Mortgage News & Commentary - The Refi Boom Part II

By
Steven Lord

The ReFi Boom, Part II

September 14, 2006

Reading the financial press these days, you would be forgiven for thinking the real-estate market as we know it is about to self-destruct. Granted, the slowing of the housing market – evidenced by a 10%+ decline in new home sales and a 28% drop in mortgage originations in June compared with last year – and ever-rising interest rates have finally taken some of the air out of the housing bubble. The conventional wisdom is that the party is over.

A significant part of the problem is that the real-estate market is not liquid. With the stock market, investors wanting to exit the market can normally do so in a relatively orderly fashion, since the underlying market is so broad and diverse as to allow literally instantaneous fulfillment of sell orders. In a sense, there is almost always a ready buyer for each ready seller. Not so with housing, in which a sale can easily take six months and supply typically enters and leaves the marketplace in waves.

So far, the slowdown in residential real estate is following a very traditional path. Historically, homeowners that have been either thinking of selling or holding out for higher prices rush to put their houses onto the market so as to “catch” the top, thereby causing a flood of supply into an illiquid market and thus depressing prices further. Builders, for their part, operate on a 18-24-month timeline and therefore continue to break ground on new developments even as existing home sales drop.

This particular cooling period also has a few unique characteristics, most of which are products of the boom that preceded it. First, interest rates went so low last year that a great deal of renovation and other spending was driven by cash-out refinancings. Indeed, homeowners extracted a massive $244 billion in equity from their homes last year, money that was typically spent putting on additions, installing new kitchens, or going toward major large-ticket durable good purchases. Secondly, this boom resulted in a much larger of second and/or vacation homes, condos and apartments than in the past, a function of a large number of wealthy, 50+ baby boomers whose children have grown.

Now, with rates higher, house prices at best stabilizing and at worst falling, and the economy slowing, people are naturally less likely to take significant equity out of their houses. Indeed, the first quarter of 2006 was the first time in five years that more than half of Freddie Mac refinancings were done at higher interest rates than the original loan – a significant development for an industry that has enjoyed a trend of continuously lower mortgage payments since the start of 2001.

While the housing industry itself has clearly become a buyer’s market in recent months (and will probably stay that way for the time being), we don’t think the refinancing market is going to fall off a cliff. The massive American love affair with renovation is not going to stop overnight, and with the economy slowing to a sub-2% annual rate of GDP growth in the latter half of this year, conditions may actually dictate Fed rate CUTS early in 2008, not hikes. Moreover, an extremely large number of mortgages taken in recent years have been ARMs, or ones with adjustable rates that reset to current market levels once each year. As such, many borrowers will be looking to refinance this year when these ARMs hit their first rate reset. In fact, if the Federal Reserve continues on it’s “mini-hike” course for the rest of the year, a large portion of these ARMs are likely to be refinanced into either fixed-rate ones or new adjustable-rate loans with a lower initial rate.

The bottom line: The bloom is off the housing market, and with it the refinancing boom. But neither one is likely to experience the doomsday scenarios popular in the media these days (the same media that hyped housing to no end only a year ago). Instead, we think both will undergo a slow metamorphosis from hyper-growth to slow-and-steady consolidation, especially if the Fed pauses its rate hikes later this summer. Barring a full-scale recession, growth in housing prices in most areas are likely to revert back to their historical averages, which will be a significantly reduction from recent years but a much more sustainable amount. And with U.S. interest rates nearing the end of their tightening phase, chances are better than good that you will see rates declining by this time next year. With many homeowners still sitting on significant appreciation in their property values, interest rates still historically low, and a large number of ARMs resetting between now and the end of the year, the mortgage industry should have little trouble navigating the housing slowdown.

Other Articles by Steven Lord:
Call To Arms
Other People's Money
Watching The Fed