Tuesday, October 28, 2014

Low Mortgage Rates - Prosperity & Diminishing Benefit by Cal Haupt

Low Mortgage Rates - Prosperity & Diminishing Benefit

Quantitative Easing, QE, in its various forms, is an activity that drips monetary policy directives into the economy and builds potency like medicine in your body.  See Definition Below.  When you take a pill, you want immediate results; however, medicine does not work that way.  That is why antibiotics are taken over 5 -6 days to build potency and eliminate its target.  Get impatient and take too much medicine and there are consequences.  With respect to QE, these consequences occur as risk profiles change and rates rise, creating an optimistic mentality in the economy.  If the correct dose of monetary policy is applied, the scenario plays out well for all; however, if too much is applied, a point of diminishing return can occur, slowing the economy to the next recession and or depression.  You need just enough medicine to cure the patient and not create a terminal event.  The issue is there are no directions, the weight of the patient is unknown, and the illness being treated is not clear.  Odds are with an overdose at some point in the next 5 years.

The US economy is still absorbing QE 1–3.  This level of stimulus is historic.  The normal result of a QE 1 is some level of inflation once the economy recovers.  With QE 1-3, inflation is a given at some point. It is a matter of when and how much.  There is no data to correlate the outcome of the current level of stimulus in the economy from QE 1-3.  It will cause home prices to rise, inputs to home construction to rise, and equity markets to rise.  People feel better about life in general when their stock portfolio rises and their homes are more valuable.  As a result of this “happy…happy” time, everyone loses sight of 2008 and buys stock at highs, new homes, vacations, cars etc. which creates the expansion cycle.  In my opinion, we are about to experience one of the best periods we will ever see in the Real Estate Industry.  If QE 1-3 was the correct dose of medicine, this will all play out nicely with little disruption or dislocation.  We will know in a few years as the full effect of QE 1-3 is absorbed by the US economy.

History proves there is a point of diminishing return of lower mortgage rates for Consumers and the Real Estate Industry.

Every 7-8 years everyone – Mortgage Borrowers, Realtors, and General Business – cheers the decline in the rates needed to stimulate the economy out of a slump.  This stimulus is necessary and generally short-lived.

The backlash of low rates is normally tighter credit for borrowers and home builders.  The lower rate environment excludes many participants in two important segments of the Real Estate Industry.  Why does this happen?  In an economic slump, there is a flight to safety and some builders and consumers get caught off guard and experience various levels of financial hardship.  Banks and Secondary Markets all take the same path and tighten credit to protect their balance sheets until a recovery is on the horizon.

While rates remain low, there is a corresponding tighter credit policy. Banks retain their risk adverse posture until there is visibility on a better risk return profile.  Builders and Developers have to seek private money or borrower construction perms to fund projects, thus constraining inventory.  Once banks can earn an acceptable return for risk at higher rates, they will open the gates to their coffers and housing will take off.

Banks and Secondary Markets think a lot like a consumer.  If you were offered .25% for your $5,000 in savings, you are probably indifferent between stashing the money under your mattress or depositing it into your savings account.  In an economic decline, trust is lacking and the mattress looks good.  If you are offered 5% at the bank, you are probably willing to take additional risk for the return and do not want to forgo the interest for the safety of your mattress.  As a result, you put your money to work in the bank’s capital structure.  The same logic is used at Banks.  If rates are low, they prefer to mitigate risk and put it in safe instruments like Treasuries or other instruments with low risk.  When yields are higher, they assume more risk and put their deposits to work which provides the capital to expand the economy further – especially the Real Estate Industry.

The same holds true for consumers.  They will accept higher risk as they feel better about the economy and their income prospects.  Even though rates are higher, consumers tend to buy homes when they are confident.  The same holds true for the stock market.  Most consumers never buy during a correction and tend to buy when highs are reached and euphoria exists in the market.  The current low rates are not stimulating new home buyers; however, as rates rise credit will moderate which stimulates new home purchases from the new entrants to the housing market.  At the same time, Bank’s will adjust their posture and fund builders and developers which will create a surge in inventory.

Economic slumps given time will generally seek an equilibrium in the free market; however, the government usually does not have time to allow a natural solution to occur.  This is what occurred in “The Great Recession”.   As a result of necessity or political pressure, our government engaged in monetary policy initiatives to stimulate the economy. 

Everyone should want rates to normalize and seek their natural higher level based on current economic data points.  It will be great for Consumers, the Mortgage Industry, Real Estate Sales Industry, and Builders / Developers.

Cal Haupt
Chairman and CEO
Southeast Mortgage of Georgia, Inc.

Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.  A central bank implements quantitative easing by buying specified amounts of financial assets from commercial banks and other private institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the monetary base.   This is distinguished from the more usual policy of buying or selling short-term government bonds in order to keep interbank interest rates at a specified target value.

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