Stewart Blog

U.S. home prices have declined across the nation in the past year—albeit at varying levels.  Latest national price declines (and again I invoke the TINSTAANREM Clause — There Is No Such Thing As A National Real Estate Market) range from as little as 4.5 percent (Dallas, Texas) on a year-over-year basis in February to as great as 35.2 percent (Phoenix, AZ) according to S&P’s Case-Shiller Home Price Indices.

It is the anticipation by many prospective buyers for further home price  erosion that keeps them on the sidelines and from participating in homeownership despite  the lowest  interest rates since Freddie Mac commenced the statistical series in 1971. 

While further price declines may be realized, I believe the likelihood of rising interest rates makes purchasing now a better option than waiting for further potential value declines.  Simply stated, there is a greater possibility of interest rate increases than potential value declines.  Even with the price decline, the interest rate increase may result in the buyer no longer being able to qualify for a loan on a home they wish to purchase for which they qualify today.  Despite facing a potential in declining home values, now may be a better time to buy.

To make the comparison simple, let’s assume a loan amount today of $100,000 with a 30-year fixed-rate residential loan at 5 percent.  Nationwide at the time of this writing, the average 30-year rate was 4.85 percent per Freddie Mac.  Fannie Mae forecasts an average rate in all of 2009 of 5.13 percent.  So the 5 percent is a reasonable assumption.

The following table shows the monthly payment for each loan amount and interest rate.  A buyer today at 5 percent interest borrowing $100,000 has a monthly principle and interest payment of $536.82.  If prices decline 5 percent (and the loan amount does also) and interest rates rise just ½ of 1 percent, then the monthly payment remains the same ($539.40). 

So if rates go up just 1 percent to 6 percent per year, then prices must drop at least 10 percent for that same buyer to qualify for the same monthly payment.  A 1.5 percent increase in rates to 6.5 percent requires a 15 percent price decline, and a 2 percent increase necessitates a 20 percent price decline to qualify.  Note: This 1 percent interest rate change to a 10 percent price change is only true when interest rates are 5 percent as they are today.

Admittedly, at the same loan-to-value ratio, as prices decline so does the down payment.  Since, however, many buyers select the price range of homes they consider buying based on their monthly payment potential, rising rates may force future buyers into less expensive homes and hence properties they find less desirable.

Why do I expect rates to increase in the future more than price declines?  First examine the Case-Shiller Table above.  Aggregate 20-city prices have already declined 29.1 percent since peaking in July 2006.  I believe much of the price decline has already taken place.  And why do I anticipate rate increases?  There are several reasons.  Interest rates are the lowest in recorded history.  But perhaps most important is the record deficit spending by Congress and the Administration and the expectation for that to continue.  Borrowing a couple of trillion dollars this year coupled with a now-projected decade of deficits of at least $1 trillion per year sets the stage for a weakened dollar and corresponding rising interest rates. In plain speak—the massive deficit spending has a high potential to drive up inflation and hence interest rates.  A topic to be discussed in a future blog.

If you agree with me, quote me.  “Postponing a home purchase waiting for home prices  to decline further may price you out of the market.”  Ted C. Jones, PhD, Senior Vice President—Chief Economist, Stewart Title Guaranty Company.

Agree or disagree, let’s have some comments.

Ted

What Happens to Residential Mortgage Rates When Treasury Rates Rise?

Executive Summary:  For the past 36 years the spread between 10-year Treasury note rates and 30-year residential rates on a monthly basis has averaged 1.7 percent or 170 basis points. The current spread between the two is more than 50 basis points greater than normal.  This would indicate that even if 10-year Treasury rose one-half percent (or 50 basis points) from the current level, residential mortgage rates could conceivably remain stable.  Alternatively, if 10-year Treasury rates remain at or below 3 percent, 30-year residential rates could fall into the 4.5 to 4.7 percent range.  Either way, the potential for residential rates to remain at current levels or decline is positive. 

Just as water and carbon are the building blocks of life, the 10-year Treasury note is the building block for similar duration but greater-risk loan rates.  The 10-year Treasury note is seen as the benchmark for risk-free longer-term borrowing (the U.S. government is deemed risk free since any other loan in the world is more risky).  So goes 10-year Treasury rates, so goes fixed-rate residential borrowing costs. 

• Since 1972, monthly 30-year residential interest rates have averaged 1.7 percent or 170 basis points more than the corresponding 10-year Treasury note.
• February 2009 residential rates were 226 basis points greater than the comparable 10-year notes.
• For the week of March 9, 2009, the spread remained at 225 basis points.
• The 10-Year Treasury rate as of March 12, 2009 of 2.89 percent, assuming a 170 basis point spread, would portend a 30-year residential rate of 4.59 percent.  Hence there is potential for treasury rates to increase without increasing residential rates or there is potential, assuming Treasury rates remain at or below 3 percent, for residential rates to fall into the 4 percent range. 
• A linear regression model with residential interest rates as a function of 10-year Treasury rates at 3 percent projects 4.48 percent (4.5 percent rounded) 30-year fixed-rate residential loan interest rates.
• During recessions since 1972, the spread has averaged 199 basis points compared to 163 basis points in non-recessionary periods.  A second regression which includes the impact of recessions on spreads indicates that the current residential rate should be less than 4.75 percent—again confirming a potential for reductions in the interest rate for residential lending. 
• In the past 36 years, there have been only 19 months out of the 446 month total (4.3 percent) in which the spread has been less than 100, just 17 months in which the spread has been greater than 200 basis points (3.8 percent) and only three months in which the spread has exceeded 400 basis points.

The graphs below show 10-year Treasury note and 30-year residential loan interest rates—the first since 1972 and second since 2000. 

Periods of recession are times of great uncertainty, greater risk, and therefore theoretically times of greater variability.  That is verified in the spread, which averaged 199 basis points in recessionary times versus 163 basis points in non-recessionary periods.  The following graphs show the spread during these periods.  Not all recessions impact the spread equally.  The current recession shows much larger spreads (akin to the recession in 1981-1982) while the recession in 2001 was similar to the recession in 1990-1991.

Regression Analysis: Residential Rates as a Function of 10-Year Treasury Rates

The first regression is a simple linear model in which 10-year Treasury rates estimate 30-year residential rates.  The model is statistically significant and yields the following statistics and estimated interest rates when applied.

Model Y = 1.33254157 + 1.05003866 x 10-Year Treasury Rate

Adjusted R Square = 0.96431

F Statistic = 12,025.2

Coefficient      t Statistics    P-Values

Intercept           17.683            < 0.01

Treasury          109.6505         < 0.01

Regression Analysis: Residential Rates as a Function of 10-Year Treasury Rates and Whether There is a Recession

The second regression models 30-year rates (again, a simple linear model) but includes both 10-year Treasury rates and a dummy variable of one when a recession is present and zero when there is no recession. 

Model  30-Year Residential Rates = 1.29751+ 1.04519 x 10-Year Treasury Rate + 0.33387 (when in recession)

Adjusted R Square = 0.96607, F Statistic = 6,441.54

Coefficient      t Statistics    P-Values

Intercept           17.739            < 0.01

Treasury           112.354          < 0.01

Recession            5.614          < 0.01

Before you get to the solution you first must accurately define the problem.  As The Wall Street Journal pointed out this past week, we are merely treating the symptoms of the financial crisis and not the disease itself.  What caused this entire debacle was that once upon a time we had copious quantities of cheap money for short intervals, and we created too much capacity in the housing industry.  We had too many people who did not have fixed-rate loans, and for many, even if prices had not declined, they would not have been able to afford their mortgage rate reset.  Then declining property values made it impossible to sell the property for the loan balance. And, ultimately, the lender of these non-performing loans which progress to REO (real estate owned by lenders) must mark them down. And if they mark down enough, lender insolvency sets in.  So the culprit today, the problem, is declining residential property values. 

Once again I have to invoke the TINSTAANREM clause—There Is No Such Thing As A National Real Estate Market.  All real estate is local in nature, but we are still going to talk on an aggregate national market basis here.

A few definitions to set the stage.  A bubble means that for one asset or goods class, prices rise more than alternative investments or goods.  This, in turn, fuels additional investment ratcheting up prices even further.  Bubbles can and do burst, and we are seeing that real-time today in many markets.  If prices of all goods rise, that is merely inflation and not a bubble.  Alternatively, devaluation is when the values of all goods and services decline—a topic of a future blog.

As a result of the residential real estate bubble, we produced too much supply of the product—in this case housing of all types, colors, heights, elevations, locations and attributes.  The double whammy here is that not only did we oversupply the housing market, but demand contracted dramatically at the disappearance of the easy and cheap money.  As we say in Econ 101, “oversupply coupled with contracting demand dramatically pushed prices downward.”  And that continues today as we have yet to see stabilization in prices much less a bottoming in the number of properties sold.  If home prices had remained stable, there would be no problem in the financial markets today.  If one individual homeowner, for example, had a financial crisis in their lives and could no longer afford the property they purchased (assuming no negative amortization on their loan), they could simply sell the property in the open market and make their lender whole.  No write-offs, no write-downs, no liquidity crisis.  See—it’s all about the price of housing. And having equity at the onset.

The airlines have an effective way to reduce capacity and ultimately increase prices.  They merely fly airplanes to an airstrip in Arizona and park them on the tarmac and put protective coating on the windows.  Park enough airplanes and cut enough flights and every plane will be full and prices will rise.  For housing, short of catastrophic events such as Hurricanes Katrina and Ike, the best way to reduce the surplus is to get people to own and be able to pay for the housing. 

Equity is an essential component in leveraged investments.  And that is an easy statement to prove.  Say you go to Las Vegas.  You put no money on the gambling table, but they let you play anyway. If you lose—you don’t care.  You can bet even more.  You did not have any of your money bet anyway.  But if you win, all the gains are yours to keep.  Essentially, this exactly explains people that purchased homes with no down payment—no equity.  They had no downside, but all winnings were theirs to keep.  And as a result, they over bet.  And that enlarged an already expanding bubble.

Like throwing gasoline on a fire, the use of loans that were not fixed-rate for the anticipated term of ownership of the property accelerated both the dramatic increase in the demand for property and likewise quickened the plunge in values.  But how can we criticize consumers that obtained these ticking financial time-bombs when the then world’s smartest man encouraged them to do so?   Alan Greenspan told Americans “they could have saved tens of thousands of dollars in the past decade if they had ARMS,” (adjustable rate mortgages).  In the same 2004 speech Greenspan noted, “Overall, the household sector seems to be in good shape.”

http://www.usatoday.com/money/economy/fed/2004-02-23-greenspan-debt_x.htm

So here is where we are today:

• There is an oversupply of housing in the market—prices are still declining.
• Many individuals who desire to purchase a home cannot qualify under the lending requirements present today.
• Consumers will not buy a property on the expectation that values will decline further in the future.
• We have proven, once again, that if a consumer has no equity in a property at the time of the purchase, the house from the onset truly belongs to the lender and, under certain circumstances (such as declining home values), will ultimately be owned by that lender.
• This is a problem we have seen in the past — not our first rodeo — and will likely see again sometime in the future.  Did we not learn anything from the housing meltdown of the late 1980s?

When I was a professor at Texas A&M University in the late 1980s I vividly recall an auction of hundreds of homes, townhouses and duplexes of foreclosed real estate in Bryan and College Station, Texas.  The terms of the auction were simple.  You had to put 10 percent down, and if you were the successful bidder you then received a fixed-rate 30-year fully amortizing loan (no qualifying necessary—the 10 percent down took care of that). All transactions costs, including loan origination and title insurance were included. 

Side note: For those in the market today and not in the late 1980s, a 10 percent fixed-rate loan was highly attractive, and it was the first time since the early 1980s rates had been so low—no kidding.  For a series of residential interest rates since 1971 see:

http://www.freddiemac.com/pmms/

Hundreds of residential properties auctioned were sold at prices far greater than anticipated.  Why? 

My wife and I previewed a home included in this auction and decided to bid up to $135,000.  As an appraiser, I figured this was towards the upper end of values in this highly depressed market, but it beat the alternative of having a home built to our needs.   

So what did the property we were pursuing sell for?  In excess of $170,000.  $35,000 greater than this learned appraiser considered market value.  The ultimate buyer was an individual whose business had declared bankruptcy, and even though it was still in business, the buyer could no longer qualify for a mortgage under existing loan-qualifying terms.  The tough economic times of those years saw many of the prospective buyers on the sidelines because they could not qualify for a loan under the new, more restrictive terms offered by the market in the later 1980s. Many of the buyers had gone through foreclosures, so they were technically out of the market.  Sound reminiscent?   Yet this auction allowed buyers to obtain a home with a fixed-rate fully amortizing loan, and all they had to do was scratch up 10 percent down.  It was amazing how aggressive people were in collecting the 10 percent to allow them to bid on properties.  I recall one couple that even sold a relatively new model car and bought an older one since they saw this as a perhaps once-in-a-lifetime to be able to buy a home given their credit history.

One last issue. As stated above, the key to getting people off the sidelines other than available lending is the belief that property values will not be less tomorrow than today.  Here’s a unique strategy from the Farm Credit Bank in St. Paul, Minnesota from the 1980s as told by Charles Gilliland, PhD, a senior research economist at the Real Estate Center at Texas A&M University.  The Farm Credit bank was facing the same issues on rural land they had taken back as we face today in housing.  No one was going to buy on the belief that values would decline further.  The St. Paul bank then made this basic offer.  Put 10 percent down, they give you the loan, and as long as you take care of the property, pay the mortgage, insurance and tax payments, they will give you back your down payment in five years if the property is not worth what you paid.  While there were some other details such as if you got your money back you then needed to pay rent of the farm and ranch land for those years (which I am sure came out of the down payment), this was pretty much a clean deal.  It is my understanding the bank did not get any of the properties back.

So here is my solution to reduce the market supply of housing and ultimately increase residential property values; the plan looks like this:

• REO residences can be bought from lenders for 10 percent down or they can be assumed from current homeowners for the same 10 percent down provided a closing of the property takes place to clean up legal issues and a new loan is issued.
• The buyer will be charged a fee at origination of the loan and per year to pay for the insurance coverage for the potential of declining property values (this is not mortgage insurance but property value insurance).  This means that the homebuyers rather than the tax payers pay for this protection and coverage.
• Five years from now the lender will give back the 10 percent down payment (provided wear and tear is normal) less market rent as stipulated in the purchase contract if the property value has declined.
• The buyer receives a 30-year fixed-rate loan at prevailing rates with no additional qualifying requirements.
• The property cannot be resold or refinanced except by agreement of the lender and U.S. government.

So what do you think?  Agree? Disagree?  Add your comments.     

Ted

Any parent who has ever been on a trip with a child knows the all too frequent question of “Are we there yet?”  That question is no longer exclusively relegated to children on trips—it is now the mantra of homeowners and prospective homebuyers across the country.   So, in terms of home prices, are we there yet—at the bottom, that is?

In one word, no.  First the caveats.  When discussing home prices everyone needs to be reminded that there is no such thing as a National Real Estate Market.  All real estate is local in nature and responds to the supply and demand in each respective market.  Even within a city, price changes impacting each and every home are different at the same point in time depending on neighborhood, price range, product type and specific location. Nevertheless, we will still address a national price. 

So how much have home prices declined? The answer to that depends on which source is utilized.  The National Association of REALTORS® (NAR- of which I am a member) shows the median home price decline of 9.5 percent from August 2007 to August 2008.  That is an accelerating drop from the 7.1 percent decline from July 2007 to July 2008.  The Case-Shiller Home Price Indices indicate a 16.3 percent decline from July 2007 to July 2008 for the 20-city composite, and a 15.4 percent decline on a national basis from the second quarter of 2007 to the same period in 2008.  The Office of Federal Housing Enterprise Oversight (OFHEO) estimates that home prices declined 4.8 percent in the second quarter of 2008 from the same period in 2007.  The difference is that each source has a different dataset used to generate their statistics. 

NAR bases its data on a sample of multiple listing services across the US.  NAR data, including national and state sales numbers and national and metropolitan area homes price and methodology can be seen at http://www.realtor.org/research/research/ehspage.

OFHEO’s data are available monthly on a national, regional, state and Metropolitan Statistical Area basis at http://www.ofheo.gov/hpi.aspx.

OFHEO uses a similar methodology to Case-Shiller in that repeat sales are weighted and used to calculate an index.  The data, however, are all conforming loan data from Fannie Mae and Freddie Mac transactions. 

The Case-Shiller index is based on tracking of same-home resales over time.  They make available a 20-city index and aggregation of those cites on a monthly basis through the parent company Standard & Poors.  They also release a national estimate quarterly.  http://www.standardsandpoors.com

The latest Case-Shiller Home Price Indices covering data though July 2008 reveals significant differences in price changes across the 20 metropolitan statistical areas covered ranging from the smallest one-year price change of 1.8 percent reduction in Charlotte, North Carolina, to the largest decline in Las Vegas, Nevada, of 29.9 percent.

Real estate bubbles were not responsible for all of these declines.  Look at Detroit, Michigan, for example, showing a decline of 26.6 percent from the high in December 2005 through July 2008.  They never had a real estate bubble—but what they had was a massive reduction in the number of jobs in the Detroit market.  Since August 1999, the Metropolitan Detroit area has gone from 874,000 jobs to 742,100—a decline of 15.1 percent or 131,900.  That decimates a housing market and is vividly shown in the decline.

Which do I like the best?  Probably the Case-Shiller National Index.  As a former appraiser, matched pairs are hard to beat in extracting trends and these pairs are the same homes selling at different times.  Granted, OFHEO’s index is calculated in a similar measure, but since it is limited to just loans passing through Fannie and Freddie it misses much of the truly distressed real estate that had sub-prime, Alt A loans or other exotics such as option-payment ARM mortgages. 

All three indicate an accelerating rate of decline.  Trends basically continue until something changes the trend. Thus, I believe that these trends will continue, and we have yet to reach bottom.  Further examination into supply and demand, the cost availability of loans and the economy (read that as jobs) all provide further details of a declining economy.

The news on jobs is bad.  Really bad.  Since January 1 this year, the US has lost 760,000 jobs.  And when you consider we need to add roughly 100,000 new jobs per month just for the people entering the workforce for the first time, we are now short 1.6 million jobs.  Just like housing price declines accelerating, so are job losses.  Total jobs lost from August to September this year were 159,000 compared to a monthly average decline this year in the first eight months of 75,125.  No jobs lost due to Hurricane Ike were included yet, so the number of lost jobs will likely rise even more in October.  Other than retirees, most people need a job to buy a home.

We continue to overbuild—much akin to doubling down on a losing black jack hand.  In the past 12 months, the US has lost 519,000 jobs but at the same time has issued 1.35 million permits for dwelling units (single family, duplexes, condos, townhouses, coops and apartments).  In a normal market and economy, you need 1.25 to 1.5 net new jobs per new dwelling unit.  We have lost 2.6 jobs per new dwelling unit.  So the hole we have to climb out of is getting deeper every month. 

We are not overbuilding everyplace, however.  Laredo, Texas, has created 2,300 net new additional jobs in the past 12 months while only starting construction on 1,154 new dwellings.  Ditto Anchorage, Alaska, which had posted 900 new jobs and 548 new dwelling units—for 1.64 new jobs per new dwelling.  On the other end of the spectrum, for example, was Phoenix, Arizona which has lost 41,700 jobs in the past year while adding 33,167 new dwellings.  A great source for easy access to building permits data and employment statistics for the US, States and all Metropolitan areas can be found at the Real Estate Center at Texas A&M University at:  http://recenter.tamu.edu/.

What are the implications on home values and future real estate lending of the just-passed Emergency Economic Stabilization Act of 2008? Unfortunately not very positive on real estate.   In my opinion there is very little that will slow the fall of residential home values (in those markets where they are declining).  These actions were more targeted at keeping banks solvent rather than making new loans. 

It is highly appropriate that the portion of the Act that allows either guarantees or outright purchases by the US Government or mortgage-related securities is known as the Troubled Asset Relief Program, (TARP) rather than the Commercial and Residential Property Economic Tourniquet (CARPET).  Why so?  Because you can hide a whole lot more dirt under a TARP than a CARPET, and that is exactly what Congress has done with this Act.  While the TARP segment of the bill is $700 billion, congressional members added another $112 billion of pork projects and earmarks.  To name just a few of the more than 2,300 earmarks swept under the TARP:

• $192 million rebate of excise taxes to US Virgin Island and Puerto Rican Rum produces
• $33 million reduced corporate taxes on income earned in American Samoa
• $478 million tax incentive to Hollywood movie and TV producers to do US productions in the next 10 years
• $2 million tax break to Oregon manufacturer of wooden toy arrows
• $49 million tax benefit to plaintiffs involved in the 1989 Exxon Valdez oil spill
• $100 million in tax breaks to racetrack owners in the next seven years
• 2008 repeal for 20 million tax payers from the alternative minimum tax
• Renewal and expansion of renewable energy incentives and alternative fuels
• Tariff relief to US wool fabric manufacturers,  $148 million
• Fringe benefits to bicycle commuters from employers, $10 million

So where will home prices go?  Down is the primary direction.  Fewer jobs, a more stringent qualifying requirement for loans, lack of liquidity in the market
place and ongoing over-construction, all point to sustained price declines.   We still are facing more than two million foreclosures in the next 18 months.  

The primary question is whether we will be seeing the sequel to TARP a year from now.