Housing Market Sinking, But Mortage Rates Still Near Historic Lows

by: Tim Iacono

The most disturbing fact regarding the nation's teetering housing market - where the imbalances between dramatically rising inventory and slowing sales have built such momentum in recent months that prices are now in severe danger of broad declines - is that traditional mortgage rates are still near historic lows.

In recent days, 30-year mortgages could be had for just under six percent - something virtually unheard of for decades, yet commonplace since 2003.

Now everyone is carping about how far prices will fall - not if they will fall - and the impact they will have on the economy. With interest rates for traditional mortgages at multi-generational lows!

How the heck did we get into this situation?

Let's review the Fed's three-pronged mission for conducting monetary policy - maximum employment, stable prices, and moderate long-term interest rates. That would be:

* Under five percent unemployment (near optimum)
* About a four percent increase in the CPI over the last year (a bit high but still low by historical measures)
* Long-term interest rates around five percent (very low)

The Federal Reserve is doing its job splendidly - where's the problem?

What kind of upside-down, inside-out world is it that we are living in if people are worried about a housing market where prices are still rising modestly and monetary policy is in near-Utopian condition?

The OFHEO Report

Yesterday's OFHEO (Office of Federal Housing Enterprise Oversight) report of the second quarter Housing Price Index (.pdf), probably the most reliable report available for the purposes of judging the direction of prices, showed that while prices have not yet begun broad outright declines, that is likely to occur in the next few quarters given the most recent trend.

It seems that downward price pressure may intensify in 2007 as the toxic mortgages of the last few years wear on their once-proud owners who find that while monetary policy may be ideal, their cash flow and balance sheets are far from it.

Toxic loans have a way of distorting homeowner finances as well as entire economies. Maybe the Federal Reserve should update its mission statement to include a goal of not subjecting the entire planet to systemic risk by helping out in regulating the mortgage lending industry.

The OFHEO report had a couple of interesting highlights, the most notable being the unprecedented decline in quarterly price changes as indicated in the red highlighted area in the chart below. Of course nobody seemed much concerned with the trend prior to the recent reversal. Most people tend to ignore most things when most people are getting rich - something about not looking a gift-horse in the mouth, the beneficial but temporary effects of asset bubbles ... that sort of thing.

The folks at the OFHEO put it thusly:

Appreciation for the most recent quarter was 1.17 percent, or an annualized rate of 4.68 percent. The quarterly rate reflects a sharp decline of more than one percentage point from the previous quarter and is the lowest rate of appreciation since the fourth quarter of 1999. The decline in the quarterly rate over the past year is the sharpest since the beginning of OFHEO’s House Price Index [HPI] in 1975.

In all fairness, it could be said that housing is coming off of a series of such good years that maybe a national decline in home prices of ten or twenty percent won't do too much harm - if prices rise by 50 or 100 percent over a period of five years, then a decline of some small fraction of that amount might be just what the doctor ordered.

And maybe not.

Maybe that systemic risk thing will come into play - we'll find out soon enough.

Home Improvements

One aspect of the OFHEO report that gets little attention is the effect of home improvements on the home price data. With somewhere around a half trillion dollars of equity being "extracted" each year, and a goodly portion of that amount going into home improvements of some sort, just how much of the price increase could be logically negated by improvements that have been occurring at rates not seen since cave men began drawing pictures on walls?

When your home appreciates $200,000 over a period of a few years, and then you pull out $100,000 or so to put in that custom barbeque, a couple walk-in closets, an extra room for the cat, and a new garage for the RV, boat, and jet skis, there seems to be something left unaccounted for somewhere in the OFHEO data.

The OFHEO data does not factor home improvements into their calculation - it simply records the change in price for the same home when it is resold or refinanced.

There may well be a whole new set of home improvment guidelines offered in the years ahead if the OFHEO home price trend of the last year continues. It used to be that kitchen and bath upgrades held their value best, while landscaping and spas yielded much less at resale. Next year, homeowners won't know where to spend their home equity for the best return.

But there is little to worry about regarding home prices right now. So far, the OFHEO data is still mostly looking at declining price increases.

Prices are still going up - they are just going up less than they were going up a year or two ago when everyone was still gaga about real estate. Now that many are gagging on real estate, in the form of resetting mortgage payments and stalling appreciation that is increasingly thwarting plans for real estate mogul status, recent trends point to danger ahead.

Can't we just go back to a normal economy? Whether they deflate slowly or just pop, serial asset bubbles are probably not a good way to run an economy.

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