Federal reserve underestimates sensitivity of housing to mortgage rates
The federal reserve couldn’t have prevented the housing bubble and bust through interest-rate policy alone.
In response to the housing bubble and bust, Congress passed the Dodd-Frank financial reform. These new mortgage regulations will prevent future housing bubbles by effectively banning destabilizing loan products with interest-only and negative amortization features used to inflate previous bubbles. Those loan programs enabled buyers to greatly inflate house prices from stable levels set by wages and mortgage rates.
Despite the groundbreaking change to real estate markets caused by this recent legislation, most housing market analysts and real estate economists fail to recognize the impact of these changes on the market, and they continue to make predictions based on previous history and their previous understanding of how housing markets work.
The toxic loan products banned by Dodd-Frank were invented to solve the problem of affordability. In a stable housing market, the equilibrium price is the highest price consumers can finance, so under pressure to complete more deals, lenders seek ways to increase the size of the loans lenders provide borrowers. Unstable affordability products were born out of this constant market pressure.
Since affordability products were designed and used to solve affordability problems, when interest rates would spike higher, lenders had a way to close deals and sustain sales momentum. After Dodd-Frank, this was no longer the case. In February 2013, before the taper tantrum of May 2013, I wrote that Future housing markets will be very interest rate sensitive due to the lack of affordability products. This was dramatically confirmed when rising rates abruptly ended the reflation rally.
Even though the evidence of housing market’s extreme sensitivity to mortgage interest rates is convincing, the real estate economists at the federal reserve still haven’t figured this out. They don’t foresee the upcoming problems rising mortgage rates will bring, and they don’t see how past changes would have mattered.
Further, in the federal reserve’s desire to absolve themselves of responsibility for the housing bubble, they applied their faulty understanding to the housing bubble and determined they would have needed to raise interest rates to 8%, ruining the whole economy to prevent the bubble back in 2004.
Wild swings in asset prices over the past 20 years and the associated boom-bust cycles have sparked considerable debate about how monetary policy might play a stabilizing role…. Some policymakers, such as then-governor of the Federal Reserve Ben Bernanke (2002), argued that interest rate policy should focus exclusively on achieving the Fed’s dual mandate of stable prices and maximum employment. That is, threats to the stability of the financial system should be dealt with separately through financial regulation and supervision. More recently in the aftermath of the Great Recession, another former governor, Jeremy Stein (2014), argued for using interest rate policy to reduce financial market vulnerability and as a complement to regulation and supervision. Such an approach entails a tradeoff: Raising interest rates to curb financial risk could mean deviating from the dual mandate, therefore entertaining higher unemployment and lower inflation.
This interest-rate dilemma is a false dichotomy. The authors believe low interest rates in 2004 was necessary to revive the economy, which is probably true, and they believe the interest rate policy that revived the economy also caused house prices to destabilize and become a bubble — which is not true.
The low mortgage rates of 2004 and 2005 were not the cause of the housing bubble. The low rates temporarily increased affordability, and these rates may have served as a precipitating factor to get the rally started, but mortgage rates only account for 10% to 15% of the huge runnup in house prices that was the Great Housing Bubble. The bulk of price inflation, 85% of the massive increase in price, was caused by toxic mortgage products like the option ARM that allowed borrowers to obtain loan balances eight to ten times annual income.
The real failure of the federal reserve — and there was a huge failure at the federal reserve — but the real failure was one of regulation and oversight. The federal reserve allowed the option ARM and other toxic mortgage products, and they allowed unrestricted credit default swaps on mortgage pools stuffed with toxic option ARMs. Investors pumped hundreds of billions of dollars into collateralized debt obligations insured by credit default swaps the ultimately found its way into millions of Option ARM mortgages at eight to ten times a borrower’s income. This greatly inflated house prices and set up an entire generation with debts too-big-to-manage and banks too-big-to-fail.
This Economic Letter investigates the link between interest rates, mortgage lending, and house prices. Quantifying this link is important in assessing whether or not interest rate policy can be used to guard against leveraged asset price booms in practice. Housing plays perhaps the most important role among asset classes because purchases are typically leveraged through mortgages. Many consider the 2002–06 housing bubble an important trigger of the subsequent financial crisis. However, economists disagree about the role that low interest rates played in fueling the house price boom.
As I noted above, mortgage rates were only a small factor contributing to the housing bubble. Lowering the rates in 2004 may have got the party started, but once set in motion, the problems with lax oversight allowed the entire housing market to destabilize.
Our goal in this Letter is different. We instead ask how much interest rates would have had to rise to keep housing prices under control. Our rough figures suggest interest rates would have needed to rise around 8 percentage points to completely avoid the boom-bust cycle. However, such a boost also could have caused significant damage to the Fed’s main objectives of full employment and price stability. …
Since low mortgage rates only account for 10% to 15% of the price increase during the housing bubble, it isn’t surprising that the math shows 8% mortgage rates would have been necessary to erase the other 85% to 90% of the price inflation.
In the real world, the interest rate rise wouldn’t have needed to be so large.
First, any rise in rates would have removed the price momentum so many were intent on capturing. If prices hadn’t been rising so rapidly, people wouldn’t have been motivated to participate, so much of the impetus to buy would have evaporated.
Second, rising interest rates would have provided investors with other, superior investment alternatives. One of the main reasons money flowed into mortgage-backed securities that were package into CDOs is because this money had nowhere else to go. In a higher interest-rate environment, this money would not have flowed into housing in a way that inflated house prices.
Third, any increase in interest rates would have weakened the economy, which also would have reduced housing demand.
The 8% number the economists calculated takes into account none of these three factors. But when you really think about this study’s purpose and context, the real purpose was to generate the largest number possible to underscore the hopelessness of this approach. They didn’t want to look back and discover a better path; they want to look back and believe all their decisions are both justifiable and correct.
Several complex factors caused the Great Recession. This Letter focuses on a particular mechanism. Our experiment based on the trilemma of international finance indicates that using interest rate policy to bring down housing prices would have required a severe tightening in 2002. There are several caveats to this result. First, the initial federal funds rate increase indicated by our analysis could have been smaller. For instance, preventing a financial crisis might not have required bringing house prices all the way back to trend. Second, households might have eventually revised their expectations about the Fed’s new resolve against asset price booms, thus requiring a smaller initial intervention. Third, even a fraction of our projected 8 percentage point increase would have been sufficient to sink the economy into recession, which would have also slowed house prices more rapidly than we calculated, albeit at a cost of added unemployment. Finally, one has to factor in the inevitable uncertainty that surrounds any empirical analysis.
What is the takeaway then? Slowing down a boom in house prices is likely to require a considerable increase in interest rates, probably by an amount that would be widely at odds with the dual mandate of full employment and price stability. Moreover, the Fed would need a crystal ball to foretell house price booms. In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable.
Back in May I asked Can the federal reserve identify and prevent financial bubbles? Given that economists failed to see one of the largest, most obvious, and most destructive financial bubbles in modern history, what reason do we have to believe they can spot any financial bubble?
I have my doubts federal reserve economists will agree on the right course of action even if they can agree on a bubble. Some economists will vehemently disagree with their colleagues. Many economists get caught up in their own confirmation biases and interpret incoming data through the filter of what they want to see happen. Reaching a consensus will be difficult. Just look at the problems the Canadians, Chinese, and Australians have admitting to their housing bubbles.
With the realities of identifying and then agreeing on a course of action being so problematic, for as much as I like the idea of stamping out housing bubbles before they blow up, unless we get much better at identifying them and crafting policies to deal with them, we must focus on solutions to cleaning up the mess after the fact.
Unfortunately, while a financial bubble inflates, everyone involves makes a great deal of money, and huge profits have a way of blinding and paralyzing even the most intelligent and vigilant regulators.