Wednesday, December 03, 2008

House Prices and Interest Rates

by Calculated Risk on 12/03/2008 09:18:00 PM

There were two stories published today concerning house prices and interest rates.

The first story came out this morning, and quoted a report from Global Insight suggesting "the housing market is now slightly undervalued". Please stop laughing ...

And later today, the WSJ reported that the Treasury would "purchase securities underpinning [GSE mortgage] loans at a price equivalent to the 4.5% rate". The purpose, according to the WSJ:

Treasury views this plan as potentially halting the slide in home prices by enabling borrowers to afford bigger mortgages, thus increasing demand for homes and pushing up home values.
The Treasury plan is only for purchase loans, not refis.

If we look at the Global Insight methodology for evaluating home prices, we see:
For example, a conventional 30-year mortgage of $200,000 carries a monthly cost of $1,468 with mortgage interest rates of 8 percent. At 6 percent, however, a homebuyer could service a far higher $245,000 mortgage with the same monthly expense.
Clearly both stories draw a strong connection between house prices and interest rates. But what is the relationship?

It is true that the rent vs. buy decision moves in the "buy" direction with lower interest rates.

Say someone is paying $1000 per month in rent, and they are interested in buying a $240,000 house with $24,000 down (10%). With a 6% mortgage rate the principle & interest (P&I) payment alone would be $1295 per month. Add in insurance, maintenance, mortgage insurance, property taxes and other costs and fees (like HOA) and subtract the income tax break, and it probably doesn't work.

We need a spreadsheet and more details to work it out exactly.

But at a lower mortgage rate - say 4.5% - the P&I would be $1,095 and depending on the other costs, and with all else being equal, buying might make sense.

But why would this push up prices as suggested by the Global Insight analysis? Prices would increase because of higher demand - not directly because of lower interest rates. A rational buyer wouldn't pay more just because the interest rate is lower - although they might have to pay more because the demand is greater. 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.

This suggests the Global Insight analysis is flawed, as is the "affordability index" from the NAR, or any other measure of house prices based on interest rates. In fact house prices are still too high as suggested by the price-to-income ratio and real prices.

The WSJ article correctly noted that lower interest rates "increas[e] demand for homes", but do they push up home values? The answer in the current environment is probably no.

This may be a little surprising since lower interest rates will likely increase demand.

In a perfect market, an increase in demand would push up prices. And an increase in supply with steady demand would lower the price enough to clear the market.

However, housing is an imperfect market - house prices are sticky downwards and typically take several years to adjust (what we are seeing!) - so even though there is currently far too much supply, prices still have not fallen far enough to balance supply and demand.

An increase in demand from current renters deciding to buy, would probably only make a small dent in the huge excess supply. And house prices would continue to fall - so the goal of supporting house prices would not be met.

In fact, it could be worse. Landlords, already struggling with high vacancy rates and falling rents, would probably lower their rents further and make the rent vs. buy decision more difficult again. So lower interest rates might not boost demand very much, it might just lead to lower rents.

This is a bad idea from the Treasury. And leaking this story is a terrible idea, since some potential homebuyers might potentially wait for lower interest rates.

This is very different than the Fed program to buy agency MBS. That program makes sense since the GSEs have effectively been nationalized (in Conservatorship) and also helps current homeowners refinance, although I don't understand why the government just doesn't announce the GSE debt is backed by the U.S. Government.