|The Great Reflation|
This week economists, investors and politicians were treated to some of the "best" home price data since the frothy days of 2006 when home loans were given out like cotton candy and condo flipping was a national pastime. The Case-Shiller 20 City Composite Home price index was up a startling 10.9% for the 12 month period ending in March. Prices in all 20 cities were up, with some (Las Vegas, Phoenix, and San Francisco) notching gains of more than 20%. Meanwhile the National Association of Realtors announced that April pending home sales volume reached the highest level in nearly three years.
The strong housing data is taken as proof that the economy has turned around and that a recovery is under way. Cooler heads may simply see how government policies have channeled money into real estate in order to reflate a bubble that has been collapsing for the last five years. Although the money is entering the market through slightly different paths than it did in 2005 and 2006, its effects on housing, and the broader economy, are the same as they were before the bubble burst. When the inevitable happens again, the ensuing damage will be eerily familiar.
After five years of dismal real estate performance and a lackluster economy, it’s hard to fault people for believing that rising home prices are a good barometer of economic health. There can be little doubt that rising home prices feel good. Even single digit appreciation can make modest home buyers feel like mini-moguls. The effect is magnified in a falling interest rate environment where any appreciation can be instantly turned into an opportunity for cash out refinancing. The “wealth effect” created by such activities then translates into consumer spending and other seemingly positive economic developments. But some things can taste great but be very harmful (cinnamon buns come to mind). It felt good when real estate prices were rising during the pre-financial crisis bubble, but that rise only exacerbated the problems when the bubble burst. The questions we should now be asking ourselves is why are prices rising, are those higher prices sustainable, and what are the costs to the broader economy?
The truth is that most buyers cannot afford today's prices without the combination of government guarantees and artificially low mortgage rates. The Federal Reserve has been conducting an unprecedented experiment in economic manipulation. By holding interest rates near zero and by actively buying more than $40 billion monthly of mortgage-backed securities and $45 billion of Treasury bonds, the Fed has engineered the lowest mortgage rates in generations. At the same time, Federal control of the mortgage industry has become nearly complete, with government agencies Fannie Mae, Freddie Mac, and the FHA buying or guaranteeing virtually all new mortgages. In addition, a variety of Federal programs, such as the Home Affordable Modification Program (HAMP) are in place to help keep underwater homeowners in homes that they could not otherwise afford. Taken together, these programs create far more favorable terms for home buyers than those that existed before the crash.
The big difference between then and now however is that banks are much more reluctant to extend loans to people with bad credit. But that has not stopped money from flowing into real estate. Ultra low interest rates also mean that fixed income investments, that have long been the staple of hedge funds and private equity funds, no longer deliver decent returns. To find yields in such an environment, many of these professional investment funds have scooped up single family homes out of foreclosure and put them into the rental market in order to generate a decent return on equity. These buyers come to the table with war chests full of cash which puts them in a position to avoid all of the credit obstacles that continue to plague individual buyers.
This trend has allowed a recovery in home sales even while the national home ownership rate has dropped to 65%, the lowest rate since 1995 (down from almost 70% during the last decade). Now that most of the available foreclosures have been picked through (with the rest log jammed with litigation and red tape), many of the new classes of investment buyers are striking deals directly with the large home builders to buy homes before they are even built. It is no coincidence that the southern tier markets with the fastest appreciation, and the fastest declines in inventories, have been those with the greatest participation of institutional investors.
But their activities have a latent downside. The new ownership class is not motivated to buy and hold the way Mom and Dad would. They are not looking for a place to live, raise families, and retire. They are simply looking for a decent return on equity relative to other investments. Many would happily put money in higher yielding bonds where landlord headaches don’t exist. If better deals beckon, or if risks increase in the real estate market, the homes they bought will be dumped even faster.
In the meantime, bidding wars involving hedge funds are forcing real buyers to pay more, oftentimes pricing them out of the market completely. Then as these properties hit the rental market, an absence of qualified tenants will depress rents. Lower rents will in turn put downward pressure on property values. Many rental houses will also sit vacant. Though hedge funds are cash buyers, most borrow large percentages of that cash to lever up their returns. However, when interest rates rise and rents fall, hedge funds will be forced to sell. But where will the buyers come from? The current crop of renters cannot afford to buy even with mortgage rates at historic lows. When rates rise, prices will have to plunge before real buyers could even qualify for mortgages.
The current combination of low rates and investor demand has succeeded in pushing up prices. But that doesn’t mean the market is healthy. For the first quarter of 2013, the Federal Reserve reports a 10% delinquency rate for residential mortgages (those with payments that are at least 90 days past due). This is more than 6 times the rate in the first quarter of 2006. In contrast, credit card delinquencies currently stand at 2.65%, the lowest rate in decades and 31% lower than the rate in the first quarter of 2006. Whether it is by choice, or simply by the ability to pay, Americans are clearly placing a low priority on paying their mortgages.
But rising home prices are currently creating residual benefits even for those who have no intention of selling. In the second quarter of this year, rates on 30 year mortgages hit the lowest level on record. Although the data has not yet been published, it would be logical to assume that homeowners have taken the opportunity to refinance, lower their payments, and in some cases, pull money out. But even if they haven’t, there is evidence to suggest that an owner’s belief that his home has appreciated is enough to encourage greater spending.
The “wealth effect’ from rising home prices combined with the similar influence of rising stock prices creates an aura of recovery. In fact, this week's revisions to first quarter GDP revealed that consumer confidence and spending are up despite real discretionary per capita incomes plunging at a 9.03% annualized rate. That is worse than the largest plunge during the 2008-2009 crisis (7.52%). Additionally, the household savings rate fell to an abysmal 2.3%, the lowest since the 3rd quarter 2007. Debt-financed consumption supported by inflated asset prices is what led to the financial crisis of 2008. It's amazing how willing we are to travel down that road again.
Of course rising asset prices are completely dependent on continued Fed support. As we have seen time and again, whenever the Fed even hints at tapering its massive QE programs the stock market sells off. The housing market is even more dependent on that support. Given the risks, it is arguable that no private market for home loans would even exist without government intervention. The bubble that popped in 2008 consisted mainly of government-guaranteed mortgages. This time, the mortgages are not merely government-guaranteed, but government owned.
In the meantime, by blowing more air into a deflating housing bubble, the Fed is misdirecting money into a sector that investment capital should be avoiding. A successful economy can’t be built on housing. Rather, a robust real estate market must result from a healthy economy. You can’t put the cart before the horse. As a nation, we do not need more houses. We built enough over the last decade to keep us well sheltered for years. Private equity funds should be using their investment capital to fund the next technology innovator, not wasting it on townhouses in Orlando and Phoenix.
Of course the real risks in housing center on the next leg down, in what I believe will be a continuation of the real estate crash. We can’t afford to artificially support the market indefinitely. When significantly higher interest rates eventually arrive, the fragile market will again be impacted. We saw that movie about five years ago. Do we really want to see it again?
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