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Wednesday, October 6, 2010

The Coming Housing Price Crash

Disclaimer:  This is neither investment advice nor legal advice. You are solely responsible for the investment decisions you make.

Residential real estate could be in for another nasty crash.

Treasury bond prices are at incredibly high prices while their yields (the annual return they pay out) continue to fall.  Short term bond yields are approaching zero.  All in a flight to what people hope is quality.

When the "bond bubble" bursts and bond prices crash, and bond yields take off in an inverse relationship, interest rates that banks will charge for capital will follow.  This will mean that mortgages will no longer be available at record-low rates (the 30-year-fixed mortgage rate has been well below five percent for some time.)

Housing has fallen an average of about 40 percent since the residential real estate bubble began deflating in 2005-07 (depending on your location).  This price crash has reflected the reduction in credit for new purchases, that is, credit in the form of mortgages.  Mortgage financing became much more difficult to get, relative to the period between 2001-07, and generally banks have wanted lower loan-to-value ratios (requiring larger down payments) to guard against anticipated price declines.  Yet the interest rates have fallen since those years.

For those who can still get mortgages, on any terms, the low interest rates have kept the affordability of real estate relatively low, as measured by monthly payments, and the significant price declines have made real estate more affordable for many than was the case five years ago.

What happens when mortgage rates skyrocket?

Take a homeowner who wants to buy a $400,000 house with a 20% down payment, let's assume that a $320,000 mortgage (30-year, 5% fixed rate) plus property taxes and homeowners' insurance would result in a monthly payment of $2,200.  

Now, if we simply change one variable -- the interest rate -- and move it up a few notches to a 7% rate, that causes a $533 increase in the monthly payment.  If that first mortgage above was granted by the bank on the basis of affordability as measured by the ability to pay the monthly payment, you have to keep that amount constant to determine the amount of the mortgage the purchasers would qualify for.  My math says the homeowners would only get a $240,000 mortgage -- an $80,000 decrease, or 20% of the purchase price.  (That decrease, coupled with the average national price decline since the 'height' of the residential real estate market, would produce an average price drop in excess of 50% from the peak.)

If purchaser affordability drops just due to interest rate hikes and is not offset by bank lending policies (and there is no sign that will change), it is reasonable to expect a further and significant price decline.

Interest rates have been near historical lows and I would think they are much more likely to revert to the mean -- the historical levels -- than to stay at the current, depressed, record levels. 

What happens when inflation becomes an issue again?  What happens when the central banks, including our Federal Reserve, no longer can control inflation -- or its wicked stepsister, deflation?  

What happens if our political leaders decide one day that the solution to America's debt crisis is to inflate our way out of debt?

If these things happen, those low mortgage rates will be a thing of the past.  So will home prices seen anywhere in the last 15 years. 

Eric Dixon is a New York lawyer who comments frequently on legal, economic and policy issues.  This article is not intended to be legal advice.  Mr. Dixon is available for further comment and consultation, on various legal, economic and strategy issues, at 917-696-2442 and via e-mail at edixon@NYBusinessCounsel.com.
 

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