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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.

5 Comments – Post Your Own

#1) On December 11, 2007 at 6:17 AM, saunafool (< 20) wrote:

My conclusion (I am a rentloser, or as Robert Kiyasoki likes to say, "savers are losers"): Eventually easy money will lead to inflation, someone with a backbone will come along to slam on the breaks with higher interest rates, and the mortgage norm is 12%, then it is time to buy.

Great series. Thank you. 

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#2) On December 11, 2007 at 7:12 AM, abitare (30.19) wrote:


Again, we think alike,, and our CAPS points are getting killed, alike. I am trying to reduce my underperform exposure. It seems the FED is going to do whatever it takes to "juice" the stock market for the presidential election. Reguardless of the risk to the dollar and economy.

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#3) On December 11, 2007 at 12:31 PM, Imperial1964 (94.00) wrote:

Good series.  A part 7 on what it means to investors would be good.

I guess I'm lucky.  The median home in my area probably meets the definition of affordable, or is at least close to it.  (I don't exactly know the median income for my town).

Furthermore, I bought a house for half the median price, and my income is a bit above median, so my house was very affordable at around the level of my income.  Three years later I'm still remodeling, though.

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#4) On December 11, 2007 at 9:16 PM, floridabuilder2 (98.06) wrote:

totally off topic dwot, but I have read prior blog posts by you just haven't commented because i for one don't look at comments of prior blog posts... but i agree with your base metal implosion...  i've posted that oil is going to implode back to the 60s... the US is still the biggest pig in the world when it comes to commodities and if our economy slows drastically, consumption stops and china produces a lot of our consumption... if the dollar weakens that should be good for our agri business, but how many jobs are there.....  i unloaded a lot of my metal/commodity type stocks and have went to a trading mode of buying ultrashort etf's when the market has had a run and when the market takes a big enough dive, i will start buying ultra long etf's...  i just think this market is going south but will be volatile thus providing opportunities to make on the up and down through these big swings

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#5) On December 13, 2007 at 1:09 AM, dwot (29.13) wrote:

Thanks Saunafool.

Abitarecatania, seems like my cap score is recovering.  Looks like yours is as well... 

Yeah Imperial, I have been thinking about a part 7, lots of work writing the first six parts.  I certainly enjoy doing the type of analysis I do and when I actually look at the numbers I learn and see things that I didn't know.

I wasn't so lucky/smart with housing, managing to get in around a top in an expensive housing market -- one that would not meet the definition of affordable.

But, I had this belief system that you scarific your earlier years to built up wealth and equity because then your wealth and equity make your lifestyle so much better.  I knew from working in the banks that people that paid extra on their mortgage did really well, yet I paid extra, and paid extra, and paid extra, and well, the debt load just still seemed never ending.  That's probably when I started looking what was happening with my lower rate mortgage compared to the higher rate ones when I worked in the bank.  Part of it was also due to upgrading to nicer homes.  The first home was so tight we had to push all the living room furniture out of the way to pull out the dining room table if we had company.  The space really was designed for just a small two-four seater kitchen table, a couch and an extra chair.

Right now median price for all types of housing for Vancouver is $540k. Where I live in Burnaby for a house it is $736k, for a townhouse it is $440k and for an apartment it is $335k.  Something to realize here is that the "median" price includes an excessive number of one and two bedroom apartments because that's all couples can afford right now.  Few singles are able to enter the Vancouver market these days.  And Canadians can not deduct mortgage interest.

Vancouver still has speculation and I think it has better price support by local people because of the 2010 Olympics.  Local people remember what Expo 86 did to our housing market, basically a triple from 86 to 93, and they think that when the next cycle of the world's people coming to Vancouver and the media attention of an Olympics will drive prices up even more.

I think our housing was undervalued in 86.  We had a speculative bubble in 80-81 that hurt a lot of people and people still weren't over their fear of the market.  Our housing market went up and then it came down maybe 20% off the high.  This event lead to our stronger lending laws.  In 86 the median home price was about $90k.  At best wages are up 50%.  Vancouver is not going to see a repeat of what happened for Expo simply because the valuation is so grossly different but a lot of people believe that housing will go up further because of the Olympics and really don't consider the economic differences in their beliefs.  The Olympics comes up every time I talk about the housing market in Vancouver.

I consider the Olympics a real wild card for Vancouver.  

Floridabuilder, when I started thinking about all the energy used that goes into products in a new home, well, I came to the same conclusion that energy would come down.

I've been reading that the US agri business has been doing incredibly well.  I do wonder how long it will continue to do well.  I think the biggest concern for it is water supply.  The US has also been the biggest pig in water use and reserves are hurting everywhere.  In Florida there is evidence that the entire land mass has sunk due to depleting underground water reserves.  Draining of swamp land has reduced the ability of the everglades to replace the water supply by more than half.  I think it is estimated that underground water supply is only being replaced at about 40% of the rate it used to, and then you have this increasing population that wants green lawns.  I've been to Florida about 4 times and the unabated sprinkling systems...

Well, I think Florida has a water crisis and Florida just doesn't know it yet.

Lake Mead that feeds California is down to levels hardly seen before, as is the water supply behind Hoover Dam and the water reserve at Mt Shasta.  The freight ships traveling the great lakes have been forced to lighten their loads by 10% so they don't scrap the bottom...

I tend to think the petri dish called Earth is showing some of its limits... 

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