Does increasing payment affordability make houses a bargain?

When I checked bankrate.com yesterday, the rate on a 30-year mortgage was 3.55%. That is the lowest reading I have ever seen, and we should be seeing news reports about new record low mortgage interest rates. These new low rates are making my reports on affordability show housing is a screaming buy in many cities even here in Orange County. However, super low interest rates have a problem. What happens when interest rates go up? Will rising interest rates cause house prices to crash?

I don’t think interest rates will rise fast enough to cause house prices to crash again. The federal reserve needs to bail out its member banks by pushing house prices back up to the peak to put collateral value behind the trillions of dollars in underwater mortgages. I believe the fed will keep interest rates low even if that means inflation becomes a problem. I don’t think they have a choice. Consumers need debt relief, and banks need higher house prices. Banks may not like getting repaid in devalued currency, but it beats the alternative of not getting paid back at all.

If interest rates get low enough — and they are probably low enough now — debt becomes an attractive inflation play. If you can borrow money at 3.55% today and lock that rate in for 30 years, it’s very likely inflation will rise above that value for some period during the loan term. In fact, we may see inflation much higher than 3.55% once the deflationary headwinds abate. If inflation is higher than the interest rate on your long-term fixed-rate mortgage, the currency is devaluing faster than the debt is growing. Assuming wages or other investments keep pace with inflation (it may not), borrowers with cheap long-term debt gain a tremendous benefit.

But does inflation greater than the interest rate make house prices a bargain? Well, the nominal prices may still be inflated, but if you finance most of the purchase with really cheap debt, even outrageously high prices become manageable. Even cash buyers may find the nominal prices more attractive because their returns in competing investments are even worse. Saving 3.55% on a mortgage is better than earning 0.25% in a CD.

Since banks are unwilling or unable to lower the cost of houses and remain solvent, the only solution available to them is to keep lowering interest rates. That’s why the fed keeps working to push mortgage rates lower, and now some want to see just how low rates can go.

Why not Uncle Ben’s Crazy Housing Sale?

By Ezra Klein, Published: July 23

… there’s a real mystery as to why the Federal Reserve is not doing more to help the economy. Ben Bernanke, after all, keeps saying the central bank can do more, and if the economy gets worse, it will do more. But the economy keeps getting worse, and the Fed keeps not doing more.

When I say “the economy is getting worse,” I’m using the Fed’s own data. In January 2010, the Fed projected that that the economy would grow 4.15 percent in 2012. By June 2011, it had revised that down to 3.5 percent. By April 2012, it was down to 2.65 percent. And in June, officials lowered expectations once again, saying they expect economic growth to be a mere 2.15 percent in 2012. Ouch.

I can’t believe anyone put out such Pollyana projections with a straight face. With the debt overhang and a broken housing ATM, where was this money going to come from?

Some argue that there’s nothing more the Fed can do. But Bernanke is not one of these people. “I wouldn’t accept the proposition, though, that the Fed has no more ammunition,” he said in June. “I do think that our tools, while they are nonstandard, still can create more accommodative financial conditions, can still provide support for the economy, can still help us return to a more normal economic situation.”

I have no doubt the federal reserve can screw up the economy further with more market manipulations and distortions. Perhaps they should let things be?

So why isn’t the Fed using those tools? Explanations vary. Some believe the Fed doesn’t think it can do much more, and it prefers to hold the few options it has left in reserve in case there’s another major crisis.

That would be wise… which probably means that isn’t why the federal reserve isn’t doing more.

Others think Bernanke is cowed by Republican pressure and dissent among the Board of Governors. Another explanation — and the one Bernanke has voiced — is that, right now, the Fed believes the risks of doing more outweigh the benefits, but that if the economy worsens, that calculus might change.

I don’t pretend to know what is truly in the heart of our top central banker. But in conversations with Fed watchers and economists, I am convinced that there is something more the Fed can do, and that now is the right time for them to do it. I call it Uncle Ben’s Crazy Housing Sale.

Everyone has lost faith in the free market. Any time we have a problem, we must look to the government or the federal reserve to “fix” it. Perhaps our problems are the result of all the “fixing” they have done already?

Tomorrow morning, Bernanke could walk in front of a camera and announce that the Federal Reserve intends to begin buying huge numbers of mortgage-backed securities with the simple intention of bringing the interest rate on a 30-year mortgage down to about 2.5 percent and holding it there for one year, and one year only.

The message would be clear: If you have any intention of ever buying a house, the next 12 months is the time to do it. This is Uncle Ben’s Crazy Housing Sale, and you’d be crazy to miss it.

What a dumb idea. Didn’t we try something similar in 2010 with tax credits? We gave people credits of $8,000 nationally and an additional $10,000 in California to anyone who wanted to buy a house. As a result, people overpaid by $40,000 or more to take advantage of the credits. Of course, as predicted, when the credits expired, sales volumes plummeted and prices soon followed. Do we want to repeat that disaster?

This is a particularly good time for Uncle Ben to launch his sale, because the housing market appears to be turning: More houses are being built, the price of existing homes is beginning to rise, and inventory levels are falling. A recent Wall Street Journal poll of economic forecasters found that 44 percent thought housing had bottomed out, while only 3 percent thought the housing market had further to fall.

The housing bottom consensus could be very wrong.

The Fed, in other words, would be working with the economic trends rather than against them. People already sense that the housing market is recovering, and that this might be the time to buy — in the unusual, self-perpetuating way of the economy, that’s part of why the housing market is recovering. But with an announcement like this and the attendant media coverage — people would know, with some certainty, that this is the time to buy, and there won’t be a better one for a long time.

Everyone is doing their duty to dupe buyers into acting. The entire economy is a confidence game, right?

This idea comes with high-profile supporters. Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics and a former associate director of the Federal Reserve’s Monetary Affairs Division, has a proposal along these lines. Dan Tarullo and Janet Yellen, both members of the Federal Reserve Board, and Charles Evans, Eric Rosengren, and John Williams, who lead the Federal Reserve’s Chicago, Boston and San Francisco branches, have all suggested that the Fed should buy more mortgage-backed securities. Even Bernanke has called it “a viable option.”

So come on, Ben. Start the sale.

Despite how dumb this idea is, the federal reserve is working to lower mortgage interest rates to spur demand. They haven’t put a target or a timetable as Mr. Klein suggests, but they have been following his suggested policy. It may or may not be a good policy for the country, but it’s necessary to save the banks, so that’s what’s going to happen. After all, the financial elites must be saved, right?