8 August 2003 Focus United States

Joseph Abate
+1 (212) 526 0067

Housing Market Rate Risk

For families with large balances, higher interest rates are only mildly worrisome. However, higher rates do pose a threat to new
construction and home sales—potentially subtracting a full percentage point from GDP growth over the coming year.

Mortgage rates have followed treasury yields higher—rising from 5% in early June to
6.25% today. Will this torpedo the housing market and undercut the overall economic
recovery?

• Although homeowners have record high debt burdens, the increase in rates will
probably not pose too much of a threat, as most mortgage debt is fixed rate.

• The rise in rates will stop the inflow of marginal buyers.

• However, rising rates will slow home price appreciation, curb construction, and
end the cash-out refinancing boom.
Our rough calculations suggest that after adding nearly a full percentage point to
growth last year, if maintained, the current level of rates could be a similarly sized drag
on growth over the next 12 months.

Households owe record
amounts of mortgage debt…
Mortgage debt
Households currently owe over $6 trillion in outstanding mortgage balances. Not only
does this figure equal roughly 78% of their after tax income, it has also grown sharply
in the past two years, at roughly a 10% annualized rate. As Chart 1 reveals, growth in
mortgage debt has exceeded growth in after-tax income and overall household assets
by a wide margin since the recession started in March 2001. Moreover, projections for
originations this year point to another record year of issuance. According to FNMA,
roughly $1 trillion in new mortgages will be issued this year.
With so much mortgage debt on the balance sheet, and a growing tendency to use the
home as an ATM machine for cash, the ratio of mortgage debt to overall real estate
wealth has risen (Chart 2). The US household sector currently owes about $0.45 per
dollar in house wealth owned. As we have written in the past, this is partly due to
increased home ownership but it is mainly because the average balance has jumped to
$130,000 from $80,000 in 1995. Were this trend to continue, the household sector
would have as much as $0.48 in debt per dollar in real estate wealth.

“Float like a butterfly…”

…and debt burdens are But with so much debt on its balance sheet, is t he household sector vulnerable in light
already high… of the recent run-up in mortgage rates? And does this mean that, in spite of very low

Chart 1: Mortgage debt, asset and income Chart 2: Mortgage debt share of real estate
growth (% y-o-y) assets (%)
20.0 48
Lehman forecast
Assets Mortgage debt 46
15.0
44

10.0 42
40
5.0 38
36
0.0
Disp. income 34

-5.0 32
30
-10.0 Jun-70 Jun-76 Jun-82 Jun-88 Jun-94 Jun-00
Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03

Source: Federal Reserve, Flow of Funds and Commerce Dept. Source: Federal Reserve, Flow of Funds.

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 8 August 2003 Focus United States

levels of delinquency, many homeowners will now find themselves in serious

economic distress, as they cannot afford to make their monthly interest and principal
payments—especially when these payments are already consuming a record 6.4% of
after tax income?
Floating rate debt is a small Higher servicing costs do not pose a significant risk to the econ omy in the next several
proportion of overall years. Given the historical preference for 30 -year fixed rate mortgages in the US, only
mortgages… a relatively small proportion of mortgage debt floats. Indeed, of the record amount of
debt issued last year, only 18% had floating coupons, and we estimate that only 20% of
the total $6.2trillion in outstanding mortgages (some $1.2trillion worth) currently floats.
…and most of it will not reset In addition to the relatively small percentage of floating rate debt, the characteristics of
until 2007 these borrowings offer some hope of immunity from the dire consequences of higher
borrowing costs. First, most of these loans are fixed for five years, and the vast
majority has been issued within the past two years or so. As a result, only a small
percentage of these loans will reset within the next year. Instead, as Chart 3 suggests
from data compiled by our mortgage research team, higher floating rate debt will not
start to bite until 2006 or so. Moreover, most of these borrowers are fairly well off. The
majority of these loans exceed the maximum thresholds for securitization by FNMA
and Freddie Mac of just over $300,000. Generally, these are not borrowers who will
suffer much if the combination of floating rate debt and higher interest rates pushes
their monthly payments up a few hundred dollars.
At the lower end of the income distribution, although higher mortgage rates may price
out some would-be buyers, home affordability remains very high by historical
standards. For these families, we suspect that, as long as income growth holds up, so
too will affordability.

“…and sting like a bee…”

Higher rates will slow home
price appreciation and
household wealth…
But higher mortgage rates will not leave the economy unscathed. Instead, they will
work through several channels to reduce significant ly the stimulus they have prov ided
for the economy since the recession began.
Higher mortgage rates will slow home price appreciation and cool the growth in
household wealth. Our rough reckoning suggests that each 1% increase in mortgage
rates slows constant quality home price appreciation by the same amount. And
although the drag on GDP from shrinking equity wealth has received all the press over
the past three years, rapid home price appreciation owing to super low rates and the
lack of other investment vehicles has boosted real estate wealth from $11.4 trillion in
2000 to $13.9 trillion today. This has significantly softened the blow to GDP from
falling stock prices. Indeed, model simulations suggest that housing wealth has added
half a percentage point to GDP growth over the period (Chart 4). Because
homeownership is far more equitably distributed than stocks, even a minor slowing in
home price appreciation could have serious implications for house wealth—enough to

Chart 3: Approximate volume of ARM resets Chart 4: “Wealth effect” on GDP growth
($bn) (%)
100 2.0

90 1.5
80 1.0
Housing
70 0.5
60 0.0
50
-0.5
40
-1.0 Stocks
30
-1.5
20
-2.0
10
0 -2.5
Mar-00 Dec-00 Sep-01 Jun-02 Mar-03
2003 2004 2005 2006 2007 2008 2009
Source: Washington University Macro Model.
Source: Lehman Brothers Mortgage Research.

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 8 August 2003 Focus United States

reduce the size of the positive contribution to GDP growth long before household
equity wealth has a chance of recovering.
…reducing liquidity… Higher interest rates will also reduce an important source of liquidity for the household
sector. As long as interest rates remained at super-low levels and home prices
continued to move higher, families had plenty of incentive to take out, or liquefy some
of their home’s equity. Since the beginning of 2002, we reckon that nearly $200bn
worth of equity extraction has occurred. And since roughly half of these funds
ultimately ended up financing home improvements, autos, and vacations, anything that
chokes off this important channel could have serious consequences for the
consumption outlook.
…and hurting new home Similarly, higher rates would also dent residential investment and new home
construction construction. Residential investment has accounted for roughly a fifth of the increase
in GDP over the last two quarters. But with the cost of undertaking a new home
improvement project or building a new house now higher, we suspect the demand for
construction will wane—especially if slower home price appreciation convinces
families that homes are no longer a sure-fire investment (Chart 5).

Chart 5: Housing “returns” (%)

-2
Lehman forecast
-4

-6

-8
Mar-88 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03

Note: “Returns” equal owner’s equivalent rent plus home price appreciation less mortgage rates.
Source: Lehman Brothers, Bureau of Labor Statistics, and OFHEO

More worryingly, there is some evidence suggesting that home building may have
overshot economic fundamentals over the past two years. Based on econometric
simulations using the Washington University Macro Model, actual new starts are
running about 100,000 units (or 7%) higher than justified by pure economic
fundamentals, like household formation rates, income, interest rates, and overall
wealth. As a result, there is a potential for a more serious correction or mean reversion
once higher interest rates begin to kick in—with new home construction operating for
an extended period well below the level justified by economic fundamentals.

Looking forward
With the economy picking up, we do not expect the housing sector to collapse, but
housing indicators to fall to more sustainable levels, with less construction, almost no
wealth extraction, and much slower price appreciation.

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I, Joseph Abate, hereby certify (1) that the views expressed in this research report accurately
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report and (2) no part of my compensation was, is or will be directly or indirectly related to the
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 8 August 2003 Focus United States

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