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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Saturday, August 11, 2007

Mortgage Payment Reduction Fuels Consumer Spending

In this commentary, I show the impact of lower mortgage rates on economic activity with some illustrative math. Consumer spending was boosted with the aid of mortgage payment reductions. Now that is over, purchase power needed to fuel the continued economic expansion appears to be at risk.

Mortgage Math & Economic Effects:
Falling interest rates allow homeowners to refinance their mortgages into lower monthly payments thus boosting consumer spending significantly. Since mortgage payments are non-discretionary, they essentially resemble taxes as they reduce gross income into actual, disposable income. Thus, reductions in mortgage payments (or taxes) are highly stimulative for the economy.

The example below helps to illustrate that point as we compare 8.5% and 5.25% rate loans with 150K loan amount. For the sake of simplicity, we will ignore tax-effects. There is only a $325 difference in payment, but a $117K difference in total interest paid over the life of the loan.

8.50% 30yr Fixed Rate Mtge
Loan Amount: $150,000
Monthly Payment: $1,153
Total Interest Paid: $265,213

5.25% 30yr Fixed Rate Mtge
Loan Amount: $150,000
Monthly Payment: $828
Total Interest Paid: $148,190

Monthly Payment Diff: $325
Annual Payment Diff: $3900
Total Interest Paid Diff: $117,023

After 5 years, more than 95% of the loan balance remains @ 8.5%. This prompts many borrowers to make extra payments to reduce outstanding principal quicker, which results in lower total interest paid.

At 8.5% total interest paid is 1.75x the amount borrowed (265k/150k). Assuming that a borrower doesn’t want to pay more total interest than amount borrowed, we assume in the first 60 months the borrower pays an additional $350 per month. Total interest paid now is slightly less than the loan amount.

Assume: 8.5% Borrower-
First 60 months- pays extra 30% of Payment:

Orig Monthly Payment: $1,153
Add’l Principal Payment: $350/mo
Total Monthly Payment: $1503
Total Interest Paid: $148,010

For the 5.25% loan, we assume no extra payments since total interest is less that loan amount. thus less urgency to reduce principal balance. The difference between the 8.5% and 5.25% is much greater, $675 monthly or 8100 per year. That’s a huge boost. Yet, it doesn’t end there.

Let’s assume a borrower took a 8.5% mortgage in ‘98 when rates were high. The borrower paid an extra $350 plus the $1,153 regular payment for 5 years. In 2003, rates were at historical lows and the borrower qualified for a 5.25% mortgage. At this time, only $117k of principal balance remained so the homeowner took a 5.25% for $117k to pay off the 8.5% original. The new monthly payment is now $647 versus $1503 leaving $856 in extra income per month, or $10,272 annually.

Another alternative is borrowing against the value of the home. Assume home values have risen 10% annually; the property appraises at $250k. With $117k still owed, home equity is 1 - (117/250) or 53%. Withdrawing equity so that it falls to the customary 20% results in a $82,820 cash payout. The monthly payment will be $1104 / month, with monthly/annual savings of $399/$4788

Alternative 1: Refinance Balance @ 5.25%
Balance @ 60m w/ extra pmt: $117,180
New Monthly Payment: $647
Old – New Payment: $856
Annual Savings $10,272

Alternative 2: Cashout Refinance
New Property Appraisal: $250,000
Loan Amount @ 80% $200,000
minus payoff old loan - $117,180
Cash Received: $82,820
New Monthly Payment $1,104
Old – New Payment: $399
Annual Savings $4,788

Current Cycle History:
Estimated home ownership is close to 70% of the 110+ million households in the US. If the average household has $10k more a year to spend, then that’s a huge boost for the economy.

And that’s what we observed beginning to happen in 2002 as mortgage boom started to take shape and GDP started to quickly accelerate. Lower house payments freed up massive amounts of discretionary spending spurring economic growth.

After the 2000 bubble, businesses had over-invested and still had excess capacity needing to be filled. Exports were weak due to the strong dollar, government spending was accommodative (yet focused on defense and national security), and a lack of capital investment meant consumers had to carry the economy on their backs. With super aggressive monetary policy, the Fed coaxed interest rates down to levels not seen in decades. This sparked a massive refinance boom and infused huge sums of money into the economy. Corporate profits grew and eventually job growth became robust pushing unemployment down into the mid 4% range.

Well Runs Dry:
In order for growth to continue, consumers must find sources of expendable income. Hence, rates must continue to decline so that borrowers can keep lowering their monthly payments to increase spending power. When rates bottom and level off, eventually most all outstanding mortgages will catch up meaning that they carry the lowest rate possible and no additional savings can be attained through refinancing.

Appreciating home values may temper this effect to some degree. Essentially, higher property values translate into credit limit increase similar to that of credit cards. Home equity grows faster from rising home values than actual paid-in equity. Thus, homeowners have a more valuable asset to borrow against resulting in greater purchasing potential.

Consumers can then run up all other types of high interest debt, such as credit cards, then tap home equity to consolidate high interest debt into essentially a low-interest long-term obligation. When home values stop appreciating, then the consumer can only withdraw equity that has actually be paid-in.

REFI Addiction:
As the consumer lowers his monthly payment by refinancing from 8.5% to a 7%, he notices the increase in discretionary funds. A year later when rates have fallen he refinances from the 7% to 5.5%. More additional income is available. He hopes rates fall even further so that another refinance opportunity presents itself. So, do mortgage lenders. They make a bundle on all the fees they charge for refinancing. When there are no more mortgages with a rate high enough worth refinancing, mortgage lending suffers.

So what’s the solution? We know consumers would love to lower their monthly payment and lenders love charging money to make that happen. But, the market dictates the rates which neither the borrower nor the lender control. One solution is to alter the product offering in such a way that it offers lower payments than what the rate market requires, and capture the below market portion on the back end.

1 month, 6 month or 1 year ARMs that offer a teaser rate. Initial interest is set way below market, then later resets to current market plus a margin. Interest-only products allow the borrower just to pay interest for usually half of the loan term, then Interest and principal must be paid during the second half which means they payment increases significantly. Another product that offers lower monthly payments is option ARMs. Borrowers don’t even have pay to the full interest due, instead they can make a predetermined minimum payment. Unpaid interest is tacked onto the loan balance leading to interest building on interest. The borrower can end up owing more than the original loan amount.

As home appreciation began to stagnate (thus rising home equities) lenders reduced the required amount of residual equity. Some products allow borrowing against the full value of the property.

Additionally, Lenders can influence housing prices with products that increase borrower’s willingness to pay more for a home. A key determinant of affordability is the standard 20% down payment.
A borrower may be able to handle the extra $500 in payment for a $300k versus $200k home, but not the extra $20k in down payment. Lenders offer zero-down mortgages where there is no upfront cash requirement.

Since humans are more focused on the immediate future, many are preoccupied with what they have to cough up now, less so on future interest and principal payments.. So, when home shopping, this product can foster the “Buy now, Pay later” attitude resulting in buyers to be less price-conscious.

Credit Crunch:
As rates reset on exotic and risky mortgage products, monthly payments increase resulting in higher default rates. Lenders respond by tightening credit requirements and cutting back offerings on risky products. As a result, the amount which can be borrowed decreases putting more expensive homes out of reach. Homeowners unable to afford the increased payments now have significantly fewer people able to buy their home before foreclosure. Foreclosures prompt further increased lending standards. Home values plummet as owners try to unload compounded by fewer available buyers able to get financing.

Spillover Effects:
The ending of refinancing eliminates the consumers’ ability to increase disposable income. The reduction in home values prevents the cash out of equity for spending purposes. Consumer’s that have become over-extended, reign in spending and focus on debt reduction. Credit card lending becomes tighter and more expensive. All of this, pressures consumer spending and overall economic activity. Industries related to housing experience a falloff in revenues, which means less employment hence less marginal consumer spending.

We have begun to see some weakness in the consumer as retail numbers have been soft. Retail stocks have seen some heavy selling. It will be interesting how this all plays out, but it definitely has the potential to be very bad for the economy. The fed needs to recognize the severity of this situation and act soon by lowering rates. There is an impact lag in monetary policy, thus by the time problems actually appear it will be too late.


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