Another puff of black smoke has come forth from the chimney of the Federal Reserve. If you’re scratching your head, asking “why all the fuss?” you are forgiven. Should we in the mortgage industry be so obsessed about interest rate targets set by the Federal Reserve?
Let’s start toward an answer to those questions by first recognizing that interest rates are the cost of money. More specifically, interest is the cost of spending today versus saving it and spending it in the future. Of course, there is also inflation, which works in the opposite direction, increasing the cost of spending money in the future versus spending it today. Thus, the difference between nominal interest rates and inflation is referred to as the “real” rate of interest. In general, the farther into the future you lend or borrow, the higher the rate. This is referred to as the “yield curve,” which normally is upward sloping.
When the Federal Reserve “changes interest rates” in the traditional way, the specific action it is taking is to change its target range for the Federal Funds Rate, which is the rate at which banks lend each other money overnight. Yes, overnight, as in one day. That’s the short end of the yield curve! Traditional Fed Open Market Operations, as they are called, only affect very short-term interest rates. In order to lower long-term rates (5 to 10 years), the Federal Reserve began a series of other Open Market Operations, intended to be a temporary response to the Great Recession. This activity, known as “Operation Twist,” involved large purchases of longer-term Treasury bonds and mortgage-backed securities from Fannie Mae, Freddie Mac and Ginnie Mae. The Federal Reserve has stopped these purchases, but it is reinvesting all principal payments from those securities into new ones, maintaining its $4.2 trillion portfolio. In addition to announcing no change in the target Federal Funds rate, the Fed reaffirmed that it would maintain its investment in long-term bonds.
For those of us in the real estate finance business, long-term rates are more important than short-term rates for several reasons. The most obvious reason is that mortgage rates are generally tied to 10-year Treasury rates, so changes in long-term Treasury rates directly impact borrower payments. Most people stop there and assume those changes to monthly payments will affect housing affordability, but I disagree. Remember the first point above:
That brings us to the second point above, that interest rates are the cost of spending today instead of tomorrow. An increase in long-term rates makes it more expensive to spend money on housing today relative to spending it tomorrow. Thinking of housing purely as a consumption good, and more specifically, as a durable good, an increase in interest rates makes it more desirable to consume less housing today and to save to consume more in the future. From a consumption aspect then, rising interest rates should reduce the demand for housing today. In economic terms, this is a shift in the demand curve, not a movement along the curve. A downward shift in demand, with no supply response, means we can expect prices to go down.
As we all know, however, housing is also an investment, not just a consumption item. A fundamental principal of investment valuation is that the cost of financing does not impact the value of the asset. That would imply that a change in interest rates should have no impact on the value of housing. Again, things aren’t that simple. As an income-producing asset, the value of housing should be equal to the discounted present value of the net income it produces. The discount rate used to measure that value is the risk-free rate plus an additional amount for risk. If the risk-free (i.e., the Treasury) rate changes, then the discount rate should change. An increase in that rate reduces the value of income-producing assets.
Thus, all else equal, an increase in long-term rates will decrease the investment value of real estate, regardless of how it is financed.
So, both from a consumption effect and from an investment-asset effect, we can expect an increase in long-term rates to translate to lower home values. Housing values are sticky, particularly in a downward direction, so downward movements tend to happen slowly. An exception to that, as we learned in 2007, is when housing values are well above equilibrium value. In that case, values can drop very quickly, indeed. The good news I have for you is that housing values are not well above equilibrium value at this point, so an increase in rates might slow down housing appreciation, but it is not likely to cause home values to drop significantly. In fact, there are other reasons why demand for housing should be expected to increase in the near future, putting upward pressure on prices, as delayed household formations recover with anticipated strong wage growth. An increase in rates will likely slow down the origination of refinance mortgages, but that might happen only after an initial surge of people taking the opportunity to lock in long-term low rates and take advantage of recent home price appreciation.
As for predicting the future, the Fed has signaled it intends to raise short-term rates this year, but gave no signal regarding long-term rates. Think about this scenario: You have a $4.2 trillion portfolio of long-term bonds funded by $1.3 trillion of zero-interest notes (those Dead Presidents Millennials don’t carry) and $2.9 trillion of overnight debt. You can easily change short-term rates (your cost of funding, currently around zero), but the only way you can change long-term rates (your source of income) is to buy or sell long-term bonds in large quantities. What would you do?Tags: Federal Reserve, Interest Rates, Mortgage Banking, Mortgage Industry