Mortgage interest rates are determined in an open market and are subject to the forces of supply and demand. These rates are the sum of three main components: riskless rate of return, risk premium, and inflation expectation. The housing bubble was characterized by historic lows in the federal funds rate, risk premiums and inflation expectations which resulted in the very low mortgage interest rates. These low mortgage interest rates allowed people to finance large sums of money, and these larger bids helped inflate the housing bubble.
When credit tightened as prices started to decline, the federal funds rate was lowered in an attempt to provide liquidity to the financial markets. This did temporarily lower one of the three components of interest rates; however, since other central banks around the world did not immediately follow with similar rate cuts, the value of the dollar declined and inflation began to rise. This increased the inflation expectation among investors.
The impact of increased inflation expectation was greater than the drop in short-term interest rates, and mortgage interest rates rose steadily. Declining prices also caused losses for lenders as many borrowers defaulted on their loans and the value of the collateral was not sufficient to recover the loan balance. As lenders and investors lost money, they began to demand higher risk premiums. The greater risk premiums and higher inflation expectations caused interest rates to rise and house prices to fall.
Higher interest rates had a dramatic impact on exotic financing as it became more expensive for borrowers. Interest rate spreads grew and the qualification standards tightened to the point they were not usable. This was driven by the defaults and foreclosures. In the heyday of negative amortization loans, lenders qualified borrowers based only on the teaser rate payment without regard to whether or not they could afford the payment at reset.
For more sophisticated borrowers, lenders allowed stated income or “liar loans.” Basically, borrowers would tell lenders how much they wanted to borrow, and lenders would fill out fraudulent paperwork showing the borrowers were making enough money to afford the payments. This is amazingly irresponsible lending, but it was widespread. Once the price crash began, lenders required borrowers to be able to actually afford the payments; of course, this makes many borrowers unable to obtain financing. When a negative amortization loan costs 13.8% rather than 3.8%, few borrowers wanted it, and if lenders required borrowers to actually afford the 13.8% interest rate, few borrowers qualified. Either way, negative amortization loans died, and the fate of stated income loans was no better.
Mortgage rates for prime customers were very low because they rarely default. During the rally few defaulted because prices were rising; people just sold if they got in trouble. This allowed banks to originate risky loans at very low interest rates because the loans did not appear risky. Once the market stopped rising, the underlying risk started to show with increasing default rates and default losses.
When prices crashed, defaults rates increased for all borrower classes. Prime borrowers did not default at the high rates of sub-prime borrowers, but they still defaulted at rates higher than in the past; therefore, interest rates increased for prime borrowers as well. The crash in house prices caused all mortgage interest rates to rise. Banks have to make enough money on their good loans to pay for the losses on their bad loans and still make a profit. Higher interest rates make for lower amounts of borrowing, and this in turn leads to lower house prices.
In short, low interest rates make for high prices, and high interest rates make for low prices. Therefore, it is best to buy when interest rates are high and refinance when interest rates are low. You can refinance into a lower rate, but you cannot refinance into a lower debt.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author’s daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/
[tags]housing, real estate, buying real estate, housing bubble, real estate bubble, house for sale[/tags]
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