Polls show President Bush is unpopular right now because the Iraq War is going badly.
But these numbers could soon look like the good old days. They are his despite a pretty good economy. Housing starts keep rising, sales keep rising, and there are jobs available in building and selling homes.
So what’s the problem?
Look at these numbers:
| 03/14/06 | 4.49 | 4.59 | 4.80 | 4.75 | 4.66 | 4.72 | 4.68 | 4.69 | 4.71 | 4.89 | 4.71 |
Plot them on a graph and you will get today’s yield curve. The yield curve describes the price of money against time. The numbers to the left define prices of short-term loans, those to the right prices for long term loans.
It doesn’t take a rocket scientist to see that, when you do this, the line you get is pretty flat right now. That’s the problem. It should be sloped. It should look like the image above, from Investopedia.
What does this have to do with the price of housing?
Housing represents most of the assets held by individuals. We buy as much house as we can, we refinance, we live off the proceeds. Housing is the engine of the U.S. economy, and has been for years, because Fannie Mae (or Freddie Mac) will buy any loan, turn it into a bond, then sell what looks like a government security. Banks don’t have to look at your loan application closely because they aren’t loaning you money. So long as you can make a payment, banks are sales agents.
The hole in this scheme is the price of money.
When the yield curve flattens, one of two things must happen to un-flatten it. The price of short-term loans must change. Or the price of long-term loans must change.
History says the change will be higher long-term interest rates. In fact, a flat yield curve is a very common bear signal. Traders know a flat curve is a sign that interest rates will soon go up, becoming better investments, so the price of stocks will go down.
But what about the price of housing? With today’s yield curve, a 6% loan can easily be made. You’ll pay $6,000 in interest the first year on a $100,000 note, $500/month. But if the rate is 7% you pay $7,000 in interest costs per year. Multiply that by 5, because houses are more expensive now, and you’re talking about $5,000 more in annual interest costs if the rate on mortgages rises by just 1%.
The higher the price of money, the less money you can borrow.
The less money you can borrow, the less house you can afford.
So what happens when interest rates go up? Housing prices must fall.
And there’s the problem. So many people are so highly-leveraged, having borrowed all they can to either buy their homes or refinance them, that millions may find their homes worth less than they have borrowed . Banks will also see this, and so will the holders of housing bonds.
The result will be a nationwide crash in the price and value of housing, sending economic shock waves through the economy. Bonds will become poor investments and their values will crash. This will happen wherever you are. In places like San Francisco, where supplies are constrained, speculators will get hit first. In places like Atlanta, where supplies are not constrained, builders will be hit first. But everyone, everywhere will be hit when the housing bubble pops. .
The spiral is a vicious circle. Prices fall, people are forced to sell, prices fall some more. Prices fall, loans go bad, the price of money goes up, and prices fall some more.
It is going to happen. The only question is when.
If you’re a politician, you don’t want to be in power when it happens.
