Calling the Bottom?

May 6, 2008

Two weeks ago, I said it. Now commentators are saying the same thing on the WSJ op-ed page and on (snippets below): house PRICES may still be at historical highs, but house AFFORDABILITY is not, which may mean prices don’t have to fall any farther. The crucial forgotten variable is mortgage rates.

Here’s what I noted two weeks ago:

With a fixed rate 30-year mortgage of 18%, a $2000 monthly payment will buy $132,000 worth of home. Cut the interest rate to 6% and the same $2000 payment will buy $334,000 worth of home.

In terms of affordability, the two homes are totally equivalent. Remember, when you buy a house with a mortgage, your monthly payment has two components: a principal payment to pay down the debt on the total cost of the home AND interest on that debt.

While I agree overall that house prices have to fall, I’ve become skeptical about conclusions drawn from [analyses comparing house PRICES to median income]. The fundamental flaw I see is that it is based on a home’s price, not the total cost of home ownership. Maybe I’m missing something here, but it strikes me as obvious that house prices relative to income were lowest in 1982…interest rates were 18%!

If incomes are stagnating, and they are, then affordability is the key. What percentage of your income is actually being used on a monthly basis to pay for the roof over your head? The two authors I’ve cited use the house affordability argument to claim that the housing market has hit bottom.

But I’m not so sanguine. There are three problems with concluding that home affordability today means house prices have no farther to fall:

  1. Home inventories are still off the charts. With supply exceeding demand by such a great amount house prices likely have to fall farther in order for the market to return to normal. The affordability argument suggests sellers can wait out buyers at this point, though at the margin buyers still have leverage due to the sheer number of homes on the market.
  2. Incomes could fall. With the economy entering recession, employment is likely to fall, especially in the financial service sector, which is much larger than it once was. The affordability argument assumes that incomes don’t fall relative to home affordability. But if unemployment spikes, median income will go down. Bulls would counter that this is a housing-led recession and if housing has bottomed out, then we don’t have to worry about recession. A good point.
  3. But perhaps most importantly: Interest rates will have to go back up. Homes are only affordable right now b/c interest rates are so low. And interest rates are so low only because the Fed is aggressively easing to fight off recession and foreign governments are still buying loads of U.S. Treasuries and mortgage-backed debt with the dollars we send them each month by virtue of our trade deficit. But the Fed will have to raise rates at some point when inflation again becomes the primary worry, and foreign governments can buy American debt only so long.

That last point is the strongest one I think: interest rates won’t stay this low forever. You can’t buy perpetually high home prices with low interest rates. Not without sparking inflation. Interest rates have to return to normal too. When they do, home prices will have to fall farther for homes to remain affordable.


Here’s what Cyril MoulleBerteaux has to say on the op-ed page of today’s Journal:

So what’s going to stop the housing decline? Very simply, the same thing that caused the bust: affordability.

The boom made housing unaffordable for many American families, especially first-time home buyers. During the 1990s and early 2000s, it took 19% of average monthly income to service a conforming mortgage on the average home purchased. By 2005 and 2006, it was absorbing 25% of monthly income. For first time buyers, it went from 29% of income to 37%. That just proved to be too much.


Since then, house prices have fallen 10%-15%, while incomes have kept growing (albeit more slowly recently) and mortgage rates have come down 70 basis points from their highs. As a result, it now takes 19% of monthly income for the average home buyer, and 31% of monthly income for the first-time home buyer, to purchase a house. In other words, homes on average are back to being as affordable as during the best of times in the 1990s. Numerous households that had been priced out of the market can now afford to get in.


Many pundits claim that house prices need to fall another 30% to bring them back in line with where they’ve been historically. This is usually based on an analysis of house prices adjusted for inflation: Real house prices are 30% above their 40-year, inflation-adjusted average, so they must fall 30%. This simplistic analysis is appealing on the surface, but is flawed for a variety of reasons.

Most importantly, it neglects the fact that a great majority of Americans buy their houses with mortgages. And if one buys a house with a mortgage, the most important factor in deciding what to pay for the house is how much of one’s income is required to be able to make the mortgage payments on the house. Today the rate on a 30-year, fixed-rate mortgage is 5.7%. Back in 1981, the rate hit 18.5%. Comparing today’s house prices to the 1970s or 1980s, when mortgage rates were stratospheric, is misguided and misleading.

A similar argument was made this week on Smart Money:

What establishes value in a home price? Like anything else, it’s a question of historical norms. So how do we determine the norms? Try this way on for size.

Let’s think of value in terms of affordability — the ability of people to buy the home they want. That has three elements. First, home prices — the lower, the more affordable. Second, mortgage rates — again, the lower, the more affordable. Third, personal income — the more of it, the more affordable.


Today home prices have fallen so much, mortgage rates are so low, and personal income is so high — that homes are more affordable today than at any other time, ever — with mortgage payments on the average home eating up about 40% of income.

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