March 10, 2004

Quote of the Day: An All-Consuming Mortgage Payment

From "Household Debt and the Macroeconomy," a supplement to the Quarterly Review of the Bank of International Settlements. I'll have more from this publication later. "Households may be surprised in later years by the proportion of income still required to service their debt, and hence have lower than desired consumption. The higher aggregate debt/income ratio means that households will be more exposed to shocks, and will also remain exposed for a longer period than in the past." Update: This gloomy quote comes on the heels of mortgage rates making new lows and applications for new mortgages growing. The mortgage Bankers Association reported that its purchase index rose 1.4% to 428.6 for the week ended March 5. I prefer the purchase index to the overall number because the purchase index measures requests for new loans instead of refinancing for old loans. New loans, in my view, are the key to rising home prices. They represent new and growing demand. Without them, the steam behind the housing engine cools. Of course the whole thing starts with new or first-time buyers being lured in through low interest rates. At low interestst rates, buying a home appears to be more affordable even for borrowers with less money to spend on a mortgage payment. At a low interest rate, the mortgage payment is a smaller part of disposable income. But the aforementioned BIS study shows that the marginal buyers who come in at low rates are in for a rude surprise if and when rates rise. And that while the value of the asset may fluctuate (i.e. go down from its current highs) the value of the debt does not (unless you pay it off with inflated dollars.) That same BIS report goes on to say that,"Regardless of whether the increase in household debt is sustainable, the greater indebtedness has important macroeconomic implications. The household sector will be more sensitive to movements in interest rates, particularly if they are unexpected, and to changes in income, most notably arising from unemployment." One side effect of low interest rates is that they've encouraged riskier borrowers to buy homes. This has had the effect of driving up the debt/service net income ratio to its highest level in decades. People are buying a lot of house at low interest rates. But the mortgage payment is a huge portion of their net income. The opportunities for personal financial disaster begin to mulitiply. Unemployment (a pretty radical disruption to income) becomes a huge threat, not to mention rising rates, or even the natural tendency of housing price bubbles to slowly deflate, leaving the borrower with a large note and a decreasing market value. Of course, in the meantime, the low rates may very well cause another wave of homebuying/refinancing. If people think rates are going to rise (and everyone seems to think they will, but not until next year), there may be a rush of new homebuying (sort of like gun buyers rushing to buy assault weapons for the ban went into place.) And if you look, it's clear homebuilding stocks (Lennar, Ryland, KB Homes, and even the homebuilding index HGX) are all delighted at the prospect of low rates for the rest of the year. If you've got bearish positions in any of those per the recommendations I made in the "Housing Report," you'll likely be stopped out. Tomorrow or Friday, I'll revisit the housing strategy given the prospect of lower rates for the rest of 2004. The good news is the stock market looks ahead, and some homebuilders are pricing a year's worth of low rates in right now. That means we ought to be able to find some cheap, long-term, near-the-money put options for the day when the music stops.


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