Housing market manipulations give homebuilders false signals
Artificially low interest rates and restricted inventory causes builders to focus on higher priced houses we don’t really need.
Homebuilding usually leads the economy out of recession. The Great Recession did not end with a building boom largely because of overbuilding during the housing bubble. A false price signal triggered excessive homebuilding, and it took five years to work off the inventories. The collapse of the housing bubble saw new home sales and construction fall to the lowest levels ever recorded — and those records go back to the 1960s. To make matters worse, rather than experiencing a sudden drop and a “V” bottom leading to a new boom, new home sales flat-lined at record lows for five straight years. This basically wiped out the homebuilding industry. A few years ago, I heard the Riverside County manager of KB Home quip, “I’m building 10% of the homes with 10% of the staff I had in 2006.” That’s no exaggeration.
Government and lender solutions to the collapse of the housing bubble focused on loan modifications and short sales. Back in 2011 when banks went “all in” betting on success of loan modifications, it was widely believed that loan modifications would reverse declining house prices and make distressed borrowers happy by keeping them in houses they couldn’t otherwise afford. This in turn would cause home prices to bottom, put homebuilders back to work, which would improve the economy by increasing employment and private-sector spending. It has worked as planned. Or has it?
Charles Hugh Smith, (May 15, 2014)[dfads params=’groups=4&limit=1&orderby=random’]
Our Fed-fueled lottery-ticket economy will unravel with a vengeance in the years ahead.
Malinvestment–the systemic consequence of the Federal Reserve’s policies of near-zero interest rates and abundant credit–doesn’t just inflate destruction asset bubbles: it poisons productive assets and the entire economy.
Malinvestments arise when credit is cheap and abundant, as it costs speculators very little to borrow money for gambles, and they can in essence buy lottery tickets in the asset bubble of the day without having any skin in the game, i.e. without having to put any of their own money at risk.
The classic example in the previous housing bubble were speculators who bought houses with no-down, no-document low-interest “liar loans”: with no money down and a modest interest-only mortgage payments, speculators could buy a lottery ticket in the housing mania for almost nothing, and maintain their gamble for a very modest monthly sum. Given the potential for an enormous gain should the gambler find a greater fool to buy the house in a few months, this was an entirely rational and indeed attractive bet.
Today’s asset bubbles in stocks, junk bonds, housing, art, bat guano futures, etc. are being driven by the Federal Reserve, which has replaced the nuisance of no-document liar loans with unlimited liquidity for bankers, financiers and insiders. The super-wealthy and corporate cronies can borrow as much nearly free money as they want from the Fed, without even bothering with qualifying for the credit.
When credit-money is nearly free and abundant, it becomes rational to buy lottery tickets in every asset class that is soaring in a Fed-fueled frenzy of “don’t fight the Fed” euphoria.
The federal reserve seeks to make recessions less painful. If they print enough money, and steal from anyone with stored wealth, they can buoy nominal prices of most asset classes and make the recession less economically painful for those who deserve to feel the most pain — stupid speculators.
With each round of economic intervention, the people who are bailed out learn that the consequences for their wild and irresponsible risk taking isn’t as bad as they thought. In fact, after a few cycles, it becomes widely known that any irresponsible risk taking will be bailed out by the federal reserve (anyone remember the “Greenspan Put?”) People respond to incentives, and if people realize they have huge potential rewards for wild risk taking and limited potential for downside risk, people take ever wilder and more irresponsible risks. That is the essence of moral hazard, and every policy of the federal reserve nurtures moral hazard into larger and larger financial catastrophes.
Most people don’t understand the economic cycle. After the deep double-dip recessions of 1979 and 1980, people really believed the federal reserve conquered inflation and made our economy immune to recessions. We all existed in a state of delusion and false security. Hyman Minsky noted that long periods of economic stability become characterized by increasing levels of Ponzi finance that introduces instability to the system and promotes the misallocation of resources. The purpose of a recession is to wipe out Ponzi schemes and correct these poor resource allocations. This restores the economy to health and promotes efficient use of resources in those areas where they provide the most benefit.
The federal reserve in its policies to lessen the impact of recessions prevents this natural cleansing from taking place. The Ponzi schemes of the bubble survive, people don’t learn their lessons about the dangers of Ponzi schemes, and the inefficient use of resources and outright theft of money continues.
Longtime correspondent Joe H. explains how such perverse incentives to malinvest millions of dollars in asset-bubble lottery tickets poisons not just the market’s ability to discover price but the entire economy:
Something that often gets overlooked in the abstract discussions of malinvestment are the potentially productive assets that get captured in the malinvestment.
There are 80 acres directly east of me that were subdivided into 12 lots. That happened about 6 year ago at the peak of the housing boom. Three of the lots sold. One additional lot was in process when the bottom fell out and never went to closing.
My neighbor to the south and west raises cattle. He has more head of cattle than he has land to feed them.
He approached the speculators and asked if he could fence and graze the unsold 60 acres of land until it sold.
They told him to pound sand. If he wanted the property he could spend the $10,000 an acre: the full asking price.
A full grown calf (1200 lbs) might go for $2000 at auction….but that is still not enough to support that kind of price. Further, there is no guarantee those prices will continue into the future. My neighbor said, “No thank-you.”
The owners of the property can afford to play hardball because it costs them so little to service the debt. There is little incentive for them to activate the frozen resources in productive ways. Consequently resources that could be growing beef (or potatoes or corn or green onions) are being withheld from production.
And beef averages $5.30 a pound.
How much labor is tied up in similar locked-up ventures?
How much concrete, and copper, and petroleum derived products are trapped?
Locked up and not producing, not being reallocated to a higher value process…. because it costs virtually nothing to hold on to last week’s lottery ticket in the hope that the holder will be able to redeem it in some future drawing.
Thank you, Joe, for explaining how malinvestment poisons productive investments and the entire economy. Issuing lottery tickets to the asset bubble du jour is the Fed’s core policy, and the unintended consequences of the Fed-fueled lottery-ticket economy will come home to roost with a vengeance in the years ahead.
Loan modifications succeed at removing supply from the MLS, but at a cost. Successful loan modifications require increasing borrower entitlements, which borrowers certainly like, but it creates moral hazard and entrenches a culture of entitlement that prudent Americans subsidize. In reality, lenders benefit most from loan modifications, but homeowners not so much. Loan modifications are one of the ways Washington enables Wall Street to ransack Main Street. Today’s loan modifications are tomorrow’s distressed property sales because borrowers redefault in large numbers, and the loan modification entitlement will be rescinded as prices near the peak.
Legislators, bureaucrats, the federal reserve, and members of the banking cartel of too-big-too-fail banks designed and implemented this plan in 2011. By early 2012, it began to work as the MLS inventory dried up. House prices rebounded sharply, and with the lack of competing inventory, homebuilders went back to work. It’s still working.
Anywhere and at any price point there is a shortage, homebuilders will provide supply to make a profit. If interest rates were not held near zero by the federal reserve, and if millions of homes were not held off the market by underwater borrowers, homebuilders would be supplying large numbers of affordable, entry level homes; however, that’s not what they are building today. In most markets, homebuilders are building for move-up and wealthy buyers because there is a shortage of these homes on the MLS, and because those are the only customers with the credit and down payment to close the deal.
Homebuilders are responding to current market conditions, and as a result, they are again building the wrong products in the wrong places at the wrong time. This malinvestment is the hidden price everyone pays for federal reserve policy.