Six Degrees of Leverage: Part VII
The summary of this series is Part I looks a the leverage of debt on a 10 year utility type bond, M2 and M3 money supply and the ratio of M2/M1 (which should be flat to reflect uniform risk).
Part II looks at how the amount a borrower can qualify for changes depending on interest rate and qualifying percent of income.
Part III looks at how changing the term of a second mortgage from the common 10 year term to 30 years changes the qualifying amount one can borrow.
Part IV looks at the gross limitations of how low interest rates "stimulate" the economy, and what anyone who actually believes that garbage is missing.
Part V looks at how different the debt structure is as interest rates decline for those trying to repay that debt. At low interest rates it is mostly principal that is paid back so there is much less ability to reduce overall repayment.
PartVI looks at the reducing leverage of savings for home owners refinancing at lower rates, and gives a summary of the many ways leverage works against homeowners as interest rates decline.
For this part my reading took me to a federal report mentioned on Calculated Risk. In the report is a graph showing the weighted average mortgage rates from 1991 to 1994:
In the 14 years covered you can see the 30 year fixed mortgage rate go from a high of 9.5% to a low of 5.5%. Say a household had $100k of income in 91. They would qualify for about $297k of mortgage. In 2005 they would qualify for about $440k, an increase of 48%.
In 91, 64% of the repayment amount would have been interest, but at 5.5% only 50% is interest. Paying less interest is great when the principal amount is reasonable, but in both examples the repayment amount over the life of the mortgage is $900k and the low interest borrower has reduced leverage for reducing the interest paid from making extra payment.
Over 14 years if you assumed wages have increased by 2.5% per year, then in 1991 that $100k salary today would have been about $70k. So in 1991 the amount of mortgage 30% of income would have qualified for at 9.5% interest would be $208k. With the rate decline and the wage increase over the 14 years then in 2005 that same household would qualify for $440k, an increase of 112%, or 5.5% per year.
In Canada to qualify for an insurance-free mortgage you need 25% down for a 25-year mortgage. In this model, if you consider that decreasing the interest rates and not building in anything for the extra risk due to how the nature of the debt has changed, over 14 years wages only went up about 40%, yet real estate is up 112%. If home prices were to return to that historical standard of debt risk housing would have to come down 30% and that 25% prime mortgage would be 5% under. The old US standard of 20% down and a 30-year mortgage was already a lienient standard.
To merely go back to the lienient standard of 20% down is enormously different in a low interest rate environment. Say a household is able to save 15% of their gross income per year, which tends to be a fairly aggressive savings rate. In 1991 at $70k per year they could save $10.5k per year. A property that costs $260k would require $52k down and a $208k mortgage. This is a moderately unaffordable home, with a price to income ratio of 3.7. As I stated earlier, made no mistake that qualifying for a mortgage with 30% of income means that family budgets are tight. It would take this household almost 5 years to save the $52k downpayment. In that time because of increasing income and declining interest rates, by 1996 the family would qualify for $272k, but the home would have gone up to $340k and now a $68k downpayment is required. In 5 years with pay raises and 15% savings the household would be able to save $56k.
The changes to the lending standards, and there is no question that allowing a family to qualify for a mortgage with 30% of household income in a declining rate environment is a changing lending standard that dramatically increases the risk of the loan, punished the responsible in that real estate went up $80k went they were only able to save $56k saving fairly aggressively. Why not just hit the responsible over the head with a sledge hammer? The trend to lower interest rates ultimately punished those who were doing their best to be responsible. It also punished those who were not already in the housing market, a form of transference of wealth from youth to age.
Ultimately, a young family starting their working career in 1991 would need 7 years of saving 15% per year to catch up with the 20% down payment and by 1998 they would be able to afford a $370k home with a mortgage of $296k, and have needed a $74k down payment. So, 25 when you finish university, 32 when you buy your first home, and 62 when you finally pay it off, and in a low inflation fairly flat wage environment, and the increasing costs of perhaps having a growing family, means that money is tight forever. Consumer spending to stimulate the economy is dead.
Today a family starting out with $100k in income that qualifies for a $440k mortgage because of the insane lending standards needs to save $110k towards a downpayment. When the 1991 family would have first did their budget, they would have figured it would take about 5 years to save a down payment. Today's family saving 15% of $100k would need about 7.5 years to save a downpayment. A home that costs $550k on a $100k salary is severly unaffordable. By the time this family got $110k saved, without a correction and say homes continuing up at the rate of wage increases, in 7.5 years home prices would increase another 20%, so they would ultimately need about 10 years to save a downpayment.
I did not understand the degree to which the rules were being changed prior to my own entry into the housing market. Nor did I understand the degree to which these changing rules have mislead people in their belief about housing. The lowering of interest rates without adjusting either the qualifying term or percent of income was a grossly uneven playing field for the have no home compared to the have a home families. As I have stated previously in my blog, in Vancouver, it has resulted in an enormous division of wealth. I see people getting close to 40 who have not been able to make a dent in their student loans, never mind ever owing a home. The asset price inflation has also resulted in rent increases beyond the rate of wage increases so these people have had no buffer what-so-ever to the cost of living increases.
For 10 years in Vancouver our housing affordability index was probably around 4, maybe just over 4 in 1992-1996 and perhaps as low as 3.6 before our latest housing boom that started around 2001-2002. Our housing prices declined a little from our peak around 1993-1995, and wages went up slightly which resulted in the affordability index declining. What I see in Vancouver's economy is a 10 year window of how unaffordable housing has played out in a relatively flat wage environment. Additionally, those who had homes had a leverage of disposible income due to being able to refinance debt at lower rates, so renters faced grossly increasing housing costs due to increases in rent whereas home owners saw mortgage payments decline. Probably the difference in Canadian laws prevented Canadians from using their homes like an ATM machines that has occurred in the US.
The median housing affordability index for the US is 3.7. Those that had their homes and had the opportunity to have a buffer against rising costs through home ownership seemed to have squandered that advantage as US data indicates enormous numbers of people have borrowed against their homes despite having had the opportunity to become home owners when housing was affordable. It seems to me that far more people in the US have borrowed to unaffordable levels than what I've seen in Vancouver and I can't see how this does anything but suck the life out of the economy as the burden of dealing with household debt can no longer be put off. Wages can't be anything but flat in this kind of environment, and can be declining. We saw lots of declining wages through that period as well.
We are being warned about losses from mortgage backed securities and it seems to me the analysis of how this will play through the economy is only looking at how business losses have played out through the economy in the past. It does not appear to be looking at how stiffled consumers will be for the long term because of the nature of how the debt structure has change, gross reduction of empowerment to pay off debt.
According to Calculated risk there is about $21 trillion in real estate assets, which if there is a 15% overall decline in real estate prices would be about $3 trillion in lost equity.
They also have two graphs in the post, Household Percent Equity, which would decline from 50% to 42% should home prices decline 15%. Equity would decline to 30% should home prices decline 30%.
The other graph shows home values and mortgage as a percentage of GDP. House hold value peaked at about 153% of GDP, whereas as it was typically valued at 80-90% of GDP. Mortgage debt is about 75% of GDP whereas it typically used to be about 30% of GDP prior to the credit bubble being launched in the 1980s. Should homes decline by 15% they would decline to about 130% of GDP.