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.
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. …
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.
And it will continue to work.
Housing is not going to crash, at least not due to policies of bankers or the federal reserve.