Calculated Risk is one of the best financial blogs going. Accrued Interest should only hope to get 1/10th of their hits. And the blogging world will certainly miss Tanta. She and I had several e-mail conversations over the years and I learned a lot of very useful info about real-life mortgage servicing from her.
However, I really think CR is lawyering in this post from 12/3. In it, CR claims that lower mortgage rates will not improve home prices, only improve home demand. The crux of the argument is...
But the current buyer wouldn't pay much more, because the rational buyer would realize interest rates will probably not be artificially low when they try to sell, and their future buyer would have a higher interest rate and a lower price.
To me, this argument has a few holes. First, an increase in demand, ceteris paribus, will always increase the price of a good. I suppose one could make some kind of non-linear demand curve argument, claiming that demand is higher at the current price point but does not support higher price points. CR doesn't say that, but it sounds like that's what is being advanced.
To follow his logic, however, is to say that buyers are indifferent to interest rates. If rates are high now, they are likely to fall in the future and vice versa. The data doesn't support this at all. Housing prices tend to rise when rates are low and lending standards are easy. That's exactly why we had the boom we just had!
Now maybe CR is saying that the 4.5% would be obviously artificial since its the product of Fed manipulation. Perhaps. But I will say that within the fixed income community, its is widely thought that mortgage rates are fundamentally too high. With the 10-year Treasury at 2.55%, mortgage rates shouldn't be 6%. At least not for conforming (i.e., GSE) loans. Based on more typical ratios, the rate should be 4.5-5%. If they Fed were to manipulate the loan rate back to its long-term norms, why would we expect the rate to rise precipitously in the future? Maybe because Treasury rates would rise if the economy returned to normal, but then we're back to claiming that buyers ignore rates, which they don't.
Put another way, when the Fed pushed short-term rates to 1% in 2003, did buyers abstain from those low-low-low teaser rates loans? Did they rationally assume rates would soon rise in the future? You and I both know the answer.
Another way to think about it is if a home buyer plans on living in the home for an extended period, why not take advantage of the combination of low fixed rate mortgages and low prices currently available? Even if you assume rates may be higher in the future, wouldn't we also assume that over an extended period, say 5-7 years, housing would also recover?
Now remember that new housing construction is well below normal household creation. So ignoring foreclosures, net supply of housing is negative. Thus, even if 4.5% mortgages can't stimulate enough demand to cause home prices to rise, could it create enough demand to soak up foreclosures? If so, that would certainly be a major step in the right direction, no?
The $10 trillion question is whether the Fed can succeed in pushing mortgage rates much lower. The Fed has plenty of money to do it. Remember that although the entire mortgage market is very large, the Fed only needs to manipulate new loans to change the clearing rate. Comparing the Fed's balance sheet to the entire mortgage market is the wrong comparison. Its like saying they can't manipulate Fed Funds by measuring the entire intra-bank lending market.
All they need to do is announce a target and pledge their full resources toward that target. Mortgage rates will drop down to 4.5% very quickly.
Perhaps CR is thinking in terms of 4.5% mortgages "working" in that it "solves" the housing crisis. As I wrote here, there are no magic solutions that will immediately reverse the home price decline or avoid a deep recession. But there are appropriate measures which can help either diminish the downturn or shorten its length. This is one of them.
Isn't the choice between a present-day, painful adjustment in housing prices and forestalling that adjustment to a future date and hoping the pain will be less?
ReplyDeleteIf lower mortgage rates today prop up home prices above the "trend" price, what happens 3 years from now if inflation is raging and mortgage rates are 10% or more?
Aren't mortgage rates pricing in the lender's risk that today's homes are still over-valued?
Home prices are falling because home prices got too high. Is the best medicine for what ails us really price support for housing at the current level?
Maybe I'm just jealous. I paid off my 8% fixed 30-year mortgage early some years ago and won't directly benefit from government intervention to lower mortgage rates to 4.5%. Besides my envy and self-righteous preaching of moral hazard, I also fear that the piper will still have to be paid, with interest.
I would argue that mortgage spreads were lower in the past because the perceived risk was unreasonably low and the productivity "innovations" in the mortgage industry were temporary. The Fed is effectively saying the market is acting irrational and it knows better. Perhaps the spreads we are seeing are a retrenchment to good old fashioned lending, where more overhead is required to properly originate and service mortgages, not the centralized and model-driven methods of the past decade that caused so much grief.
ReplyDeleteSure a prime borrower would be able to get 4.5% but how about the part of the market that is not "prime"? How far must their rates be lowered for them to buy on the same playing field as prime borrowers? They were given a free lunch in the past decade. I wonder how far the Fed would have to lower rates for the "subprime" and "near-prime" people for them to have any impact on the market price.
"wouldn't we also assume that over an extended period, say 5-7 years, housing would also recover?"
ReplyDeleteIsn't "recovering" what is going on right now? Why would we assume that after prices stabilize, they are ready for another cycle of speculation. A more likely outcome, IMO, is for prices increases to dwell at inflation for a long time, longer than 5-7 years nationally and even through a strong recovery.
I think your point about helping to soak up foreclosures is an excellent one, although I tend to lean towards the side of it leading to really just propping up home prices above what they need to be. Thanks for presenting another side to the argument, definitely good stuff to think about!
ReplyDeleteOregon:
ReplyDeleteLower mortgage rates would only result in a normal counter-cyclical impact. Not a return to above-trend price returns.
So I don't understand your moral hazard argument, when what you are talking about is punishing people who made good housing decisions. The 4.5% mortgages will only go to people who can put up down payments and afford the fixed payment.
By doing nothing, you are risking a downward spiral in home prices that hurts everyone. Where is the moral hazard?
Jesse:
I said prices would likely be higher, at least nominally, in 5-7 years. Inflation benefits borrowers, don't forget. You are better off in real assets given inflation!
I had been thinking along similar lines regarding the Case/Shiller index.
ReplyDeleteThat is, to some extent the index is driven by interest rates. Or, the inverse -- people are very "monthly payment" driven in their buying decisions.
Therefore, in the 1990's when interest rates were in the 8% range, index values of 100 are equivalent to index values in the 120 range with interest rates in the 6% range.
For a crude, simple explanation of housing prices, just look at monthly payments. Because thats what people really base their decisions on.
Therefore, lowering interest rates would increase demand, stabilize prices, possibly keep them from under shooting on the down side.
Also, simply doing a refi would put money in people's pockets. And even if Americans have to deleverage, save, etc. They will spend if they have it. Plus, deleveraging and saving will correct imbalances that preclude growth in consumer spending.
I don't have a problem with anything that allows more orderly unwinding of excesses, and an (additional) interest rate subsidy is fine by me.
I would, however, like it to only apply to existing housing. Hate to think that we would subsidize building more housing.
That would not go over well with the builders, and may not be politically feasible. Maybe that's a reason not to do it.
I think that the extent of a monthly payment mentality is under appreciated by analysts -- at least a lot of the time.
ReplyDeleteThe instant people got positive carry on housing with a couple of years of home price appreciation in excess of interest rates, there was a speculative bubble.
The man on the street got huge leverage and positive cash flow and his brain stopped there. Not that difference then hedge fund behavior, in a lot of respects.
The most striking recent example was the economic behavior of individuals when gas hit $4-$5/gallon. People were dumping expensive SUV's etc at huge capital losses and buying high milage cars at a premium to list prices.
These were "investments" that would have taken years to pay off at $5/gallon. But seeing out of pocket cash go into the tank had much larger weight then a more nuanced total cost of ownership perspective.
It's like (some) people didn't give a thought to how long it would take to recoup $10,000 or $15,000 in additional costs (loss on suv/premium on prius).
"Inflation benefits borrowers, don't forget. You are better off in real assets given inflation!"
ReplyDeleteIf you are highly leveraged your are not better off in real assets. This is the problem -- it is fine to inflate away debt if the debt servicing is manageable but when affordability is stretched it is catastrophic.
Thanks for the interesting article.
The moral hazard enters with support of the Feds waving a magic wand/manipulating mortgage rates/ propping up Freddie/Fannie MBS.
ReplyDeleteThe central planners will likely solve one problem and create unintended others. Painful as it may be, they are crowding out economic actors with fresh capital and not allowing a true market clearing price to surface.
jimi
It seems to me that the real question is what the clearing price would be in a normal supply demand situation, with "reasonable" pricing (spreads may be artificially wide, but you could argue that treasuries are similarly artificially low in this environment). Are prices beaten down too far, or is the weak economy, layoffs, tough affordability the cause for where prices are? If the latter, while these efforts might help on the margin, it seems a big rock to push for the government and maybe questionable as to the validity of doing it, in my mind, given that what you really want is confidence in the housing sector, not everyone holding their breath as to what might happen next. This is a tough topic though...
ReplyDeleteLower credit standards were responsible for a surge in homeownership rates rather then lower interest rates.
ReplyDeleteExcess inventory will continue to drive down home prices for years as the need for 2nd and 3rd homes become a burden rather then a investment as declining RE values force more investors to dump holdings onto the market which has been vastly overbuilt due to tax and easy credit policy's of the past.
The idea that population increase somehow solves the inventory glut forgets that what has been built is largly unaffordable to most and their locations far from the employment centers adds little or no value to owning the 3bd,2bath, 1/4 acre house. Economic viable Housing can be apartments rather then the american dream house and given the current recession and economic fallout that will be the more economic viable option in the coming years.
Found this over at the links section at NC this morning a bit and link:
ReplyDeletehttp://www.portfolio.com/views/blogs/market-movers/2008/12/07/when-lower-mortgage-rates-dont-boost-house-prices?tid=true
When Lower Mortgage Rates Don't Boost House Prices
There's been some very good commentary in recent days about whether a reduction in mortgage interest rates might help boost house prices. Counterintuitively, the answer seems to be that there's a good chance it won't:
A 2006 study of mortgage rates and New York City housing prices going back to 1975 by Lucas Finco of Quadlet Consulting found no correlation between lower mortgage rates and higher housing prices, or vice versa. "The relationship between mortgage rates and home prices is pretty obscure," says Jack Guttentag, a professor emeritus of finance at the Wharton School of Business.
James Hamilton, a professor of economics at the University of California, San Diego, says he used to think that lower mortgage rates were responsible for rising home sales in the first half of this decade, and for that reason he projected home prices would rebound in 2007. He now says rising home sales were the result of deterioration of lending standards and not lower mortgage rates. "I was wrong. The real story with home sales has to do with the availability of credit," says Hamilton. "And credit is tight now."
Cap Vandal is right on the money about monthly payment mentality. That is EXACTLY how most Americans look at everything from houses to cars to flat screen TVs. The marginal buyer of homes is not someone looking at forward curves and anticipating that higher mortgage rates in the future may have negative impact on future demand and prices.
ReplyDeleteMy hope is that whatever support is implemented can be withdrawn once it's no longer necessary. The goal must not be to get everyone above water; they just need to put in a floor. If prices could stop falling within the next six months and remain flat for the next 5-10 years, that wouldn't be a terrible outcome. Inflation (if we can create some) will allow real prices to continue to decline to sustainable levels. Time will allow mortgage balances to be paid down. Consumer confidence and the broader economy would stabilize. While private lending would not be able to compete in residential mortgages, hopefully the improved outlook would encourage lending in other other stressed sectors such as corporates and munis.
Is anyone as surprised as I am at the severity of the losses in foreclosures. I read that this is around 50% of principal for subprime mortages in CDO pools...
ReplyDeleteIf mortgage lenders must price an imbedded short "put" that is say 25% in the money, then it is hard to do this on a 4.5% interest rate.
On severity, I actually wonder the whether CDO pools who may have been scammed on the way in (falsely documentated loans) may be being scammed on the foreclosure side as well (eg large 'vulture' investors dealing with banks acting as servicers for CDO pools with their own capital not at risk but with a chance to profit from lending to vultures).
I think that the priority should be to use bailout funds to incentivize 'delinquent' owners to do a good job marketing the property while they are still in it, without using the 'f' word [suggest x months free rent in a new property post sale].
I've read some of Hamilton's commentary on interest rates and home prices. His arguement, if I recall, is that if you regress home prices against mortgage rates, you get a weak correlation. I think that has a lot to do with the fact that mortgage rates tend to fall when the economy is bad.
ReplyDeleteBut ignore that. Clearly the availability of credit matters for home prices. But you can't seriously argue that the cost of funds makes no difference! That just doesn't pass the basic logic test.
I liken it to the argument that larger deficits don't cause interest rates to rise. Academics have struggled to find the crowding out effect. But that's because there are so many other factors at play. To claim that government borrowing doesn't matter at all doesn't pass the smell test.
Consider this: does the rate matter when buying a car? We know the car is going to depreciate in the future...
ReplyDelete"To claim that government borrowing doesn't matter at all doesn't pass the smell test."
ReplyDeleteI am sure it will help with affordability but how much is required to stabilize prices and what sort of credit ratings will have access to such rates? You cannot give just prime buyers low rates; with the significant runup in ownership rates and foreclosures you have to make rates affordable for the not-so-prime buyers as well or the efforts to flood the market with low mortgage rates will be but a drop in the bucket.
I am sure many buyers will pay higher prices since the mortgage rates are lower but if a large portion of available buyers -- the "rational" ones CR alludes to -- continue to hold out, what will happen? The 4.5% mortgage rate merely buys a higher quality house as prices continue to drop -- there is still a significant supply imbalance.
I hope we can appreciate how significant a move to game the entire country's housing market's cost of capital is and how long term such a commitment it really is. It will involve way more thought than setting rates for prime borrowers.
The idea that interest rates don't matter because regressions don't work -- well -- there are lags, noise, etc.
ReplyDeleteThree data points isn't much of an analysis, but simplly look at the 80's with 12% rates common and 10% good for most of the decade. The 90's were an 8% decade, and the 00's are 6% ish.
Plot that against Case Shiller and you have a nice three point trend.
Nothing is that simple and inflation and more particularly inflationary expectations were a real driver. But that is tied to interest rates also.
Mortgage interest rates are already heavily subsidized, so it isn't like we are messing with pristine competitive markets. The nationalization of the GSE's provided liquidity and has indirectly kept home prices from falling even further/faster. This is more of the same and seems like a no brainer as a short term improvement.
I'm not buying the idea that since the problem started from the bottom, it needs to be fixed from the bottom.
The most difficult part of this problem is that new houses absolutely must not be subsidized in any fashion. An inevitable problem when you start messing with markets. I am still concerned with the builders that think they can hang on and build their way out of this.
AI,
ReplyDeleteI love your blog too. You have your own niche, fixed income market analysis. I think if more people knew about your insight into the credit markets behaviour from a trader perspective, you would be posting Pepsi ads.
Your point is good regarding CRs opinion, but it is a waste of your time and blogging resources. I would rather see you cover other topics.
I have been hoping you would hit something juicy like how the T-Bill market is going to hand YoY deflation?
So what CR was a little nerdy and unrealistic in a post, it does not mean he is not spot on 90% of the time.
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ReplyDeleteThis comment has been removed by a blog administrator.
ReplyDeletePlease do not hawk your blog/website here unless you specifically are referencing a similar article. Otherwise I'm deleting your comment.
ReplyDeleteAnd tell whoever wrote your BOT software that the salutation should match the fake user name you create!
ReplyDeleteAs per my knowledge both lower interest rates and home prices are due to ongoing economic crisis.
ReplyDeleteSo, I don't really believe it may have success.
ReplyDelete