Friday, March 26, 2010

New Home Sales and the Big Misconception

The 2.2% decline in February's new home sales to a record low of 308,000 units this week is disconcerting in that it shows that, despite some signs of tentative stabilization in existing home sales in recent months, the nearly five-year long slump of the housing market has yet to hit a reliable bottom.


Source: http://www.calculatedriskblog.com/

On the face of it, the ongoing erosion in new home sales is somewhat perplexing. After all, mortgage rates remain at historically very low levels and the first time home owners tax credit is still in effect until the end of April 2010. In reality though, the failure of new home sales to show any signs of responding to those two seemingly favorable factors makes perfect sense.




One of the greatest misconceptions about the housing market in general is that it is directly responsive to the level of mortgage rates. The reality though is that this is not actually the case, as mortgage rates represent only one of the "second-tier" factors that influence the demand for housing, the primary ones being employment levels and associated income growth as well bank lending practices in any given period. It is a plainly absurd hypothesis to argue that much would change for home sales if the 30-year fixed rate mortgage were to dip to, say, 3%, in the midst of a broader economic environment characterized by high unemployment, slow income growth and famously tight credit standards by lenders.

It is key to remember that at the peak of the housing boom in the middle of the last decade, the 30-year fixed rate mortgage was hovering around 6.5% to 7% versus 5% these days. While it is true the impressively strong demand for housing at the time was supplemented in good part by a larger share of ARM loans than today, the overriding difference between the two periods was a booming economic activity and high levels of employment and income growth as well as notoriously- and disastrously- lax lending practices at the time.

To further put the generally tenuous relationship between mortgage rates and demand for housing in a more realistic context, it is a pretty reasonable expectation to have that, over the next three-year or so horizon, the latter will be considerably stronger despite the inevitably higher mortgage rates that are likely to accompany a broadening economic expansion and aggressive underlying Fed tightening. Higher mortgage rates will become nearly inconsequential in a context where lower unemployment and stronger personal income growth will provide households with enough confidence to proceed with the purchase of the ultimate big-ticket item.

Anthony Karydakis