A Key to a Soft Landing in Housing

As I have already mentioned, the Chicago Merc housing futures market is predicting a decline in nominal house prices in several markets over the next year. While the market is still very thinly traded, it likely reflects a prevailing view among many investors and observers of the housing market.

One of the reasons for the softening of in some markets has been the increase in the federal funds rate. Some work in progress among Chris Redfearn, Stuart Gabriel and me is showing that the short end of the yield curve migh have a substantial impact on house prices in many of the coastal cities. The reason: in expensive markets, borrowers slide down to the short end of the yield curve where the cost of borrowing is generally lower. This allows borrowers to buy houses with "affordable" initial payment-to-income ratios.

The problem, of course, is that short term interest rates have been driven up by the Federal Reserve, from one percent in late 2003 to 5.25 percent today. If an Adjustable Rate Mortgage's spread over the fed funds rate is three percent (not usually the way ARMs are calculated, but lets give the example to make a point), and it amorizes over 30 years, the payment on an ARM would rise more than 50 percent per dollar of mortgage balance. This means people who could get into the housing market in a place like Los Angeles before can no longer do so, and it means many people in Los Angeles are facing payment shock. The situation is even worse for those who used "option ARMs" to finance their houses--these products allow people to pay less than the interest they owe on their mortgage every month, meaning that their loan balances are rising over time.

The good news is that long-term fixed rate mortgages, while not at rock bottom rates, remain at very low rates by the standard of the past 25 years: 30 year-fixed rate conforming mortgages last week hast week at an average rate 6.4 percent, according to Freddie Mac's survey. This means the ARM borrowers can refinance out of their ARM into a fixed rate product that is pretty reasonable. This should place a floor under house prices, particularly in an economy where unemployment is pretty low.

I think the early part of the '00s should have taught an important lesson to homebuyers--if they can't afford a house with a 30 year fixed-rate mortgage, they probably shouldn't buy a house. That is not to say the ARM isn't a good product--it is, if households use it as part of a portfolio strategy. For instance, is someone knows she is only going to live in a city for five years, it is perfectly reasonable for her to borrower with a 5/1 ARM, where the rate is fixed for only five years. Her liability, the mortgage, now matches her asset, the house, where she expects to live for five years. But when people use ARMs--especially option ARMS--to make payment-to-income ratios acceptable for a limited period of time, they are liekly looking for trouble.