4.5% Mortgage Rates & Housing Demand

Posted on December 18, 2008


Earlier this week, I suggested lower price levels would spur housing demand far more than lower mortgage rates.  Using John Taylor’s position that the Federal Funds Target rate was below the levels recommended by the Taylor Rule, it would appear that cheaper money led to the current housing glut but my conjecture is that cheaper mortgages in today’s environment will have only a marginal effect on overall housing absorption.
In today’s Wall Street Journal, Glenn Hubbard disagrees (not necessarily with me of course) –  but siding with the recommendation of the newly proposed 4.5% standard mortgage rate for homebuyers.   (What’s even more interesting is that this proposed plan hasn’t really been proposed and is purely rumor according to Treasury Secretary Hank Paulson.)
Hubbard argues:

Moreover, a 4.5% mortgage rate will raise housing demand significantly. A simple forecast can be obtained by applying the 2003-2004 homeownership rates to 2007 households. We use the 2003-2004 home ownership rates because those were the years of the lowest previous mortgage rates (the average mortgage rate was 5.8%).

Hubbard, Taylor, and Paulson know far more about economics, finance, and the housing market that I ever will.  However, applying some very basic financial and economic principles to this case:
1. Past performance is no guarantee of future results.
2. Mortgage rates (and all interest rates) should directly reflect the risk profile of the borrower.
3. If mortgage rates are set at 4.5%, this would implicate that all borrowers fall into a low-risk profile category, as rates at 4.5% are close to historical lows and represent less than a 1% real rate of return for lenders after accounting for inflation (estimated at 3.66% as of October).
There has not been a fundamental shift in the population of buyers in the market.  That is, in aggregate, today’s buyer population is not constituted of a fundamentally lower risk profile set. We can probably assume that buyers today pretty much have the same characteristics of buyers in the period from 2003-2007.  As such, providing mortgages at a price lower than a large chunk of buyer risk profiles would dictate would seems to only elongate the current housing glut since offering mortgages at 4.5% would enable those not truly lendable to receive mortgage approvals.  
One might immediately argue that there are tougher lending requirements now, so the lower mortgage rates would not necessitate irresponsible lending practices as seen in the previous business cycle.  However, with the Federal Funds Rate near 0%, banks are in a position to take more risk and provide money supply to those seeking it, which is what the Federal Reserve wants to happen to prompt economic activity.  See the circular logic here?
One could argue that because price levels are lower (and perhaps exhibiting deflationary characteristics), houses are more affordable to today’s population of buyers and thus is creating demand.   If that’s the case, will dropping mortgage rates from 5.5% to 4.5% really have an impact, or is it the change in price levels that will spur housing activity?  As argued in my previous article, it seems that lower home price levels will have a bigger impact.