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  • 8/8/2019 Mtg Rate Risk (Lb)

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    8 August 2003 Focus Uni ted Sta tes

    Lehman Brothers | Global Weekly Economic Monitor 1

    Joseph Abate

    +1 (212) 526 0067

    Housing Market Rate RiskFor families with large balances, higher interest rates are only mildly worrisome. However, higher rates do pose a threat to new

    construction and home salespotentially subtracting a full percentage point from GDP growth over the coming year.

    Mortgage rates have followed treasury yields higherrising from 5% in early June to6.25% today. Will this torpedo the housing market and undercut the overall economicrecovery?

    Although homeowners have record high debt burdens, the increase in rates willprobably not pose too much of a threat, as most mortgage debt is fixed rate.

    The rise in rates will stop the inflow of marginal buyers.

    However, rising rates will slow home price appreciation, curb construction, andend the cash-out refinancing boom.

    Our rough calculations suggest that after adding nearly a full percentage point togrowth last year, if maintained, the current level of rates could be a similarly sized dragon growth over the next 12 months.

    Mortgage debt

    Households currently owe over $6 trillion in outstanding mortgage balances. Not onlydoes this figure equal roughly 78% of their after tax income, it has also grown sharplyin the past two years, at roughly a 10% annualized rate. As Chart 1 reveals, growth inmortgage debt has exceeded growth in after-tax income and overall household assetsby a wide margin since the recession started in March 2001. Moreover, projections fororiginations this year point to another record year of issuance. According to FNMA,roughly $1 trillion in new mortgages will be issued this year.

    With so much mortgage debt on the balance sheet, and a growing tendency to use thehome as an ATM machine for cash, the ratio of mortgage debt to overall real estatewealth has risen (Chart 2). The US household sector currently owes about $0.45 perdollar in house wealth owned. As we have written in the past, this is partly due to

    increased home ownership but it is mainly because the average balance has jumped to$130,000 from $80,000 in 1995. Were this trend to continue, the household sectorwould have as much as $0.48 in debt per dollar in real estate wealth.

    Float like a butterfly

    But with so much debt on its balance sheet, is t he household sector vulnerable in lightof the recent run-up in mortgage rates? And does this mean that, in spite of very low

    Chart 1: Mortgage debt, asset and incomegrowth (% y-o-y)

    Chart 2: Mortgage debt share of real estateassets (%)

    -10.0

    -5.0

    0.0

    5.0

    10.0

    15.0

    20.0

    Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03

    Mortgage debt

    Disp. income

    Assets

    Source: Federal Reserve, Flow of Funds and Commerce Dept.

    30

    32

    34

    36

    38

    40

    4244

    46

    48

    Jun-70 Jun-76 Jun-82 Jun-88 Jun-94 Jun-00

    Lehman forecast

    Source: Federal Reserve, Flow of Funds.

    Households owe record

    amounts of mortgage debt

    and debt burdens are

    already high

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    levels of delinquency, many homeowners will now find themselves in seriouseconomic distress, as they cannot afford to make their monthly interest and principalpaymentsespecially when these payments are already consuming a record 6.4% ofafter tax income?

    Higher servicing costs do not pose a significant risk to the econ omy in the next severalyears. Given the historical preference for 30 -year fixed rate mortgages in the US, onlya relatively small proportion of mortgage debt floats. Indeed, of the record amount of

    debt issued last year, only 18% had floating coupons, and we estimate that only 20% ofthe total $6.2 trillion in outstanding mortgages (some $1.2trillion worth) currently floats.

    In addition to the relatively small percentage of floating rate debt, the characteristics ofthese borrowings offer some hope of immunity from the dire consequences of higherborrowing costs. First, most of these loans are fixed for five years, and the vastmajority has been issued within the past two years or so. As a result, only a smallpercentage of these loans will reset within the next year. Instead, as Chart 3 suggestsfrom data compiled by our mortgage research team, higher floating rate debt will notstart to bite until 2006 or so. Moreover, most of these borrowers are fairly well off. Themajority of these loans exceed the maximum thresholds for securitization by FNMAand Freddie Mac of just over $300,000. Generally, these are not borrowers who willsuffer much if the combination of floating rate debt and higher interest rates pushestheir monthly payments up a few hundred dollars.

    At the lower end of the income distribution, although higher mortgage rates may priceout some would-be buyers, home affordability remains very high by historicalstandards. For these families, we suspect that, as long as income growth holds up, sotoo will affordability.

    and sting like a bee

    But higher mortgage rates will not leave the economy unscathed. Instead, they willwork through several channels to reduce significant ly the stimulus they have prov idedfor the economy since the recession began.

    Higher mortgage rates will slow home price appreciation and cool the growth inhousehold wealth. Our rough reckoning suggests that each 1% increase in mortgagerates slows constant quality home price appreciation by the same amount. Andalthough the drag on GDP from shrinking equity wealth has received all the press overthe past three years, rapid home price appreciation owing to super low rates and thelack of other investment vehicles has boosted real estate wealth from $11.4 trillion in2000 to $13.9 trillion today. This has significantly softened the blow to GDP fromfalling stock prices. Indeed, model simulations suggest that housing wealth has addedhalf a percentage point to GDP growth over the period (Chart 4). Becausehomeownership is far more equitably distributed than stocks, even a minor slowing inhome price appreciation could have serious implications for house wealthenough to

    Floating rate debt is a small

    proportion of overall

    mortgages

    and most of it will not reset

    until 2007

    Higher rates will slow home

    price appreciation and

    household wealth

    Chart 3: Approximate volume of ARM resets($bn)

    Chart 4: Wealth effect on GDP growth(%)

    0

    10

    20

    30

    40

    50

    60

    70

    80

    90

    100

    2003 2004 2005 2006 2007 2008 2009

    Source: Lehman Brothers Mortgage Research.

    -2.5

    -2.0

    -1.5

    -1.0

    -0.5

    0.0

    0.5

    1.0

    1.5

    2.0

    Mar-00 Dec-00 Sep-01 Jun-02 Mar-03

    Housing

    Stocks

    Source: Washington University Macro Model.

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    reduce the size of the positive contribution to GDP growth long before householdequity wealth has a chance of recovering.

    Higher interest rates will also reduce an important source of liquidity for the householdsector. As long as interest rates remained at super-low levels and home pricescontinued to move higher, families had plenty of incentive to take out, or liquefy someof their homes equity. Since the beginning of 2002, we reckon that nearly $200bnworth of equity extraction has occurred. And since roughly half of these funds

    ultimately ended up financing home improvements, autos, and vacations, anything thatchokes off this important channel could have serious consequences for theconsumption outlook.

    Similarly, higher rates would also dent residential investment and new homeconstruction. Residential investment has accounted for roughly a fifth of the increasein GDP over the last two quarters. But with the cost of undertaking a new homeimprovement project or building a new house now higher, we suspect the demand forconstruction will waneespecially if slower home price appreciation convincesfamilies that homes are no longer a sure-fire investment (Chart 5).

    Chart 5: Housing returns (%)

    -8

    -6

    -4

    -2

    0

    2

    4

    6

    Mar-88 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03

    Lehman forecast

    Note: Returns equal owners equivalent rent plus home price appreciation less mortgage rates.Source: Lehman Brothers, Bureau of Labor Statistics, and OFHEO

    More worryingly, there is some evidence suggesting that home building may haveovershot economic fundamentals over the past two years. Based on econometricsimulations using the Washington University Macro Model, actual new starts arerunning about 100,000 units (or 7%) higher than justified by pure economicfundamentals, like household formation rates, income, interest rates, and overallwealth. As a result, there is a potential for a more serious correction or mean reversiononce higher interest rates begin to kick inwith new home construction operating foran extended period well below the level justified by economic fundamentals.

    Looking forward

    With the economy picking up, we do not expect the housing sector to collapse, but

    housing indicators to fall to more sustainable levels, with less construction, almost nowealth extraction, and much slower price appreciation.

    reducing liquidity

    and hurting new home

    construction

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    I, Joseph Abate, hereby certify (1) that the views expressed in this research report accuratelyreflect my/our personal views about any or all of the subject securities or issuers referred to in thisreport and (2) no part of my compensation was, is or will be directly or indirectly related to thespecific recommendations or views expressed in this report.

    Any reports referenced herein published after 14 April 2003 have been certified in accordance withRegulation AC. To obtain copies of these reports and their certifications, please contact LarryPindyck ([email protected]; 212-526-6268) or Valerie Monchi ([email protected]; 44-207-011-8035).

    This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its

    affiliates (Lehman Brothers) and has been approved by Lehman Brothers International (Europe),

    regulated by the Financial Services Authority, in connection with its distribution in the European Economic

    Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Le hman

    Brothers Asia. This material is distributed in Australia by Lehman Brothers Australia Pty Limited, and in

    Singapore by Lehman Brothers Inc., Singapore Branch. This document is for information purposes only and

    it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other

    instruments mentioned in it. No part of this document may be reproduced in any manner without the written

    permission of Lehman Brothers. We do not represent that this information, including any third party

    information, is accurate or complete and it should not be relied upon as such. It is provided with the

    understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect

    the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this

    document may not be eligible for sale in some states or countries, and they may not be suitable for all types

    of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers

    representative. The value of and the income produced by products may fluctuate, so that an investor may get

    back less than he invested. Value and income may be adversely affected by exchange rates, interest rates, orother factors. Past performance is not necessarily indicative of future results. If a product is income

    producing, part of the capital invested may be used to pay that income. Lehman Brothers may make a

    market or deal as principal in the securities mentioned in this document or in options, futures, or other

    derivatives based thereon. In addition, Lehman Brothers, its shareholders, directors, officers and/or

    employees, may from time to time have long or short positions in such securities or in options, futures, or

    other derivative instruments based thereon. One or more directors, officers, and/or employees of Lehman

    Brothers may be a director of the issuer of the securities mentioned in this document. Lehman Brothers may

    have managed or co-managed a public offering of securities for any issuer mentioned in this document

    within the last three years, or may, from time to time, perform investment banking or other services for, or

    solicit investment banking or other business from any company mentioned in this document.

    2003 Lehman Brothers. All rights reserved.

    Additional information is available on request. Please contact a Lehman Brothers entity in your home

    jurisdiction.

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