty Trusts, and, as soon as I can find them, suitable, income-producing Limited Partnerships with substantial Tax deferral characteristics.
I share his opinion that the diminishing impact of the Boomer generation will act as a drag on housing. Here's a link to an article I wrote-blog.metro-real-estate.... It also contains a link to a related article on the same subject.
Why do you think both Republicans and Democrats turn a blind eye to illegal immigration? We need the population. The problem is getting everyone up to full levels of employment and productivity quickly. This actually happens pretty quickly- usually the second generation is there. With Mexico turning into a significant manufacturing country over the last 30 years, many first generation immigrants have a lot of skills.
Your prescription is right on the money, but it won't happen. America is like the typical American, who has neglected his health through bad living habits. When the doctors says, you must start living right, and by the way, some unpleasant medical procedure will be necessary to fix some of the results of past practices, the patient exits the doctor's office and doesn't return. Eat nutritiously, give up harmful consumptions, exercise seriously, get those gums and knees operated on...no, not right now. I'll just continue on the way I'm used to, and get worse as time passes.
What you propose is an end to American consumerism, the creed that more and bigger is better. Overall, as a country, we will not let go of that lifestyle voluntarily. Cut back a little, maybe. Credit cards maxed out, evicted and bankrupt, that person will change because he has no choice. Lower your living standard and save a significant portion of your income for the future -- that's a stretch.
I recently did an analysis on housing prices and the house price to income ration and included some charts.
What they show is that the rise in home prices follows almost exactly the rise in house price to income ratio. There's also a chart going back to 1981, when the prime rate was over 18%. From 1981 through 1999 the house price to income ratio was pretty stable at around 3.0 even though there was a huge drop in the prime rate compared to what we've seen in recent years.