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Big Shock: Mortgage Applications Fall When Government Stimulus Lapses

Here’s a headline we all saw coming: “Mortgage applications slide as tax credit expiration looms.”
CNN Money reports that “Mortgage applications fell last week for the third week in a row, even as interest rates edged lower…  The drop in activity came as a popular tax credit for first-time homebuyers faced an uncertain future. The credit, which can be worth up to $8,000 for eligible buyers, is set to expire at the end of next month.”

Economics is always best understood “at the margin.”  The aggressive selling and lax mortgage lending practices in the mid-2000s pulled forward a significant number of sales of marginal buyers.  This includes both subprime borrowers (who probably should have never considered home ownership in the first place) and higher-quality borrowers who were persuaded to buy a home sooner than they might have due to the attractive financing options.

We see the same basic conditions today: the tax credit for first-time buyers has also convinced more than a few marginal buyers to step up and buy a house sooner than they might have in the absence of the tax credit. This has been one of the biggest forces driving the nascent recovery in new home sales.

There are two big problems with this, however:

1. When you finally phase out the stimulus, you pull the rug out from under the market, so to speak, and demand falls.
2. There are diminishing marginal returns to the stimulus.  In other words, it becomes less effective over time.  You cannot pull future sales forward indefinitely…eventually you run out of marginal buyers to sell to.

There really is no policy “solution” here.  The stimulus “works” only if you make it continually bigger to draw in new buyers…but this only makes the eventual burst all the more painful.

The other alternative is to quit the stimulus and let prices “reset” themselves in the marketplace.  Eventually, prices would fall to a level that would establish a clearing price.  It would also almost certainly mean more failed banks and construction companies.

At any rate, with mortgage applications beginning to fall, Congress will almost certainly extend and possibly even expand the tax credit.  It will make things marginally less bad…in the short-term.  But the taxpayer should begin to see far less “bang” for each additional buck of stimulus money.

Charles Sizemore, CFA
Co-author of the recently-published Boom or Bust: Understanding and Profiting from a Changing Consumer Economy