Futile Attempts To Reflate The Housing Bubble and The Deadly Cost
When a financial bubble bursts - can it be reflated? And what are the risks for all of us the reflation attempt fails?
In this article we will briefly review the six factors that came together to create the real estate bubble in the United States. As we will cover, the government has deemed a return to a normal housing market - one which is governed by market forces - to be politically unacceptable. Instead, an artificial mortgage market has been created with massive interventions in three different categories as the government attempts to reflate the housing bubble. Quite a risky undertaking, but the politicians have decided they are willing to risk everything the taxpayers and savers have, in an attempt to remain in office. These interventions include the Federal Reserve effectively creating money out of thin air to fund almost the entire mortgage market at below market rates. We will explore why the three interventions will not succeed in replacing the six sources of the bubble, and the severe risks for all of us when attempting the economically impossible becomes politically mandatory. We will close with a discussion of the likely implications for the housing market and the value of the dollar, as well as a brief discussion of alternative solutions for protecting your net worth.
How To Create A Housing Price Bubble In Six Steps
A number of factors came together to create the housing price bubble that was experienced in the United States during the early to mid 2000s. Perhaps the central element was a quite deliberate Federal Reserve easy credit policy that led to the lowest mortgage rates that had been seen since the 1970s, which made purchasing houses the most affordable that they had been in a generation.
Qualifying for mortgage loans is not so much dependent on home prices, but rather the ability to afford mortgage payments. As an example, let's consider a family with the median household income for the United States in 2009 of about $50,000 per year (Census Bureau estimates). Pre-bubble underwriting standards were that mortgage payments should take no more than 28% of household income, which meant $1,167 a month would have been the maximum available for mortgage principal and interest payments. According to Freddie Mac statistics, the average 30 year fixed mortgage rate between 1972 and 2006 was 9.31%. If we take the median $50,000 per year income and an average 9.31% mortgage rate, that means that the exactly median household in the US qualified for a $141,000 mortgage, and assuming 20% equity, a $176,000 house.
During the rapid growth of the housing bubble, fixed mortgage rates spent much of their time in about the 5.50% to 6.00% range. When we change our mortgage rate to 5.75%, then a family with that same median income of $50,000 per year can now qualify for a $200,000 mortgage, an increase of about $60,000, or almost half again as much mortgage (and home price).
During the peak insanity of the housing bubble - an insanity in plain view that was enabled by the federal government as well as Wall Street and the rating agencies - subprime mortgages were being underwritten at one year teaser rates such as 3.5%. At such rates a family with an income of $50,000 a year could "afford" a $260,000 mortgage, or almost twice the mortgage of a decade before, which enabled a near doubling of real estate prices. At least until the interest rate contractually reset, at which time the family would have no known means of making the payments, but Wall Street and the rating agencies providing investment grade ratings were far beyond being concerned with such trivialities by this point.
However, the plunge in mortgage interest rates was not enough to create the full housing bubble. Even a $260,000 mortgage wasn't sufficient to buy a new home in many desirable markets where prices were surging; the income simply wasn't there to sell the average home to the average worker. Many people also lacked the large down payments, the equity component of home purchases. So the solution was to simply allow people to borrow their down payments in the form of 2nd and 3rd mortgages that closed simultaneously with the 1st mortgage.
An additional hurdle was that the historical standard of 28% or 30% of income was insufficient to make payments on the new, larger loans. Now, those standards were far from arbitrary - many decades of mortgage underwriting history had shown that most people could handle housing payment burdens of that size relative to their income, but things got "iffy" above those levels. However, in the early years of the new millennium, accepting those traditional limitations was unacceptable, as not enough people could buy homes at ever rising prices. So the standards were changed. People were now allowed to borrow a total of 35%, or 40% or even 45% of their annual income in total required mortgage payments (including 2nd and 3rd mortgages).
With this combination, we were really getting somewhere in terms of "affordability". Take a family with the median national income of $50,000 a year, let them borrow at a one year teaser rate of 3.50% (with everyone involved pretending that will be the rate for the entire term of the mortgage), let them use 45% of their income to cover the package of mortgages that ensures no actual savings are needed to help fund the house - and they could now "afford" a $418,000 mortgage and a $418,000 home ($50,000 income, 3.5% teaser rate, 45% of income to 1st & 2nd mortgages).
This was still not enough, however, for people with a bad history of repaying small loans were being kept out of the market for large loans. So they were allowed in with the explosive growth of subprime lending, and were allowed to borrow their down payments, even while the percentage of income available for housing shot upwards. Changes in underwriting standards may sound a bit obscure, but the practical result was that a family that couldn't have bought a home of any kind in 1996, due to their lack of savings and poor credit history, could now buy $400,000 and $500,000 homes.
So let's review. Going from a historical average 9.31% 30 year fixed rate mortgage to underwriting based on fixed mortgage rates of 5.75% boosts the amount that can be borrowed - and the home that can be purchased - by 42% (Step 1). Underwriting at a teaser rate of 3.5% on a one year adjustable rate mortgage boosts the amount that can be borrowed even more, up to a total of 84% (Step 2). Going from 28% of income being allowable for housing payments to 45% of income (combined 1st & 2nd mortgage), separately boosts the amount that can be borrowed by 61% (Step 3). Combining the lower rate and more aggressive underwriting standard boosts the maximum amount of the mortgage by 196% (1.84 X 1.61 = 2.96), as the amount that can be borrowed by a family with a $50,000 annual income rises from $141,000 to $418,000. Add in an expansion of the homebuyer pool to include those who don't have enough excess income to save down payments (Step 4), thereby increasing the competition for each home. Add in an expansion of the homeowner pool to those who have poor histories of repaying loans (Step 5), further increasing the competition for each home. This 1-2-3-4-5 combination needs only one more ingredient to predictably set off an explosive rise in housing prices.
Home prices rose as payments fell and more buyers entered the market; human nature came into play and a speculative frenzy was born (Step 6). People looked at the sharp home price increases that were happening, month after month. They saw the new easily available credit that was flooding the market, with banks competing to offer massive loans allowing the purchasers to buy houses with essentially no money down, even if the borrower didn't have the means to pay for it. Millions of people quickly saw that buying and flipping homes would make them far more money than just about any job for which they could qualify. So a speculative frenzy kicked in that drove prices higher and higher as it drew more and more people in.
This of course led to an unsustainable environment. Because of the speculative frenzy, because of the easy underwriting, home prices reached levels in many metropolitan areas where the average family couldn't afford the average home even at very low mortgage rates. On the underwriting side, loans were being made to individuals with poor credit histories at teaser rates, where those individuals had no known means to make their mortgage payments when the interest rate inevitably reset as part of the contract. The time had come when the popping of the bubble was inevitable.
Where The Markets Want To Go
In the aftermath of this bubble it is quite clear what the housing market wants to do. Like any market that is recovering from a frenzy, what it seeks is sustainable equilibrium. Those are the fundamental economic forces in play here.
What the housing market wants to do is reach a place where the average creditworthy and stable middle-class family can afford an average home, spending no more than about 30% or so of their income on housing. For this to happen, prices truly must be much lower than they were at the peak in places like Southern California, Las Vegas, Arizona and Florida. Those were simply unreal prices. If the average home is completely unaffordable to the average buyer, but there are sellers who must sell, then the basics of economics tell us that prices must drop until sellers can find buyers - as with any other market.
Obviously, the specifics vary by the market, and this doesn't mean that three bedroom homes on big lots in good neighborhoods suddenly drop below $200,000 in Southern California. But it does mean that townhomes with postage stamp lots and a long commute have to return to a place where mortgage payments are realistically affordable for a college graduate earning the prevailing wage in that area.
In terms of mortgage rates, where the market wants to go is to a place where private lenders are bidding against each other with gusto to make mortgage loans, because the risk return combination is healthy and attractive to them. They are being substantially rewarded for taking the risk of funding housing.
Now what this translates to is materially higher mortgage rates, almost by definition. The reason the Federal Reserve has taken the unprecedented step of maintaining massive monetization to fund the mortgage market is that the alternative of mortgage lending by private participants would have been at unacceptably high interest rates. If true market rates return, this likely means that payments rise for the given price of a house, which then drives down the prices still further until home prices reach a point where - at market interest rates - the average family can afford the average home.
Unfortunately this return to normalcy is very difficult for many millions of truly innocent homeowners. By truly innocent I'm not referring to the people who in many cases were quite knowingly speculating in the housing market, or to those who never should have been able to buy a home in the first place. No, the truly innocent are the responsible, middle class families who could afford a home before this bubble occurred, and would have a healthy equity in their homes right now in ordinary circumstances. However, during the heart of the housing bubble they needed homes, and had no choice but to pay much more than what those homes should have been worth.
Which has left them with significant economic damage at this point, as they are effectively underwater in their mortgages by quite substantial sums. These families are essentially locked into their homes for the indefinite future, unable to leave, unless they either take a major loss on their home and come up with cash to pay for that, or destroy their credit rating. These millions of families are the true victims of the reckless actions of Wall Street and the Federal Reserve in creating the bubble.
When Reality Is Politically Unacceptable
There is the economic reality which we were just reviewing, and simultaneously there is something entirely different: political reality. Looking at the situation, the politicians in the United States collectively determined that they could not accept economic reality. There was too much bad news there, which would lead to too much voter discontent, which would translate to too many incumbents losing elections.
So the decision has been made to make an all-out effort to support the housing market, regardless of the cost and the risk.
Now, we're not really talking about cost and risk for the politicians. They are not, nor have they ever been, the ones who are truly bearing the risk. Rather, it is you and I bearing the risk and bearing the costs. The politicians have made the decision that there is no limit to the cost they're willing to pass on to all of us to get housing to a politically acceptable place, and there is no limit to the relative risk that they are willing for us to take. In other words, there is no limit to the financial risk for you that the government is willing to take to stay in power.
So a massive, historically unprecedented intervention by the government has been the result. An enormously expensive intervention by a government that already couldn't pay its bills. Even as the housing bubble was created by the convergence of five mortgage finance factors (not including human nature), the government's efforts to prop up housing prices fall into three broad categories.
Attempting To Reflate The Bubble - The Public Face
The public face of the government's efforts to support the housing market are the homebuyer tax credits, as featured in all the headlines. These are tax credits of up to $8,000 for first time homebuyers and $6,500 for previous homebuyers. Some estimates are that total tax credits will end up costing the government about $20 billion in foregone tax revenues.
This could be viewed as an explicit partial socialization of home purchases, where homebuyers who supposedly act in the national interest by purchasing homes are funded by the rest of the population. Another way of looking at it is every household in the United States pays an average of $180 each, so a lucky few households can get up to $8,000 each. In some ways, this could be viewed as a partial funding of the down payment for homes, allowing people to participate who otherwise would not, thereby supporting the market.
The homebuyer tax credits are a very explicit short term attempt at market manipulation. As soon as the tax credits stop, the housing market can be expected to seek whatever levels it would've gone to if the tax credits had never existed in the first place. Indeed, the market may even temporarily fall further than it otherwise would have, because anyone who could have reasonably purchased a home and benefited from the tax credit would already have done everything in their power to do so, thereby depressing the pool of homebuyers for the months or years after the program ends.
While they are the best known facet of the government's housing support program, and the only component where the cost is being openly included in the federal budget and voted upon in Congress, the homebuyer tax credits are arguably the least important of the big three housing support programs.
Attempting To Reflate The Bubble - Bigger Risks, Less Publicity
A more important form of governmental support for the housing market is both more obscure than the homebuyer tax credits and potentially much more costly to the nation as a whole. As previously discussed, it was the relaxation of loan underwriting standards that drove the expansion of the housing bubble as much or more than the reduction in interest rates. The popping of the housing bubble effectively destroyed the use of private mortgage underwriting standards. Private investors no longer want to take mortgage credit risks, at least not without payments of substantially higher fees and severe restrictions on who qualifies for loans. Which would be politically unacceptable.
Therefore, the overwhelming majority of mortgage financings these days have to meet the underwriting standards of FHA, Fannie Mae or Freddie Mac. These entities now effectively bear the credit risk - the chance the homeowner won't make payments and the losses that then need to be taken - for nearly the entire mortgage market. Since the failure of Fannie Mae and Freddie Mac and their takeover by the federal government, this means that the federal government directly controls virtually all aspects of the mortgage credit process, determining who gets mortgage loans, how large of a mortgage loan they get, and under what conditions. The federal government determines the standards for loan to home value, for payments to income, for what constitutes income for underwriting purposes, for credit scores, and far more. This is terribly dry and obscure stuff, and not at all suitable for headlines or passing coverage by TV news anchors, despite being more important than the far more public homebuyer tax credit programs in determining how many people can afford how much house in the real world.
Along with the federalization - that is, the straight up politicization - of mortgage underwriting comes the complete socialization of mortgage credit risk. The federal government sets the standards because it is willing to bear the cost of all the mistakes, for all the loans that go bad, for the entire housing market.
Except that, of course, the federal government doesn't really take any losses. It's you and I who take the losses and bear all the risk.
So a more accurate way of phrasing what is happening is that political appointees under instructions to keep the housing market propped up regardless of costs - and effectively operating almost out of view of the media and the public - are taking massive risks in the name of extending credit to as many homebuyers as possible. Expensive risks that could dwarf the homebuyer tax credits - but that don't have to be included in the budget. After all, the losses haven't occurred yet, and can therefore be quite easily made to disappear through the flexible use of optimistic assumptions.
There is no way for anyone outside of the government to quantify the full extent of the risk, and it is indeed unlikely that anyone inside the government is keeping track on a multiagency basis (with real world assumptions anyway). However, recent congressional testimony about the Federal Housing Administration can provide insight into a small part of the bigger picture. FHA is in big trouble, with reserves down to about 0.5% of mortgages insured, compared to the legally mandated 2.0% minimum. The agency is treating mortgage modifications by people who previously couldn't pay their mortgages, as if they were essentially of the highest credit quality, rather than subprime. Yet at the very same time, the FHA commissioner assured Congress that there wouldn't be any problems. A political appointee telling incumbent politicians exactly what they wanted to hear, which was that the housing market could be aggressively supported through government guarantees of questionable but politically desirable loans -without worrying about bothersome technical details.
The headlines about what has been happening with the complete politicization of lending standards for one of the largest loan markets in the world may indeed become quite common - after it is already too late.
Attempting To Reflate The Bubble - Risking Everything
The Federal Reserve had already created close to $1 trillion through straight-up monetary creation as covered in my article "Creating A Trillion Out Of Thin Air" for a short-term intervention in the commercial paper market and emergency bank lending. It was a daring risk, a tremendous risk on a scale that was unprecedented. On a scale that risked the value of the dollar itself, and therefore put in peril the value of all of our savings.
The Federal Reserve succeeded in their first gamble. The original plan, as covered in my article "Containing Inflation Via Unlimited Money Creation: The Fed's Strategy", was to quickly return that cash to the void from whence it came, before the value of the dollar was jeopardized. However, because of the problems in the housing market and political requirements, the Fed took a different approach. They doubled down and more as they took that fabricated money, and instead of getting rid of it, they just put it back out in a much riskier strategy than the original one. What the Federal Reserve did was create an entirely artificial market for mortgages, which means an entirely artificial market for housing. The Federal Reserve wanted mortgage rates lower than what a rational private lender would loan at.
So the Fed effectively bought the entire new mortgage security originations market, essentially funding every conforming new mortgage that was coming down the pipeline, and thereby funding the purchase of nearly every home that was being sold in the United States. With the source of that money being the trillion dollars that had been effectively created out of thin air. This put a floor beneath the fall of the housing market, but it didn't create a healthy market.
The Plausibility Of The Exit Strategy
The economists at the Federal Reserve know that this is an unsustainable and risky situation. They know that they can't indefinitely fund an artificial market in the most real of assets through creating money out of thin air, with no economic growth to support that money and no taxes to support that money. So they know that they have to leave. And they're saying that their plan is to start withdrawing from the housing market by around the end of March of 2010, and to steadily pull out. Indeed, the Federal Reserve is already expanding its list of eligible counterparties for transactions designed to drain the cash it created from the system, and the New York Fed has been conducting live trial runs in the marketplace. There are some complications here, however.
The Fed can do the fiscally responsible thing and get rid of the excess money and unwind its positions, but what would really happen if mortgage rates jump 1%? And what if this shuts down a housing market which is already in pretty bad shape, and is not responding all that well even to these artificially low mortgage rates?
Even worse, what happens if mortgage rates rise 2%, and not just the housing market shuts down, but the construction industry also stops in its tracks? What do the politicians do at that point?
The Midterm Elections
There are some crucial political equations that we need to be taking into account here. Being that the midterm elections are approaching, will the government really withdraw its support for the mortgage market and thereby the housing markets? Will the government be willing to endure steadily growing pain as the economy likely plunges down along with the housing market, with voters feeling ever more pain every month as the election approaches? Will incumbent politicians of either party voluntarily lose the upcoming elections for the economic good of the country?
Or will they instead choose an approach that stretches our fantasy mortgage and housing markets out just a little bit longer?
That's the problem with a strategy like this. There never is a convenient time to leave the strategy, because the markets always want to return to fundamental levels. And the decision has already been made that those fundamental levels are not politically acceptable. So any exit strategy may be doomed before it even starts.
Housing prices have temporarily stabilized, and have even recovered a bit in some areas, but some fundamentals are getting even worse. Between five and seven million homeowners are seriously behind on their mortgages, and may be foreclosed upon at any time. The reason they haven't been foreclosed upon is that the banks have been under intense political pressure not to foreclose on too many homes. This creates another form of artificial market, where there is an overhang of millions of people living in homes upon which they haven't been making payments. There are strong indications that the pace of foreclosures may pick up again in 2010, in which case a flood of repossessed homes on the market could quickly drive down prices.
This wave of foreclosures is however quite different from the previous wave, because it isn't about subprime borrowers. It's about responsible people with good credit records who didn't borrow too much - but have lost their jobs in the greatest depression/recession since the 1930s. Prime mortgages extended to unemployed borrowers are what most threaten the mortgage markets now.
Could Anyone Have Predicted This?
Using my background as a mortgage derivatives expert and author, in a series of public articles in early 2008, I connected the dots as I saw them, and drew what seemed to me to be the obvious conclusions: that the subprime crisis would get much worse, and would have the potential to melt down Wall Street in a week. Not from accounting losses, but rather from creditors pulling loans from the highly leveraged financial giants when they realized the extent of the losses. I further predicted that the government would not allow this to happen, and that instead there would be a massive bailout that would not only lead to huge deficits, but necessitate the Federal Reserve resorting to creating money out of thin air in an attempt to contain the damages. In other words - what has happened. While a number of people predicted catastrophe, to the best of my knowledge, this makes me the only person to accurately publicly predict not just that there would be a crisis, but how the crisis would unfold, the government bailout, the Federal Reserve's monetization, and where the response to that crisis would logically lead: to the place we are covering in this article in early 2010. In my opinion - this is a time where some more dot connecting is badly needed.
(The referenced articles from early 2008 are "The Subprime Crisis Is Just Starting", "Credit Derivatives Dangers In 2008 & Beyond", and "Why Inflation Will Trump Deflation".)
Connecting The Dots
All three components of the government's attempts to reflate the housing market are massive and need to be understood - but they aren't enough. What history shows us is that there is no credible reason to believe that an asset bubble can be successfully reflated in real terms (inflation-adjusted) by a government. The irreplaceable element required for an asset bubble is millions of people who are not just willing, but eager, to risk their own financial security to bid prices to irrational levels - even after just having been burned in the same market only a few years before. Bubbles can quickly follow each other when the market changes, as shown by the housing bubble so quickly following the tech stock bubble. (Particularly when the central bank deliberately intervenes to facilitate creation of the second bubble, in order to mitigate the economic damage from the first bubble.) However, the public has to be able to convince themselves that the second bubble really is different from the first bubble that just burned them, and this is near impossible to accomplish in the same market.
This is why the housing market has not yet "recovered", despite desperate and massive efforts by both the Federal Reserve and the US Government. Everybody just got burned in the last bubble, and it is very hard to get them to participate in another bubble with what is left of their savings, particularly in the midst of depression / recession. To reflate the bubble requires people risking everything they have to return prices to fundamentally irrational levels - and it's no small wonder they don't want to do that. As fundamental as this problem is however, it is also more or less irrelevant as a determinant of government policy, for the reasons previously reviewed.
The Federal Reserve may be talking the talk when it comes to the economic necessity of draining its artificial cash from the system and exiting the mortgage market - but will it really pull out just as foreclosures accelerate and new mortgage investors fail to return at below market rates? During an election year?
The complete control of credit underwriting standards for the housing market by political appointees, with the federal government unconditionally guaranteeing the results of those political decisions - is financial dynamite. Particularly when the explicit goals for the agencies involved are now political, in terms of supporting the housing market rather than minimizing losses. Off budget though they are now, the eventual financial outcomes of this unprecedented change is sadly only too predictable.
In more general terms - the question is one of the public good versus the re-election of incumbents (in both parties, this is very much a bipartisan issue, and has been so at each stage of creation and response). If the value of the dollar and of our investments that we have worked our lives to build are to be preserved - then this extraordinary creation of an entirely artificial mortgage market funded by an already bankrupt federal government must be abandoned. Even if the cost is the destruction of the careers of many career politicians.
How do you think that decision will work out?
And more importantly, what are you doing to protect what you have?
Bubbles & The Redistribution Of Wealth
We face a tragic situation for many millions of people who have done nothing wrong. Government policy and fundamental economics are combining to create a situation of simultaneous monetary inflation and asset deflation. The government can't reflate the housing bubble, but the political dynamics require the attempt to be made. Even at deadly risk to the value of the dollar, and to a lifetime of savings for many tens of millions of households. So the value of the dollar falls, the value of the assets fall, and eventually the fall in the value of the dollar exceeds the fall in the value of the assets, thus finally creating the façade of a reflating bubble in nominal dollar terms (but not inflation-adjusted). False profits, existing only because the value of the dollar is falling, are then generated across multiple asset categories, which lead to inflation taxes, and the hapless average citizen ends up simultaneously losing the purchasing power of their money and the purchasing power of their assets, while paying whopping tax bills in the process.
This dire situation may appear overwhelming, and even hopeless, if one is limited to conventional investment methods. For these methods generally do not provide solutions for even one of these three problems, let alone the catastrophic damage that can be wreaked by all three working in combination. However, the good news is that where there is crisis there is also opportunity, and this crisis is indeed rife with personal opportunities. When we see with clarity and utilize unconventional methods, then simultaneous asset deflation and monetary inflation can become an environment of investment opportunity. Indeed it can be a potentially "target-rich" environment, because so few investors see the world in those terms.
As one example, this environment creates major opportunities for precious metals investing. Unfortunately however, purchasing gold as a simple monetary inflation hedge at the highest prices in a generation with no protection from inflation taxes may lead to substantial losses for most investors in after-inflation and after-tax net worth, even if gold does rise to $10,000 an ounce or higher with an effective collapse of the dollar. When we buy gold or silver with an informed understanding of how precious metals perform during a time of severe economic crisis - with simultaneous asset deflation and monetary inflation - then we have the ability to potentially create wealth on a multigenerational scale. Because during crisis, gold performs best as an asset deflation play, rather than as a monetary inflation hedge, and if we don't see that, then we may miss the best precious metals investment strategy of our lifetimes.
Real estate is where things getcounterintuitive. Yes, even if substantial real estate price deflation persists in real terms over the coming years, we can still potentially reap rich rewards through real estate investing. Indeed, the Federal Reserve has created an unprecedented opportunity for wealth creation through its actions. However, these opportunities are not based upon the simplistic real estate investment methods of maximizing leverage that are so successful when bubbles are inflating, but can be deadly during a time of ongoing asset deflation. Rather, to make money as a bubble continues to deflate even while markets are systemically manipulated, we must play monetary inflation off of asset deflation, using a calculated and deliberate methodology, and in the process, create wealth in a risk-reduced and tax-advantaged manner.
Simply put, what we have reviewed in this article creates a situation of enormous potential volatility. The pressure may be released at almost any time, and in the process lead to a massive redistribution of wealth that devastates most people, pension funds and governments. Conversely individuals can take personal action to position themselves so that they benefit from this redistribution. The difference between individual peril and opportunity is one of vision - and education.
Would you like to find practical solutions to the issues raised in this article? Find out how to position yourself to benefit from what happens when political decisions place the value of the dollar at risk? Do you want to know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information on the course is available at DanielAmerman.com or InflationIntoWealth.com.