When we first moved onto our block almost twenty years ago, mortgage rates were in rapid decline, and the neighborhood was engaged in a competition to see who could get the best loan terms. The fellow in the house across the street from us was a mortgage broker, so it seemed as if he had an unfair advantage
until his business failed because of faulty documentation practices. A harbinger of things to come for the industry!
There seems to be a similar refinancing race going on right now across the country. It has never been a better time to be a creditworthy borrower; rates on home loans have fallen to levels not seen since the 1950s, and refinancing has consequently jumped.
An important contributor to the decline in mortgage rates has been the Federal Reserves quantitative easing, which has added more than $800 billion in mortgage-backed securities to the central banks balance sheet. The latest program (QE III) calls for an additional $40 billion in purchases every month.
The resulting increase in refinancing has provided cash flow that boosts household consumption. As an example, moving from 4% to 3% on a $300,000 house saves about $150 every month for the 30-year duration of the loan.
The benefits should actually be even more generous. As shown in the right-hand chart above, the difference between the mortgage rate paid by a borrower (the primary rate) and the rate earned by an investor in a newly-minted mortgage security (the secondary rate) is especially wide at the moment.
The spread between the two drives the profit earned by financial institutions that originate mortgages. Third-quarter earnings releases consequently reflect very strong results from this business line. As justification for wider margins, banks have cited the increased cost and uncertainty of regulation, as well as limited underwriting capacity. As these ease, mortgage rates could fall by an additional 50 basis points or more.
We had expected that the benefit of QE III would be primarily felt through accelerated refinancing. But recent data on home sales and construction has been much improved.
Despite this improvement, we are still a long distance from any kind of new normal. As we wrote last month, there may be a hard road ahead for housing. Two factors will have a significant bearing on the trajectory of this sector:
To be clear: housing is past the bottom, and the sector is adding to GDP growth for the first time in several years. The future looks promising. But lingering headwinds will stretch out the healing process.
I think my wife is still intent on winning that race to the lowest loan rate. Even though we paid off our home a few years ago, she recently suggested re-mortgaging so that she could brag to the neighbors about securing a rate of less than 3%. Im not going to go back into debt just for conversation value.
A Driving Force
While housing sales continue a slow march to recovery, auto sales have accelerated much more rapidly. Purchases of this second-most durable good reached a four-year high last month.
This is an especially encouraging development, considering where the automakers and auto finance companies stood in 2008. And it has occurred despite secondary markets for auto loans that remain largely closed, and the absence of financing incentives that were so prevalent ten years ago. (Interest rates are next to nothing at the moment, so zero-rate loans are much less of a lure.)
How can one account for the relative success of autos versus housing?
First of all, far fewer auto owners owe more on their auto loans than their cars are worth. The strength of used car prices (illustrated in the right hand panel above) has kept borrowers from getting upside down. This leaves them with equity that can be used in trade for a new model.
Secondly, lending standards for auto loans have gotten considerably more supportive. Part of this is stronger residual values, but another part is the more modest influence of new regulation on auto finance.
Getting loan principal in line with collateral values and providing regulatory clarity can accelerate the recovery of purchases dependent on credit. Those setting housing policy should take notice.
European policy makers may finally have contained the anxiety surrounding Spain. The challenge of fixing the countrys financial problems lies ahead, but programs may now be able to proceed in a calmer atmosphere.
Spain sold bonds of different maturities amounting to 4.6 billion on October 18. The 10-year bond was quoted at 5.46%, down from 5.67% at the last comparable auction on September 20. This reversal is critical; high interest costs aggravate an already deep Spanish budget deficit, which has risen from 40% of GDP in 2008 to an IMF-projected 90% of GDP in 2012.
Sustainability of debt requires maintaining the ratio of debt-to-GDP stable in the long run. If nominal GDP growth continually falls short of rates of interest, as has been the case for countries like Spain, this ratio rises and tests the patience of investors and ratings agencies.
Policy makers have been working hard to bring these two elements back into closer alignment. Obviously, lower borrowing rates are a step in the right direction, but better growth would be a great tonic as well.
In that regard, the announcement this week of a plan to bring bank supervision under the direction of the ECB in 2013 is a very positive step. Strong and uniform monitoring of financial institutions is an important foundation for recapitalization; no one is willing to sink additional support into struggling banks without some assurance of oversight.
The migration to a common European regulator should make it much easier for the European Stability Mechanism (ESM) to provide the necessary funds to countries like Spain, where lending has declined sharply. The recapitalization of banks should help restore the flow of credit, which has been stunted over the past year.
To be sure, there are still a series of careful steps that must be taken. Spain has yet to make an official request for a financial bailout; while they are expected to do so in the weeks ahead, the timing of the request is unknown. For political reasons, the Rajoy government would prefer to minimize the domestic cost of a bailout and the conditions that would be attached to aid. The approach of provincial elections may have led the government to buy time and paint a façade of sovereignty before approaching the ESM.
The political approval process for funds through the ESM also intensifies the timing problem. The Bundestag and parliaments of other eurozone members have to vote on the aid package to be delivered by the ESM. At the present time, the respective parliaments are scheduled to vote on an aid package for Cyprus in November. In order to minimize the political stress of separate approvals in quick succession, the consensus appears to be that the Spanish package, and possibly additional funding for Greece, will be bundled with that of Cyprus. Thus far, the Spanish leadership has been obstinate and continues to delay the day of reckoning.
The favorable market response to this weeks Spanish auctions is tied to expectations that Spain will eventually concede weakness and apply for help. And yet, Spanish policy makers seem to be using this temporary respite to defer the request on which the market is relying. Resolving this apparent irony will be critical in the weeks and months ahead.