Feb032016

The secret price for the government’s intervention in housing

Rising interest rates and a falling affordability ceiling will limit home price appreciation for a decade or more.

There is no free lunch — at least according to economists. However, if you work for the federal reserve, you truly believe you can have a free lunch. They lowered interest rates to reflate the old housing bubble, and they convinced people nobody has to pay for it. They created wealth out of thin air — that and printing about four trillion dollars.Yellen_fed_reflation

Unfortunately, there is a price to be paid. It will either be paid by holders of wealth through currency debasement and inflation, or it will be paid by future homeowners through lower levels of home price appreciation.

Think about it — if the federal reserve could create several trillion dollars worth of real wealth in just a few short years, why did it wait so long? Why doesn’t it create wealth like that all the time? Why not keep lowering rates? Why not take rates below zero? At some level, people must recognize the events of the last few years are too good to be true.

But how will the price be paid, and by who will pay it?

The real long-term impact of interest rate reversion to the mean

Since inflation is very low, it doesn’t currently look as if currency debasement will rob holders of wealth. That means the most likely path is a slow rise in interest rates that will lower the rate of home price appreciation to a slow crawl. This slow rise in mortgage rates is a necessary reversion to the mean.

Reversion to a mean is a concept from statistics that says values return to historic norms over time. Record low mortgage rates will not last forever. Each time values get detached from the mean, they revert back over time, and when they do, house prices generally fall in line at the new equilibrium level.

In the collapse of any asset bubble, values tend to overshoot to the downside as everyone who overpaid is flushed out in wave after wave of capitulatory selling. We didn’t get that this time due to a myriad of policies and market manipulations from lenders, regulators, and politicians.

If the federal reserve had not lowered interest rates, and if government regulators hadn’t suspended mark-to-market accounting, and if lenders had not embarked on a can-kicking loan modification policy to dry up MLS inventory, the housing market would have crashed far lower than it did. If the overshoot to the downside from rental parity were extrapolated to fundamental value, house prices in Orange County would have dipped well below $300,000.

Forestalling the disaster by artificially lowering interest rates means a longer and more painful period of reversion to the mean ahead. The chart below is one potential way it could play out. Of course, Mortgage interest rates may not go up and housing may prosper.

Interest rates must rise from about 4.5% to 7% to reach historic norms. If this happens over a 7 year period — which is a very gentle rise — rental parity will still fall from its current level even as rents and fundamental values rise. Since rental parity will serve as a more rigid ceiling on appreciation in the future, when prices rise beyond this barrier, it will serve as a major drag on appreciation.

House prices may rise above the affordability ceiling over the next few years for two reasons:

First, the percentage of all-cash buyers is near record highs. All-cash buyers are not constrained by financing, so the affordability ceiling does not apply to them.

Second, until prices get close enough to the peak for borrowers to get out from under their bad loans, lenders will continue to restrict inventory keeping prices artificially high.

After a few years, lenders will liquidate enough of their bad loans that they will effectively lose control of the supply. Once organic sellers take over, sales volumes should increase, and sales prices will have to adjust to levels financed buyers can afford.

Plus, all-cash investors will start looking for the exits in a few years, and when they do, they too will need to find a financed buyer. Many all-cash investors may choose to keep holding their properties to get a better price, but with the ongoing pressure of rising rates, some will lose patience and get out while they are still ahead.

The bottom line is that the falling affordability ceiling will be a drag on future appreciation. Unless the magic appreciation fairy finds a new mechanism to push prices higher, this cycle of bubble reflation will be shorter than previous real estate rallies.

Once interest rates revert to the mean, and once the market adjusts to this new equilibrium, we will finally reach a state of market normalcy similar to the 1993 to 1999 period. Perhaps by 2020 we may finally be past the excesses of the housing bubble.

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