An Unexpected (but Welcome) Consequence of Rising Mortgage Rates

Common sense seems to dictate that rising mortgage rates will hurt the housing market by depressing the demand for purchase-money mortgages. But here's the thing: The data suggests that the exact opposite may be occurring.

At the end of last week, the nation's two largest mortgage originators, Wells Fargo (NYSE: WFC  ) and JPMorgan Chase (NYSE: JPM  ) , released earnings for the second quarter. Insofar as headline numbers go, both banks had stellar quarters, netting $5.5 billion and $6.5 billion, respectively -- Citigroup (NYSE: C  ) , which reported today, had a similar experience.

But if you dig a bit further, and into their mortgage operations specifically, the story is more nuanced. As expected, the volume of refinance mortgages fell markedly relative to the first quarter. Wells Fargo's dropped by 17% and JPMorgan's by 6%.

Unexpectedly, however, both banks reported dramatic sequential upticks in purchase-money mortgage originations. Volume at Wells Fargo was 46% higher than the first quarter, and JPMorgan reported an improvement of 44%.

I say "unexpectedly" because of what we've seen happen to mortgage rates since the Federal Reserve first hinted on May 22 that it may begin to taper its support for the economy. Following the announcement, the rate on a 30-year fixed-rate mortgage went from 3.35% at the beginning of May all the way up to 4.51% today.

As the price of a mortgage goes up via the interest rate, conventional economics tells us, the demand for one should go down. But clearly that's not happening here.

There are at least two explanations for this apparent paradox. The first is that homebuyers are rushing to lock in current rates, which are still exceptionally low on a historical basis, before they head higher.

"I'm afraid we're going to miss the boat," an aspiring homeowner recently told CNBC's Diana Olick. "I feel like we might get priced out of the market in a few months, and just depending on the mortgage payment whether we could afford it if the interest rates go up more."

The problem with this conclusion is that purchase-money mortgage applications are going down. You can see this in the figure below, which charts the Mortgage Bankers Association's index for purchase-money and refinance mortgages.

While applications for purchase-money mortgages may not have taken as dramatic a dive as refinance applications, one can't help but notice a subtle downward slope over the past two months.

It's for this reason that I prefer the second explanation. Namely, given the precipitous decline in refinance applications, mortgage lenders now have both the motive and the opportunity to pursue purchase-money mortgages.

The motive stems from the twilight of the refinancing wave. In Wells Fargo's case -- which matters disproportionately because it controls upwards of a third of the domestic mortgage market -- the revenue hole is huge. Last quarter was the seventh consecutive time that it had more than $100 billion in mortgage originations. In the vast majority of those quarters, roughly two-thirds of the volume related to refinancing activity.

And the opportunity is similarly grounded, given the vast quantity of manpower that the bank can -- and, at least in part, will -- redirect to originating purchase-money mortgages.

The net result is that, while the absolute number of purchase-money applications might decline in the face of rising interest rates, the proportion of them that are approved by lenders may be on the ascent.

For anybody who cares about the housing market -- and I say that somewhat facetiously because, as my colleague Morgan Housel has noted, "there hasn't been a strong economy without a strong housing market in modern history" -- this is very good news, as it supports the idea that home sales will continue their upward momentum.

It's estimated that every single-family home built by the likes of D.R. Horton (NYSE: DHI  ) and PulteGroup (NYSE: PHM  ) generates between two and three sustainable jobs. In addition, an increase in demand for housing will presumably push home prices higher, which will reduce the number of underwater homeowners and thereby spur consumer spending. It is, indeed, a virtuous circle.

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Read/Post Comments (11) | Recommend This Article (36)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 15, 2013, at 11:58 AM, fritziebrickwall wrote:

    Just opinion based on personal experience where the proof of my statements can be found by using any home search engine. The facts are this is a manipulated market. The manipulation by every facet of the home industry from realtors, to investment houses, by private citizens, flippers and of course banks. Economics 101 it is called supply and demand. Buy up or create all the foreclosed homes and you create your own market. Think not, well sorry know NOT!

  • Report this Comment On July 15, 2013, at 12:47 PM, jacksinternet wrote:

    It seems to me that the rising interest rates are making the folks that are dawdling about closing on their housing choices go ahead and buy now. While the future home purchase will be somewhat depressed by this rise in interest rates, the facts are that people still need to buy and use housing and our interest rates are low by historic comparison.

  • Report this Comment On July 15, 2013, at 2:31 PM, Johny205 wrote:

    fritziebrickwall ^

    The housing market is manipulated, but the securities markets aren't? At least with housing prices are still low based on what it would cost to build the same house new and also compared to prices from 2006. If you can buy an existing 3 bedroom home for 120K and it would cost you $160 to build that house new, that's not too bad of a value. Obviously every city/region has a different market and some are better buys than others.

  • Report this Comment On July 15, 2013, at 2:55 PM, tmoore51 wrote:

    I remember the early 1980"s when mortgage rates were 15%. I repeat, 15%! We waited in line all night long to get a government mortgage at 10% and thought that was a miracle. A 5% mortgage is still incredibly cheap.

  • Report this Comment On July 15, 2013, at 4:47 PM, DonkeyJunk wrote:

    The rise in the number of mortgages may be due to the fact that banks aren't as strict as they ought to be.

  • Report this Comment On July 15, 2013, at 6:06 PM, markmti wrote:

    Oh my...

    of course none of the banks' earnings would reflect lower purchase originations on the "surge" in rates.

    That's because it takes 30-days+ to close a purchase money loan.

  • Report this Comment On July 16, 2013, at 11:56 AM, editengine wrote:

    An increase in purchase money sales with rising interest rates has been widely predicted for some time. For whom is this a surprise? If HARP is expanded we may see another temporary bounce in refis as well.

  • Report this Comment On July 17, 2013, at 5:38 PM, frogburger wrote:

    But there isn't a strong housing market without a strong economy either i.e. a faith that things will be good and that people won't struggle to pay the mortgage. It's a bit of chicken an egg problem. Last time the housing market was hot is when the dotcom bubble exploded. People had faith in the future. Right now I'm not sure the faith isn't fragile, especially with Obamacare and things like that.

  • Report this Comment On July 17, 2013, at 5:48 PM, Seanickson wrote:

    First of all, may 22nd is more than halfway through the quarter. Secondly, most of the loans beyond that would have already been locked in at the lower rates. We'll have to wait and see for the real answer.

  • Report this Comment On July 17, 2013, at 6:10 PM, foolhardy7 wrote:

    Good analysis. I would have bet on the first explanation, and in fact have been replying out loud to the radio reports I hear in the morning that are predicting a drop in new mortgages, "no, dummy, because people have been putting it off, and now they will rush to not miss the boat." But your two charts poke a hole in at least part of that analysis.

    Of course the other mantra I have been repeating for the past year is that the problem with this market is that the lenders all went from total irresponsibility to totally irrational requirements – with the result that many deserving people have not been able to get a loan. If that is changing, as you propose, then you are correct that it will be good all the way around. Here's hoping for some attentive, rational, home loan underwriting on the part of banks.

  • Report this Comment On July 17, 2013, at 6:50 PM, tbarth88 wrote:

    DonkeyJunk,

    I can say that having just completed a refi and asked for every sort of documentation short of a DNA sample, that is NOT the case...

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