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Inflation,Home Prices,and Mortgages Home prices continue to soar in California, with prices having accelerated again in recent months after a relatively slack period in late 1978 and early 1979. Many analysts as well as dumbfounded casual observers have attributed the phenomenal post-1976 increase to irrational speculative forces. In their view, once the speculative bubble bursts, the result could be depressed homebuilding conditions and large capital losses for unfortunate home-buyers who "get in" at the end of the price runup. Thus they believe that loans to speculators should be restricted, and that prospective resident owners alone should be permitted to purchase homes. Actually a number of economic factors have served to increase home prices. Considered together, these factors suggest that recent home-price increases represent a rational response to economic realities. In the August 17 issue of this Weekly letter, Randall Pozdena explained home-price increases in terms of demographic changes, tax advantages accruing to homeownership, and other factors. Our main addition to this list is the effect of accelerated inflation on mortgage interest rates. By raising mortgage interest rates and therefore creating implicit capital gains for holders of old, low-rate mortgages, inflation can cause steep home price increases. This and other implications of inflation are discussed below. General effects On the basis of Pozdena's analysis, we can construct a list of five widely recognized factors affecting the housing market: (1) swelling of newhomebuyer ranks, due to the accession of the "baby boom" generation into the 25-34 age group, increased divorce rates, and more delayed marriages; (2) limits or moratoria on urban and suburban building, especially in California, thanks to longstanding environmental concerns; (3) increasing attractiveness and relative accessability of home-related tax breaks, especially in the current high-.inflation period; (4) shifts from renting to homeownership, because of the prospect of future rental-housing shortages as a result of rentcontrol laws; and (5) Proposition 13's effect of discouraging home turnover by allowing major reassessment after a home sale. These factors have all served to increase the demand and/or decrease the supply of housing, and so have increased relative prices for housing. Nevertheless, the nondemographic factors generally are either of very recent origin or are indigenous to the California market. Yet the boom in house prices has persisted since 1976, and has shown up to some extent in other states as well as California. Inflataon and home prices One nationwide and long-standing factor that shou Id also be considered is the effect of accelerating inflation, as it operates through rising interest rates. This effect arises from the fact that when a person owns a home, he owns both the building itself andalso right to payoff the debt on the building through the mortgage he has contracted. A mortgage is a financial instrument having some initial value, some subsequent outstanding or book value, and some contracted interest rate. Essentially, however, a mortgage is nothing more than an agreement to pay a given amount per month over a certain period of time. Thus, if, ten years ago, a homeowner took out a $30,000,. 30-year mortgage at a 7.6 percent interest rate, he would have committed himself to $212.65 monthly payments for 30 years. Now, ten years later, whatever the current mortgage rate and housing conditions, his commitment is to pay $212.65 per month forthe remaining 20 years of the agreement. Again, the economic meaning of a mortgage is the responsibility to fulfill a stream of fixed payments over a specified period. The true economic value of this commitment will depend on current interest rates. In this sense, increase current mortgage interest rates. This need not immediately change the value of a house itself to prospective buyers or sellers, since the future inflation has notyetoccu·rred. However, it will create capital gains on existing, low-rate mortgages, and so will increase the price a current owner will demand for his house in order to compensate him for giving up this "asset." In general, the supply of houses for sale at any given price will therefore decrease when interest rates rise due to inflation expectations. a mortgage is little different from a long-term government or corporate bond. Just as the market value of a bond falls when interest rates rise, and vice versa, so the truevalue of a mortgage declines when current mortgageinterest rates rise, and vice-versa. Yet the bank's book value of the mortgage is calculated not at present interest rates, but at the interest rate originally contracted. This serves to create a difference between the book value and true value of the mortgage. Consider again the mortgage example discussed above. The essence of the mortgage is now the commitment to pay $21 2.65 per month for the remaining 20 years of the agreement. The current book value of this mortgage is $26, 118, and indeed that wou Id be the true value of this commitment if interest rates were sti II 7:6 percent, as they·· . were ten years earlier. However, when evaluated at recent 1 2.5-percent rates, the value of the mortgage is only $1 8,71 7, a difference of $7,401 from the book value. In other words, at 12.5-percent rates, a commitment to pay $21 2.65 per month for 20 years wou Id finance a loan of only $1 8,71 7, which thus determines the current true value of the outstanding mortgage. Because the true value is lower than the book value-because he can finance a $26,1 1 8 debt with a commitment that is now worth only $1 8,71 7 -the homeowner has in effect enjoyed capital gains. He owns a liability that is "locked in" at a low interest rate, and so has lower monthly payments than he wou Id if he were to refinance at current interest rates. By the same token, to the extent prospective buyers can assume old mortgages, the higher current rates will increase the price they'd be willing to pay for the house and its mortgage, and so will increase the demand for existing homes. Bothforces will serve to raise actual selling prices. Again, these price increases occur solely because of the higher expectations of future inflation which serve to raise interest rates, and so impact on mortgages. In addition, as the expected inflation actually occurs, the value of the houses themselves will also increase. Combined with the interest rate effects, this factor should increase home prices faster than the general inflation rate. Of course, if the higher inflation rates (and so interest rates) were maintained, old lowinterest rate mortgages would eventually be paid off. The respective capital gains would then be realized, rather than anticipated, and so their effect on home prices would also disappear. In the long-run, then, we would expect home prices to rise by the same amount as prices in general, due to higher inflation. Nevertheless, in the short run, accelerated inflation would have more volati Ie effects on home prices, for the reasons discussed above. This effect could occur even if homeowners are not explicitly aware of the capital gains on mortgages. All the homeowner need realize is that if he moves from one house to another of equal price, and if he gives up his old low-rate mortgage for a new one, his "mortgage" (i.e., its book value) might not change, but his monthly payment will increase sharply. This sobering thought will make him less likely to move, or else more likely to seek com pen- The difference between the book value and the true value of a mortgage due to inflationinduced interest rate changes can in turn affect the sales price of a house. This is because the homeowner, on selling his house, must give up his low-rate mortgage as well. Thus he in effect sells two assets,the building and its advantageous financing agreement; and his sellingprice should reflectthe valueof both theseassets. Capital gainsand prices Higher expectations of future inflation will 2 Thirty-year Mortgage Contracted in 1969 $ Thousands 30 20 10 o 1969 Prevailing 7 64')(, Interest Rates . 1971 1973 1975 1977 1979 7.38')(, 7.62')(, 8.73')(, 8.78% 12.5')(, sation in the form of a higher selling price, and so in either case will serve to raise home prices. lenders enforce "due on sale" clauses on mortgages when interest rates have risen but impose prepayment penalties for paying off mortgages when rates have fallen. A recent California Supreme Court decision-the Wellenkamp decision -appears to have given leverage to borrowers by voiding "due on sale" clauses in mortgages issued by statechartered institutions. This doesn't mean that borrowers necessarily will gain, because in the past, market competition frequently channeled lenders' options into offering lower mortgage rates than would otherwise have existed. It does suggest, however, that borrowers henceforth wi II have more say on liquidation procedures for existing mortgages, and that new borrowers should shop around for mortgages with liquidation specifications favorable to them, as these wi II vary across institutions .. How large a price change can these phenomena explain? From June 1 977 to June 1 979, inflation increased from about an annual rate of 6.0 percent to a rate of about 1 1 .2 percent, while mortgage interest rates rose a comparable amount from 8.7 percent to 1 2.5 percent. If we impute these rate changes entirely to inflation expectations, and assume normal home-financing arrangements, inflation phenomena can explain as much as a 36-percent increase in home price over this period, even though the concurrent increase in consumer prices was only 19 percent. By itself, this change may not seem substantial, especially in view of the large increase in California home prices over this period. But recall that these calcu lations abstracted from the five more general factors listed earl ier. When the effects of these factors are added to the estimated effects of inflation, the home-price increases of recent years begin to look very rational indeed. In addition, if lenders anticipate future losses as transfers of low-rate mortgages become more prevalent, they will increase theirfixedrate mortgage rates and loan costs high enough to compensate them for these risks and/or will market variable-rate mortgages (VRM's) more strenuously. Variable rates, of course, will lower lenders' risks, because they reduce the discrepancy between the book and market value of a given mortgage. Implications for homeowners What other insights can the average homeowner glean from this analysis? First of all, some ofthe runup he has experienced in the market value of his home is due to capital gains on a valuable "asset" he hardly ever considers, his low-rate mortgage. Thus, if he moves from one house to another or refinances his house merely to realize his total capital gai.ns, he may be buying himself much higher monthly payments without much spendable cash or a much better home to show for it. His "book value" equity may increase, but his real welfare may not. Second, as long as mortgage rates stay high, both buyers and sellers should attempt to have each old mortgage assumed by the new buyer. This analysis suggests that increased housingmarket volatility and an increasing prevalence of VRM's are both byproducts of high and accelerating inflation and its attendant uncertainty. Fixed rate mortgages have sheltered older home-owners from some of these risks in the past. Yet as lenders seek more and more protection from inflation, the sources offunds for such shelters as "cheap," fixed-rate mortgages will probably disappear. The ultimate solution to these problems is not increased housing-market regulation or increased home-owners' subsidies, but rather a halt to the inflation which is responsible for much of these problems in the first place. Of course, there's an asymmetry here. Though both buyer and seller are willing to keep the old mortgage when the contracted rate is lower than current market rates, neither wants it when the contracted rate is higher than market rates. By the same token, Michael Bazdarich 3 !!EMEH • • 4Eln a E!UJOJ!lEJ CD):0)<§ • EpEi\aN • o4EPI E U O ZP V" E>jSEIV JrdI CD) ZS,£'ON OIVd :l9V1 50«l 's'n llVW SS\fl: J JJ \ill JJ Jr\2?<dI <?i>COI IiU JJ\2? BANKING DATA-TWELfTH FEDERAL RESERVE (Dollar amounts in millions) SelectedAssets andliabilities largeCommercialBanks Loans (gross, adjusted) and investments'" Loans (gross, adjusted) - total# Commercial and industrial Real estate Loans to individuals Securities loans U.s.Treasury securities'll Other securities'" Demand deposits - total# Demand deposits - adjusted Savings deposits total Time deposits - total# Individuals, part. & corp. (Large negotiable CD's) WeeklyAverages of Dailyfigures MemberBankReserve Position .Excess Reserves (+ )/Deficiency (-) Borrowings Net free reserves (+ )/Net borrowed (- ) Amount Outstanding 10/10/79 134,815 111,606 31,857 41,024 22,781 2,260 7,608 15,601 45,772 32,589 30,284 54,842 46,478 20,453 Weekended 10/10/79 + 53 96 43 Change from Change from yearago@ Dollar Percent 10/3/79 275 364 36 + + 239 70 + 13 95 + 6 194 + 1,448 80 + 348 + 265 + 184 - + 18,990 + 18,158 + 4,201 + 8,417 NA NA + + + + + + Weekended 10/3/79 + + + + + 25 NA NA 735 1,567 3,434 763 404 8,563 9,229 2,562 - + + + + + + 8.81 11.17 8.11 2.40 1.32 18.50 24.78 14.32 Comparable year -ago period + 96 71 16.40 19.43 15.19 25.81 + 80 36 44 federalFunds- Sevenlarge Banks Net interbank transactions [Purchases (+ )jSales (-)] Net, U.5.Securities dealer transactions [Loans (+ (-)] 113 - 514 +1,263 + 238 - 289 + 111 + '" Excludes trading account securities. # Includes items not shown separately. @ Historicaldataarenot strictlycomparable dueto changes in thereportingpanel;however,adjustments havebeenappliedto 1978datato removeasmuchaspossibletheeffectsof thechanges in coverage. In addition,for someitems,historicaldataarenot availabledueto definitionalchanges. Editorialcommentsmaybeaddressed to the editor (William Burke)or to the author.. .. free copiesof this and other Reservepublications can be obtained by calling or writing the Public Information Section,FederalReserveBankof SanFrancisco,P.O.Box 7702, SanFrancisco94120. Phone(415) 544-2184. <?i> CQI
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