With all of the talk these days about the debt ceiling I wanted to post something about its relevance to the housing market:
As negotiations continue on whether and how to raise the debt ceiling, it is important to keep in mind housing market impacts that could occur due to the some of the possible outcomes being discussed in Washington.
Under the present law debt ceiling, the federal government may not borrow more than $14.3 trillion. The effect of this limit is that on August 2nd the federal government will not be able to pay all its obligations with cash-on-hand and incoming tax receipts. For example, to run even with current tax receipts would require a 40% cut in current government expenditures.
Most analysts expect the debt ceiling to be increased under a plan that cuts a significant amount of government spending. Negotiations are occurring today that revolve around rival plans championed by Speaker of the House John Boehner and Senate Majority Leader Harry Reid.
But what impacts could the housing market experience if these negotiations fail to produce legislation that lifts the debt ceiling?
Most experts believe the government would continue to pay interest/principal on outstanding debt first, followed by expenditures like social security payments. Last in line would be certain discretionary government payments, perhaps including wages of federal employees. The loss of these payments would certainly have a significant short-term contractionary impact on the economy. This kind of “anti-stimulus” would be particularly harmful at this moment given ongoing weakness with GDP growth and unemployment, both factors resulting in weak housing demand.
Moreover, under this scenario, even if the government continued servicing outstanding debt, thus avoiding even a temporary default, the bond rating agencies could downgrade the AAA rating of federal government debt. In fact, it is possible that absent an adoption of a long-term deficit reduction plan, a debt ceiling increase allowing ongoing payment of all federal obligations will not satisfy the ratings agencies. These institutions could keep the U.S. government on creditwatch or even downgrade given the forecasted size of future government spending.
The United States government is currently one of 18 countries that have this top-tier, AAA debt rating. Loss of the rating would have multiple negative economic consequences. It would reduce demand for U.S. Treasuries, which would lower bond prices and increase interest rates. Higher risk, non-government debt could also be sold off as investors seek to maintain a certain average credit rating of owned assets. Pension and money market funds in particular may need to reduce their holdings due to a loss of the AAA rating. In turn, higher interest rates for U.S. government debt could also increase long-run government expenditures by increasing interest expense making the long-run fiscal challenges worse.
Given that many interest rates are pegged to Treasury rates as matter of market practice, these impacts could certainly increase interest rates for home mortgages, auto loans and other consumer durables and business loans. Along with weaker macroeconomic variables, an increase in mortgage rates would further weaken housing demand and place downward pressure on prices.
How much would interest rates increase? There are many estimates, but none certain. The bond markets have viewed the ongoing negotiations with a posture of confidence in a deal getting done. However, it is possible that government interest rates could rise 100 basis points or more in the case of a temporary default, which might spillover as higher rates for home mortgages. For the case of downgrade, the impact on interest rates would be smaller, but any increase in rates would weaken housing demand.
The timing of impacts for housing could also be delayed as increases in mortgage interest rates might take time to materialize in the market. A contrarian might also argue that demand for mortgage-backed securities might even increase somewhat, as investors move out of Treasuries and move into other assets perhaps offsetting a mortgage interest rate increase.
Nonetheless, the primary effect of a default or downgrade would be increased uncertainty. Home buyers are making purchase of a capital asset that they will own, on average, for ten years. Given other sources of uncertainty, particularly from the labor market, the largest impact from a failure to reach a deal that increases the debt ceiling would be to further increase concern and anxiety of families attempting to make long-term economic decisions.
And as we have seen, weakness in housing markets can easily produce a vicious cycle whereby housing price declines reduce household wealth, which reduces consumption, business growth, and job creation, further weakening housing demand and placing more downward pressure on housing prices. And of course the debt ceiling occurs in an environment full of housing policy debates, including the mortgage interest deduction (MID), the expiration of the conforming loan limits, and the qualified residential mortgage regulations (QRM).
What the housing market needs now is more, not less, certainty, with respect to housing policy and access to capital via the mortgage markets. This will help stabilize housing prices, thereby helping households repair balance sheets and set the stage for more robust economic growth.