What's next for the mortgage marketplace?

Jeff: The average rate on a 30-year fixed rate mortgage is lower than it has been in a number of years. Do you see this downward trend continuing?

Dan: I do not. I believe a recession is already priced into the mortgage market. Rates on conforming loans have fallen dramatically in recent weeks, while rates on subprime or nonconforming loans have been very sticky downward. Since I do not think the United States is in recession – or likely to be this year – I expect mortgage rates to trend higher over the next year.

Jeff: There is a lot of talk about adjustable rate mortgages (ARM) resetting. If fixed rate mortgages are probably about as low as they're going to go, is this an ideal time to refinance an ARM?

Dan: Since 1981, homeowners who financed their home purchases with an ARM have benefited from the downward trends in inflation and short-term interest rates. Recall that in 1980, inflation was more than 14%, and the federal funds rate was as high as 20% in 1981. In 2002, inflation had fallen to a mere 1.1%, and in 2003 the federal funds rate was at 1.0%. Although inflation and rates bounce around considerably from year to year, the disinflation trend apparently ended in 2002. As such, the ARM advantage over fixed rate mortgages that was available for decades may be near an end, if not already a thing of the past.

Jeff: In general, what are the implications on the mortgage market of the Federal Reserve's recent decisions to reduce its federal funds rate target?

Dan: The aggressive reduction in the federal funds rate over the last month or so, combined with other Federal Reserve actions, should be more than enough to provide sufficient liquidity to allow credit markets, especially the mortgage market, to recover from its current slump. This is one reason I believe that the housing slump is closer to the end than most economists are willing to admit at the moment. However, beware of the possibility of the double-dip in housing as we forecast the overall economy slipping into a recession sometime in 2009.

Jeff: What is your outlook for home prices and home sales in 2008?

Dan: I think home prices and sales most likely will continue to drift lower for another month or two before stabilizing. There are a few encouraging signs to suggest this may be the case. In particular, the home affordability index, which measures the ability of the average household to buy the average-priced house with a fixed rate prime mortgage, has rebounded from its low and is now back to a level very close to where it was when the current housing slump started.

Jeff: What are the regional differences, if any, in the current housing slump? Will some areas recover faster than others?

Dan: Regional differences always exist in the housing market. Currently, most regional markets are experiencing a price correction in housing, but the correction is more substantial in some regions than in others. For example, most analysis suggests that the bulk of the pain has been in Florida, California, Nevada, Michigan and Ohio. In the first three states, it was excessive speculation rather than economic fundamentals that probably contributed to the decline. In the latter two states, weak economic fundamentals probably were the driving forces behind the slump. As a rule, I expect excessive speculation to dissipate faster than weak fundamentals improve. Moreover, California, Florida and Nevada are three states that continue to enjoy population growth, even in the face of a housing slump.

Jeff: With the recent volatility in the markets, do you think people should consider using debt, like a HELOC, rather than liquidating investments to fund cash needs?

Dan: People should manage their debt appropriately. That being said, if a person must take on more debt, using his or her house as collateral may be a tax- and cost-efficient way of borrowing. But beware. Taking on more debt in a declining market environment could be problematic. This is the reason investors are limited in how much equity they can buy on margin.

Jeff: Overall, do you expect the use of home equity lines of credit to grow, contract or remain the same and why?

Dan: I expect the use of home equity lines of credit to grow. First, despite all the bad news about housing, there still is considerable equity available to homeowners to borrow against. Second, it is still the most tax-efficient way to borrow, as long as it is done responsibly. Finally, it probably offers the lowest loan rate available because it uses the house as collateral. However, I doubt that home equity lines will surge given that commercial banks have tightened their lending standards. Not everyone will be able to establish a home equity line as easily as they might have a few years ago.