Apr152013

Can the Fed reflate the housing bubble without negative side effects?

Economists say there is no free lunch. Apparently, those economists don’t work at the federal reserve. Interest rates are near record lows, and the federal reserve has been printing money to buy $40 billion a month in mortgage-backed securities to reduce mortgage rates further and provide direct stimulus to the housing market. The reason they’re doing this is simple, Banks are still exposed to $1 trillion in unsecured mortgage debt, and if the federal reserve doesn’t make house prices go up to restore collateral backing to underwater borrowers, the too-big-to-fail banks will fail. Whatever misgivings many critics may have of federal reserve policy, the policy makers at the federal reserve don’t feel they have  other options. They must make house prices go up — at any cost.

In the real world, there is no free lunch. The federal reserve’s zero interest rate policy does have real financial consequences. First, printing money ultimately leads to inflation, the erosion of buying power of the currency. Each dollar printed without a commensurate increase in productivity or value is essentially stolen from every other dollar in circulation. Anyone with savings or wealth in currency (cash, savings accounts, CDs, and so on), experiences a decline in the stored value of their labor.

Second, the federal reserve’s zero-interest-rate policy inflates the value of commodities across the board. For businesses that rely on these commodities for raw materials — including the food industry — higher commodity prices are not a plus. Further, inflating stock, bond, and house prices sends a false signal to producers.

The housing industry has ramped up production again because prices are rising, and with limited MLS inventory, they can easily sell product, but do we really need more houses? I attended an economic presentation some time ago where the presenter showed that California added no net new jobs in the 00s. Every new job created from 2000 to 2007 was wiped out in 2008 and 2009. That means every new home constructed in the 00s doesn’t have a wage earner who can pay for it. By the measure of job growth, we don’t even need the houses we currently have. If the banks were sitting on them and allowing squatters to live in them for nothing, we would have plenty of houses to meet current demand.

All these economic distortions and false market signals direct our scarce resources to places those resources shouldn’t go. It’s economically inefficient. We pay for that inefficiency with tepid economic growth, the opposite of what the federal reserve wants to achieve. It’s difficult to foresee all the potential problems that can arise from poor allocation of resources, but these side effects have a cost, and the federal reserve is imposing that cost on all of you, whether you like it or not.

Is the Fed Blowing a New Housing Bubble?

Edward Pinto — Updated April 9, 2013, 7:44 p.m. ET

Stagnant real incomes suggest that rising home prices reflect artificially low interest rates.

Over the past year, the Federal Reserve has ramped up its policy of quantitative easing, with the result being new stock market highs and surging bond prices. Moreover, housing prices jumped 8%, the biggest annual gain since 2006.

The result is that more than a trillion dollars have been added to the market value of single-family homes. Homeowners are now wealthier and according to what economists call the “wealth effect,” they should be willing to spend more, helping the economy.

In my opinion, The “wealth effect” is the most dangerous euphemism in economics. What happens in the real world is not an increase in spending of savings, but an increase in Ponzi borrowing based on inflated asset values. It’s the behavior that lead so many to foreclosure as I document daily. The wealth effect is help the economy doesn’t need.

(Don’t miss today’s property profile: Over $1,000,000 in mortgage equity withdrawal and four years squatting. It’s a really bad one.)

But there is another, less sanguine view of the housing recovery. Recent data released by the Federal Housing Finance Agency (FHFA) suggest that the increase in house prices is not being driven by a broad-based improvement in the economy’s fundamentals. Instead, the Fed’s lower rates are simply being capitalized into higher home prices.

I’ve made the same observation dozens of times on this blog. It’s refreshing to see the truth exposed in the mainstream media.

This does not bode well for the future.

A comparison of FHFA’s conventional home-financing data for February 2012 and February 2013 shows that borrowers bought newly built and existing homes in 2013 for 9% and 15% more respectively than in the previous year. Increases of this magnitude cannot be attributed to higher incomes, as these rose a mere 2% over the last year, just keeping up with inflation. It appears that home prices are being levitated by quantitative easing. Because interest rates were .625% and .90% lower on new and existing homes respectively this year compared with last year, the monthly finance cost to purchase a new home remained the same and went up only 3% for an existing home.

My monthly reports have been showing the same thing. Despite the rapidly rising prices locally, the cost of ownership is still near historic lows relative to rent.

While a housing recovery of sorts has developed, it is by no means a normal one. The government continues to go to extraordinary lengths to prop up sales by guaranteeing nearly 90% of new mortgage debt, financing half of all home purchase mortgages to buyers with zero equity at closing, driving mortgage interest rates to the lowest level in 100 years, and turning the Fed into the world’s largest buyer of new mortgage debt.

We have a completely engineered recovery based almost entirely on both federal reserve and government policy. The fundamentals are still poor; job growth is weak, unemployment is high, wage growth is slow, owner-occupant demand is flat, and millions of people are living in homes they either aren’t paying for or can’t afford when their loan modifications expire.

The problem with an engineered recovery based on policy initiatives is that these policies may change. In fact, we know they will change at some point. The government and federal reserve hope to wean the market off supports and subsidies when fundamentals improve. However, since it is a policy-controlled market, and the pressures on policy makers are myriad and complex, we have no way of knowing how long these stimulative policies will be in place or what the consequences will be when they change them.

(See: Will the deflating bond bubble cause housing to crash again?)

Thus, with real incomes essentially stagnant, this is a market recovery largely driven by low interest rates and plentiful government financing. This is eerily familiar to the previous government policy-induced boom that went bust in 2006, and from which the country is still struggling to recover. Creating over a trillion dollars in additional home value out of thin air does sound like a variant of dropping money out of helicopters.

It is dropping money out of helicopters except that the cash only falls on bankers and homeowners.

Will history repeat? When it comes to interest rates, whatever goes down must go up.

The average mortgage rate during the first nine years of the 2000s was 6.3% compared with today’s rate of less than 3.5%. If mortgage rates were to increase to a moderate 6% in three years, say, some combination of three things would have to happen to keep the same level of homeownership affordability.

Incomes would need to increase by a third,

With high unemployment and a weak economy, we know wages are not going to rise by 33%.

house prices would need to decline by a quarter,

This is the only flaw with his analysis. If interest rates rose to 6%, monthly payment affordability would decline 25% or more. That’s just the math. However, since most housing markets across the country are not reflated to historic levels of payment affordability, a rise in interest rates wouldn’t necessarily make house prices go down. However, it would certainly slow the rapid rate of appreciation and hinder efforts to reflate the bubble.

The real danger comes three years from now when the bubble is fully reflated with prices pushed back up to the limits of affordability. Then a rise in interest rates would pummel the market as Mr. Pinto suggests.

or lending standards would need to be loosened even further.

Isn’t that repeating the same mistake that caused the housing bubble in the first place?

The National Association of realtors and the rest of the government mortgage complex can be relied on to push for looser lending. The Consumer Financial Protection Bureau recently came out with new rules that would grease the skids for relaxed lending standards, compliments of Fannie Mae, Freddie Mac and the Federal Housing Administration.

Given the continued subpar economic recovery and our past experience with the disastrous impact of loose lending encouraged by federal policies, homeowners would best be cautious about spending their new found “wealth.” Americans have seen this movie before and know how it ends.

Reasonable and cautious Americans will be wary, but the Ponzis don’t care. They just want their free money to spend, and if the banks with government backing are willing to hand it out, the Ponzis will certainly take it. Reinforced by the reflation of the housing bubble, moral hazard is it’s lasting legacy.