Robust Mortgage Market Is Recovery’s Foundation

Housing and mortgage markets have been the cornerstone of the U.S. economy’s recovery from the recession of 2001. One-third of the economy’s growth since the start of the decade can be attributed to housing and mortgage market activity. While equity markets tanked, home prices soared.

Homeowners’ equity has risen by more than $4 trillion since 1990, offsetting the losses in the stock market. Without the booming housing and mortgage markets, the overall economy would have experienced a far more severe decline and might still be mired near recession.

The numbers tell the story. Mortgage rates at 40-year lows drove mortgage refinancing to record levels in the last several years, reaching a peak of more than $2 trillion in 2003. The refinancing resulted in homeowners cashing out more than $300 billion, fueling consumer demand. Hot mortgage markets and housing starts continue to support gains in the economy. The construction industry broke ground on 1.85 million new homes in 2003, up from 1.7 million in 2002. According to the most recent data, housing starts in December were up again at an astonishing annualized rate of 2.1 million units. Moreover, permits for future construction also rose, indicating that home-building will remain strong well into this year.

The contribution of the housing market to the economy in recent years is unprecedented and unmatched elsewhere in the world. Historically, housing market downturns have preceded and heightened the severity of recessions. Why the change? The difference in recent years has been the rapid growth of the mortgage-backed securities market, which through sophisticated financial engineering repackages home buyers’ mortgages and sells them to investors worldwide.

With the growth of this secondary market, U.S. mortgage markets are now fully integrated into overall global capital markets. The secondary mortgage market ensures a steady source of mortgage credit to home buyers, vastly expands the types of mortgage loans available, facilitates the prevalence of fixed-rate mortgage loans and accelerates the speed with which mortgage rates adjust to changes in global interest rates. This means that interest-rate declines translate almost literally overnight into lower mortgage rates for U.S. homeowners. The mortgage rate declines of the last few weeks, for example, have already fueled an upturn in mortgage applications. In the past, it would have taken weeks or even months for this to occur.

Another economic benefit of the burgeoning secondary market is that it has facilitated the prevalence of fixed-rate mortgage loans that can be refinanced without financial penalty. More than 80% of U.S. homeowners have such loans, and close to 40% of U.S. households have a fixed-rate mortgage. Fixed-rate loans are vital in a weak economy, because when homeowners refinance these loans to lower their monthly mortgage payments and take cash out in the process, they spend the money.

The U.S. is unique in the depth of its secondary markets and the prevalence of prepayable, fixed-rate loans. The major instruments used to fund house purchases elsewhere continue to be adjustable-rate mortgages, balloon loans and fixed-rate loans with onerous prepayment penalties. Households elsewhere thus have limited ability or incentive to refinance even in response to substantial interest-rate declines. The U.S. economy has benefited significantly more than the rest of the global economy from the decline in interest rates in recent years. Going forward, the U.S. economy also will be far more protected than the rest of the world economy from the destabilizing effects of interest-rate increases.

Mortgage rates cannot fall indefinitely and will eventually rise with the improving economy. The housing and mortgage markets will cool, but they will not collapse. If the Mortgage Bankers Assn. is correct in predicting 8% rates by 2005 (soon after the election), this will surely slow growth in new starts, first-time home purchases and home sales. Nonetheless, the rapid growth of the secondary market into the principal source of funding for the housing and mortgage markets ensures that U.S. mortgage borrowers will always have access to mortgage credit and a wide range of mortgage products. The prevalence of fixed-rate loans will also ensure that the housing and mortgage markets will provide important benefits to the broader economy’s performance throughout the business cycle.