With interest rates rising - marked notably by the 25 basis point hike in Fed funds last week - market participants are concerned about the impact on homeowners, especially as consumer debt has increased substantially through the last recession. There are mixed views on the issue. Some analysts have said that borrowers are going to be more adversely affected this time around, while others believe that the so-called fragility of the consumer is merely a myth.
In a recent report, UBS noted that many economists believe the recent period of low mortgage rates was unmistakably beneficial to homeowners. However, as rates rise, this becomes a short-lived benefit for many, as housing turnover accounts for roughly 6% to 8% CPR per year. With rising rates, it will be more expensive for existing homeowners to move for job relocation or other reasons, as they will have to give up a low rate to make the move. Furthermore, if rates rise sharply, this could have a significant impact on turnover rates.
"So while the fixed-rate borrower who is not planning to move reaps a benefit from his low-rate mortgage, the homeowner who wants or needs to move will give up that benefit as soon as the existing loan is paid off," analysts said. "For the past several years, falling rates have largely offset many of the costs associated with a move. Now, rising rates will not offset, but will add to moving costs."
In the report, researchers focused on the impact of rising rates on homeowners with ARMs or hybrids, although they did not discount the effect of rising rates on fixed-rate borrowers. Researchers concluded that, in contrast to previous periods, increases in the share of the ARM sector would not be followed by a quick return to lower rates in this cycle, analysts said. They add that rising rates will have a larger-than-usual impact on consumers. Both conclusions are based on several factors, and do not exclude the fact that mortgage debt and consumer installment debt is now at an all-time high. Furthermore, in the mortgage sector, the subprime market makes up a much larger portion compared to earlier years and HELOCs are at a record level and growing.
"The fact that we are going into a strong period of economic growth will mitigate some of the impact on consumer credit, but it seems unlikely to totally offset the effect of rising rates," wrote analysts.
In contrast to UBS, Morgan Stanley said that concerns about rising debt are "overblown" and that this is offset by refinancing and slower debt growth, as both have given lasting benefits to consumers.
In research, Morgan Stanley chief U.S. economist Richard Berner debunks myths about the American consumer, including the belief that the recent refinancing boom singlehandedly kept consumer spending afloat in the last two years and that the end to the refinancing boom will stop consumer spending.
Berner believes the impact of refinancing is ongoing. "Most consumers have locked in rates on fixed-rate, tax-deductible mortgage credit, substituting the proceeds from cash-out' refis for high-cost debt in order to reduce debt service," wrote Berner. He added that mortgage refinancings benefited consumers by reducing mortgage interest payments by $20 billion last year. Aside from this trend, about one-third of cash-out proceeds were used to pay down high-cost non-mortgage debt with lower-cost mortgage debt. Berner estimates that these paydowns netted consumers after-tax interest savings of $10 billion last year.
He also addressed issues of the so-called housing bubble, shrinking homeowners' equity and the squeeze resulting from rising interest rates. He mentioned that home prices would probably decelerate to a 2% to 4% pace in the coming 18 months with rising interest rates. This probably means that "home prices will rust rather than bust," Berner said. In terms of dwindling equity, the drop in equity is mainly due to the surge in homeownership by young, new homeowners, who probably have little equity in the homes they just purchased. He also said that while higher interest rates will "clobber" borrowers who are heavily in debt, most borrowers have locked in low-cost, fixed-rate mortgage financing.
Projections for the year
Despite rising interest rates, housing numbers are expected to remain robust. In fact, Fitch Ratings has revised its projection upward of total housing starts, at 1.89 million units this year. The single-family component of it, the largest part, is expected to reach 1.54 million, rising from 1.50 million last year. This constitutes a 2.6% increase.
"Even with the adjustment upward, I think it's a conservative forecast for the year because business has been so strong, and it seems quite unlikely that demand would fall off enough so that the year doesn't show some improvement," said Robert Curran, senior director at Fitch. He cited May numbers in which total housing starts were up 12.5% and single-family starts were up by 17.5%.
If rates were to continue to rise moderately, resulting in a rate increase of 1.5%, Curran expects a 4% to 5% drop in housing starts in 2005.This is still a fairly healthy statistic based on the standards of the last two to three years or even in a broader context, Curran said. "This decline would occur because people will be priced out of the market," he added. "However, I view this as a kind of a worst-case scenario for 2005." The companies' credit metrics are probably going to be maintained through this year and into the next, Curran noted.
In contrast to previous cycles, today's homebuilders usually have unsecured debt, a combination of revolving credit facilities and public long-term debt - which is much less expensive - making them less vulnerable to the movement of rates. He noted that the top 10 public homebuilders have almost 20% of the market.
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