Recent news about continued problems in the housing market — including rising defaults by people with bad credit — has readers asking what might happen next. Julio in Arizona is wondering why the Federal Reserve doesn't step in and lower interest rates? Speaking of interest rates, Betty in California wants to know: why do bond prices go down when interest rates go up?
Why doesn’t the Fed lower interest rates to stabilize the housing markets, since inflation seems to be at a point where it can’t go much higher than it is?
— Julio, Phoenix, Ariz.
The folks down at the Fed would be very relieved to hear that inflation can’t go much higher. Unfortunately, that’s not the case. While inflation does seem fairly tame by historical standards, the Fed is officially more worried about inflation than recession. One reason is that wages continue to show strong gains. When people have a little more money to spend, they may become a little less demanding about getting the lowest price possible, which gives makers and sellers of consumer goods an opening to nudge prices higher without losing business.
But even if inflation could be declared officially “not a problem” the Fed’s primary lever on interest rates is the overnight “federal funds” rate that banks charge each other for short-term loans. Long-term interest rates — like mortgage rates — are set in the bond market, where investors around the world buy and sell securities that provide the capital that mortgage companies lend you when you buy a house. And right now, the bond market is a little nervous about the whole mortgage lending business.
Ironically, that's because until very recently, it was too easy to get a loan. There are a number of reasons for this: some point to excess cash in the global money system from a variety of causes, including the Federal Reserve's aggressive rate-cutting early this decade and piles of dollars being recycled by a booming economies like China. Others say, in the pursuit of profits, some lenders simply ignored the risks of lending money to borrowers who had little chance of paying it back.
Whatever the reason, things in the housing market just got out of hand: with people buying and “flipping” houses they never planned to move into and lenders selling mortgages to people who couldn't afford to repay them. Now that home prices are falling in some areas and some adjustable loans are pushing monthly payments higher, defaults and foreclosures are rising.
For the moment, mortgage rates are still reasonably low for borrowers with good credit. And though regulators have started clamping down on the riskiest lenders, so far they don’t seem to be overreacting by tightening up too hard on new loans for people with good credit.
The problem is that the people who borrowed more than they could afford – and the companies that sold them the loans — are now in pretty deep hot water. By some estimates, as many as a third of the people who got a mortgage last year — many of whom had bad credit histories to begin with – would have a hard time getting a new loan now that the lenders who catered to them are in trouble.
This borrowing hangover hurts the housing market two ways. First, it knocks a lot of would-be home buyers out of the market because they can't get a loan. Second, all the homes bought by borrowers who got in trouble — and are now defaulting on their loans — are being put back on the market. That means there are even more unsold homes, some of which are now owned by banks willing to cut prices to get rid of them quickly.
No one can say for sure how — or when — this downward trend will turn around. But, as the CEO of one of the biggest U.S. homebuilders said famously last week, the 2007 housing market looks like it’s “going to suck.”
WORST CASE SCENARIOS
... Since the economy has started to slow down, home prices are coming down too. However, the U.S. has a large deficit which keeps getting even larger. If foreigners lose their patience and start selling dollars, the dollar will devaluate. What will then happen to the home prices inside the U.S. Will they go up or down?
— Anonymous, Greenbrae, Calif.
A lot of other variables are probably more important to home prices than the value of the dollar. But it you continued your scenario, a falling dollar (depending on how quickly it falls) would typically force interest rates higher, which would throw more cold water on the housing market, which could further hurt prices.
But at each stage of your scenario, other forces are at work that could knock it off course.
Markets tend to correct themselves — even if painfully in the short term. We had a much worse real estate scenario brewing in the late 1980s. It cost taxpayers hundreds of billions to clean up failed savings and loans that made bad loans. Some homeowners lost money, and some developers got wiped out. But the lasting impact was relatively mild: a short recession in 1991.
But not everyone got hurt in that housing slump. One reason is that for owner-occupied residential housing, the best defense against a market downturn is usually to stay put if you can. That tends to dampen the kind of pressure that typically force other investment markets (like stocks) into steeper — and more rapid — declines when the selling starts.
At the moment, the surge in defaults among borrowers who are in trouble seems to be contained. If these credit problems spread, you could see an overreaction by lenders, a contraction of consumer spending (which accounts for 70 percent of U.S. GDP) and a resulting recession.
But we’re not there yet.
I have money invested in U.S. treasury index mutual funds. Some money in a long-term fund and some in an intermediate fund. I've noticed that as interest rates rise, the net asset value of the funds decrease. Why? It would seem to me that their net asset values would increase as interest rates increase.
— Betty T., Santa Maria, Calif.
Bond prices fall as interest rates rise — and vice versa. The reason takes a little getting used to.
Let’s say I buy a bond at a Treasury auction for $10,000. The way it works is investors tell the Treasury the lowest rate they'll accept, and the Treasury takes the lowest bids. If my winning bid is, say, 5 percent, that means I’ll get roughly $500 in interest each year from the government, paid in quarterly installments.
But by the next auction, winning rates are up to 6 percent, which means someone who buys a $10,000 bond now gets $600 a year. If I try you to sell my 5 percent bond in the open market, you’ll (understandably) ask: why should I buy a bond that pays $500 when I can get a new one that pays $600?
But I really need to sell my bond. So I say, “OK: I’ll make you a deal. I’ll sell you my 5 percent bond for $8,333.33. Now you’ll get 6 percent on your money.” ($500 = 6 percent of $8,333.33)
You’ll still get $500 in dividends. But now that will represent 6 percent return on your investment. The same works in reverse: if a bond pays 5 percent at auction and then rates go down to 4 percent, that 5-percent bond now pays better than freshly-auctioned bonds. So you’ll have to pay a little more to buy that bond on the open market because it’s paying higher-than-market interest rates.
The original amount ($10,000) is sometimes referred to as “par” value, and bonds trade at a “discount” or a “premium” depending on whether the rate when issued is higher or lower than the current market rate. The rate that’s fixed when the bond is auctioned is sometimes called the “coupon” – because you used to have to clip the coupons off the bond and send them in to get paid. The return that’s set by changes in the price of already-issued bonds in after market transactions is sometimes called the “yield.
These bond deals are made minute by minute every weekday by bond traders moving billions of dollars through the system splitting rates into tiny slices. If you buy sell bonds $1 million at a time, you need to think in terms of thousands of a percentage point. A “basis point” — the smallest measure bond traders use — represents one one-hundredth of a percent. (100 basis points = 1 percent).
So now you can talk like a bond trader.
(NOTE: We dropped a zero from our hypothetical $10,000 bond when the column was first published. Thanks to an alert reader for catching it.)
DUELING FOR DEFICIT DOLLARS
Here in Portland, Ore. we are engaged in a lively debate about how much we should invest in transportation infrastructure — most of it done with federal dollars. Some of us would like to see very controlled investment in only the most cost-effective projects. But if other communities lavish spending, won't this continue to cause federal budget deficits?
— Ron S. Portland, Oregon
Absolutely: especially with no limits on spending levels or on the practice of “earmarks” — which allows powerful members of Congress to tap the Treasury like a piggy bank for pet projects at home. That’s how we got the $230 million “Bridge to Nowhere” linking a few dozen inhabitants on a remote Alaskan island with the mainland. (The plug was eventually pulled on that one.)
One solution, which the new Congress seems to be trying to impose, is to ban earmarks and the restore so-called “pay as you go” rules (or “paygo”) that were in place in the 1990s. The idea behind paygo is simple: before you spend on a new program, you have to either raise taxes or cut spending elsewhere to pay for it. If you can’t, the new program doesn’t get funding.
But earmarks (aka “pork”) are a lot tougher to eradicate. As long as spending is done by committee, and those committee rules give broad power and discretion to the handful of members who run them, the risk of “lavish spending” is pretty tough to eliminate.