The Great Reflation By Peter Schiff |
June 1, 2013
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
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
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
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?