dwot (99.54)

Six Degrees of Leverage: Part VI

December 11, 2007 – Comments (5)

The first 5 parts can be found here. 

So what you have here simply from interest rates declining and no adjustment of lending standards to account for the gross differences in the consumer’s ability to handle the debt over the long term is a leverage of money supply, the bank is able to loan $475k versus $290k with a decline in interest rate from 12% to 7%.

I saw 12% mortgages when I worked in the bank in the early 80s so it is a generational difference in the level of empowerment to manage debt.  Anyone trying to say that higher interest rates were harder has the foulest smelling diarrhoea of the mouth.  There is huge empowerment to reduce the repayment burden.  Further, they had the benefit of seeing rates drop and with it the ability to renegotiate lower rates.  Having an already fixed debt and interest rates decline is what made lower interest rates easier for them, and empowered them to stimulate the economy.  They are comparing a starfish to a giraffe and ought to be able to see the difference.

Furthermore, the household benefit of seeing lower interest rates and being able to refinance to save money also has reduced leverage as interest rates decline.  Take two households 3 years apart, the first had 12% to qualify and the second had 10% to qualify.  Say the rate declines 2% for each.  So, the home was not bid up for the 12% buyer and the mortgage was $243k and the payments were $2500/month.  To simplify, lets say the very next day they homeowner was able to lock in at 10% instead.  Keeping their payments the same, they drop down from a 360-month amortization to a 200-month amortization.  This is the stuff that stimulated the economy with initially dropping interest rates.  That 2% decline in interest with the homeowner just maintaining their payment saves them a whopping $400k of interest.  Now look at the homeowner that came along three years later when rates were 10%.  Home price got bid up to $285k, but they get the same lucky deal where the very next day they get to lock in 2% less at 8%.  They kept their payment the same as well.  They benefit, but their amortization only reduces to 214 months.  Their savings in interest is $365k, still very good, but that is almost a 10% decline in leverage for savings.  At 8% that declines to 6% the amortization declines to 228 months for $330k savings, and 6% that declines to 4% has an amortization decline to 243 months for a $293k savings.

So, when interest rates first went down there was huge amounts of money to be saved through households easily being able to reduce their total payments due to most of the payment stream being interest.  That money was freed up and available to stimulate the economy, but at the same time, anyone not in the market ended up in a housing market that got bid up based on payments that could be paid at lower interest rates.

The lower the interest rates when entering the housing market, the more burdensome the nature of the debt to be repaid.  Whereas for existing home owners lower rates offered enormous leverage for savings on mortgage payments and enormous ability to free up capital, the utter opposite is true for those who have entered the housing market later at lower rates.  There is a gross decline in leverage to control and tackle debt and there is forever a reduce ability to free up cash for other things.  By changing the terms of second mortgages from 10-years to 30-years newer buyers don’t even have eliminating the second mortgage as a source of freeing up cash flow.

Each year this lower-interest-rate with negligent-lending-standards time-bomb has continued it has resulted in more and more people with debt that gives little leverage to improve your financial position and it is the suck-the-life-out-of-your-financial-future-forever kind of debt.

So, the economy is now in a place where there isn’t must left to stimulate the economy from reducing interest rates, but there are an enormous number of homeowners with grossly reduced prospects of managing debt because of all the ways leverage has worked against them:

1) Homes bid up in price due to rate declines

2) Reduced leverage from increasing payments

3) Loss of equity from declining home prices

4) Reduced leverage of saving should rate decline

5)  Homes bid up in price due to second mortgage term increasing

6)  Homes bid up due to allowing a higher percentage of income to qualify for the loan.

Early homeowners have already reaped the rewards of lower interest rates.  And some of them have probably painted themselves into the same corner and destroyed their economic future as well by saddling themselves with the economic slavery kind of debt in order to upgrade their home or whatever else they might have wanted.

To further put this into perspective, out of 159 cities/suburbs in the world ranked for affordability, the US has 14 of the 25 cities in the world deemed to be the most unaffordable, including Los Angeles, San Diego, Honolulu, San Francisco, Ventura County, Stockton, San Jose, Riverside-San Bernardino, Miami, Modesto, Fresno, New York, Sacramento, and Sarasota.  Add the population in each city and that is an enormous number of Americans that have potentially become debt slaves.  Additionally, median affordability multiple for the US is now 3.7, meaning half the cities looked at have a lower level of affordability and half have a higher level of affordability.  Out of the 107 US cities looked at only 35 are affordable, or median home price to median income is 3 or less.

Suffice to say that various leverage of mortgage debt is currently hurting home owners enormously in how home prices have been bid up to what they can “afford” with negligent lending standards.  Homeowners have less power to control and reduce debt and that power has been declining as interest rates have been declining.  Lower interest rates only helped those with existing debt that were able to refinance at a lower rate.  Each percent decline in interest rate provides less leverage for reducing total interest payments when homeowners refinance.  Interest rates have been low long enough that dire hazards to homeowners from the many levels of reduce leverage for getting ahead likely out weigh the initial benefits early home owners had in being able to reduce total interest payments and free that money up to spend in the economy.

 Today’s newer homeowners have marginal prospects of being able to save for retirement, save for their children’s university, replace their aging vehicles, and indeed keeping their home should unplanned expenses or events happen such a job layoff, marital breakdown, health problems or unexpected pregnancy.

I still haven't look at how this plays out for investor in mortgages...  Perhaps a part 7 is coming.