🏠 Your dream house or your job?

Hey hey, happy Monday!

This week: a look at why houses are so expensive, and why lower mortgage rates may not take us back to a pre-COVID housing market. I know…not so optimistic, but an important dynamic to understand as we move into this brave new world of lower rates.

But before we get there, check out OptimistiCallie on The Long Game podcast with my good industry friends Tom Kopelman and Jacob Turner. We chatted about Fed rate cuts, investing strategies and the most important things to watch as 2024 comes to an end.

Have a friend who loves to Zillow surf? Send ‘em my way 😊

A few weeks ago, I wrote about how the economy – and Big Macs – are becoming more affordable.

It’s true…except for one major asterisk: housing.

Over the past few years, the cost of buying a home has literally gone vertical.

Just look at this chart of your monthly 30-year mortgage payment if you bought a house at the median sales price with a 20% down payment:

It’s not just home prices, either. Everyone I know has a story about the insane experience of buying a house in the 2020s, even if it wasn’t them making the purchase. There are crazy tales of fights at open houses, nasty bidding wars, and exorbitant listing prices that some wealthy out-of-staters jumped on sight unseen. (My fellow Charlotteans feel that last point deep in their bones)

Now, with rate cuts underway, there’s a glimmer of hope that the housing market could come back down to earth.

But I’m not so sure.

In my eyes, one fact has become painfully evident: to get affordable home prices back, some of us may have to make a deal with the devil.

The housing market has been the economic poster child of the COVID era.

To understand why, you have to rewind to the global financial crisis of 2007. The crisis threw the residential construction market into disarray, and since then, we’ve faced a surplus of prospective homebuyers and a shortage of houses. This episode of The Daily podcast summarizes the housing market imbalance well.

COVID made a bad situation worse. From early 2020 through 2021, home prices shot up as buyers took advantage of 30-year mortgage rates as low as 2.8% during a nationwide case of cabin fever. We were all stuck in our homes, and a lot of us decided it was time for a change – and a yard, and thick walls without adjoining neighbors.

Not only that, but the average millennial entered their 30s during the COVID years. Suddenly, much of the largest generation alive was shacking up, having babies and…you guessed it!...buying houses.

The Federal Reserve—those snuggly, heartwarming, interest rate-toggling folks in DC—started hiking rates in early 2022 to get prices under control. This worked everywhere but in the housing market. Mortgage rates climbed to 8%, while prices continued to rise at a 7% annual clip.

That brings us to today. Millennials are still shacking up and having babies, and it’ll likely take government intervention to build more houses. For now, homebuyers’ most practical hope is lower interest rates.

Luckily, the Fed has answered our prayers. Sort of. 

Before we go any further, I want to make one thing clear: the Fed does not directly control mortgage rates.

Instead, the Fed directly controls the rate banks pay to borrow money overnight, and this base rate sets expectations for all other types of interest rates.

Because markets anticipated cuts, mortgage rates have dropped from 7.2% to 6.7% in the past three months, even though the Fed didn’t officially start cutting rates until September 18.

Yes, housing is getting cheaper. There is some reason to be optimistic here.

But I need to be real with you.

Buying a house is still not affordable by any stretch of the imagination, and it likely won’t be for years to come.

Let me illustrate with some math.

Ultimately, you can call mortgage rates a mixture of market rates – or specifically the 10-year yield – plus some extra percentage points added on for time, default, uncertainty and straight profit (because banks love making money). Wall Street calls this the “mortgage spread”, and the Fed Bank of Richmond wrote an explainer on the spread last year. 

BTW, I used to work at a bank and I sat in pricing strategy meetings for jumbo mortgages. Fascinating stuff.

With this spread and a few assumptions, you can estimate on where mortgage rates could go from here. 

Right now, the Fed swears up and down that the economy is fine. Based on last week’s jobs data, that’s a fair statement. If the economy stays afloat, the Fed may only cut its policy rate another 1.5 to 2 percentage points, according to Fed members who submit rate forecasts every few months.

Let’s say the Fed’s main rate settles around 3%. If that happens, companies keep hiring and unemployment stays low. Many of us get to keep our jobs and generate a living so we can buy things (like houses).

This is the best-case scenario, but it probably doesn’t lead to cheap mortgages.

With a Fed rate at 3%, you can assume the 10-year yield is at least 3%. This is basic I-owe-you/bond market theory. If you’re lending money to a friend, you should demand a higher interest rate if you loan them the money for 10 years versus a few days. In a healthy economy, rates should move higher as the borrowing period lengthens.

Now, let’s add on the mortgage spread. Lately, the spread has been unusually high – about 3% for most of this year. Over the past 10 years, the spread has averaged a more reasonable 2%. Add 2 to 3% to a 10-year yield of 3%, and you have 30-year mortgage rates landing in a 5 to 6% range in a stable economy.

Remember that chart of mortgage payments going vertical? Here it is with 5% mortgage rate on the median house price:

Yep. A $1,800 monthly payment, which is still 80% above the payment at the end of 2019.

The TL;DR: mortgage rates – the affordability penicillin that everybody is raving about right now – probably won’t fall enough to save us.

Nor will it get many people excited about buying a house, according to a recent survey from John Burns Research & Consulting. Just 21% of people said they’d be willing to take on a 6% mortgage to buy a house. 

There are a bunch of economic and market implications here. The housing market – and housing-related sectors could stay dormant for a while longer. The Fed’s rate cuts may not be as potent as we think – even outside of the housing market.

But on a basic level, we may be facing 6% 30-year mortgages for at least another year.

To be honest, there is always a way out of any situation, but it might be a little diabolical.

This is where the devil comes in with a little proposition.

Mortgage rates can theoretically go lower if the Fed cuts its main rate below 3%. Or, you know, if bond market theory fails and the 10-year yield falls below the Fed’s main rate. Housing prices can also decline, too.

But for any of those scenarios to happen, we’d likely need the economy to fall apart. A recession, in Wall Street terms.

That’s the deal we’re faced with today.

Your job or your dream house. You can only pick one.

It’s a nasty double-bind. 20-something Americans desperate for a house may choose the first option. Heck, I’ve said once or twice in my early years that I’d welcome a recession if it meant cheaper houses.

I don’t say that any more. Recessions are incredibly pernicious, and the job loss can be staggering. You can’t afford a house if you lose your primary source of income.

As you can see, housing affordability is a crisis of its own.

We may have a few paths out of this mess, but lower mortgage rates may not be it.

The optimistic angle here is that the government seems to be paying attention. Housing affordability is a main point on both presidential candidates’ platforms, and it seems like we may be at a turning point.

But for now, be careful what you wish for.

Thanks for reading! Better vibes next week, I promise.

Callie

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