Tuesday, February 2, 2010

Is The Government Facilitating The Next Housing Bubble?

Moses Kim from Expected Returns discusses the government intervention in the housing market which could be facilitating a new housing bubble. The artificially low interest rates and tax credits may be artificially inflating homes above what they would be in a purely-free market. See the following post from Expected Returns.

The ongoing economic crisis has brought about massive government intervention in the free markets- intervention which, if history is any guide, will cause more harm than good.

There is a prevailing view that the housing bubble has popped for good, and that clearer skies lie ahead. The thought that housing can once again reach bubble valuations after such a steep decline seems laughable. However, bubbles are formed on the foundation of low interest rates and excessive credit, which promotes an unrealistic illusion of prosperity. These are the conditions the government is currently actively supporting.

Government support of the housing market, if left uncontained, will eventually lead to bubble-like conditions. From Marketwatch, Mortgage Bubble Warning:
The government's $700 billion bank bailout bill has met its goal of helping bring the financial markets back from the brink, but has so far failed to increase lending from the banks who received the taxpayer assistance, a key government overseer reported Sunday in a generally critical review of the program.

The report, which was authored by TARP's Special Inspector General, Neil Barofsky, also warned that the Obama administration's and the Federal Reserve's policies to support the mortgage market could in fact be creating another dangerous housing bubble.

"Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car," said the report.
Bubbles aren't necessarily characterized by prices way above historical norms, but merely valuations that are significantly above what they would be in a purely free-market system. Without the direct purchase of MBS debt, which effectively lowers interest rates, many more homeowners would be out of a home. As is, the government is simply delaying the inevitable readjustment in home prices that will come as a result of the lack of employment.
The report charges that high prices for homes between 2004 and 2007 were the result of unrealistic expectations for house values, low interest rates, in-accurate high ratings for mortgage securities, lax standards by lenders for mortgages.

It argues that that the Federal Reserve could be creating another housing bubble with its response to the crisis by keeping short-term and long-term interest rates low, setting up programs to support the mortgage market that also keep rates low, as well as a first-time homebuyer tax credit and a program near completion to purchase $1.25 trillion in mortgage-backed securities.

"Because increasing access to credit increases the pool of potential home buyers, increasing access to credit boosts home prices," the report wrote. "The Federal Reserve can thus boost home prices by either lowering general interest rates or purchasing mortgages and mortgage-backed securities."

"Both actions, which the Federal Reserve is pursuing, have the effect of lowering interest rates, which increases demand by permitting borrowers to afford a higher home price on a given income. Similarly, the administration is boosting home prices by encouraging bank lending and by instituting purchase incentives such as the First-Time Homebuyer Tax Credit. All of these actions increase the demand for homes, which increases home prices," said the report.
I would argue that many of the same conditions that led to the housing bubble are currently present, albeit on a smaller scale. It is quite amazing that we are not seeing a more powerful snap back rally in home prices given interest rates at 0%, sub-5% mortgage rates, and tax incentives.

The Inevitable Hangover
However, critics argue that long-term interest rates could increase in response to the Fed's decision to wrap up its $1.25 trillion mortgage-backed securities purchase program by March 31, along with other federal actions, could result in higher interest rates at a time where many regions continue to experience a depressed housing market and record foreclosures.
The coming double-dip in our economy will likely be led by a resumed decline in national home prices. Home prices still have a ways to fall, as price to rent ratios and price to income ratios have not adjusted to a point where one would be comfortable calling a bottom in housing.

I sense we are very close to a key inflection point in our economy. Sentiment will likely nosedive and hopes of a quick recovery will disappear. Keep an eye on housing, bond rates, gold and the dollar.

This post has been republished from Moses Kim's blog, Expected Returns.

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