Why Housing Looks Rickety

Is the housing market safe from higher mortgage rates? The market seemed to be betting that way earlier this week. On Tuesday, the Standard & Poor's 500 home builders index, which includes DR Horton (DHI), Pulte Homes (PHM), KB Home (KBH), and others, jumped 4%.

Investors seemed to be excited that wholesale prices, excluding food and energy rose just 0.1% in March, indicating that "core" inflation is under control. Plus, the Federal Reserve released the minutes from its March meeting, indicating that it may not need to keep raising short-term rates after May. Investors took heart that if rates stop rising, buyers will be able to keep on buying property, and housing sales volumes -- and prices -- will remain strong.


  Hold the celebration, though. The rise in rates may not be coming to an end. On Apr. 19, the government reported a bigger-than-expected 0.3% March increase in the consumer price index, excluding food and energy, stoking fresh inflation fears. Yields on Treasury notes, which had dipped below 5% on Tuesday, climbed right back above 5%, and the S&P Homebuilders index gave up most of its Tuesday gain.

Also weighing on the market was another record in the oil market, where the price climbed 82 cents a barrel to $72.17. In Bentonville, Ark., Wal-Mart Stores (WMT) CEO Lee Scott told analysts that high energy prices are sapping buying power from Wal-Mart's key customers, though he said he still expects a "good, stable year."

Stepping back, it's hard to see why interest rates would stop rising now. Not only have oil prices soared, but gold is booming, the world economy is strong, unemployment is low, corporate profits are rising at a healthy clip, and, most important of all, inflation over the past year has been above the Federal Reserve's target range.


  The Fed may not stop after just one more rate hike in May, despite the hints in the March meeting minutes. And even if the Federal Reserve does pause in raising the short-term rates that it controls, long-term rates may well keep rising anyway. That would happen if buyers of Treasury bonds and mortgage-backed securities get nervous about the Fed's commitment to inflation-fighting and sell. When bond prices fall, interest rates automatically rise. And borrowers, including home buyers, pay the price.

Until recently, the housing market has been strangely insulated from the Fed's rate-hiking campaign. In June, 2004, right before the Fed began hiking, the federal funds rate that it controls was at an extremely low 1%, and the effective rate on 30-year fixed rate mortgages (factoring in points) tracked by Freddie Mac Corp. was at 6.29% -- a gap of more than 5 percentage points. The Fed proceeded to jack up the federal funds rate, but mortgage rates actually fell. That fueled the housing boom. It's only in the last few months that housing has clearly begun to slow down. For example, housing starts fell 7.8% in February and another 7.8% in March, according to a Census Bureau report.

Things could get a lot worse from here if mortgage rates move up in line with the increase in the federal funds rate. So far they haven't. Even though the federal funds rate has gone up by 3.75 percentage points, the 30-year mortgage rate is only 0.2 percentage point higher than it was when the Fed started raising. Diane C. Swonk, the chief economist of Chicago-based Mesirow Financial, predicts that the 30-year rate will climb to 6.9% by the end of 2006 and 7.25% by the middle of 2007. (She uses a different index that has rates at about 6.4% now.) The super-low mortgage rate "was a fairy tale environment and it had to end," says Swonk.


  It doesn't take a realtor's license to see that a big rise in mortgage rates would be bad for housing. With prices zooming over the past five years, the only factor that has kept houses within reach of buyers has been low mortgage rates. If rates rise, prices will have to fall in order for buyers to afford the monthly payments.

Creative financing won't do the trick because most of the ideas have already been played out, from low or zero down payments to interest-only mortgages to negative amortization loans. The market was precarious already because of the run-up in prices, notes Swonk, who says: "You add higher mortgage rates to the equation, you're going to get further affordability issues."

Not everyone agrees that things will play out this way. Some economists argue that housing demand will remain strong despite higher rates because the labor market is healthy, with the unemployment rate down to just 4.7%. James W. Paulsen, chief investment officer of Wells Capital Management in Minneapolis, predicts that rates will rise, with the federal funds rate possibly getting as high as 6%. But, he says, "as long as there are jobs, housing may slow but it won't go away."


  Other economists, who are more pessimistic on housing, say the economy is actually not so strong and there's no justification for raising rates. David A. Rosenberg, chief North American economist for Merrill Lynch, contends that the real unemployment rate is much higher than 4.7% because many people have become discouraged about finding jobs and have dropped out of the labor force, so they aren't being counted. Even though Rosenberg doesn't believe the Fed will raise rates again after its May meeting, he does think housing is overpriced -- and due for a fall. In fact, he thinks a slowdown in housing will chill the economy so much that the Fed will be cutting rates by this time next year.

Homeowners enjoyed an amazing windfall from price increases over the past five years. But with rates on the upswing, it looks like rough times are ahead.

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