Lower interest rates create added purchasing power. The lower the rate, the lower the monthly payment and the higher a home price people can afford. The math is fairly simple here. During the Wild West days of the mortgage market, teaser rates and other odd mortgages essentially provided the illusion of a low rate initially. That went away and the market contracted. What these loans also provided was easy access to low down payment options. Today that segment of the market is made up by FHA insured loans although these are expensive when you factor mortgage insurance premiums rising to make up for growing defaults. The Fed has essentially been a witness standing by when the first bubble hit and also, a pusher for the housing market as it is today by outright mortgage backed security purchases via the QE machinery. It is interesting to track the data over the last decade because you can see that the Fed is fully focused on the housing market. Is this low rate environment causing another housing bubble but of a different variety?

Fed Funds and 30-Year Mortgage Rates

There is a bit of story to the below chart. If we go back to the late 1990s and the early 2000s, the Fed pushed the Fed Funds rate to record low levels to combat the deflating and bursting technology bubble. But starting in 2005 the Fed realized real estate values were getting out of hand and the market was overheating (never publicly stating this of course). So they pushed rates back up but at that point the housing bubble momentum was already in full force. After the pop in 2007, it is interesting to see that the Fed pushed rates even lower than the previous cycle but also, went into other more aggressive measures by increasing their balance sheet to well over $3 trillion:

I think the chart tells two big stories here:

-1. The first 2000s housing bubble was largely led by the low rates and lax enforcement of crazy mortgages in the private market (i.e., subprime, option ARMs, Alt-A, etc). With all good bubbles, greed from every corner also added fuel to the flame. -2. The recent move in home prices is definitely coming from the low rate environment caused by the Fed and the impact it is having on the 30-year fixed rate market. What is also causing this mania is the record low inventory on the market. Moratoriums and banks moving like molasses on foreclosures has caused a modern day purgatory for the housing market (works for their bottom line).

I think the second point is fascinating. If you look at the chart, the 30-year fixed rate mortgage stayed relatively stable throughout the first housing bubble. Even with the Fed funds rate going from 1 percent in 2004 to over 5 percent in 2007 the 30-year fixed rate mortgage stayed around 6 percent. The reason for this is that other products were leading the charge when it came to purchasing homes and 6 percent with bubble prices simply did not work.

Today, the big push in home prices is coming from the drop in interest rates from 6 percent to close to around 3.5 percent. This large push makes a big difference. Take a look at a scenario for a $500,000 home:

This is an important point here. A drop from 6 percent to 3.5 percent lowered the principal and interest payment by 25 percent. This is a big deal considering housing is the biggest monthly expense for most Americans. What is fascinating above though is look at how much more home a person can buy when rates drop. At 6 percent, a $500,000 loan will carry the same principal and interest payment as a 3.5 percent mortgage with a balance of $667,500 (a price increase of 33 percent).

What is interesting is that home prices in the US are still down by 26 percent yet home buyers today with a 30-year fixed rate mortgage have been given essentially 30 percent more leverage on the principal and interest side. Yet the issue with this kind of aggressive low rate approach is the Fed has caused banks to look elsewhere for higher yields. It also conditions a market to low rates. As we know for the last few years, investors have had a ferocious appetite when it comes to investment properties.

In California, roughly 30 percent of all purchases for the last few years have come from all-cash and investor buyers. That is incredibly high when historically this figure is closer to 10 percent. Not only is that the case, but you also had FHA insured buyers making up another 20 to 25 percent of all purchases. So you have the investor class coming in with all-cash and those barely scraping by for a down payment making up over half the market.

Is this a bubble? There is an interesting definition of this at Investopedia:

“Bubbles form in economies, securities, stock markets and business sectors because of a change in the way players conduct business. This can be a real change, as occurred in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift, as happened during the dotcom boom in the late ’90s and early 2000s. During the boom people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurs. Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate. Thus, there is little long-term return on those assets.”

I think the bolded section is important to recognize here. What has occurred with this market is the Fed has shifted the financial sectors attention from lending to Americans or searching for more useful investment options to driving hot money into a market that is now raging up while overall household incomes are not improving in a way to match the massive jump in home prices. Plus, there is no historical evidence to show what the consequences will be of a Fed that is carrying a balance sheet of well over $3 trillion and is buying billions of dollars in MBS each month to keep the market at the current level.

What is certain is a large amount of money is now flooding into the housing market from investors and the yields they are chasing are not impressive. Many large investors are now pulling away. We are seeing aggressive flips in California once again and bidding wars are now going into their second year.

Look at a place like Pasadena that region wide has seen home prices increase by over 15 percent in one year and are now at multi-year highs:

What is interesting is rents are not necessarily keeping up:

Once again the CPI index will miss the inflation in the housing market since it tracks the owners’ equivalent of rent. Is this a bubble? Probably but a very different kind of one with big Wall Street money competing with local buyers stretching every last dollar they have to make that monthly payment on that Fed induced lower interest rate and a market so constrained on supply that investors are crowding into open houses like lemmings inching closer to the cliff.

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