October 15, 2008 (Housing Market Monitor)

Housing Market Monitor

Interest Rates and Refinancing Both Jump in Bankers’ Survey

October 15, 2008

By Dean Baker

"Even if it succeeds, the bailout will not prevent prices from falling."

The Mortgage Bankers Association (MBA) weekly survey of its members showed that the average interest rate on 30-year fixed rate mortgages jumped to 6.47 percent last week, up from 5.99 percent the prior week. In spite of this jump, the MBA reported an increase of 12.5 percent in its refinancing applications index, although the purchase index fell by 0.3 percent.

It is difficult to reconcile these seemingly contradictory movements. One obvious possibility is that the interest rate data is a fluke (weekly data are always erratic) and that there was not really such a large spike in interest rates. On the other hand, given other accounts of credit freezing up, it certainly is not impossible that rates did rise sharply last week.

It is also important to remember that the index measures applications, not approvals. It is likely that the percentage of applications being approved has fallen in the current environment. This could mean that the jump in refinancing applications indicates that people are applying to more banks in order to get a loan. This is presumably the case with purchase mortgages also, which means that the drop in the issuance of purchase mortgages is much larger than the data imply.

The pending home sales index for August jumped by 7.4 percent from July, putting it 8.8 percent above its year ago level. While this was taken by many as a sign of the market turning, a more plausible explanation is that the jump is attributable to the change in the FHA’s policy on seller-assisted down payments. Beginning October 1, the FHA no longer issue guarantees on mortgages with seller-assisted down payments. These loans were a surprisingly large share of all FHA loans.

Many builders and realtors highlighted the impending change in policy as a reason for buyers to move quickly. This undoubtedly pushed some purchases forward, which means that September and October data are likely to look worse as a result of this jump.

There has been considerable confusion over the likely effects of the bank bailout on the housing market. The immediate issue that the bailout was intended to address was a potential freezing of credit. Assuming that the measures put in place by the Treasury and the Fed are successful, credit will return to its more normal flow in the weeks ahead.

While this should prevent a marked worsening of conditions in the housing market, it will not lead to a turnaround in the housing market. The decline in the housing market is a fundamental issue of supply and demand. The bubble-inflated prices of recent years created an enormous excess supply of housing. This excess supply shows up in near-record inventories of unsold new and existing homes and, most of all, in record vacancy rates for both ownership and rental units.

The excess supply was not apparent for several years because reckless lending artificially inflated demand by both allowing people to buy homes at prices they could not afford and also by encouraging speculation. Even if lending returns to normal, there will still be a huge excess supply that will only be eliminated with a further decline in price.

Proposals by politicians and economists to try to prevent further price declines will inevitably prove counterproductive. They are likely to encourage more oversupply through more building (unless we also restrict building, in the same way that farm price support programs often restrict agricultural production) and will simply lead more people to buy homes at bubble-inflated prices.

The best course for the economy and the housing market would be if house prices fell back to their trend levels as quickly as possible. At the recent pace of price decline, house prices should reach their trend levels by the middle of next year. Of course, tight credit and the further weakening of the economy could bring this date forward. It would be reasonable to try to prevent prices from overshooting on the downside, but this would mean focusing on the markets where this could occur (e.g. Detroit and Cleveland), not a blanket effort to prevent price declines nationwide.

Dean Baker is Co-Director of the Center for Economic and Policy Research, in Washington, D.C. CEPR's Housing Market Monitor is published weekly and provides an incisive breakdown of the latest indicators and developments in the housing sector.