Thursday, May 10, 2007

Interest Rate See-Saw

It's a given that rising supply (inventory) and slackening demand (fewer buyers) lead to price declines in any market--for instance, housing. Since interest rates fell for an entire generation (22 years) from their peak in 1981, the relationship between housing prices and interest rates has been largely forgotten or at least neglected.

As interest rates rise, the "see-saw" of higher rates and dropping house values will place pricing pressure on even the most desirable housing. Here is a simple depiction of the relationship:

please go to www.oftwominds.com/blog.html to view the charts

The current quasi-religious belief in "low interest rates will last forever" runs against both history and the inevitable decline of Chinese support of our low interest rates via their stupendous, unrelenting, trillion-dollar buying of our low-return Treasury bonds: As this chart reveals, the only reason U.S. interest rates have stayed low is the Chinese have poured virtually all of their dollar surpluses into U.S. Treasuries.

Interest and mortgage rates, as I have often noted here, aren't set by the Federal Reserve, but by the market. If there is huge supply (our government selling hundreds of billions in new bonds and rolling over hundreds of billions more each year) and slackening demand (the Chinese have announced they're diversifying their holdings into other currencies), then rates will have to rise, regardless of what's happening behind closed doors in the Fed or in the U.S. housing market.

History also suggests (see chart) that interest rates move in about 20-year cycles. We have clearly ended the cycle of declining rates and are just beginning a 20+ year cycle of rising rates.

So what's this got to do with the value of U.S. homes? In a word: affordability. The majority of home buyers are not cash-rich foreigners seeking investment property, but working stiffs whose chief concern is "making the monthly mortgage nut." As shown on our charts, a buyer with an adjustable-rate mortgage at 4.5% was able to "afford" a $500,000 mortgage with a "monthly nut" of $1,875. (For simplicity's sake, the principal payment has not been included.)

Alas, were interest rates to rise to 9%--historically, not even a high rate--then the home buyer can only afford a $250,000 mortgage payment. That means the price of the house being purchased has to drop 50%. Some 6 million homes trade hands every year. Some small percentage are purchased with cash, meaning the buyers are immune to interest rate considerations.

But prices of all commodities are set on the margin. Which means the price of 100 homes in a neighborhood are set by the last house sold. Even if 99 of the homes were purchased for $500,000, the value will drop to $400,000 the moment a comparable residence in the area sells for $400,000. As interest rates rise, then the next house might sell for $350,000, the next for $300,000 and thre next for $250,000. It would only take a handful of sales to drop prices 25% - 50%, and in a much shorter period of time than the market thinks possible.

In a time of declining interest rates, buyers could "afford" more house because their monthly payment stayed the same even as their mortgage rose. The reverse will work the same way, only in the opposite direction: the same payment will support a smaller mortgage, requiring sellers to lower the price of their homes to what is "affordable" to buyers.

Another factor which has supported higher mortgages and monthly payments over the past 20 years has been rising income and wealth. There hasn't been a decline in consumer spending since 1991. An entire generation has grown up and matured in a "permanent" Bull Market in stocks, bonds and real estate and ever-cheaper borrowing costs.

But the coming recession of 2007-2011 will very likely see incomes and wealth both decline in absolute terms. This reduction in net income will further reduce buyers' ability to finance huge mortgages at higher interest rates. As interest rates rise, bonds fall in value, and as recession cuts corporate profits, the stock market will decline as well. All these forces together will reduce buyers' perception of their wealth (the "wealth effect") and reduce the bonuses, raises and dividends which added to their income during the past 20 years of prosperity.

Please see the Readers Journal for new commentary on healthcare costs from Michael S. and a new essay on the recent elections in France by correspondent/author John Kinsella.

Thank you J.B. ($20) for your unexpectedly generous donation via check. I am greatly honored by your support. All contributors are listed below in acknowledgement of my gratitude.

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