The surplus of homes for sale is now over 2.0 million, mostly existing homes, and will still be over 1.0 million by the end of 2010 even if housing start increases are slim and household formation returns to non-recessionary trends. The surplus a year and half ahead will be partly due to the excess building in 2003-07, partly due to the still depressed, although recovering economy, and partly due to lower housing demand from reduced net immigration, real estate speculation and willingness to buy second homes.

Surplus inventory will still be depressing home sales and starts in 2011. Optimistic forecasts expect housing starts to reach 1.5-1.6 million in 2011 which is still well short of the demographic plus replacement demand of at least 1.8 million.

Today’s 4.86% 30-Year fixed rate mortgages are unusually low and have prompted a surge of refinancings to lock in low nominal interest rates. However, low inflation means that the real cost of mortgage credit is not low. Adjusting for inflation with the core personal consumption expenditure deflator (+1.8% Y/Y), the real cost of mortgage credit is an about average 3.1%. Using the CPI (-0.6% Y/Y) yields a 5.5% real cost of mortgage credit. This is at the bottom of a recession; real credit costs rise a year or two into recovery.  And the rise will be substantial this time because of the worldwide shortage of credit from the recent destruction of lender’s capital by loan defaulters and lender’s new unwillingness to leverage their capital as much as they did in 2003-08.

Almost all subprime mortgages today are being bought or guaranteed by Fannie Mae, Freddie Mac, FHA and other government housing agencies. Of course, they do not label them subprime.  Freddie Mac calls them “affordable mortgages.  FHA calls them “Obama” mortgages. Among the various mortgages available, some have no down-payments, or up to 105% loan to value ratios.  Haven’t we learned that buyers with no equity are more prone to default? Applicant debt to income ratios of up to 45% are accepted compared to the private commercial standard of 30-33%.  Years ago, I struggled for six months with a 29% debt to income ratio.  My savings disappeared and my credit card balance went up. No one can carry this debt load for an extended period.

Generally these loans come with reduced requirements for mortgage insurance.  The government is implicitly guaranteeing the loan so mortgage insurance is redundant.  Many of these loans are processed manually instead of in the low cost online systems used for prime mortgage loans. This added cost is passed on in prime mortgage rates and fees.

Many of the government mortgage programs permit an initial 2% reduction in the interest rate for several years. The adjustment shock back to market rates is what caused a large share of recent defaults.  Government housing officials are not concerned that they are creating a new set of mortgages doomed to fail because they also have a big toolkit and line of credit to reduce mortgage payments for people in danger of default. Together Fannie, Freddie and FDIC have recently got an additional $300 Billion line of credit (off-budget so Congress has no responsibility) to change mortgage principals, rates and terms.

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