Why Do Long Term Interest Rates Puzzle Alan Greenspan?
Alan Greenspan is puzzled how mortgage rates remain low as he continues to raise short term interest rates, but the real estate market understands the real reason. “Mr. Greenspan repeatedly expressed puzzlement at the persistence of low long-term interest rates like those on mortgages.†– Speaking before the Joint Economic Committee†NYT 6/9/05
Here is a good article from eMedia Wire (http://www.emediawire.com/). I think the writer makes a good point. Sometimes these big-wigs do get stuck in a particular way of thinking and lose their way.
Economics 101
1) Lower risk to lenders equals lower rates to borrowers.
2) Short term rates help create debt (credit cards), but long term rates help create wealth (home equity).
In rising real estate markets both home buyers and mortgage lenders have less risk. Lenders now focus on real estate value appreciation to reduce their risk and bail them out of any defaults.
For example: Say you buy a $200,000 home in a good neighborhood and put 20% down or $40,000. A year later you lose your job and can’t make the mortgage payments.
The lender takes back your home. Ouch! Which has appreciated 15% thanks to your good neighborhood. (The median price of homes increased 12.6% last year with Nevada homes increasing 31.2% according to USA Today 6-2-05.)
The loan balance is still $160,000 (if you had an interest only loan) but, the house is now worth 15% more or $230,000. So the lender now has $70,000 equity in the property ($230,000 minus $160,000) or a 43% return on their initial investment in one year.
Of course the lender still has to sell the property which will reduce the return to only 36% after all the paper work and sales fees. If the original interest rate was about 6% they still made a profit in one year equivalent of six years of interest.
But, what if the market stalls? Even in soft markets real estate will usually sell quickly at a 25% price reduction. $230,000 minus 25% equals $172,500. This distressed sales price less a 6% sales commission is $162,150. So the lender still recovers the original mortgage amount. The market appreciation has virtually eliminated the entire risk.
That’s why long term lenders are still willing to “take the risk†and not raise mortgage rates now.
Maybe, Mr. Greenspan needs to think more like the average American investor, who has most of their wealth invested in their homes, and less like a wall street broker if he wants to understand today’s consumer driven markets.