Rate spike threatens housing industry

A sharp rise in mortgage and bond rates since June has cut short the refinancing boom, created a panicky rush to buy houses and spooked the stock market.

Fueled by record budget deficits and signs of a strengthening economy, many analysts worry that mortgage rates approaching 7 percent could hobble housing, the strongest sector of the economy, and thwart what was looking like a promising economic recovery.

Since touching a record low of just under 5 percent in mid-June, the average rate on 30-year mortgages for purchasing homes has climbed above 6 percent and the rates for refinancing loans are close to 7 percent.

The spike ended serial refinancings and homeowners’ game of trying to beat their neighbors’ unbelievably low refinance rate. The Mortgage Bankers Association yesterday reported that refinancing applications are down by more than 50 percent since June.

The unprecedented refinancing wave over the past three years had greatly lowered homeowners’ debt burdens and freed up hundreds of billions in cash from home equity to spend on other items, buoying the economy in tough times.

The rate change came so quickly that many homeowners have not even noticed, while it has taken aback professionals on Wall Street.

“Everything happens so fast nowadays. It’s sort of like broadband-type speed in the interest-rate markets,” said Lawrence Kudlow of Kudlow & Co, who argues that rates have risen too far, too fast in light of the low level of inflation and modest economic growth.

The unexpected rise in rates created a rush to buy homes at lower rates that buyers locked in before the uptick and a shift by many buyers into adjustable-rate mortgages, which have short-term rates controlled by the Federal Reserve and are expected to remain low.

The frenzy to buy before rates rise further sent home sales surging to a record high in June, and they remained strong last month. But industry experts say the historic boom in the housing market faces a big test later this year as the full effect of the rate increases sinks in.

Sung Won Sohn, chief economist with Wells Fargo & Co., said a sustained rise in mortgage rates to 7 percent in the next year would snuff out the growth in home sales and lower overall economic growth by a half percentage point.

Rates as high as 8 percent would do even more damage to housing and pose a dangerous “head wind” for the economy, he said, but he expects home prices even in such a scenario to keep rising and adding to consumer wealth.

Mr. Sohn argues that rates fell too low in June because of the unrealistic belief among bond investors that the economy would fall into a destructive bout of deflation and the Fed would come to the rescue by taking the unprecedented step of buying Treasury bonds.

“The deflation scare pushed bond yields to unreasonably low levels; now the scare has diminished, bond yields are returning to where they should be,” he said.

The group most vulnerable to the rate increases are first-time home buyers, who already were being squeezed by soaring house prices and often need the lowest possible rates to qualify for mortgages.

Until recently, falling mortgage rates more than offset the double-digit gains in home prices. While typical home prices have risen more than 20 percent since 2000, according to the National Association of Realtors, the typical monthly payment actually fell by 6.2 percent to $774.

This spring, the lowest interest rates in 45 years made owning a home possible for the first time for millions of young Americans and immigrants, pushing the homeownership rate to a record high of 68 percent.

Besides reducing hopes of buying a home, the higher rates pose a challenge to the stock market, both because they threaten to diminish economic growth and because they make bonds a more attractive alternative to stocks.

After a stellar rally this spring, the stock market leveled off and grew skittish about the time the yields on 10-year Treasury bonds shot up from a low of 3.1 percent in mid-June. With the yield at nearly 4.4 percent yesterday, more gurus on Wall Street are advising a shift from stocks into bonds.

“The higher bond yields provide increased competition for investors’ cash,” while reducing the “fair value” of stocks, TD Waterhouse said in a note to clients yesterday. “The higher the Treasury yield rises, the less room stocks have to advance.”

Ed Yardeni, chief investment strategist at Prudential Securities, said rising rates have made stocks look more expensive, but they remain undervalued by 25 percent by some measures.

Bond investors have driven up rates partly because they no longer fear deflation and partly because they woke up to the realization that the government will sell record amounts of bonds to finance “huge and widening deficits,” glutting the market in the next few years, Mr. Yardeni said.

“The federal deficit is now projected to exceed $450 billion,” Mr. Yardeni said. “Moreover, it is likely that the extraordinarily stimulative combination of economic policies might actually work. This has triggered a dramatic reversal of sentiment in the bond market.”

Mr. Yardeni worries about what will happen now that higher rates are starting to deflate the housing market, which for years has been sustained by a “Ponzi-like” scheme of falling interest rates that nurtured sales, refinancings and rising home prices.

“The risk is that this mechanism’s gears are put into reverse,” causing a bust in the housing market, he said.

But Richard Berner, chief economist at Morgan Stanley, said the housing market and the economy should be able to withstand the damage from higher rates.

“Home prices will rust, not bust, for the next few years,” Mr. Berner said.

And although the refinancing boom is over, consumers and businesses largely are protected from the ravages of higher rates because they locked in low rates by refinancing with fixed-rate loans.