Home prices and interest rates

With mortgage rates near record lows, due both to low inflation and negative real rates, the leveraged purchasing power of real wages is near historic maximums. Additionally, for the most part, it looks like the bottom is in for housing price declines. Does this make it a good time to buy leveraged real-estate to capture future price appreciation while financing it at low rates? I do not think it's as clear as many people think it is. Below we'll explore why.

Purchasing power of a $1,000 monthly payment on a
30-year fixed-rate mortgage assuming 15% down-payment.

The purchasing power of a fixed monthly payment is dependent on two things, the number of periods, and the interest rate. If we maintain the the number of payments constant and put interest rates on the x axis and purchasing power on the y axis, you can see how purchasing power declines at a declining rate as rates increasing. In other words,  it is an inverse exponential function, the first derivative of purchasing power with respect to rates is negative while the second derivative is positive.

"primary-secondary" spread

To keep this exercise simple, we will consider the interest rate on a mortgage to be a function of a risk-free rate and a spread. For the sake of simplicity we will consider this spread as compensation the lender receives for taking-on various risks and duties (credit and prepayment risks as well as compensate the the servicer of the loan). The two accompanying screenshots illustrate the "primary-secondary" spread, or the spread between mortgage rates and the yield on mortgage-backed securities, and the spread between the yield of a 30-year current coupon MBS and the 10-year US Treasury Note. The sum of these two spreads roughly represents the aggregate spread between risk-free rates and the national average average mortgage rate.

Fannie Mae current coupon, 10-year US Treasury Note spread

As previously discussed, this is one of the main channels in which the Fed has been supporting the property market. By lowering the Fed funds target and through LSAPs (Large Scale Asset Purchases, colloquially known as QE or Quantitative Easing) they increased the purchasing power of payments by lowering the spread of MBS trade at to treasuries and lowered interest rates. Later on, by buying US Treasury notes and bonds, in what is sometimes called QE2, they lowered interest rates. And, finally, with 2011s "Operation Twist," they helped flatten the yield curve and bring down longer-term interest rates. By buying Treasuries and Agency MBS, the Fed pushed underlying risk-free rates down and and helped put downward pressure on the spread by pushing down the value of the embedded option in the securities (lowering implied volatility of the embedded option).

Finally, we need to recognize that the risk-free rate is also a function of two factors, the real rate of interest and future inflation expectations. The real rate of interest + inflation expectations equal the nominal rate of interest. We can observe the real rate of interest through Treasury Inflation Protected Securities (TIPS) and can compute inflation expectations by comparing that to the yield on regular treasuries, this is called the break-even rate. Therefore we now see that the purchasing power of a monthly payment is dependent on the mortgage spread, the level of real rates, and the market's expectation of future inflation.

You're probably thinking, "gee, thanks for the lesson, but what does this have to do with home prices?" Well, everything. As you can see from the charts above, both the spread on MBS and the level of real rates (how much return lenders expect to earn after inflation) are both at historical lows and the primary-secondary spread is refusing to fall despite record-tight spreads to treasuries. Increases in either real rates or MBS spreads would, unless accompanied by falling inflation expectations or lower primary-secondary spread, cause a fall in purchasing power. In fact, an increase from present mortgage rates of just 0.50% would lower the purchasing power of a payment by almost 6%!

Historical % of median household income required to buy
 a median-price existing home at prevailing mortgage rates

Until now we have worked through this exercise assuming the payment is fixed but, historically, we find that home prices tend to roughly follow wages. As you can see from the chart to the right, the payment required to buy a median price existing-home using the national average of mortgage rates mostly oscillates between 25% and 35% of median household income (mean is 30%). In other words, housing prices are constrained by purchasing, which is a function of wages and and interest rates. Which, finally, leads me to the reason I do not believe increases in home prices are as sure a bet as many think.

Purchasing power of various payments at a 3.5% interest rate

For home prices to sustainably exceed inflation, wage gains have to outpace inflation by more than the increase in rates over that same time period. We saw in the first chart that purchasing power increases at an increasing rate as rates decline. Here, we can see that see that, at a fixed interest rate, purchasing power increases at a stable rate with payment. This means that for home prices to sustainably increase, growth in wages not only has to outpace inflation, but it has to outpace it by a margin wide enough to compensate for losses in purchasing power from any changes in the mortgage rate during that same period.

The Federal reserve is taking extraordinary actions to keep interest rates, risk-spreads and implied volatility low in order to stimulate the economy and achieve their 2% inflation-rate target. Remember Chairman Bernanke publicly stated, "[the 2 percent target is] not a ceiling, it’s a symmetric objective." While this leaves the door open for future easing in the near-term, we need to remember that, at some point, the easing cycle will stop and drop in real rates will stop, even if it seems unthinkable now.

My good friend David Schawel and I like to joke around that the Fed was nice enough to allow us to recognize all the future income of our bonds early. And, in a way, this is exactly what the Fed is trying to achieve with housing. By inflating purchasing power through lower real rates and compressed spreads, the Fed has allowed home-owners to recognize the future appreciation of their property at an accelerated pace. In the future, as real growth returns and, with it, real rates rise, the purchasing power of a payment will drop and rising home prices will require either households to devote a larger % of household income to housing and/or wages to increase at a rate faster than inflation. Remember, a 0.5% increase in mortgage rates from current levels would reduce purchasing power by about 5.94% if we maintained payment unchanged. At the same time, the increase in payment for a stable loan price if rates rose 0.50% would be 6.32%. In other words, to maintain prices stable, monthly outlays need to increase at a faster rate than pricing power decreases due to any change in rate moves.

Depressed real estate prices and low financing rates are leading many to see the current climate as a golden opportunity to buy leveraged real-estate, but price increases are not guaranteed, and the pay-out on a leveraged bet on housing is dependent many different factors. While affordability remains high and payments as % of income are near historic lows due to the Fed's extremely accommodating policy, an economic recovery can put an end to Fed accommodation and suspension of the Fed's MBS reinvestment program would be reflected on both, the risk-free interest rate and the spread at which MBS trade, turning a tailwind into a headwind for price appreciation. Leveraged buyers also run the risk of near-term price declines or inflation rates below the rate priced in by nominal rates. Leveraged real estate requires price appreciation and/or profits from rents to outpace the rate of inflation built-in to interest rates, which as we already saw, is not near lows.

I don't have an opinion on whether residential real-estate is a good or bad investment, it's not my line of work, but I think many investors are failing to see that a leveraged bet on real-estate price appreciation is, indirectly, a bet on inflation exceeding current inflation expectations and future wages increasing at a rate faster than inflation. Under an inflationary environment, increases in the real price level of real estate would require a mix of an increase in the % of income spent on housing and real wages in order to allow growth in outlays to outpace the loss in purchasing power created by any increase in real-rates, inflation expectations, or mortgage spreads.

Buy Home, Sell Gold?

Presented without comment.

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage

Hypothetical payment of a median-price new home purchased using a conventional 30-year mortgage as a % of median household income

Median-price of a new home expressed in troy oz of gold.

Mobility and Underwater Homes: A humble suggestion

Today, the Washing Post reported:

Labor mobility has nearly ground to a halt in the past two years, and policymakers are increasingly worried that the slowdown is not just a symptom of the nation's economic struggles but also a barrier to overcoming them.
...
The biggest factor seems to be the large number of unemployed homeowners who have little or no home equity. Between 2006 and 2009, the number of renters who moved out of state decreased by 13.6 percent, according to census statistics, while interstate migration among homeowners has plummeted by 25.5 percent.

It must be a slow news day because this is no news. The WaPo covered it in June 2008. Bill over at Calculated Risk added:

approximately 1 in 8 households (the same proportion as with negative equity) will probably not accept a job transfer now because of depressed home values - and that is about 200,000 fewer households per year that will probably not move for better job opportunities.

This was all later confirmed by the Census Bureau in December 2008 and even more supporting evidence showed up in Paul Krugman's blog yesterday (source: Atlanta Fed). But I'm not here to berate the WaPo on repeating themselves, we all do it, I'm here to put a couple of things together and make a suggestion.

The problem
People with low or negative equity are not moving to the areas where they could find a job because they are trapped by unrealized losses or don't want to realize these losses. I would be willing to venture the guess than in the past households used proceeds from capital gains or built-up equity to fund relocation expenses; with low/negative equity, that just isn't possible.

Credit to MacroBlog

Additional obstacles
Cutting people's principal is a non-starter in many cases. Banks don't want to get a reputation for cutting loan principals and non-delinquent homeowners see it as reckless buyers getting rewarded at their expense.

A proposed solution
Seeing as how the government is already throwing massive amounts of money away trying to either reflate, or turn people into permanent renters, I suggest something slightly different. The government could maybe create a facility that lends money to underwater homeowners that need to free themselves from a home.

This is not a giveaway, it is a loan. This is not a below-market-rate loan, and therefore carries no implicit subsidy. The loans should probably made at a rate similar to or slightly higher than the original mortgage rate. Home-owners who are underwater and are being held-back from taking a job in a different area should be offered the loans, which would be contingent on a job offer. The loans would be used to pay-off negative equity at the time of a home sale. The borrower could then free him or herself from the home anchoring him or her down and return to employment.

I don't know if this next part is possible, but if the lending facility vowed to reduce the rate on the loans by a set amount if the borrower transformed the loan into a second lien on any new property bought, it could furthermore enhance the quality of these loans. These loans could then either be kept until maturity or sold to banks for securitization for a profit. Why a profit? Well, if the transaction was correctly orchestrated, the borrower rid him or herself of the anchor home, allowing them to enter a new job. If the borrower decided to buy a new home, the drop in rates would almost ensure they will be able to buy a similar home for a smaller monthly payment, improving the debt-to-income ratio. Because of the same lower rates, the new monthly mortgage payment plus the loan payment should be lower than the original mortgage payment, putting the borrower in a better position to meet their obligations. Additionally, banks holding undercollateralized loans would get to rid themselves of those loans and the possible losses associated with future defaults or short-sales. Finally, freeing people from their underwater properties would increase liquidity in the real-estate market, encouraging price discovery, getting assets to the people that want them and getting people to the employers that want them. Here's the list of pros in my mind:

• Worker mobility is augmented
• Worker / employer mismatched is reduced, increasing employment and PCEs and income taxes collected
• Putting people to work reduces unemployment benefits being paid out
• People decrease their debt service expense, leaving more money for PCEs
• Real-estate liquidity improves
• A couple of commissions are generated for brokers
• Price discovery is sped up
• Undercollateralized loans are reduced

There may be no debt permanently retired, but increasing mobility and employment prospects should put the underwater borrowers in a better position to pay-off their loans. If they still default, well, they probably would have done so anyways, and seeing as how the Fannie & Freddie black-holes probably guaranteed that paper, the Treasury would have probably taken the same loss on the assets--more if you include the added expense of the foreclosure process. Before you argue that it's basically a subsidy for the MBS holders, think about who owns $2T in MBS and who guarantees a whole lot of the rest.

Housing Affordability 1971-2009: Payments, Prices and Capacity

This post is part of the series Housing Affordability 1971-2009

In the last post I talked about the growth in prices in percentage terms. Today's post includes the same data, but using a nominal scale. While I think the percent change charts are great for looking at long-term, the nominal charts do a better job of communicating the differences in dollars and cents.

Here we can see the relationship between the median-price for new homes and the purchasing power of a payment equal to 30% of the median-household income. Judging by the gap, my estimate of 30% is close, but not perfect. I discussed my reasons for using this figure in Two Ways of Looking at It.  Once I post the source spreadsheet you will be able to fill-in any values you want to see plotted for the %-of-income and down-payment variables. Please note these are not in log-scale because the actual figures became a harder to read. You can find the log-scale versions at the bottom of this post.

Housing Affordability 1971-2009: Long-Term Trends

This post is part of the series Housing Affordability 1971-2009

In the last post I discussed the comparison I used for this analysis and why I chose certain data series over others. In this post we will look at long-term trends in income and prices and how lower interest rates have allowed prices to rise faster than income. Rents and the CPI less shelter figure are also included to illustrate the divergence of the trend home prices from the trend in consumer goods.

I am excluding shelter from the CPI figure because I want to display how the trend in housing differed from everything else and comparing housing prices to an unadjusted CPI would understate the growth in prices.

For rents, I decided to use the "rent of primary residence" series in the CPI. The BLS does not publish rents in their average price survey, and the only nominal figure I found came from the HUD, and after looking at collection methods, I was not impressed with the quality or coverage of the survey. Since the Census Bureau does not offer a national figure, I am still looking for better rents data¹.

Housing Affordability 1971-2009: Two Ways of Looking at It

This post is part of the series Housing Affordability 1971-2009

In the previous post, I discussed how borrowing capacity changes with respect to interest rates, finishing up with an example of the buying power of a $500 monthly mortgage payment from 1971-2009.  The example is obviously a gross oversimplification; income and price levels can and have changed since then.  To try to make some sense of this all, I decided to look at the data from two sides:

• The change over time in the cost of a median-price new home and the monthly mortgage payment necessary to buy it, a function of the price level and interest rate. 
• The change over time in the median-household income and the borrowing capacity based on it, a function of the income level and interest rate.

I chose to define borrowing capacity by calculating the amortized loan principal that would require a payment equal to 30% of a median-income household's earnings.

Housing Affordability 1971-2009: Interest Rates and Borrowing Capacity

This post is part of the series Housing Affordability 1971-2009

We'll begin the series by talking about interest rates and borrowing capacity. If you are already familiar with the subject, this may not be of interest to you as the discussion will be a bit basic. There will be more interesting things in the future, I promise.

For purchases that are as large and have as little equity as most home purchases, the effect of interest rates is very large. For example, a $100 monthly payment at the current rates of 4.4% could buy a $22,188 home assuming a 10% down-payment. The same monthly payment at 18.45%, last seen in October 1981, could only buy a $7,197 home assuming the same 10% down-payment; that's about a third of the purchasing capacity. While I picked the most extreme points in the data-set, the example serves its purpose. For this same reason, it is useless to talk about home prices without also talking about interest rates, as affordability is measured in the monthly payment, not total cost, for most people. With mortgage rates at historic lows, the buying capacity of a monthly payment is the most it has ever been. Furthermore, if deflationary pressures and extremely loose monetary policy don't cease, we could see that capacity increase even more, since purchasing capacity increases at an increasing rate as interest rates drop, as you can see below (click for larger image).

Housing Affordability 1971-2009: Introduction

This post is part of the series Housing Affordability 1971-2009

The purchase of a first home by people I know in their mid-late 20s--a purchase many believed they had been permanently priced out of a few years ago--has been a common theme lately--and for good reason, homes are more affordable now than they have been since at least the 60s. From some of my work friends, to some of my old high-school friends, not a week went by over the last six months where I didn't hear or see (primarily on facebook) a reference towards buying or shopping for a new home, and it makes sense. With mortgage rates at historic lows, lower prices in many areas and a little help from the government, there hasn't been a moment in the last 39 years where housing has been so affordable when compared to buying capacity at current median incomes.