Housing Market Reversal Should Have Been Obvious to Everyone

Dr. Irwin Kellner, chief economist for MarketWatch, asks a simple question:

Why are so many people so surprised that the housing market has weakened and that a growing number of home loans are in default?

It should have been as plain as the noses on their faces.

A roof over one’s head is one of those things that everyone needs. Those who can afford to will buy while those who can’t must rent.

Since the 1930s, it’s been national policy to encourage people to become home owners. Besides creating wealth for individuals and growth for the economy, homeownership is believed to reduce crime as well.

People who own their own homes can deduct the interest they pay on their home mortgage, as well as state and local taxes. But for these incentives to be helpful, housing must first be priced within a range that people can afford.

Thirty-five years ago, in the early 1970s, the average home price was about 2-1/2 times the average family’s annual income. This was considered very affordable, and so the rate of homeownership rose sharply.

But for one reason or another, home prices soon began rising faster than incomes. By the mid-1990s, they averaged almost four times the typical family’s income - making mortgage loans nearly impossible for many to come by.

Affordability sank and with it homeownership.

In response, policymakers and lenders devised ways to make home mortgage borrowing easier, since interest expense is the biggest cost of owning a home.

These helped a bit - but they really didn’t kick in until the Federal Reserve began cutting interest rates in early 2000, eventually pushing mortgage rates to 45-year lows by 2003.

Since short-term rates were well below long-term rates, many borrowed with an adjustable-rate mortgage, believing that rates would stay low indefinitely, or that housing prices would continue to rise indefinitely, thus enabling them to refinance at a fixed rate at some future date.

Needless to say, home prices rose even faster than before, as these lower rates (along with new types of loans and creative sales tactics) increased the effective demand for housing faster than supply.

In some areas, homes wound up costing five times the average family’s income or even more. Nationwide, average home prices shot up 50 percent from 2000-2005 - clearly exceeding household income growth by a considerable margin.

Few were disturbed by these trends.

Indeed, no less an authority than Alan Greenspan said in early 2004 (when short rates were at their lowest) were worried about a mortgage refinance problem, saying that homeowners may have saved “tens of thousands of dollars” over the past decade had they held adjustable, rather than fixed-rate mortgages.

Coming from the person who, as head of the Federal Reserve, had the most control over short-term rates, this might have given borrowers and lenders alike the feeling that it was safe to borrow on a floating-rate basis, since the Fed was unlikely to raise short rates after giving them such a ringing endorsement.

Alas, all good things must come to an end, and the end to the housing market bubble (which Greenspan belatedly characterized as “froth” by 2005) came as the Fed began hiking interest rates starting in the middle of 2004.

Rising rates reduced the demand for housing, causing prices in some areas to top out and start falling. Readers of this column were informed that the party was over and that some homeowners would soon have difficulty paying off their mortgages.

Others missed this sign until it was too late. Now they are trying to shut the barn door after the horse has escaped.

SOURCE: MarketWatch