Lessons From 1994 on Rates and Housing

 | Jul 09, 2013 | 3:00 PM EDT
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The surge in U.S. Treasury yields this year has led to a lot of debate about the potential impact that this will have the housing industry and on home values as mortgage rates are pulled up. 

The arguments are roughly divided between two anecdotal conclusions. The glass-half-full logic is that housing will strengthen, as rising rates will cause people to accelerate their purchase of homes before debt costs and home prices rise further. The glass-half-empty view is that the concurrent rise in prices and debt-carry costs will cause potential buyers to punt or simply not qualify, causing home prices and transactions to decrease again.

In this column, I'm going to address the issue in a little bit of a different fashion, sharing my first-hand experience as a commercial mortgage company owner in 1994. I've written about what happened in 1994 in two columns this year, and I suggest reading them again for some background, as I will not rehash those issues here.

The early 1990s were a time of great change in the U.S. economy, capital markets and real estate. The savings-and-loan crisis had devastated the real estate industry, and one of the aggravating issues was that banks simply got out of the business of making construction loans and commercial real estate mortgages.

This hole in the capital markets, however, also allowed for the creation of what at the time was called conduit financing. Investment banks, led by Bear Stearns and Lehman Brothers, went into originating commercial mortgages and packaging them for sale to investors as mortgage-backed securities. They were essentially copying the residential model created by Fannie Mae.

This brought life back into the commercial real estate market, and I was on the cutting edge of it with a firm that specialized in offering mortgages that were designed to fit the program guidelines required by Lehman Brothers and Nomura Asset Management.

Although there are many differences between the economic and capital market environment of 1994 and what we see today, the fundamentals are very similar. In both cases, roughly five years had passed since a banking and real estate crisis had occurred that had been caused by irrational and imprudent behavior by lenders, borrowers and regulators.

The real estate market appeared to be on the mend. Developments that had been idled were being restarted, and the Resolution Trust Corporation, which had been set up to disposition the assets of the failed S&Ls, was winding down.

The crisis appeared to be fading, and people had a lot of optimism. During the height of the crisis, between late 1988 and mid-1992 the Federal Reserve had lowered the fed funds rate from a high of 9.75% to 3% in an effort to offset the drag on the economy that was due to the shuttering of S&Ls and stagnation in the real estate industry.

Then, in early 1994, the Fed, then led by Alan Greenspan, began the process of increasing the fed funds rate, as I discussed in the previous columns.

At first, similar to the current environment, it appeared that although mortgage rates were increasing, this wouldn't cause any great problems. But rates just kept rising, and within a few more months the real estate market began to suffer. Within nine months, the entire real estate industry and related industries had essentially seized.

The stock prices of the publicly traded homebuilders fell back toward the bottoms they had put in after the recently passed S&L crisis. The sale of both residential and commercial properties stopped, because the rise in rates caused buyers to stop. The resulting lack of liquidity of the mortgages intended to be sold into securities almost caused the newly formed commercial mortgage-backed securities industry to shut down.

There were opportunities that resulted from the 1994 disruption, though. I had a money-management client who bought $10,000 worth of NVR (NVR) at about $0.20 a share and sold it about a decade later for about $600 per share for a $30 million profit.

As it stands now, the increases in Treasury yields and mortgage rates this year have been accelerating, as they did in 1994, but at an even more aggressive rate. If the trend continues for even just another month or so, and if the 10-year yield gets to the 3% area, the increase in mortgage rates will most probably result in the same kind of environment we had in 1994. 

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