The Paradox of Housing
Assume a home buyer purchased a condo for $500,000 using a zero-down, no-doc, interest-only ARM. Let's assume that his interest rate was 4%, with taxes, insurance and maintenance adding another 1% per year. The annual cash cost would be $25,000, or just over $2,000 per month. However, if the buyer assumed an annual appreciation rate of 10%, creating the potential of $4,000 per month in equity extraction, the expected monthly cost becomes negative $2,000. (In a survey last year the typical Los Angeles homebuyer expected an annual appreciation rate of 20%) In other words, our condo buyer actually expects to be paid $2,000 per month as a result of his purchase. So even if he had monthly income of only $3,000, he would have no qualms about assuming a mortgage equal to almost 70% of his actual pretax income and lying about his income to qualify for the loan.
Now assume the interest rate
on a zero down $500,000 interest-only mortgage rises to 7%.
Assuming taxes, insurance and maintenance still add 1%, the annual
cost is now $40,000, or $3,300 per month. However this 65% increase
is actually just the tip of the iceberg. If the borrower, now
more modest about his expectations, assumes an annual appreciation
rate of only 5%, his expected annual cost is now only reduced
by $25,000, resulting in an expected annual net cost of $15,000.
From the buyers perspective a house which once paid its owner
$2,000 per month to live in it now costs $1,250 per month to
own. Therefore the true increase in cost is not just 65% but
3,250%! Of course, if housing prices remain stable or fall,
the real cost is far higher. Since the $1,250 per month represents
over 40% of the buyer's pre-tax income, these higher mortgage
payments will now be a difficult burden to bear, even with the
diminished equity extractions. Without the cash outs, affordability
would be impossible.
Rents and the CPI
The Fed of course now has a real conundrum on its hands. It either plays down the significance of the core, possibly excluding rents entirely as they now do food and energy, or continue to raise rates even as housing prices collapse. The former, which amounts to a version of "heads I win, tails you loose", risks exposing the Fed as hypocrites. The loss of any remaining faith in the Fed will cause a run on the dollar and even more inflation. On the other hand, to continue raising rates will surely tip the economy into a recession.
My guess is that the Fed is already preparing the markets for a pause even as core consumer prices continue to rise. The spin will be that peaks in core consumer prices historically occur with a lag relative to the end of a tightening cycle. This will likely buy the Fed a little extra time until the markets finally notice that rather than peaking, core prices just keep on rising. Therefore, the greatly anticipated, highly illusive pause will not be the least bit refreshing.
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Mr. Schiff is one of
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