Why Mortgages Are Expensive Compared To Treasuries

Why are current interest rates on 30-year mortgages so high given that 10-year treasuries are so low? In effect, the current difference in the interest rate of 30-year mortgages and 10-year treasuries is more than double its normal and historical average. 30 yr mortgages are normally compared to 10 year treasuries because both the duration and the average life of a 30 year mortgage is closer to 10 years then 30 years, making the spread over 10 year more appropriate then 30 yr. It is currently about 3 percent or 300 basis points.

Mortgage spreads over treasuries contain at least two components. One is the risk of default, including the risk that the collateral for the mortgage, i.e. the house will decrease in value below that of the mortgage amount.

The other is the cost of an implied option right that gives the mortgagor the ability to prepay the mortgage before the 30 years through sale, refinancing or through additional principal payments. The cost of the option is borne by the mortgagor through a higher spread since it is the mortgagor who owns and pays for the right to prepay.

The two work in opposite direction. The longer one expects to continue to pay a mortgage, the greater the risk of default and the higher the spread. The increase term increases the likelihood that the mortgagor will encounter economic difficulties, such as a job loss, unexpected large medical or other expenses, or a significant decrease in home value, etc. In the first 15 years of a mortgage, about 70 percent of the principal remains and after 20 years, almost half the mortgage principal remains.

The longer one initially expects to reside in the home and pay the mortgage, the less one is willing to pay for the option that gives right to prepay in the early years and this will decrease the spread.

The above average spread of mortgage rates over treasuries can mean either of two things. It can mean that the average life of new 30-year mortgages will be significantly less than 10 years and people are willing to pay a premium in the spread for the right to do so. It can also mean just the opposite, that people are expecting to stay in their homes way beyond ten years and that the average life of a mortgage will be significantly more than 10 years with a higher chance of default that historical average spreads suggest.

Both a longer term with a higher chance of default and a willingness to pay a premium for the right to prepay early for a shorter term will increase mortgage spreads above historical averages over treasuries. People who have worked in mortgage finance computing option adjusted spreads for mortgages could probably compute which effect is the dominate one in the current environment.

Any action the government takes to attempt to decrease the current mortgage spread must either decrease the risk of default on longer-term mortgages or decrease the cost of the likelihood of early payment of mortgages without interfering with people’s ability to refinance or move.

In either case, guaranteeing the GSEs debt with the full faith and credit of the US or having Treasury borrow on their behalf as Nobel prize winning economist Paul Krugman recommends in his December 26, 2008, NY Times article will not do the trick. His solution most likely will not impact the underlying factors that make up the mortgage spread over treasuries.

Possible Cause of Housing Decline

Could the collapse of mortgage securities, CDOs, and house prices have an efficient market, rational expectation explanation other than over building and subprime mortgage lending?

A December 2008 released Pew Research Center Social & Demographic Trend survey found; "Only 13% of Americans changed residences between 2006 and 2007, the smallest share since the government began tracking this trend in the late 1940s." The survey was conducted during October 2008 and released on December 17, 2008.

A decline in relocation would cause a decline in demand for housing and a decline in consumer purchases related to setting up a new house. It would also cause an increase in the expected life of mortgages due to a decline in mortgage payoffs caused by the sale of an existing mortgaged house. It would also cause a decline in the demand for employment by existing labor to the extent that two wage earning couple are willing not to relocate.

Pew attributes the decline to an older population which is less likely to relocate and to two career couples because it is difficult to coordinate a move when two wage earners are involved.

The Pew news release is available at
http://pewresearch.org/pubs/1058/american-mobility-moversstayers-places-and-reasons
and the full Pew report at
http://pewsocialtrends.org/assets/pdf/Movers-and-Stayers.pdf

Job Growth

The US has approximately 145 million workers and the US population grows about 1.1 percent per year. The US needs to add about 3.3 million jobs over the next two years just to keep unemployment at current levels. President-elect Obama's plan to add 3 million jobs to the economy over the next two years will do little if anything to reduce unemployment.

Confidence Is Never An Economy Problem

The press likes to talk a lot about consumer confidence as one of the important factors in the current financial crisis. Commentators are often saying if only we could restore consumer confidence then the economy would be better. They will often also say that once consumer confidence is restored people will start spending money again. Both statements are false.

Numerous economic, consumer and corporate measurements become available at various times and fall into one of three categories. Either, they are lagging, concurrent [aka coincident], or leading measurements of behavior and the economy. Most economic, consumer and corporate statistics are concurrent or lagging measurements. Very few are leading indicators of the economy or consumer behavior. There are three economic leading indicators. The percent change in the price of the overall stock market, the slope in the US Treasury interest rate yield curve, and the premium for corporate debt over matched maturity treasury bonds.

When consumers are spending because they and their neighbors have jobs, consumer confidence is high. When consumers stop buying or saving because of job layoffs, health issues, shortages, etc. their confidence is low. Confidence does not create spending. It is just the opposite. Spending creates consumer confidence. Psychologists know that doing happy things makes people happy and not the reverse.

Therefore, consumer confidence is a concurrent indicator. It is low because people are not doing things such as spending and working. If more people were working and spending, confidence would be higher.

Granger Causality and the Financial Crisis

When the media, the public and politicians look for a cause of an economic event such as the recent severe stock market decline, the current economic slowdown, and the spate of financial institution failures, there is a strong tendency to look for some related event that happened before, such as the decline in home prices. The consensus becomes that since it happened prior, it must be the cause of the economic problems. These days there is a lot of talk about the nationwide decline of home values and about seeking solutions to stabilize home prices. The thinking is that stable home prices will restore economic growth and that the decline in home values precipitated many if not all of the economic problems.

Unfortunately, in economics, finding causes is not that easy. Economic agents and economic values respond to expectations about future events, such as the future value of assets and cash flows. Two economic events, A and B, can both respond to some future expected event, C, but A can reveal itself before B happens and both can happen before the expected C occurs. This is called Granger Causality. It looks like A caused B but both were simultaneously affected by the expectation of C. It is just that A is noticed before B happens. In the current economic environment, it is the change in some economic expectation that caused the decline in home values that is also causing the economic slowdown and many if not all of the other current economic problems, such as the credit tightening and freeze. It could be a host of factors. Some possibilities are the election of a Democratic Congress or President, an expected increase in taxes, a new war, a terrorist attack, or a change significantly affecting corporate profits to name a few but not all possibilities.

A simple, common example of Granger Causality is as follows. People wake up in the suburbs and commute to the city to work. When they wake, they listen to weather forecasts and if the weather person forecast rain later in the day, many of the commuters will take an umbrella with them to work. A person living in the city, who wakes up after the commuters start arriving in the city can look out the window and see if the commuters are carrying umbrellas. The city person will observe that when many commuters carry umbrellas, there is a good chance of rain later in the day. Statistically and through observation, the city person can conclude that commuters carrying umbrellas cause rain. This observation is known as Granger Causality since the commuters carrying umbrellas are caused by an expectation of rain later that day from the weather forecast and the umbrellas do not cause the later rain. Commuters carrying umbrellas happens before rain but does not cause the rain. Umbrellas are linked to rain because they are used for rain but they are not the cause.

Likewise, in the current economic environment, there was a change in an economic expectation that caused house prices to decline. (See my previous piece on Home Values Were Not In A Bubble.) This change in economic expectation also caused the increase in credit spreads, an increase in the risk of debt default by institutions, corporations and individuals. All are responding to the expected future economic event that will cause a decline in all asset values, including commodities, equity values and corporate cash flows and not just home values. It is just that the decline in home prices happened before or simultaneous with many of the other events. It does not show that house prices caused these other events. In fact, since houses are assets like many other assets, such as commodities and stocks, houses needed some expectation change for house values to decline.

Recessions Reallocate Resources

All the time, people put money into the economy to sell services and products with the hopes of making a future profit. These hopeful people lease and build commercial space, hire staff, order supplies, research and innovate, and make or order products for resale. These business people allocated time, money, capital and people to these operations to make money. Some of these ventures will be highly profitable and others will fail to achieve profitability. Those that fail to make money will close.

The closing of unprofitable business ventures occurs in good and bad economic times, but business closings accelerate in recessions. In a robust economy, in addition to the many profitable businesses, some businesses eke out just enough profitability to meet expenses but not make an adequate profit for the investment deployed. In good economic times, many economically unprofitable businesses that are just meeting their expenses will continue operations and will increase in number. These economically marginal businesses continue because their owners hope that their businesses will become profitable. These continued unprofitable operations divert capital and talent from more profitable business opportunities.

In a slowing, recessionary economy, there is an overall decline in the sale of services and products of most businesses, but the economic decline will more adversely affect marginal business operations. These marginal ventures will suffer economic losses and need additional capital investment. Many of these business owners will not want to continue to have business losses or put new funds into what appears to be a failing business venture and these unprofitable operations will not survive a recession. The closing of these marginal operations will free up resources including capital and human talent for use in other business enterprises that face greater prospects of profitability.

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.

Markets Are Efficient But Can Be Wrong

Markets are efficient and the press and the other media often ignore or misstate the concept's meaning and ideas.

A market is efficient if past prices cannot be used to predict future prices. The period to period change in the prices of actively traded assets such as stocks is random and it is this randomness that makes stock efficient.

In an efficient market, as in all other random markets, the best basis for predicting tomorrow's price is today's price plus a gain for the risk of buying the stock. Likewise, the price of the asset traded in an efficient market already reflects the effects of any information that is available whether through announcement, deduction, logic or expectation. Numerous studies over the past fifty years have upheld the efficiency of actively traded markets.

So any statement about the future movement of a stock's price based on its previous stock price movement is hogwash no matter the terminology used such as top, bottom, stochastic, candlestick, capitulation, and many others. Likewise, any statement that a stock price does not reflect announced information or that it will take several days for the stock price to reflect the news is also hogwash.

The concept of efficient markets does not mean that a market's prediction about a stock's price is always correct. The price in an efficient market is the market's best guess based on all knowable information. The market can guess wrong. Just as in any prediction about future events that have not taken place yet, a guess can be wrong or unexpected events can happen. In an efficient market, the price of a stock is fair in that it is just as likely to be too high as it is too low and no historical information about past stock prices or past events can give an investor an edge over a naïve investor who just buys and holds.