April 2008: Why Loan Rates Are Cheap

Despite all the hype, rates (or, actually, the tradeoff between rate and cost) are pretty darned good right now. I'm at home right now, but yesterday, for someone with average credit (national median) and 20% down payment or equity, I could have locked a thirty year fixed rate loan at 5.875% with one total point, and delivered same in thirty days. Lest you not understand, that's very good by historical standards. Last summer the same loan was in the 6.5 range, and I remember not too long ago when rates in the sevens were considered good. Nice, sustainable fully amortized 5/1 hybrid ARMs that most people will never keep five years anyway are in the low 5s for the same cost (starting to look like a worthwhile alternative again).

But you'd never know it to look at the headlines. "Lender meltdown!" and "You can't get loans!" are things you see in the mass media every day. "Hard to get mortgage" returns 435,000 hits.

The truth is, there is a meltdown. Lenders have suddenly figured out that risky loans are risky loans, and since they have their sense of humor surgically removed upon hiring, now they're mentally trapped in a humorless game of Paranoia. People with marginal credit or little in the way of down payment are finding it difficult to buy, and since their former ability to qualify was priced into the market, this limits the demand for real estate, shifting the supply and demand equilibrium (aka price) down. The loan market controls the sales market, and when the loan market makes it harder to qualify than it has been, times get bad for sellers. People looking to buy for the first time have to save more, and the people who would have sold to them aren't going to be able to move up either.

So all of the marginal cases that subprime lenders were lining up to serve until about a year ago can't get loans, and even people that have A paper credit may be forced to consider subprime loans, if they can get anything at all, due to high Loan to Value Ratio. This has become very much a positive feedback situation. Falling demand triggers tightening of lending standards, causing values to fall, further exposing lenders to loss, causing them to tighten their standards further.

When a lot of people have fallen below lender thresholds for acceptable risk, they can demand loans all that they want, but the lenders isn't going to supply those loans. But the lenders still have that money. If they don't loan it out, they're still paying interest on it to their depositors, and the investors are going to be angry that their stock isn't paying any dividends. So they've got to find somewhere to lend it out that does meet their standards.

So if you are one of those people who do meet lender standards, they want to lend to you, and there aren't as many people eligible to compete for that lender cash, which means the money is cheap in terms of what it really costs. The margin over inflation is lower than it was in Summer of 2003, when the rate/cost tradeoffs were lower than they had been in fifty years. Lenders want to lend money. For those who qualify, money is cheaper now than it was then, because the 5.875% loan you get today is less expensive, when considered in the form of "rate minus inflation," than 5% was then.

Having observed a few market cycles before this in cyclical San Diego, let me ask what happens as soon as things stop getting worse? Lenders figure out that they've been overly paranoid, they loosen the standards just a little bit, and because the loan market controls the real estate market, real estate prices starts rebounding as the new people who can now qualify in the loan market enter the real estate market. That same market that the loan climate has been hampering, gets helped when the loan climate loosens just a little bit. San Diego has been on the bleeding edge of this whole phenomenon. I see a lot of evidence, and hear of a lot more (thus far, still anecdotal because official records take a while to catch up) that says we're ready for a turn

Indeed, that lending wedge is already present, in the form of new FHA limits of $697,500 locally, when their former limit of $362,000 locally had meant FHA loans couldn't finance anything above a two bedroom condo. The FHA program in its base form gives a government guarantee of the loan for loans up to 97% of the purchase price, and there are ways to make an FHA purchase with zero down. Lenders like government guarantees - it means that even if the property does get foreclosed upon, they'll probably get their every penny of their money back. (I should also mention that the VA loan limits have also been raised, and VA loans are a better deal if you're eligible. Never go FHA if you can go VA, and I'm getting wholesalers telling me they'll do VA loans up to 1.5 million dollars) The control upon this whole thing is, of course, the fact that all government programs require borrowers to qualify "full documentation". Stated income and NINA loans are not allowed by any government program. However, San Diego's local economy will more than support current pricing levels. More than enough people make more than enough money to qualify for home loans at current prices "full documentation", and when people figure out that the mass media's Fear and Greed campaign is misplaced, what do you think is going to happen?

Caveat Emptor