Tuesday, February 19, 2008

NAR's Economist's Commentary!

Refueling the Housing Bubble?
By NAR Chief Economist Lawrence Yun

The Federal Reserve has been aggressively cutting rates recently and the question is being raised about parallels to the past. Back in 2001, in the aftermath of the internet stock bubble collapse and the September 11 terrorist attacks, Alan Greenspan — then the Fed chairman — made deep cuts in interest rates in order to stave off a possible economic recession. Many also blame Mr. Greenspan for having fueled the housing market bubble and subsequent collapse by keeping the rates too low for too long.

Now in early 2008, with the economy possibly heading into a recession — as evidenced by the GDP growth rate slowing from 4.1% in third quarter to 0.6% in the fourth quarter — the current Fed Chair, Ben Bernanke, has been following a very similar step of sharply cutting fed funds rates in order to revive economic growth — partly by making home buying financially enticing. Though there is never a direct correction between the Fed funds rate and mortgage rates, which are outside of the Fed's control and determined by the global bond market, the current 30-year mortgage rates have come down to essentially 45-year low levels. Aside from a few months in 2003, mortgage rates have never been this low since the early 1960s. A drop in the average mortgage rate from nearly 7% in mid-2005 to the current 5.7% would reduce monthly mortgage payments from $1330 to $1160 on a $200,000 mortgage. The average savings would be $340 per month or $4,000 per year on a $400,000 mortgage.

Therefore, could the Fed be simply refueling the bubble by dangling financial incentives to buy a home? Well, let's replay the key factors related to the recent bubble-collapse and see whether the same behavioral patterns will reemerge. Keep in mind that there are significant local market variations, but the markets that had the huge swings followed the below pattern:

The Fed started cutting rates from 2001 — with the Fed funds rate eventually reaching 1% by mid-2003.

The mortgage rate fell to 5.5% by the summer of 2003 from 8% in 2000. ARMS rates fell from 7% to 3.5% over the same period.

Housing demand rose with existing and new home sales hitting successive high marks in 2003, 2004, and 2005. Inventory fell as a result.

Home prices accelerated. For example, in the D.C. region home prices more than doubled from $204,000 to $426,000 from 2001 to 2005. Homeowners' net worth leapt by over $200,000 as a result — a figure many would considered good lifetime savings.

Given the general weakness in the stock market and relative "easy" wealth gains for real estate owners — there was an increasing view of homeownership and real estate as a financial play rather than in terms of family and housing needs considerations.

Housing demand ran exceptionally high, but the demand could only be realized if people could get the financing.

Global capital providers were chasing after high yields and were eager to provide the financing because…

Ratings agencies gave their blessing on subprime products, giving the impression that these were 'safe' alternatives.

Moody's, Standard & Poor's, and other ratings agency raked in revenue by giving out top Triple-A ratings (an inherent conflict of interest exists when ratings agencies get their revenue from mortgage underwriters/securitizers… rather like a professor who gives out a lot of "A" grades will draw more tuition paying students to his class).

With funding plentiful, subprime and no documentation loans proliferated — if you had a heartbeat, you could get a loan.

Housing demand was further pushed higher as herds of house-flippers entered the market, and home prices accelerated in those markets. Prices grew by leaps and bounds in markets of around 70% in short two years — places like Las Vegas, Miami, and Phoenix, and Sacramento.

Inventories were pushed down to exceptionally low levels and homebuilders could not keep up with demand.

From late 2004, the Fed began to tighten and mortgage rates climb in 2005.

Housing demand naturally fell off.

Inventory quickly built — from a combination of lower demand, builders continuing to build at a high pace, and some speculators/flippers realizing that the period of easy price gains was coming to an end.

Rising inventory held back price gains.

Price stagnation no longer permitted mortgage refinancing. Flippers/speculators started carrying burdensome mortgage costs — some begin to simply walk away — pushing inventory higher.

Non-flippers — primary homeowners, who took out subprime loans, also faced the same price stagnation, but also the resetting higher interest rates. Refinancing is not possible and some have been forced to foreclose

More and more flippers/speculators and homeowners are unable to carry the high resetting interest rates and simply walk away. Lenders begin to write-down loan losses.

After the fact and very late, the ratings agencies stated that subprime loans are no longer Triple-A quality.

Global capital providers stopped funding subprime loans and the subprime market came to a halt.

Global capital providers, having been burned, also stop funding any U.S. mortgages other than those with Fannie and Freddie backing. The jumbo loan market, therefore, struggles.

From mid-2007, a lack of market liquidity and economic slowdown forces the Fed to cut rates.

Conforming mortgage rates again fall to historic lows, but not jumbo loan rates.

The Fed has been and is further ready to make deeper cuts.
Going back to our earlier question: is the current action by the Fed simply trying to replay the same volatile game? The answer is an unambiguous NO. The same game is played out because the global capital providers will not be taken for fools again. After being burned, German mutual funds or the Chinese government or the Florida's teacher pension fund will no longer buy toxic subprime loans. Without the loans, homebuyers simply cannot enter the marketplace independent of their desires. We are back to the careful underwriting standards of verifying people's income, requiring escrow accounts, and back to thoroughly checking borrower's ability to repay the loan.

However, the current low interest rate policies of the Fed are a big help to housing because low rates can begin to furnish genuine potential homebuyers with the financial capacity to think seriously about becoming a homeowner. Furthermore, the rate cut is lessening the degree of forthcoming ARM resets, thereby lessening the burden the current subprime loan borrower faces. So the current policy of Ben Bernanke will help stabilize the housing market.

The Federal Reserve, however, should be mindful to not lower the fed funds rate too greatly. Inflation is expected to head lower in 2008 but too much money can fuel inflationary pressures. If that happens, 30-year mortgage rates will RISE, and therefore, choke off any housing recovery. A careful balance must be taken regarding how low to bring down the fed funds rate.

Though some in the blogosphere have figured Alan Greenspan as one of the key persons to blame for the current housing mess, I do not blame Mr. Greenspan. I believe there is plenty of blame to go around due to other factors. Global capital providers misunderstood and were simply not careful about purchasing securities composed on little income documentation and of risky-borrowers. Mortgage originators just originated loans to anyone including to suspicious borrowers because they had no skin in the game (see the recent academic article on this topic by a group of professors from the University of Chicago). There were also many books about how to endlessly profit from real estate. Consumers — particularly the flippers/speculators — also need to bear some of the blame.

But the biggest blame in my view goes to Moody's and Standard & Poor's — the rating agencies. If they had properly assessed the risk as is their job, then global capital would have never reached subprime homebuyers and flippers. The housing boom would have stopped dead in its tracks. We do not yet know how much of the ratings firms' assessment were clouded by their financial interest in giving out easy Triple-A grades. Many workers at Moody's and Standard & Poor's took home hefty bonus checks when revenue skyrocketed from providing high ratings.

It is also fine for people to point the finger at me. In a fast changing market conditions, I too have been off on my forecast. I knew that the boom was clearly unsustainable and I made the forecast in early 2007 that home prices were likely to experience a price decline on a national level for the first time since the Great Depression. The national median home price indeed fell by 1.4%. I believe I downgraded my forecast for ten or so straight months in 2007 as it was strongly pointed out to me. At the same time, the Blue Chip consensus forecast, comprised of about top 50 private forecasters, including forecasts by Merrill Lynch, Goldman Sachs, UCLA, and the like — had also downgraded the housing forecast by more than 20 straight months. Forecasting is never perfect. Forecasts are bound to be off but the forecaster's job is to make the best prognosis given the available information at the time. The readers should always view any forecast with caveat emptor.

But back to the original question: Will we experience a re-emergence of a housing boom from the current easy money policy by the Fed? The answer is no because as Abraham Lincoln said — fool me once, shame on you. Fool me twice, shame on me. It will be impossible to part global capital providers' money with another foolish investment.

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