Oct022012

Will reflating the housing bubble deny home ownership to the middle class?

Super low interest rates have allowed today’s homebuyers to bid home prices up near peak levels in many areas. This helps lenders recover more capital from the bad loans they made during the housing bubble, which is why the federal reserve is intent on driving mortgage interest rates even lower. As a result of all this artificial stimulus, price-to-income ratios have remained elevated far above historic norms. Unless interest rates are going to remain this low forever, one of three things must happen: either house prices must go down further, debt-to-income ratios must increase, or wages must go up. Higher debt-to-income ratios proved disastrous because borrowers cannot sustain the payments, so that outcome isn’t likely. Since the federal reserve will not let house prices fall further to ensure the solvency of it’s member banks, that means interest rates will remain low until wages catch up. With very high unemployment and millions of discouraged workers, the federal reserve is committed to is low interest rate program for many years to come.

The low interest rate policy is not without side effects. Federal Reserve’s policy to save housing is forcing seniors into foreclosure. And with prices being elevated much higher relative to incomes than historic norms, some are starting to wonder if the middle class will be forced to abandon home ownership as part of the American Dream.

How Is Federal Housing Policy Populist When Prices Are Rising?

By Robert Bridges — 9/27/2012

It would seem that a government seeking to display a true populist streak by helping its citizens buy houses would do so in a way to ensure prices as low as possible. For those who are not yet homeowners, how is it populism when recovery makes houses more expensive rather than more affordable?

In the eyes of a banker, lower interest rates makes a house more affordable. My reports bear this out as well. As interest rates go down, rental parity goes up. On a payment affordability basis, houses are as affordable as they’ve ever been despite the high prices. Affordability is relative to the cost of money, either the opportunity cost of savings or the borrowing cost of debt, and federal reserve policy has lowered both.

For some time now, demand for houses has been artificially boosted by federal and state tax policies, rising governmental involvement in residential-debt financing, and persistently low interest rates orchestrated by the Federal Reserve.

Yes, it has. We have tried every financial stimulant possible to stop prices from falling further.

This intensified demand has not been relieved by sufficient new supply of houses, resulting in intractable upward pricing pressure that has put home-ownership beyond the reach of growing numbers of moderate-income buyers.

Actually, that’s not true. The super low interest rates have made houses affordable to more people than ever before. The limitation is not income, it’s credit qualification. And contrary to what realtors believe, lowering credit standards is not the answer. Credit qualification must be based on the borrower’s ability and willingness to repay loans. Unfortunately, we trained an entire generation of Ponzis who are not responsible enough to sustain home ownership, so credit qualification must remain a barrier until the borrower pool learns prudence and responsibility all over again.

Future housing markets are likely to be increasingly vulnerable to destructive price swings if credit-fueled demand and no-growth sentiment continue to flourish.

We are seeing this now with the jump in prices this spring and summer.

The middle class and those aspiring to be part of it are discovering that owning a home has not been a great financial planning option when compared to other long-term investments. Ownership ties up credit and investment capital, saps income and constrains geographic mobility. Even the traditional 80%, 30-year, fixed-rate mortgage now has its skeptics. Little principal is repaid in the early years of such loans, and the housing bust has made it painfully apparent that prices can move more than 20% to the downside.

It will be painful to watch how quickly people will forget the grim realities exposed by the collapse of the housing bubble. The harsh truths of the housing bubble will be glossed over with realtor lies and eagerly lapped up by a public who would rather believe the fantasy of kool aid.

Despite a more sophisticated investing public and the recent housing debacle, a nascent market revival is taking hold with the old policies intact – all but assuring results at odds with the egalitarian rhetoric. Meanwhile, the federal government has virtually nationalized residential lending through the Federal Housing Administration, Fannie, Freddie and other programs, thereby substituting political control for market forces.

It will be interesting to see if the government does relinquish control of housing finance or if nationalized housing finance is here to stay. I think nationalized housing finance is an aberration that exposes taxpayers to needless risk. Banks see it as a way to generate fees and make riskless transactions.

The push to put people in homes and save the casualties of housing downturns has caused a gradual long-term divergence between housing prices and incomes, paradoxically putting us on an inexorable path to redefine the middle class as property-less.

For as much as I would like to embrace his rhetoric, it simply isn’t so. Low interest rates are making properties available. The people who will end up property-less are the squatters who get forced out while prices recover. They will endure their period of recovery while prices make their steepest ascent.

For young, immigrant, wage-earning families with average incomes of $49,445 in 2010, the simple truth is that a home remains unaffordable despite a 22% drop in its median price between 2006 and 2010. Consider:

In 1990, the median price of a home was about 3.25 times median annual income. At the peak of the housing bubble in 2005, the multiple climbed to 4.73, but even in 2010, ostensibly a point of historic affordability, it was still 3.5. To return to the 1990 multiple, the median price of a home would have had to drop another 7.2% below 2010 levels.

If prices are only 7.2% elevated from the 1990s price-to-income multiple, then real estate is significantly undervalued considering interest rates in the 1990s were around 8% and they are less than 3.5% today.

Prior to the housing collapse, fluctuation in house prices was the familiar story of supply and demand. New building activity constrained speculation by putting a lid on outsized run-ups in prices. Substantial down-payment requirements – the FHA still backstops loans with as little as 3.5% down – made homeowners less prone to panic selling. Houses were not ideal rental candidates because there was no shortage of apartment units and other for-rent housing options. In such circumstances, downturns occurred when too much supply hit the market at the wrong time.

The trigger for the recent crash was very different: The reversal in fortunes came when demand, fueled by easy money and rampant speculation, collapsed.

If history is any indication and political realities being what they are, once government programs are put in place to help one group of troubled borrowers or another, they will never disappear, thereby locking in the government as a perpetual source of demand stimulus.

A sad but true state of affairs. The government may never get back out of residential property lending.

As markets recover, it’s likely that additional efforts will be made to expand credit availability and reduce the cost of financing. The Federal Reserve may be complicit in all this, as its mandate to boost employment sweeps the entire nation’s housing markets into a basket with all other assets sensitive to interest rates, whatever the needs of local markets.

It’s natural for credit standards to loosen up when the economy expands. That’s part of the natural credit cycle. Unfortunately, lenders never know where to stop. Rising prices bails out lenders who make bad loans, so over time those loans proliferate and actually contribute to the price rally. The system goes on until the defaults get so rampant that lenders stop lending, and the whole system collapses with a massive credit crunch (see subprime lending for details). Part of what fueled the housing bubble was the complete abdication of lending standards. We can only hope that mistake is not repeated.

Another danger for future housing cycles is that the sources of ever-increasing demand — intensified by policy and population pressures – seem irreversible. Raw land in desirable residential locations has largely run out. Extreme no-growth zoning and building policies have made all but small-scale development impossible, particularly on the coasts. Changes in zoning and building codes continue to transfer many infrastructure and social costs from the public to developers. New construction, forced to the periphery by restrictions and the high costs of urban development, will promote sprawl and dependence on expensive transportation options. And if the supply of apartments continues to be constrained, rents and the prices of homes converted to rentals will continue to support higher housing prices.

The result will be future speculative feedback loops with prices simply running up until the bottom falls out again, leaving in its aftermath the familiar story of the aggrieved looking to the government – complicit in the tragedy – to be rescued, protected and ostensibly made whole.

That is exactly what will happen. I see nothing to prevent it. That’s what saddens me most about this situation.

To make room for a future middle class, policymakers need to abandon the idea that the fortunes of the economy turn on rising home prices rather than the reverse. It’s in everyone’s interest that home values gradually increase. But when housing prices rise faster than middle-class incomes, that’s nobody’s populism and may indeed bring about the end to the cornerstone of middle- class life — the owner-occupied home.

It’s true that we want house prices to rise with wages. Gently rising house prices is sustainable, and real estate equity can be a source of retirement savings. However, what we get is unlimited HELOC access which exacerbates the desirability of real estate which causes wild swings in pricing. Some participants win, and some lose. The winners include the irresponsible Ponzis who game the system and those who through good luck manage to time the housing cycle. The responsible and the unlucky get screwed. What an awful system. Welcome to the American middle class.