Reinflating the Housing Bubble

It may seem hard to imagine, but with housing prices still falling and the construction industry in a depression, the Federal Reserve is managing to reinflate the housing bubble that nearly destroyed the economy in the first place. This time, the structure of the bubble is different, but it is out there nonetheless. For the last three years, the Fed has been doing its best to keep interest rates low. Short term rates are near zero. Long term rates are also very low; ten year rates for treasury securities are around 2% and thirty year bonds are at about 3%. These rates are the result of persistent policies by the Fed to drive rates down and keep them there. Indeed, based upon the latest statements from the Fed, it seems likely that these low rates will stay with us through the rest of this year and into next year.

So let's look at what this means to the housing market. First of all, low rates for treasuries means low rates for mortgage loans. Thirty year fixed mortgages are available for under 4% and a fifteen year fixed mortgage at 3.25% is not hard to come by for a qualified borrower. Those folks who are able to refinance are busy doing just that. The key, however, is to look at just who it is that is issuing these new mortgages. Nearly 95% of new mortgages are now coming from either Fannie Mae or Freddie Mac and these entities are just operating with government money. Most banks are not trying to make new long term loans at rates below 4% unless they can immediately sell the loan to the government through Fannie and Freddie. Why would they? Inflation is running at about 2% which the Fed calls the target. It is hard not to see the areas where inflation is actually exceeding this target. A loan for 30 years at 3.75% could easily fall to less than the inflation rate if there is even a mild pickup in the inflation rate. No rational bank wants to hold that risk.

So what is happening is that the Fed's actions on interest rates are driving traditional mortgage lenders out of the market. Indeed, as creditworthy homeowners refinance, the traditional lenders are losing more and more of their borrowers with good credit, leaving them only with those who do not have the credit to refinance either due to their personal finance or the decline in the value of their homes. When interest rates rise again, and they will, Fannie and Freddie will be left with billions or trillions of dollars in loans paying between 3 and 4 percent when the cost of funds rises to 5 or 6 percent. In other words, it is inevitable that Fannie and Freddie will have enormous losses at that point; the only one to bail out those losses will be the American taxpayer.

The truth is that it would be very painful for the housing economy if rates were to rise. The only way for the market to reignite then would be for the house prices to fall further until they became attractive to those with the wherewithal to buy. The problem is, however, that while the Fed fights to prevent that pain from happening, it instead is setting up the economy for a much harsher bout of pain a few years from now when the rates and housing prices do start to recover. Indeed, the Fed's current program is likely to prevent a real recovery in housing for the foreseable future; and nascent recovery will get squelched by the very programs that the Fed is currently using to "help".

Maybe some day those at the Fed will realize that they are not smarter than the market. I hope so.