Jul142014
Did federal reserve policy inflate housing for another crash?
Federal Reserve’s zero interest rate policy made debt cheep and widely available to investors who inflated asset values setting the stage for another crash.
Pundits like to call asset bubbles; it attracts attention and helps make a name for the analyst. Most often they are wrong, but every once in a while, someone calls a bubble just before one pops, and they look like a prescient genius — and sometimes they are: Robert Shiller called both the internet bubble and the housing bubble right at the peak of each, and he won the Nobel Prize for his efforts.
The pundit sounding the alarm today is Charles Hugh Smith. I like his writing, and he generally displays a great understanding of financial history and the workings of housing markets; however, this time I think he is wrong. Like every other housing bear, he overlooks one basic fact: inventory restriction overrides all bearish predictions.
Why Housing Will Crash Again–But For Different Reasons Than Last Time
Charles Hugh Smith, Tuesday, July 08, 2014
Institutionalizing the speculative excesses that inflated the previous housing bubble has fed magical thinking and fostered illusions of phantom wealth and security.
The global housing market has been dominated by magical thinking for the past 15 years. The magical thinking can be boiled down to this:
A person who buys a house for $50,000 will be able to sell the same house for $150,000 a few years later without adding any real-world value. The buyer will be able to sell the house for $300,000 a few years later without adding any real-world value. The buyer will be able to sell the house for $600,000 a few years later without adding any real-world value.
And so on, decade after decade and generation after generation: a house should magically accumulate enormous capital (home equity) without the owner having to do anything but pay the mortgage for a few years.
There is nothing magical about this thinking, only the rapidity of the appreciation is unrealistic. Slowly rising wages and stable interest rates causes house prices to gently rise as each subsequent generation of homebuyers takes their rising incomes and bids up the price of available housing stock. Most buyers believes this happens at a rate of appreciation far in excess of reality, but there is fundamental support for the basic idea.
The capital isn’t created by magic, of course: it’s created by a greater fool paying a fortune for the house on the speculative confidence that an even greater fool will magically appear to pay an even greater fortune for the same house a few years hence.
This is the result of housing transmogrifying from shelter purchased to slowly build equity over a lifetime of labor into a speculative bet that credit bubbles will never pop. This transmogrification is the final stage of the larger dynamic of financialization, which turns every asset into a speculative commodity that can leveraged via debt and derivatives and sold into global markets.
The magic of something for nothing is especially compelling to a populace whose earnings have stagnated for decades. The housing bubble fed the fantasy that a household could set aside next to nothing for retirement and then cash out their “winnings” in the housing casino when they reached retirement age.
What believers in the sustainability of the housing casino conveniently ignore is the enormous risk (and debt) being taken on by the last greater fool: if the buyer pays cash, they are gambling on rents continuing to skyrocket along with home valuations, though these two are not as correlated as many assume. …
This diatribe fit in 2006 — and I’ve written similar sentiments — but today, the same ideas are hollow echoes of yesterday.
Younger buyers have less disposable income than their elders due to deteriorating wages, higher student loan debt and higher taxes on earned income. As a result, the risk of their defaulting or being impoverished by the collapse of housing valuations is much higher than the risks faced by the buyers who rode the first bubble up to (ephemeral/phantom) riches.
This is true, and today’s buyers have reason to be cautious and temper their expectations.
The only way a young household can buy a $150,000 house for $600,000 is if interest rates are low enough to enable a modest income to leverage a huge mortgage. This is the basis of the Federal Reserve’s campaign to buy Treasury bonds and mortgages: by driving interest rates to unprecedented lows, the Fed enables marginal buyers to become the last greater fool.
Artificially low mortgage rates do enable today’s buyers to finance the ridiculous bubble-era prices, but it also allows them to do so with stable loan terms. The distinction is critical. In 2006 buyers were using option ARMs and other unstable loan products almost guaranteed to fail. Today, they are financing the same sums with stable 30-year fixed-rate mortgages. This difference is more than semantic; it’s structural.
The question in the title of my post is “Did federal reserve policy inflate housing for another crash?” There is no question the federal reserve inflated housing. They knowingly and intentionally did that, but they did it using loan terms that will insulate the market from another crash.
The first housing bubble circa 2001-2008 inflated as a result of financialization. The second, current echo-bubble has inflated on the socialization of financialization: the FHA and other government agencies have essentially taken over the entire mortgage market, guaranteeing or backing 95% of all mortgages, while the Fed has pushed rates down to historic lows to enable marginal buyers to make bets in the housing casino.
This is where he jumps the shark. Yes, we socialized the losses from financialization by extending the loan guarantee to have explicit government backing; however, with this government backing comes stable loan products, and that makes all the difference.
The current echo-bubble has another speculative source: cash buyers of homes to rent. About a third of all home sales in many markets are cash buyers, speculators hoping to cash in on the bubble by selling to a greater fool, or investors seeking the safe returns of rental housing.
Unbeknownst to the majority of these investors, there is no guaranteed return in rental housing when you overpay for the property and a recession guts demand for rentals. This is another form of magical thinking: nothing ever goes down.
The last recession, the largest in 90 years did not gut the demand for rentals; in fact, it increased them as many former owners became renters. If that recession did not cause a catastrophic decline in rental rates, why would the next one do so?
The stock market goes higher forever, housing goes higher forever, and the Fed has banished recessions forever. If this isn’t magical thinking, then what is it? Faith in the New Normal? Based on what?
The new normal is based on four characteristics: low mortgage rates, low supply of MLS inventory, low demand from owner-occupants, and expensive but affordable homes. It is what it is, but there’s nothing magical about it.
Let’s quantify the magical thinking and the echo bubble with a few charts. Home prices are still 130% above pre-bubble valuations.
That chart illustrates the impact of 25 years of falling mortgage rates, but it does not establish that current pricing is overvalued.
Declining mortgage rates (courtesy of the Fed) fueled the first housing bubble and the current echo-bubble.
If there is any reason for caution about current pricing, it’s the potential for rising mortgage rates to destabilize housing.
Measured by household earned income, mortgage debt is more than double the historic average of wages-to-mortgage-debt.
The chart above is to be expected during a period when mortgage interest rates declined from 18% to 3.5%.
Take a look at the Fed’s purchases of mortgages: from zero to $1.2 trillion, and then another $800 billion for good measure. The Fed has intervened in the Treasury market to the tune of almost $2 trillion to suppress interest rates.
This is the mechanism by which the federal reserve engineered the decline in mortgage rates, but so what? They will unwind these positions over time, probably by holding many of these mortgages to term. The odds of the federal reserve dumping its holdings and causing a bond market crash is basically zero.
The Fed’s pause in mortgage purchases caused the housing market “recovery” to nosedive. This should make us wonder what will happen when the Fed’s mortgage purchases finally end.
The federal reserve is ending its mortgage and bond purchases, and so far, bond yields have dropped. Far from an Armageddon scenario, it looks like a very orderly taper with few visible negative effects.
Relying on greater fools and expecting the rental housing market to magically ignore the ravages of recession for the first time in history is not a formula for financial or speculative success. The current echo-bubble in housing will pop, just like every other leverage/credit-fueled speculative bubble in history.
Why? By what mechanism? Saying it will happen without proposing a reason isn’t even speculation; it’s fear mongering. Is the federal reserve going to dump mortgage bonds or treasuries? No. Is the federal reserve going to foreclose on the deadbeats in it’s bad mortgage pools and flood the market with REO? No. Will the fed idly sit by and allow interest rates to spiral out of control? Given their past behavior, this doesn’t seem very likely. Are the banks suddenly going to start foreclosing and dumping properties on the MLS? No. Then what is going to precipitate the crash?
Institutionalizing the speculative excesses that inflated the previous housing bubble has fed magical thinking and fostered illusions of phantom wealth and security. The damage that will be unleashed by the echo-bubble deflating will be substantial, and in line with the The Smith Uncertainty Principle, not as predictable as many imagine:
The Smith Uncertainty Principle: Every sustained action has more than one consequence. Some consequences will appear positive for a time before revealing their destructive nature. Some consequences will be intended, some will not. Some will be foreseeable, some will not. Some will be controllable, some will not. Those that are unforeseen and uncontrollable will trigger waves of other unforeseen and uncontrollable consequences.
As I stated above, this post would have been great reading in 2006. I would have embraced it and agreed with most of its points, but we live in a different world now, and those ideas are about eight years behind the times.
Why housing won’t crash
House prices are not going to crash. No matter how good the argument, none of the conditions burdening the market are going to bring must-sell inventory to the MLS forcing prices down. As I noted back in October of 2012, The housing bears are right, but prices will go up anyway. So why is that true?
Lenders are not being forced to liquidate, and without forced liquidations like we saw in 2008, house prices simply don’t go down. Lenders face almost no carry cost on their books, and regulators are allowing them to carry the value of underwater loans at face value, so like the loanowners they have trapped in loan modifications, lenders wait for higher prices to restore collateral value to their loans rather than foreclose and take a loss.
Further, mortgage interest rates are low and likely to stay that way. Low mortgage rates makes for excellent affordability, and it gives more people the ability to buy homes. But most of all, lenders will continue this policy because withholding inventory is working. In a normal market, thousands of individual owners control the supply. However, once prices crashed and borrowers owed more than their mortgage balances, they required lender approval for a sale — an approval the lender can and does deny.
Also, crashing prices and toxic mortgages caused so many borrowers to default that lenders began foreclosing and acquiring a large inventory of REO. Between the sales they must approve and the properties they directly own, lenders and government entities own or control a huge portion of the housing stock. With such control comes the ability to act as a cartel and manipulate price — and they have. In fact, since 2012, they have been quite successful at withholding inventory as evidenced by 40% or more reductions in for-sale inventories across most of the Southwest. A small uptick in demand, mostly caused by investors, coupled with a huge decline in supply forced prices to move higher.
It worked.
And it will continue to work.
Housing is not going to crash, at least not due to policies of bankers or the federal reserve.
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[…] Did federal reserve policy inflate housing for another crash? A person who buys a house for $ 50,000 will be able to sell the same house for $ 150,000 a few years later without adding any real-world value. The buyer will be able to sell the house for $ 300,000 a few years later without adding any real-world value. Read more on OC Housing News (blog) […]
“at least not due to policies of bankers or the federal reserve”
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Wut??
If we see a crash, IMO, it’s more likely because of Chinese owners liquidating to raise cash. They are a source of must-sell inventory lenders and the federal reserve can’t control. If it’s up to the bankers, they can control inventory and prevent a crash.
For the Chinese, US real estate IS the flight to safety. Assuming that the Chinese will sell California real estate to raise cash is like assuming that Indians (or Chinese) will sell their gold to buy rupees or yuan. Why does this make sense to anyone?
As the real estate bubble bursts in China, I wouldn’t be surprised if California purchases by Chinese investors, not decreases. I think I said something to this effect about a year ago. When the curtain goes down, every one rushes to the exit. I would be more concerned about California housing prices when China’s real estate prices bottom, and assets are sold in California to take advantage of rock-bottom prices over there.
I think you’re forgetting the liquidity crisis that may occur due to the excessive leverage by non-filthy rich Chinese “investors.” Yes, when China’s bubble bursting accelerates, they’ll want their money to flee China, but US currency might be the best “investment” when you’re in a liquidity crisis.
Martin Armstrong see a bottoming of China by 2020. Assuming that he’s correct than we could have another 5 years of Chinese buying (but prices might just slowly churn higher due to valuation). They might slow in buying prime areas like San Marino, Irvine or Arcadia but other second to third tier markets (in California or elsewhere) will get a boost. The prolonged weakness in the dollars will encourage more buying.
I’m with Perspective on this one. Non-leveraged Chinese may be buying US real estate as a flight to safety, but the leveraged will need to liquidate in order to pay their obligations back home. It wouldn’t surprise me to see a few prominent Chinese pretenders publicly executed to get other to repatriate their money to pay off bad loans in China. If their banking system is as leveraged as some speculate, particularly in light of the rehypothocation problem, they will need that cash back in China to prevent a meltdown.
“If their banking system is as leveraged as some speculate, particularly in light of the rehypothocation problem, they will need that cash back in China to prevent a meltdown.”
If rehypothecation is as leveraged as some speculate, liquidating foreign assets to repatriate back domestically really doesn’t mean it will prevent a meltdown. If that “meltdown” breaks a certain threshold, the action potential for an acute meltdown will be unavoidable and all economies may depolarize as result. Does anyone know for certain? …pundits say they see it coming!
San Francisco moves to stop flipping
San Francisco is trying to repeal the law of supply and demand, and that should work out as well as most other such attempts. This time it’s nothing so silly and destructive as rent control – no, they have on the ballot for November a tax measure to discourage the flipping of properties by real estate speculators.
It’s an anti-market measure that comes from the 1970s, so you know it’s spectacularly inane. The anti-speculation tax was first introduced by then-Sup. Harvey Milk shortly before his assassination in 1978, and it was revived this year during a series of tenant conventions.
The measure creates a supplemental surcharge on top of the city’s existing real estate transfer tax, a progressive rate ranging from a 24% tax on the sale of a property within one year of its purchase to 14% if sold between four and five years later.
Because it’s San Francisco, this will likely pass.
This will also likely be a disaster, because it’s exactly the sort of thing you get from politicians and populists who don’t have the remotest clue on how business or human nature works.
http://placewww.sfbg.com/politics/2014/07/11/angry-building-owners-threaten-lawsuit-over-anti-speculation-tax
Tiny houses are not the next big thing
How do journalists count? One, two, trend. This is about the 300th article saying “Tiny houses are the next big thing” which means one thing for certain: tiny house are not the next big thing.
Look, it’s time we talked, America. These are adult dollhouses, embraced by troubled people who think the answer to all problems in their lives is simplifying, when what they are doing is improperly using an architectural solution to cramped urban living.
Tiny houses aren’t for everyone, in fact, it’s the opposite of aspirational housing — the ideology underpinning the movement. Let’s hope the movement stays small enough, because one more article about this being the next big thing is one article closer to the “Tiny House Bubble About to Burst” investigative report.
http://www.deseretnews.com/article/765656596/Tiny-houses-big-with-consumers-seeking-economic-freedom.html
Fed Considers Ending Stimulus Program
The Federal Reserve appears to be confident enough in the trajectory of the United States economy that it looks to be planning to stop adding to its bond holdings in October, according to the minutes of the June Federal Open Market Committee meeting.
The decision has been months in the making. Fed policymakers have tapered their government bond purchases in $10 billion increments at each Committee meeting since December, cutting them to $35 billion a month from $85 billion. At the current pace, the Fed would be buying $15 billion in Treasury bonds and mortgage-backed securities by its October meeting.
The purchases are intended to reduce borrowing costs for businesses and consumers and to encourage risk-taking by investors but have been the subject of some controversy as inflation concerns persist among some economists.
Economists at large have speculated that the Fed may reduce bond purchases by $15 billion instead of the customary $10 billion pattern that it has displayed so far.
Closing out the program would be of considerable symbolic significance to the financial markets and to the American public that the economy is now capable of standing on its own two feet and does not need the Fed’s stimulus funding to prop it up.
The symbolic reality is not lost on the Fed.
“Participants generally agreed that if incoming information continued to support its expectation of improvement in labor market conditions and a return of inflation toward its longer-run objective, it would be appropriate to complete asset purchases with a $15 billion reduction in the pace of purchases in order to avoid having the small, remaining level of purchases receive undue focus among investors,” the minutes said.
Even after the Fed ends the growth of its bond portfolio, it plans to maintain the size of its holdings by continuing to reinvest proceeds from matured bonds. The size of the portfolio will likely stay consistent until interest rates begin to rise.
The meeting did not give any indication of when the Fed is planning to raise interest rates but the general consensus among economists is that it will likely occur in the middle of next year.
The policy makers agreed to communicate to the public later this year about the mechanisms that the Fed will use to bring up rates, as it is feared that bringing up the benchmark interest rate may not be enough because of the amount of cash in the system.
The Bank of International Settlements has warned the FED on their extreme (ponzi) QE policy, and how it must end.
Also, the existing QE policy has lost its buoyancy to assist the economy, and unless the FED increases the dosage of QE, it will not work. The Fed will likely try it again, but it will be too late and will have less impact to stop the reset from happening.
There’s really one answer here. Asset prices must be reset to fundamentals. This can be accomplished one of two different ways:
1) Incomes must increase rapidly to fill the gap necessary to support asset prices. This would include equities and leveraged assets (real estate).
2) Asset prices must decline to fill the gap necessary to be supported by incomes. This would include equities and leveraged assets (real estate).
“We believe is needed, is a RESET on the way in which the economy grows around the world” ~ Christine Lagarde, Chairwoman/Managing Director of the International Monetary Fund (IMF)
http://youtu.be/GcMXnKO3muI
I am not a conspiracy theorist, but this is just blatant!
Absolutely Bizarre but Absolutely Real … watch and you’ll understand that something VERY BIG is approaching!
http://youtu.be/QYmViPTndxw
Huh. Won’t have long to wait. “Doomsday” is this Sunday.
http://usawatchdog.com/official-2014-imf-forecast-based-on-magic-number-seven-steve-quayle/
I don’t like apocalyptic, doomsayer garbage … however, this speech fits right in with the crazies in society. This speech is the most bizarre as I’ve ever seen from a public official as powerful as Ms. Lagerde. It seems like she’s speaking lightly in a joking fashion, but then again, she’s clearly sending a message.
With that said, I do think something big is coming … I don’t think it will end the world or change America’s influence (despite what the crazies think). I don’t think it will happen this Sunday Night with the POTUS going to the American people (via TV), announcing that the banks will be closed until further notice.
http://www.businessinsider.in/moneygame/LeBron-James-Just-Showed-How-To-Solve-The-US-Housing-Crisis/articleshow/38333914.cms
When I think of Cleveland, I can’t help but recall the scene in the Drew Carey show where he is standing outside in the winter spraying a couple of aerosol cans saying “come on global warming.” There is a reason the housing costs what it does…
When I was working as a golf course development project manager based out of Orlando, Florida, I had a golf course project in Madison, Ohio, about 60 miles east of Cleveland. They get 84″ of snow each year, much of it lake effects. Cleveland gets similarly buried.
One Friday, I am scheduled to fly home, and I’m sitting on the tarmac watching them de-ice the wings prior to our flight. I was praying I would spend the weekend back in sunny Orlando as opposed to being trapped in Cleveland. Thankfully, my flight was one of the last to get out that day.
Cleveland is a dirty, depressing town. Even from the air, you see run down houses, mostly from the 1950s. I don’t know if there is any sum of money they could pay me to move to Cleveland. I can see why Lebron wanted to escape. I hope his millions buys a good heater for his mansion.
We checked-out Baker Ranch yesterday (few miles north of Irvine Spectrum in Lake Forest). They’re already offering $25k+ in incentives. There are no mello roos taxes here, so on a $1m house you’ll spend ~$667 less every month for 30 years! I like the Great Park area, so I’m hoping they start developing the next neighborhoods there soon (beyond Pavilion Park).
The appearance of incentives is a sign of the weakness in sales nobody was counting on.
Baker Ranch is very nice, and it’s close enough to Irvine, you can still enjoy much of what Irvine has to offer, plus Foothill Ranch also has some nice commercial areas. I think Baker Ranch will attract many of Irvine’s buyers as a better value.
Now if only we could do something about the greenhouse gases emitting from Sacramento Asses.
I’m in favor of the carbon tax, as long as all the revenue is returned to me personally. I promise to spend every penny, you know, to help the economy.
Maybe we should just price gasoline based on the fuel efficiency of the car? A more fuel efficient car would cost less per mile to operate, use less gas, and thereby emit less carbon dioxide (to plants detriment, I might add). Wait. We already do this.
We could also make carpool lanes to encourage people to ride-share. And we could make these lanes available to electric cars to encourage (rich) people to buy them. Wait. We do that too.
I know, we could spend $100B of taxpayer money to build a high-speed rail system that takes twice as long as flying. Oh wait. We are already doing that.
I guess this is the end game: tax the poor drivers that can’t afford to buy hybrids, or electrics, and give that tax money back to the same poor people. Well, not all of it. Some of it goes to “overhead.” Think junkets in Maui for overpaid “administrators.”
http://www.latimes.com/opinion/editorials/la-ed-adv-carbon-tax-20140712-story.html
Higher gas prices are just what California needs, right?
Oops.
Economists say it, so rest assured it’s the right answer for California.
I missed all the Paul Krugman drama as it was going down, but this article contains a great synopsis:
http://www.forbes.com/sites/ralphbenko/2013/10/21/much-bigger-than-the-shutdown-niall-fergusons-public-flogging-of-paul-krugman/
Is Paul Krugman leaving Princeton in quiet disgrace?
Forbes contributor Ralph Benko jumps on the Paul Krugman-bashing bandwagon by penning an article that hints Krugman’s departure from his Princeton position is less-than-ideal.
Krugman, who is still penning economic thunder for the New York Times, left his position at the university as professor of economics and international affairs.
Benko cites two sources that seem to indicate Krugman left his position in disgrace.
The first is Krugman being “thoroughly indicted and publicly eviscerated for intellectual dishonesty by Harvard’s Niall Ferguson in a hard-hitting three-part series in the Huffington Post, beginning here, and with a coda in Project Syndicate, all summarized at Forbes.com.”
The second is shortly after Krugman’s departure was announced no less than the revered Paul Volcker, former Fed chair and Princeton alum, made a comment — subject unnamed — sounding as if directed at Prof. Krugman:
To the Daily Princetonian (later reprised by the Wall Street Journal) Volcker stated with refreshing bluntness:
“The responsibility of any central bank is price stability. … They ought to make sure that they are making policies that are convincing to the public and to the markets that they’re not going to tolerate inflation.”
Krugman seems publicly unfazed by the criticism. Or is he?
His latest piece ran Sunday in the New York Times and struck a notably different tone as it dealt with health care and largely steered clear of economics and politics.
Time will tell if Krugman’s resignation, and the alleged circumstances surrounding it, made him a changed man.
Great post. I agree 100%.