Affordable Housing Institute : US

[Continued from yesterday’s Part 1.]

 

Yesterday we saw that, as the Economist cogently pointed out, home prices are in some sense a pricing construct of what home buyers can afford to pay to own them, so even though prices have risen relative to incomes, that’s because carrying costs have dropped with lower interest rates.  So that’s good, isn’t it?

 

Except that interest rates are in turn tied to something else homeowners care about:

 

Things would work much better if we weren’t tied to each other.

 

Most of the fall in interest rates has arisen from the collapse in consumer-price inflation.

 

Low inflation should be good, shouldn’t it?  At the very least, homeowners should be indifferent — shouldn’t they?

 

I’m not indifferent … am I?

 

In itself, that makes no difference to the real cost of servicing a loan over its lifetime. It does affect the timing, though. When inflation is high, the burden is “front-loaded” in the early years of the loan, but then eases as the real value of the debt is swiftly eroded. When inflation is low, the initial payments are more bearable but more of the real debt persists, which shunts a bigger share of the costs into the later years of the loan.

 

 

As usual with the Economist, that’s a mountain of insight in a single paragraph.  Let’s take it step by step:

 

·         In nominal currency, payments are the same throughout the loan’s life.

·         If inflation is high, later payments are cheaper (relative to early ones) than if inflation is low.

·         If earnings match inflation, the mortgage burden lightens more quickly in a high-inflation environment than under low-inflation

 

That leads to the basic division of loyalty between homeowners and everyone else:

 

 

“What do you mean, inflation’s fallen?”

 

This fall in the initial debt-servicing burden on mortgage borrowers has underpinned the rise in house prices over the past decade.  Meanwhile, British rates remain low:

 

Buyers have also been encouraged by the Bank of England’s quarter-point cut in the base rate to 4.5% last August.  This followed a tightening in monetary policy that lifted the base rate from 3.5% in October 2003 to 4.75% in August 2004.  A more important relief to homebuyers over the past couple of years, however, has come from unusually low longer-term interest rates.

 

Now, however, the Bank of England is raising rates, and that will bite homeowners:

 

British mortgages have customarily been at variable short-term rates, closely tied to the Bank’s base rate.

 

With variable-rate loans, homeowners don’t have the same inflation-bet posture, because interest rates will chase inflation.

 

I’ll catch that inflation yet!

 

But since the start of 2004, the share of fixed-rate loans being taken out has risen from 30% to 70%.  

 

Evidently the observant herd sniffed rising interest rates in the wind, and sought to hedge that risk.

 

Most of these are for brief terms, typically two or three years, but they have allowed borrowers to exploit the fact that longer-term rates have been lower than short-term ones.

 

Inverted yield curve!  Inverted yield curve!  Danger, Will Robinson! 

 

Refinance now, Will Robinson!

 

And these loans are fixed for less than three years.  Danger, danger!

 

The overall effect has been to offset about half the Bank’s monetary tightening, estimates David Miles, chief UK economist at Morgan Stanley.

 

The resilience of the housing market owes much to these exceptionally benign credit conditions.

 

Something else happens after a few years of homeownership; human psychology kicks in powerfully.  Not only do people value what they have more than what they merely desire, homeownership changes behavior, making people (especially men) more responsible.

 

The recent upsurge in immigration may also be supporting the market. But purely domestic factors such as planning restrictions, by contrast, are less important than is sometimes suggested. Other countries — notably Australia — have also avoided a bust in their housing markets, and have instead seen price increases flatten out.

 

I previously posted about Australia as a potential leading indicator of UK and US markets.  That its market has cooled, not popped, suggests something similar may be in store for us.

 

Cooling relief from high house prices?

 

This suggests a common cause: low interest rates worldwide.

 

But what has been given can be taken away. Monetary policy around the world is tightening to keep inflation at bay. The Bank for International Settlements—the central banks’ bank—said on June 26th that the squeeze must continue. The Bank of England is expected to push the base rate back up to 4.75% later this year.

 

Britain’s homebuyers are vulnerable to quite small increases in the cost of mortgages because they have taken on so much debt during the good times.

 

And because interest rates have been so low.

 

Overall household borrowing has risen from 110% of disposable income in 2000 to 150% at the start of 2005.  

 

Again, that’s the amount of debt, not the debt payment, so the low interest rates have kept this in balance.  Belief in the powers of Greenspan (now Bernanke) to keep inflation low, and hence long-term interest rates low, has kept prices high.

 

The most frightening words in the financial lexicon are that it’s different this time.

 

“It’s different this time, officers!”

 

This refrain, a favourite of boomsters, was much in vogue at the time of the dotcom bubble. It remains just as suspect when applied to a housing market that is unnervingly priced to perfection.

 

Don’t hate me because I’m priced to perfection.

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