Still More on Mortgage Rates

On December 5th, I said that 30-year mortgage rates are likely to fall to 4.5% within the next year. Although I didn't know it at the time, Bond investment guru Bill Gross seems to agree with me. In a CNBC interview on December 3rd, he made essentially the same prediction.

By the way, since then, the yield on 10-year Treasurys has fallen another 0.3 percentage points, and now stands at around 2.4%.

The World Changed in September

Sale price statistics can be volatile, but it seems safe to say that the San Francisco real estate market changed in September. Take a look at the chart, below, which shows median home prices for San Francisco County.

The pink line shows the average level of home prices for the three-year period between July 1, 2005 and June 30, 2008. A fair interpretation of the chart is that, monthly fluctuations notwithstanding, prices were in a holding pattern over that three-year period. As late as August of 2008, prices were still within 2.5% of the three-year average. When Lehman Brothers filed for bankruptcy on September 15th, however, the world changed. Stock prices fell 7% during the remaining weeks of September, and have fallen another 25% since then.

I predicted at the time that the San Francisco real estate market would suffer as a result. (Okay, that wasn't much of a stretch.) In fact, San Francisco home prices fell 10% in September alone, and have fallen another 4% through the end of November. It's not clear that the stock market meltdown caused this drop. For starters, most of the sales that closed in September would have been initiated in August, before the meltdown really started. But it's starting to look as if something important happened to the San Francisco market in September.

More on Mortgage Rates

A few weeks ago, I wrote that mortage rates are likely to improve. That was based on 1) the Treasury's proposal to push mortgage rates down to 4.5%; and 2) the fact that the spread between 30-year mortgages and 10-year Treasury's was at 2.8 percentage points, which is nearly double its long-term average.

Paul Krugman weighed in today on the subject in his New York Times blog, arguing that since Fannie Mae and Freddie Mac (i.e., the dominant mortgage lenders in today's market) have effectively been nationalized, there is little reason for investors to shun their debt in favor of Treasury bonds. In other words, Fannie and Freddie should already be able to write new loans at a spread that's comparable to historical levels.

The historical average spread between 30-year mortgages and 10-year Treasury's is roughly 1.6 percentage points. Adding that to the current 2.15% yield on 10-year Treasury's, you get a 'normalized' mortgage rate of 3.75%. For comparison purposes, mortgages are currently being written at around 5.15%, which is already the lowest since the Fed started doing its rate survey in 1971.

Deflation: You Can't Have Your Cake and Eat It Too

"What's so bad about deflation? I'd love to pay less for the things I buy." I'll admit, that thought has occurred to me lately. I'm glad that gas costs half as much as it did a year ago. I'd be singing a different tune, however, if I were in the business of selling gas. The trouble with deflation is that almost everyone is in the business of selling something. For every buyer who benefits from lower prices, there is a seller who suffers. It’s clear, therefore, that a general reduction in prices is not an unqualified boon.

The concept of deflation is difficult because few of us have ever thought about it. So let's start with inflation.

If inflation is running at 2% when you buy your house, you'll probably pay about 6% interest on your mortgage. If inflation increases to 10%, your lender will increase the interest rate it charges on new mortgages to 14%. The extra 8% interest is intended to compensate the lender for the additional 8% erosion that it expects (annually) in the real value of its principal.

What happens if you get your loan when inflation is running at 2%, and then inflation increases to 10%? In that case, you get a windfall. Your salary will start increasing at a higher rate, in accordance with the higher rate of inflation. (You'll spend more money for haircuts, but the barber will have more money to spend in your store.) Your mortgage payments will remain fixed, however, so they’ll take up a lower percentage of your income than you had counted on.

Of course, your salary increases aren't 'real'. After all, they ultimately result from the Federal Reserve's decision to print more money. We know intuitively that putting more money into circulation won’t make us all richer, but it can make some of us richer. We just saw that an increase in the inflation rate will make it easier for you to service your loan, so you'll be a clear winner. On the other hand, your lender will lose out in the deal because your 6% interest payments won’t even compensate for the 10% annual erosion in the real value of your loan balance.

In short, a sudden increase in inflation results in a significant transfer of wealth, from your lender to you.

Now let's consider the opposite case, where the inflation rate falls from +2% to -10%. As before, there will be a transfer of wealth, but this time, it will be from you to your lender. Your salary will decline at a 10% annual rate, making it increasingly difficult to service your mortgage. Conversely, your lender will be receiving 6% interest on its principal, even while the real value of that principal is increasing at 10% per year.

The problem gets worse. Because the value of your home is likely to be falling (just like everything else), your lender will be getting anxious about its collateral. If you default on your loan (an increasingly likely outcome considering the circumstances), the proceeds from a foreclosure sale may not be enough to pay off the principal. That will make your lender increasingly reluctant to extend new credit against your home. In short, while your creditworthiness is deteriorating and your likelihood of default is increasing, some banker will be losing his job because his employer isn't doing enough mortgage business.

And so on. There's more to the story, but by now it should be clear that deflation means more than discounts at Wal-Mart.

Don't Count on Foreign Buyers to Rescue San Francisco Real Estate

When the housing crash started grabbing headlines last year, real estate insiders were hopefully espousing the theory that foreign buyers would prop up demand for San Francisco housing. The idea was that the declining dollar made US real estate cheaper for foreign buyers, who naturally preferred world class cities like San Francisco and New York. Unfortunately, the theory makes little sense. The reason for any sudden drop in the dollar is that foreigners are trying to reduce their holdings of US assets. Why, then, should they suddenly increase their demand for San Francisco real estate?

The dollar has indeed declined over the last several years, but the decline has been gradual and modest. A careful look at the facts suggests that the resulting impact on foreign demand for San Francisco real estate has been marginal at best.

Currencies rarely move in lockstep with one another: while one currency is appreciating relative to the dollar, another one might be depreciating. In such cases, how can we say whether the dollar is getting cheaper or dearer? Economists address this problem by using trade-weighted exchange rates. The idea is to create an index whose value is adjusted from period to period by applying a weighted-average of the percentage changes in a representative group of exchange rates. The weights are chosen to reflect the amount of trade that each country does with the United States.

Take a look at the chart, below, which shows the inflation-adjusted value of the dollar, measured against a trade-weighted basket of foreign currencies.

Remember that this 'exchange rate' is actually an index: a 10% increase in the level of the index indicates that the dollar has appreciated by 10%, but the level of the index itself is meaningless. (I obtained this series from the Federal Reserve. I re-scaled it so that the average of the index over the last 20 years is 100.)

The index reached its peak value of 117.7 in February of 2002. It reached its recent low of 88.6 in March of 2008. The peak-to-trough change was approximately -25%, which is indeed a sizable decline. Keep in mind, however, that most of this decline happened gradually, over a six-year period. In other words, it's not as if San Francisco real estate suddenly went on sale. The index did fall at an accelerated rate beginning in late 2007, but the cheap-dollar/foreign-buyer theory had taken root long before then. And when the sudden fall did occur, foreign buying slowed, just as I suggested above. (The National Association of Realtors reported that fewer Realtors were working with foreign buyers in August of 2008 -- when the dollar was near its low -- than in August of 2007.)

The latest index value is 98.6. That represents a discount of 16 percentage points relative to the 2002 peak. Again, that's a sizable discount, but it's not exactly a half-off sale. I'm not saying that foreign demand for San Francisco real estate has not increased, but a discount of that size seems unlikely to have had anything more than a marginal impact. And once you reject that simplistic explanation, the notion that foreign demand will prop up San Francisco real estate starts looking like wishful thinking.

Mortgage Rates Seem Likely to Improve

Here's an encouraging piece of news for the real estate market: The Treasury Department is working on a plan to push mortgage rates down to 4.5%. The details are being worked out, but the essence of the plan is that the Treasury will act as a bank: They'll borrow money from private investors (by selling Treasury bonds) and lend the proceeds to homeowners. As long as the loans get repaid, the Treasury will actually earn a profit, determined by the spread between its lending rate (4.5% in this case) and its borrowing rate.

The Treasury's borrowing costs have been coming down lately, as investors all over the world dump risky assets and pour money into Treasury bonds. Since December of last year, the yield on 10-year Treasury bonds has fallen from 4.1% to 2.7% (as of December 5th). That's the lowest rate in the last 50 years, by a good margin.

Meanwhile, 30-year mortgage rates have remained stable. When the subprime loan crisis started making headlines in 2007, mortgage rates were in the low 6%-range. They've fallen since then, but are still within 0.75 percentage point of their pre-crisis levels. In contrast, 10-year Treasury yields have fallen by almost three times that amount.

With Treasury yields falling and mortgage rates remaining stable, the interest rate spread between the two classes of securities has increased to levels that haven't been seen in the last twenty years. (This is one of the primary indicators of distress in the credit markets.) From 1987 to 2006, the average spread between 30-year mortgages and 10-year Treasurys was 1.6 percentage points. Today, the spread is 2.8 percentage points. It hasn't been that high since the early 1980's, when inflation was running rampant.

Anyway, back to the Treasury's plan. Assuming that Treasury yields remain below 3% (a good bet when inflation is running at close to 0%), a mortgage rate of 4.5% represents a spread of at least 1.5 percentage points. That's consistent with historical averages. So even if the Treasury plan is abandoned, there are good reasons to expect that private lenders will push mortgage rates down to the same levels.

Banks will have to be recapitalized in order for that to happen, but I don't think we'll have to wait for home prices to stabilize. (During the housing market downturn of the early 1990's, the mortgage spread actually fell below 1.5 percentage points.) Even if the Treasury plan is abandoned, there's a good chance that we'll see 30-year mortgage rates below 5% within the next year.

A Temperature Gauge for the San Francisco Real Estate Market

How is the San Francisco real estate market doing? Unfortunately, that can be a difficult question to answer. Take a look at the chart, below, which shows historical sale prices for two-bedroom condos.

I'd summarize this chart by saying that prices plateaued in the summer of 2005, and haven't shown any obvious trend since then. So much for the last three years, you say, but what about the last three months? Consider the chart, below, which shows the annual rate of change for two-bedroom condo prices.

Unfortunately, I find this chart even more difficult to summarize than the first one. If you asked me how the market is doing and this was all I had to go on, I'd probably wind up reading data points straight from the chart. That doesn't seem helpful, particularly if you're not interested in two-bedroom condos. There must be a better way to characterize the state of the market.

You may remember that when the housing frenzy was at its peak, overbidding and multiple-offers were common. Take a look at the chart, below, which shows the percentage of two-bedroom condos that were sold above the asking price.

I've also included the change in average sale price (taken from the second chart, above). The two series track each other fairly closely, which suggests that either one can be used as a proxy for the other. The advantage of focusing on bidding activity instead of price changes is that it provides a cleaner snapshot of the market.

If I say that prices have fallen 5% in the last three months, you'll probably want to know how much they changed in the three months before that. Or maybe you'll want to know the level from which they started, and whether I believe that that level was appropriate. Pretty soon, we'll be far afield from the original question, which was, "How is the market doing?"

Okay, here goes: During the last few months, only about 20% of the housing units sold in San Francisco have gone for more than the asking price. In contrast, when the dotcom and housing bubbles were at their peaks, 80% of sales were for more than the asking price. Except for a few months following September 11, 2001, the recent rate of over-bidding activity is at its lowest level in the last ten years.

In other words, the San Francisco housing market has cooled dramatically.