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Six Degrees of Leverage: Part IV



December 11, 2007 – Comments (0)

You can find the first 3 parts here.

The analysis or suggestion that lower interest rates stimulated the economy is grossly incompetent.  In the shorter term, if you consider the masses that were already homeowners, well, they were able to reduce debt-servicing costs by refinancing and they were indeed able to stimulate the economy by spending that money elsewhere.  However, because of the insane lending standards, as rates declined, housing prices were bid up to what families could afford with 30% of their income at the lower rates, as in the table, and the length of mortgages increased from 25 to 30 years.

Rate / % income
30% 35% 40% 45% 50%
2% 676,000 789,000 902,000 1,015,000 1,127,000
3% 592,000 691,000 790,000 889,000 988,000
4% 524,000 611,000 698,000 785,000 873,000
5% 465,000 543,000 621,000 699,000 776,000
6% 416,000 486,000 556,000 625,000 695,000
7% 375,000 438,000 501,000 564,000 626,000
8% 340,000 397,000 454,000 511,000 568,000
9% 310,000 362,000 414,000 466,000 518,000
10% 285,000 332,000 380,000 427,000 475,000
11% 262,000 306,000 350,000 394,000 438,000
12% 243,000 284,000 324,000 365,000 405,000

If we look at a standard that goes from 12% to 7% on 30-year mortgages, a $100k income now qualifies for $375k first mortgage and an additional $100k for the second mortgage, for a total of $475k.  The home to income ratio, assuming zero down, has gone from an affordable 2.9 to a seriously unaffordable 4.75.  A home that ought to have been built and sold for $290k has been bid up to $475k.  There is no $185k of extra costs in that home.

It helps to explain how it is that builders have been getting compensation for their work that is grossly out of line with the realities of the rest of us.  Way too many are getting paid a million a year for the same kind of skill set that others in other types of companies make perhaps $75-150k.

One of the many reasons the economy is only stimulated short term from rate cuts is that as time goes by you have more and more first-time homeowners and these people are not benefiting from lower interest rates because their debt servicing costs have been reduced.  Indeed, they are experiencing a reduced leverage ability to get ahead, which I outline below, a huge reason for why low interest rates hurt more than they help.  Newer homeowners started at the maximum debt servicing allowed at lower interest rates.  You also end up with people who upgrade and also bid up their debt servicing costs so they are no longer a part of the benefiting population. Homebuilders who bought land cheap initially make a killing as home prices are bid up to a faulty qualifying criterion.

There is enormous extra risk when people have been paralyzed in their ability to reduce their debt burden from housing being bid up to a fixed percent of income as rates have decline.  Lending standards might as well have been designed by elementary school children for their lack of analysis and prudence to make adjustments to requirement based on the interest rate rather than the household income.  I picked up banking math errors written into law when I was a teenager with only my high school math skills, so I am quite serious to question how bankers can justify that their maths skills exceed that of elementary grade student to have not adjusted lending standards to make sense relative to interest rates.  We have yet to bear the brunt of the increased economic risk of what they have done.

 Part V next post


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