Lower Interest Rates and Home Prices

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 the 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.

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