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Guest Post: Correlation Of Mortgage Rates With Real Housing Prices II

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Submitted by Taylor Cottam of EconomyPolitics

Correlation of mortgage rates with real housing prices II

My last post Correlation of mortgage rates with real housing prices: how increasing inflation could affect housing prices, raised some questions. I didn't have the chance to respond to them.

But before I do, let me go back to
the original purpose of the article. I asked the question, "What could
happen to real estate in the event of higher inflation?" If inflation
shot up from 1% to 7%, what would happen to the real value of your home.
My thesis was: you're screwed. You will lose what little equity you
have and real housing prices could drop by as high as 50%.

This was in contrast to the central thesis of the book Irrational
Exuberance by Robert Shiller. His book included a chart which showed the
relationship between home prices, population growth, building costs and
interest rates. His chart seems to suggest that housing prices have
little correlation to the interest rate. This chart was misleading and
hides the real relationship between interest rates and housing prices.

Download Schiller Data.

Housing Prices against Population, Building Costs and Interest Rates

Once
again, what is common to the man on the street seems to elude the
academics, mainly, higher interest rates lead to lower affordability
which in turn lead to lower housing prices. I looked at the same housing
data as he did, but from a different perspective, mainly, the change in
interest rates with the change of real housing prices. I looked at real
vs nominal because there were periods of high inflation in the 70's
during which, looking at nominal inflation would give a very distorted
picture. 

I also took an average of the three years forward because there is so
much variability from year to year as to make the data difficult to
interpret. The chart below tells a very convincing story. It doesn't
take a genius to spot a trend. What really got the people going was the
mirror image of the nominal rate against the housing prices from . It
was so evident some folks suggested I cherry picked the data. Hardly.

Change in Real Housing Prices (3 year forward average) against the nominal interest rate 1970 – 2006

My own experience working as a mortgage trader during this time
reinforces that assumption. Indeed, if ask about home price increases,
without looking at interest rates they are only looking at half of the
story. I place the start of the bubble in 2003. We had had some
substantial housing price increases before them, but the interest rate
was falling so I wasn’t so worried.

After 2003, rates stopped falling. Then, as if to compensate, there were
a whole host of “affordability products” including subprime arms (which
gave a subprime borrower near prime rates for two years), Payment
option arms (which allowed borrowers 1% neg-am payments), interest only
arms (which allowed for lower than fixed rate payments) and stated
income (which allowed people to buy more house than they could afford).
In 2003, affordability products made up about 10% of my total volume,
whereas in 2006, it was up to 65% of my origination book.

The aggregate effect pushed up home prices. Once those products went the way of the dodo, home prices dropped too.

Why 1970 - 2006?

I picked the dates for three reasons. The first was practical. I wanted
mortgage rates, and I wanted one source to avoid disruptions. I had
Freddie Mac mortgage rates from 1970 on and that seemed to give me
enough data for me. I felt it important to actually look at the mortgage
rate because credit spreads can change and people make pricing
decisions based upon affordability, not the general interest rate of
treasury bonds. However, if I were to present the same information with
long term bond rates, it would look nearly identical.

Second, the graph of the time from 1979 to 1986 was also the most
relevant to my thesis because it was a time of rapidly increasing
interest rates. I am more interested in what could happen with rapidly
increasing rates, and 1977 to 1982 are the perfect example. With small
changes to the interest rate, the real housing prices are difficult to
predict, but with a large change, it becomes very clear. I am more
interested in large changes.

The third reason for choosing the time frame was because due to the
magnitude in changes from 1979-1982, it makes the whole chart preceding
1970 relatively tiny in comparison and consequently more difficult to
spot a trend. Below I have looked at the rates vs housing from 1900 to
1970 to make the trends more obvious and to make the dataset complete.  I
have also added colors for for clarity. 

Change in real housing prices against nominal interest rates 1900 – 1969

Takeaway

There are two important things to understand from this data. First, the
effect of changes in interest rates take time to work their way into
housing. I showed up to a three year lag from the time that the interest
rates change to the time real housing prices change. Second, we should
not use the correlation matrices to forecast next year's prices. There
is a lot of noise and a lot of other things that can have an effect on
real housing prices. These interest rate trends take years to play
themselves out. In the middle of a boom, we might have some years that
prices go in the opposite direction. That should be clear.

But what should also be clear from this data is that going long on
housing where inflation, and interest rates are increasing is not a wise
bet. Long term interest rate trends tend to continue for a very long
time so that once interest rates start to rise, it could be a very long
climb to the top. 

Another criticism of the article was that why worry about inflation in
the middle of deflation? Well, I didn't make that argument. For now I'll
rely on Gonzalo Lira to make that case. I stated in a previous posting on economypolitics.com, that it can take over two of years for of decoupling of M2 and GDP growth to lead to inflation.

And even though most experts say inflation is subdued, US import prices
have increased by 4.1 percent over last year.  Could this be a sign of
things to come?   

For all you data hounds out there, download the data as I used it.

 

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Sun, 09/26/2010 - 18:44 | 606066 UninterestedObserver
UninterestedObserver's picture

Like this realy matters, if interest rates hit 6,7 or 8% the US economy will blow up anyway even without the help of RE dying faster than it already is.

Sun, 09/26/2010 - 18:51 | 606079 scratch_and_sniff
scratch_and_sniff's picture

Unrelated, but should Portugal really be on the PIIGS list when it holds 80% of its reserves in Gold?  http://www.ft.com/cms/s/0/4b148650-c9a1-11df-b3d6-00144feab49a.html

Sun, 09/26/2010 - 21:08 | 606253 doolittlegeorge
doolittlegeorge's picture

great. encouragement.  what else is goin' fall out of that Central Bank once it starts shaking?

Sun, 09/26/2010 - 18:53 | 606082 snowball777
snowball777's picture

Nope, no bubble here.

 

Sun, 09/26/2010 - 18:56 | 606088 rapacious rachel wants to know (not verified)
rapacious rachel wants to know's picture

"If inflation shot up from 1% to 7%, what would happen to the real value of your home. My thesis was: you're screwed."

__________________________________

 

in addition to your well reasoned points articulated, add in that real estate (re: home ownership) as an asset class is falling out of favor

Sun, 09/26/2010 - 19:04 | 606100 snowball777
snowball777's picture

- Demo shift (the gray race)

- A year of inventory

- Another year of shadow inventory

- High UE (only true morons neglect how much this affects large purchase sentiment, even on the part of the employed)

 

Yup, this will be happening to the real value of your home (or should I say the millions of REOs) shortly anyway.

Sun, 09/26/2010 - 19:39 | 606146 tom
tom's picture

Spot on. I would just add that how inflation affects real home prices depends on the reason for the inflation. If the inflation is due to excessive credit expansion, home prices are likely to first boom then bust, as rising rates will not initially be enough to discourage speculative buying.

It was a bit similar in the late '70s. As inflation shot up, the Fed went through phases of trying to kill the inflation with higher rates and then trying to revive the economy with lower rates. There were windows for speculators to borrow at negative real rates and quickly build or flip properties for big gains, even as the general trend was downscaling. An old friend of mine made a killing back in the day stuffing people into little overpriced duplexes.

Tyler, are you never going to fix that captcha bug?

Sun, 09/26/2010 - 19:55 | 606171 gwar5
gwar5's picture

I think the Fed default position has to be towards inflation. I think that regardless the scenario, the Fed will bring it about.

The politicians seem to have gotten the message and are spending like someone maxing out the credit cards just before filing bankruptcy.

Sun, 09/26/2010 - 20:58 | 606239 newstreet
newstreet's picture

Price house prices in silver for a real eye opener.

Sun, 09/26/2010 - 21:10 | 606254 doolittlegeorge
doolittlegeorge's picture

price it in bread for something even more painful.

Sun, 09/26/2010 - 21:19 | 606268 freshman
freshman's picture

Seems too simple to explain what happened. Inflation can be caused by different reasons.  Hyper-inflation as a result of dramatic currency devaluation will NOT make your house worth less in terms of that currency. Of course, it probably won't matter since by then, the whole Ponze scheme would have blown up spectacularly anyway.

Sun, 09/26/2010 - 21:34 | 606290 Ned Zeppelin
Ned Zeppelin's picture

Definite correlation between employment and housing starts, but after looking at this recently at the homebuilding division of our company, we decided minimal correlation between interest rates and housing starts.  Rates impact affordability, and affect how much house you buy, but not whether you buy.  Rates impact price, and thus equity in the home. After the drop we've had since 2006, rates rising would make short work of whatever equity remains for owners in many homes, i.e., more underwater, illiquid and unable to move.  Trapped capital. 

Sun, 09/26/2010 - 21:43 | 606303 Village Idiot
Village Idiot's picture

Looking at the recent article regarding QE2 and the possibility of mortgage rates (maybe)approching 0, I was already wondering what the impact would be on housing prices.  My first thought is that it would be a positive for prices, at least in the short run. This latest article adds to the mix.  Temporary housing stimulus (lower carrying costs, higher prices) followed by higher rates and a drop in prices?  My head is going to blow.

Sun, 09/26/2010 - 22:22 | 606355 phgc691
phgc691's picture

A house is an asset, the debt used to buy the house is the corresponding liability.  The real value of the debt will go down as a result of increased interest rates and inflation.  Buying a real asset like a house financed with ever depreciating fiat paper in an inflationary environment isn't such a bad bet.  Getting a 30 year mortgage at 4.25% is a winner if the future is inflationary, which I believe is almost a certainty. The key is to own things with real, intrinsic value- gold, oil, real estate, whatever.

Sun, 09/26/2010 - 22:56 | 606405 Village Idiot
Village Idiot's picture

I hate overpaying for insurance. Unless, of course, the policy pays. ugh. 

Mon, 09/27/2010 - 03:21 | 606669 Bananamerican
Bananamerican's picture

"Getting a 30 year mortgage at 4.25% is a winner if the future is inflationary,"

I'm confused....

In your inflationary future house prices stay High, going higher yes?....

But one part of "That 70's show" missing from the current amerikan scene is COLA.

How much inflation, for how long, will it take for amerikans to burn through whatever savings they may have?

Union representation is what...11%..where's the wage spiral going to come from this time to ALLOW ascending anything?

 

All Ben is going to manage to do is put more more snorkels on more "homeowners" and put more renters on government cheese. Love to learn what the consensus view on this one is at ZH....

 

Mon, 09/27/2010 - 12:58 | 607420 Augustus
Augustus's picture

I geneally agree with your understanding and assessment.  IF the very high inflation returns, then incomes will also adjust upward in nominal dollar terms.  IF the buyer will continue to pay 25% of income for housing then they have increasing amounts to pay for shelter, again measure in nominal dollars.  That will overwhelm the moderate increase in rates up to some point, maybe 7% or so.  If it takes a Volker cure of 13% govt. rates to get things under control then it is a different game.

Holding real assets financed by noncallable debt at historic low interest rates is not very likely to be a bad bet in a period of high inflation.  Rents go up but the majority of operating costs are fixed with the fixed rate mortgage.

Mon, 09/27/2010 - 01:07 | 606576 enobittep
enobittep's picture

Yes.  Put more simply - home prices behave similarily as bonds.  As mortgage rates increase, housing prices fall and vice-versa.

Mon, 09/27/2010 - 01:25 | 606598 j0sh1130
j0sh1130's picture

a 1% rise in interest rates results in being able to afford 7% less loan.  It's fairly easy to figure that interest rates rising to a long term avergae of 8-9% (from 4-5%) could easily have a ~30% negative effect on home prices. of course, a lot is left to be said for what is affordable based on your income bracket, but the fact remains that you can afford that much less loan.

Mon, 09/27/2010 - 05:10 | 606738 The Navigator
The Navigator's picture

If you have a REAL housing market, before talking about home prices increasing, you need wage inflation. And with unemployment at 10% (govt stats) or 20% (shadowStats) there is no upward pressure on wage inflation.

Secondly, you have the demographic bulge of Boomers (born 1945 to 1964 - easy for a dyslectic to remember) scorched by this last fiasco, disowning RE as an investment and looking for smaller, lower tax rated, single story homes.

So there's 2 dynamics at play: (1) no wage inflation and (2) boomers looking to move to lower tax/cost areas. Still Arizona and NV aren't benefiting and foreclosure rates there are in the top 10 of the country. Show me wages that support 33% of which can go to a mortgage payment and then you'll see a RE market. Either prices fall to this or income rises to pay for it - very, very simple. 

At the heart is the feral government interfering with the market via Fannie Mae, Freddie Mac and mortgage rates. Remove these and we can return to a true market. In the meantime, all else is BS.

Mon, 09/27/2010 - 08:28 | 606916 blindfaith
blindfaith's picture

this is more BS...by yet another expert. 

 

When are we going to run out of these guys?

  How is that a history hundereds of years old (property value and ownership) is now up set by a trend of a year or two??????   Trend is you friend, you think so?  Well, this is what has taken every impatient sucker to the laundry week after week for 10 years.  I don't see or hear of any of the wealthy selling out scared, do you?

Everyone forgets conviently that 90% of Americans still have nice jobs, likely 75% have no need to move at all.  Need to move...rent you house out, afterall isn't that what all the 'experts' are saying...rent don't own.  Own your home, then do seller financing ( if we had not done these things in the late 1970's thru mid 1980's not one speck of real estate would have ben sold...and with  10% inflation rate going at the same time we roared out in 6 years).

 

I am really getting tired of the sky is falling...it is NOT, and all the cry babies who join in this chours when they are just fine.  Get off it.  There is and always will be a need for homes ( and price adjustments)..even if we sell them to the imigrants, which we should be doing along with giving green cards and income tax collection too.

GOD we are such idiots and suckers, and boy do we love to jump into the chorus any cry rivers.

Mon, 09/27/2010 - 09:53 | 607067 LadyH
LadyH's picture

The thing is that getting screwed in real terms (but flat to better off in nominal) is less painful than getting screwed both ways at the same time as any pro will tell ya.

Mon, 09/27/2010 - 10:38 | 607144 kaiserhoff
kaiserhoff's picture

Nothing new here, except the claim that long rates change very slowly.  Generally true in the past, but in this turbo-charged fed/fraud world does that still hold?  I think not.  This is not my area.  I'm still waiting for some coherant explanation of why long rates contain NO inflation premium.  Yes, I know all about Ben and Butthead, but bonds are the ultimate deep market: illiquid, hard to value, and super-specialized. 

I find it hard to believe the fed is successfully manipulating the bonds of every damned sewer district.  I think we are all missing something here, and uber liquidity just doesn't cut it.  Any thoughts?

Mon, 09/27/2010 - 22:00 | 608819 phgc691
phgc691's picture

Bananamerican-it's America asshole

Tue, 10/26/2010 - 22:38 | 679513 guccichanel
guccichanel's picture

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Sun, 05/29/2011 - 07:11 | 1320384 martinjack
martinjack's picture

I have done some research and find out the many real estate people are giving assumptions of property ups and downs and assuming that real estate or property will come to its original position, which is not true. I have been in Dubai apartment rental business since few years and realize that when any market falls it takes long time to recover. People are waiting for property market back in US. Go abroad and find your best Dubai hotel apartments or if you go specifically go for flats rent Dubai.

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