This story from ABC news relates that the fed needs to do research into preventing future speculative bubbles.
In the article, Donald Kohn, the central bank’s outgoing vice chairman is quoted as saying: “Many central bankers and economists, myself included, were a little complacent coming into the crisis.” You think? Two obvious, in hindsight at least, forces drove the real estate market to all-time highs.
First, At a time when housing values were skyrocketing (In May of 2005, the FDIC published this report showing that in 2004 alone, US average housing prices rose by 11%) mortgage rates were the lowest they’d been in 30 years. My question is: how could you NOT speculate in real estate? The reality is that most people did not. However, when you can borrow funds with an interest rate lower than the expected rate of appreciation in the financed asset, you can make money buying houses by simple arbitrage. For those among us with a thirst to make a quick buck, the temptation must have been overwhelming. Indeed it was, considering the pickle we’re in now.
Second, people were borrowing money simply to buy homes for profit and mortgage brokers were lending with no responsibility for if (when) those mortgages fail. Normally, brokers filter qualified loan applicants and match them with loan products appropriate for their goals. But, some brokers were motivated by loan fees to churn as many mortgages as possible, selling them off to investors immediately upon closing. There was no connection between mortgage risk and broker income, no consequences for making bad loans. Combined with flexible qualifications in more and more exotic loan products (many of which are clearly aimed at special borrowing circumstances and not general consumption) and the secondary market’s thirst for mortgage-backed securities, we had a very potent accelerant for the exploding mortgage industry.
This ability to easily speculate in housing had the same effect on that industry that speculation has in every other investment industry: it drove up prices. But, these price gains were never sustainable. In August 2004 and 2005 US Census press releases show that US median income did not change between 2002-2004 (incidently poverty increased from 12.1% to 12.7% in that time period). Housing price appreciation was increasing faster than the median income. If these trends were to continue in a linear manner, at some point people would no longer be able to afford homes. What happens to a market when no one is buying?
Also consider the number of buyers who purchased before they had originally planned to due to enticing home value expectations, low loan rates and unusually easy access to mortgages. This is the same acceleration of demand that we saw again recently driven by the Cash for Clunkers program. When an otherwise stable level of demand is accelerated, it is not an increase. It is borrowing future consumption and applying it to current supply. The effect in the housing market was an increase in asset prices at the expense of future stability.
The fed may be able to mitigate some of the spike in asset values, which could soften the landing when the bubble bursts. Consider that the near-term demand for home mortgages was elevated, but prices for mortgages did not show a corresponding increase. An increase in mortgage prices (interest rates) would have raised the cost of buying homes by increasing monthly payments. Without an increase in median incomes, home prices would have been reined in. Unfortunately, that only works with standard mortgages. The market was full of teaser rate, interest only, payment optional, stated income and any number of other assorted mortgages. All of these loans allowed nearly anybody to afford nearly any home. Tighter regulation of how mortgages were underwritten would have stemmed the flow of exotic mortgages and limited the buying frenzy in real estate.
Ironically, the government is currently tightening mortgage standards. Now that the mortgage market is crippled with funds tied up in non-performing loans, their actions merely exacerbate the problems we have. The one tool that definitely would have helped push our ailing housing market toward better health is lower interest rates. Too bad they’re already at historic lows.