Rates and the Rule of Thumb

With lending standards now tightening and interest rates on the rise, it’s possible that home sales, especially in the nation’s most rate sensitive and bubbly areas, could be poised for another leg down.

During the historic run-up, a combination of historically low interest rates and ultra-loose lending standards worked together to allow many more borrowers to qualify for home loans and all borrowers to qualify for larger loans.

With all the interest rates jitters lately, I thought it might be interesting to see how changes to the average 30 year fixed mortgage rate effects the income required for home loans using both the 29% of gross income “Rule of Thumb” and the ultra-loose 50% of gross income rule of the bubble.

The “29% rule” was one of those basic lending standards that went out the window with the boom and simply stated that a borrower (or borrowers) should be limited to a maximum loan “cost” of roughly 29% of their gross income.

Also, the “cost” was not merely the principle and interest payment (P&I) but was to include the property taxes and homeowners insurance (PITI) as well.

Keep in mind, in order to formulate the PITI value for the following charts I simply calculated the monthly P&I for a given loan amount at the prevailing rate and then added a $500 for property taxes and another $100 for homeowners insurance.

First, look at the average 30 year fixed rate as tracked by the Mortgage Bankers Association (click for larger version).

One interesting thing to note is that between 1999 and mid-2000, the rate significantly surpassed 8% and that between 1998 and January 2002 the rate hovered roughly around 7%.

Also note that from January 2002 to mid-2003, the rate declined to a record low of 4.99% and then proceeded to slowly trend up ever since.

Now, in order to get a sense of how affordable typical loans were at past rates and are now, review the following chart that shows the income required to qualify for a $200,000, $400,000 and $600,000 loan using the average 30 year fixed rate and the old standard “29% rule of thumb” (click for larger version).

Notice that during the bubbliest years of 2003 through 2005, a $200,000 loan could be financed conservatively with an annual income of roughly $70,000 (even less at the lowest point) and a $600,000 loan with a little as $160,000 annual income.

Remember, with dual incomes being fairly common these days, two incomes of $80,000 are not that unusual and these couples would have very conservatively been able to afford a $600,000 home loan.

Finally, look how the loose lending standard of 50% of gross income effected loan qualification (click for larger version).

Notice that during the bubbliest years of 2003 through 2005, a $600,000 loan could be financed with an income of just over $90,000.

Again, it’s entirely conceivable that a couple with good credit and a combined income of just over $90,000 (two incomes of $45,000) could be qualified for a $600,000 loan.

Remember, I only used the average 30 fixed rate to build up these charts and if considered, affordability loans such as ARMs with interest only options would make things even more dramatic.

Move Over Sub-Prime

With all the news lately concerning the sub-prime meltdown and its considerable effects on commercial (private and public) lending institutions it’s easy to forget that nearly 50% of all mortgage debt is held by the two main government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.

These two organizations, though purportedly operating both to the benefit of the public and within certain constraints not required by commercial lenders are not immune from the very same risks that commercial lenders face when managing a large portfolio of debt.

To the contrary, it appears quite possible that because of the GSEs special status and federal entanglement, they may actually be presenting a greater risk of failure, and the possible systemic fallout that could follow, than any of the larger commercial lenders.

Although the GSEs don’t technically write sub-prime or alt-A loans and restrict their lending activities exclusively to conforming loans, they have not been immune from the current culture of excessive lending.

It’s important to note that nearly 6% of GSE debt is composed of ARM loans.

Additionally, at least 3% of GSE fixed and adjustable rate loans have “interest only” options.

Furthermore, the OFHEO limit for conforming single family loan soared to a lofty $417,000 during the historic housing boom.

In a speech given last week, Federal Reserve Chairman Bernanke suggested that the GSEs have taken on more risk than typical commercial lending institutions, function with far less “market force” scrutiny than comparable commercial lenders and don’t even fulfill the public objectives set out for them by the federal government.

“The regulatory framework under which the GSEs operate has two principal objectives: first, to support the GSEs’ mission of promoting homeownership, especially access to affordable housing; and second, to ensure that these two companies operate in a financially prudent manner.”

“This line of business [the GSEs] has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that--as numerous government officials have asserted--the government has given no such guarantees.”

“Consequently, the GSEs’ ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible.”

“… they [GSE Portfolios] are not only large but also potentially subject to significant volatility and financial risk (including credit risk, interest-rate risk, and prepayment risk) and operational risk. Many observers, including the Federal Reserve Board, have expressed concern about the potential danger that these portfolios may pose to the broader financial system; that is, the GSE portfolios may be a source of systemic risk. … with possibly serious implications for the performance of the broader economy.”

“Unlike other private firms, however, the GSEs face little or no market discipline from their senior debt holders because of the belief among market participants that the U.S. government will back these institutions under almost any circumstances.”

“… because of both regulatory requirements and the force of market discipline, banks hold much more capital than GSEs hold. The very largest bank holding companies generally hold equity capital equal to 6 percent or more of assets, and the largest regional banks generally have capital ratios of about 8 percent. (As I am sure you are keenly aware, community banks often have a capital-to-assets ratio exceeding 10 percent.) In comparison, the GSEs hold capital equal to roughly 3.5 percent of assets. The justification for the low capital holdings of GSEs relative to banks is unclear.”

“However, evidence that Fannie and Freddie have had beneficial effects on the supply of affordable housing (over and above the benefits of their securitization activities for the mortgage market as a whole) has been difficult to find. After conducting several studies of the effects of GSEs on the mortgage market and establishing the GSEs’ disappointing results”

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Fueling the Fire

Today, the Bureau of Economic Analysis (BEA) released their second installment of the Q4 2006 GDP report showing a series of significant downward revisions to the preliminary estimates released last month.

Remember that last months preliminary report showed GDP growing at an annualized rate of 3.5% giving many Wall Street bulls optimism that the 2.0% growth seen in Q3 2006 could have represented a temporary anomaly.

But today’s release revises down the preliminary estimate 1.3% to an annualized rate of 2.2% with significant revisions to, amongst other things, non-durable goods and net imports (as I had suggested last month might occur) as well as durable goods.

Additionally, residential investment is showing a continued and dramatic fall-off registering a decline of 19.1% shaving 1.16% from overall GDP.

Furthermore, the decline to non-residential investment that first showed up in last months report as a meager 0.4% was today revised to a far more substantial decline of 2.4%.

Taken together, the declines to both residential and non-residential fixed investment are now depressing GDP by a stunning 1.43%.

As with last months estimate, today’s release is still showing unusually large increases to non-durable goods, net exports of services, and defense spending as well as an unusually large decrease to net imports, all working to boost overall GDP figure.

Be on the lookout for these values to be revised in next months final Q4 2006 GDP report possibly depressing GDP further still.

The following chart shows real residential fixed investment and nonresidential fixed investment versus overall GDP since Q1 2003 (click for larger version).

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