Can a mortgage product tainted by the financial crisis come back to revive US housing? The answer could reorient the housing market and give the Federal Reserve greater control over consumer spending in the years ahead.
A lack of affordability has hindered housing transactions the past two years, frustrating would-be buyers and, more recently, hammering the stocks of developers. Those waiting for popular 30-year mortgages to sink to what’s considered a reasonable rate — around 5.5% by my estimation — have been repeatedly disappointed. To the surprise of many, loan rates climbed after the Fed began easing monetary policy last year. They have averaged 6.9% since February 2023, according to data from the Mortgage Bankers Association.
Indeed, the mortgage market may be ready for a fundamental reshaping in an world where sticky inflation and hefty government borrowing keep longer-term interest rates elevated.
The outsized concentration of homebuyers in 30-year fixed-rate mortgages is an anomaly. In the two decades prior to the 2008 financial crisis, a fifth of homebuyers, on average, opted for adjustable-rate mortgages, which reset after a few years, deciding based on the difference between short- and longer-term interest rates. But following the crisis and until mid-2022, there was no reason to shop around. Rates on 30-year mortgages were kept ultra-low by an extraordinary and extended period of monetary stimulus. That became the new normal for homebuyers and ARMs went out of favor. They accounted for just 6% of mortgage applications last year.
This may start to shift given how stubbornly the 30-year has clung to levels near 7%, and as a cooling economy raises the prospect of further Fed rate cuts. The central bank has greater influence over the front end of the yield curve in a conventional easing cycle – and, with it, ARMs – than the 10-year Treasuries to which 30-year mortgage rates are tied.
Late last June, 10-year Treasury yields were 0.5 percentage point lower than two-year yields. Today, the 10-year is higher by 0.30 percentage point, still a far smaller gap than existed in the early 2000s.
ARMs were big drivers of the housing market in those years. For a time, they accounted for as much as a third of home-loan applications before falling out of favor during the sub-prime mortgage crisis, which left bitter memories of homeowners getting into trouble when their rates reset higher. The 2010s were also marked by low longer-term interest rates and relatively good housing affordability in most of the country.
For affordability-stretched first-time homebuyers today, the financial crisis is ancient history. And various issues hanging over government bond markets suggest that, even in a mild recession, 10-year Treasury yields look unlikely to return to the low levels that persisted from the financial crisis up to the pandemic.
The government’s outstanding debt is $36 trillion and growing. De-globalization is putting upward pressure on inflation. And, more recently, German bunds drove a global selloff in sovereign bonds as investors estimated that shifting US foreign policy would lead countries to borrow more to spend on defense.
Over the past two years, even when investors have priced in significant Fed easing, with a terminal rate as low as 2.75%, the 10-year yield has barely fallen below 3.5%. This was the case during the failure of Silicon Valley Bank in 2023 and at the start of Fed policy easing in September.
If the 10-year struggles to fall below 3.5% during a Fed easing cycle, it’s unlikely 30-year fixed-rate mortgages would drop below 5.5%. But a 5/1 ARM — that’s fixed for 5 years and then adjusts every year thereafter — may well fall into the mid-4s. That has the potential to unlock a lot of housing demand from homebuyers even as it exposes them to interest-rate risk in the future.
Shorter-term or adjustable mortgages are common in the rest of the world, and they make monetary policy more potent. One reason the economy remained immune to the Fed raising rates quickly and significantly in 2022 and 2023 is because most homeowners have fixed-rate mortgages, so their monthly mortgage interest payment didn’t rise. About 96% of home loans in the US are long-term fixed-rate mortgages, while variable-rate and short-term fixed-rate mortgages are most prevalent in other countries, according to the Dallas Fed.
A housing market where more borrowers have ARMs would be more exposed to changes in Fed policy, albeit after an initial multi-year fixed-rate period. This would give the central bank greater control over household spending at pivotal moments for the economy. In the shorter term, such a shift from homebuyers may help unlock a broadly frozen housing market.
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