patrick.net

More on Greenspan's primary role in creating the bubble: Greenspan the Goat

One thing tatupu70 has not used (surprisingly) as an argument is that interest rates are currently lower than they were during the boom, yet prices are continuing to fall, and therefore would suggest that it was the combination of other factors which was primarily responsible. This would actually be a great argument, if it wasn't for the fact that we are now IN a recession, which again differs from the environment present during the boom.

The Fed has already signaled that it will raise rates again dramatically and significantly when it determines we are out of recession and and it must then respond to inflationary pressures. What will happen to real estate values then? Just another reason to justify Patrick's many arguments against buying real estate in this market.

Interest rates have a long noticed direct effect on house prices.

For the typical Joe HowMuchaMonth who just wants to know how much house he can get for $1,500/mo:

At 6%, it is a $250,000 house

At a a 3.5% teaser rate , it is a $330,000 house.

Unfortunately, due to the aggregate of Joes, it is the same house.

investor90 says

If you just look at a mortgage loan from the perspective of prudent Risk Management loan principles, I would speculate that mortgages should be around 12-13% interest per year.

In a way that's what it is.

When lenders collect 5% interest on a mortgage inflated 2.4 times they indeed collect 12% interest. And that's what they do when they pass all risks to government guarantors/bail outs.

It's very simple calc. Since the lenders do not invest any real money (they just create them while creating a mortgage), it does not matter to them if they lend $360K or $150K.

Let's assume you buy a $450K house using a traditional 30y 20% down mortgage.

You put down $90K and take a $360K mortgage. Your annual interest is $18K. However, the real value (what it would be without various ways prices are artificially pumped up) of the house is $187.5K.

Would it be a free market you would take $150K mortgage with 12% interest rate. Your interest payment and lenders interest would be the same: 18K/year. The lender collects the same as in our current 5% interest world. Obviously the lender invests the same amount of work in creating $360K out of thin air as $150K. And it takes the same risk - namely zero risk, since the risk is passed away.

The differences are:
1. You pay an inflated down payment of $100K (instead of $37.5K) on house worth 187.5K. By doing this you subsidize the whole housing industry.

2. You pay inflated commissions, fees and taxes, subsidizing all kind of parasites.

3. You will pay much higher principal over the lifetime of the mortgage (with the same effects).

4. Those who would otherwise buy homes with cash as well as those who may be able and interested in quickly paying off their mortgages are strongly discourage from doing this. Indeed, why would anyone spend $500K of cash on a property worth less than $200K.

But worst of all, this has devastating effects on the overall economy. It causes overbuilding of oversize houses, in areas often not appropriate for residence. It causes huge unnecessary financial investments. It supports very low standards of American residential construction. It causes waist of energy. etc, etc, etc.

On top of all this it is subsidized by debt we all assume (not only those miserable home-debtors).

>>Unfortunately, due to the aggregate of Joes, it is the same house.

LOL, and therein lies a major problem.

So important question is what is probability of housing market conditions to return to Free Market, seeing current Fed behavior doesn't look likely..

michaelsch says

investor90 says

If you just look at a mortgage loan from the perspective of prudent Risk Management loan principles, I would speculate that mortgages should be around 12-13% interest per year.

In a way that’s what it is.
When lenders collect 5% interest on a mortgage inflated 2.4 times they indeed collect 12% interest.

Not sure of the logic of this since they are selling a spread between the cost to borrow - say 1% and the cost to loan - say 6%. That's a 5% margin on the loan amount. The fact that your virtual interest rate is 12% based on the perceived intrinsic value of the home is irrelevant. What is relevant is the increased risk of reduction of asset value. When the asset value declines and the loan is then sold (to govt or otherwise) then the NEW purchaser of the debt has a virtual 12% interest rate. But by that time the originator has already lost his shorts.

Would it be a free market you would take $150K mortgage with 12% interest rate. Your interest payment and lenders interest would be the same: 18K/year. The lender collects the same as in our current 5% interest world. Obviously the lender invests the same amount of work in creating $360K out of thin air as $150K. And it takes the same risk - namely zero risk, since the risk is passed away.

The lender is taking on much more risk on the 360k/5% mortgage since his margins are lower and his risk of equity erosion is higher. It is never zero risk, unless the originator immediately sells the mortgage on the secondary market at a profit.

4. Those who would otherwise buy homes with cash as well as those who may be able and interested in quickly paying off their mortgages are strongly discourage from doing this. Indeed, why would anyone spend $500K of cash on a property worth less than $200K.

This can actually be WORSE for the high mortgaged investor since he has reverse leverage working against him as prices decline, i.e. he can lose far more than his initial investment when it goes under water. His main advantage is he can walk away and stick it to the bank, whereas the outright purchaser is stuck with the loss.

OK--several posters have written since my last post, so I feel I must at least answer them. I think most understand my feelings that Headset is correct, but that in no way does he describe a "bubble". He describes a free market economy. Think of oil prices. One day they are $40, then a few years later they are $80. It's the same oil. But market conditions have changed--namely supply and demand. Same as housing prices change with changes in mortgage rates. Lower rates create more qualified buyers, therefore more demand, therefore higher prices. Not a bubble.

Now--Rogerer's last post was interesting. The end at least. The beginning is the same arguments that I don't agree with. The disparity between prime rate and interest rates could create some unusual conditions. I'll have to think about that one. Oh--and I thought I had made the argument that interest rates are still historically low. Thanks for having my back. You made my point though--the bubble burst during a period of low rates. Because of mortgage defaults--not because of rising mortgage rates.

Justme--you state that the prime rate has little to do with mortgages. But this topic is concerning the Fed and interest rates--you realize that the Fed doesn't set mortgage rates, right? The Greenspan quote is interesting. I will do some research to see the context in which it was made. Here's one for you. From Wiki-- "Robert Shiller does compare interest rates and overall U.S. home prices over the period 1890–2004 and concludes that interest rates do not explain historic trends for the country.[22]" Another one "Some believe that mortgage standards became lax because of a moral hazard, where each link in the mortgage chain collected profits while believing it was passing on risk.[70] Mortgage denial rates for conventional home purchase loans, reported under the Home Mortgage Disclosure Act, have dropped noticeably, from 29 percent in 1998, to 14 percent in 2002 and 2003."

I'll try to state my contention a different way. Imagine that you are a broker/Wall St. investor/bank or whoever is making the loans. Even if I gave you a supply of free money--ie 0% interest rate--would you loan it to someone that you knew wasn't going to pay you back? Of course not. So the only way these guys would make these loans is if they didn't understand the risk involved. Or if they were only concerned with next quarters financials and not 2-3 years down the road when the shit hit the fan...

tatupu70 says

Lower rates create more qualified buyers, therefore more demand, therefore higher prices. Not a bubble.

It was not just the low rates, but the accompanying low lending standards that shifted the demand. Note "shifted the demand." as in not just an "increase" in demand, but a shift of the demand curve itself. If that is not a bubble, what would be?

Now you may have a point about interest rates themselves not increasing prices, but only if credit itself is tightened up. When very few people qualify for a loan at a going 4%, it will have less of an effect than when all mirror foggers qualify when the rate is 6%.

Bottom line: Lax lending at low rates shifted the demand curve for houses far enough to push prices well above the level supportable by current earnings (wages of the owners or rents from the houses), i.e., a bubble. Remove the easy credit and the demand curve shifts back to reflect demand based on current earnings.

What makes a cake a cake? Is it the flour? The sugar, the frosting? Or is it the process of baking everything together that makes it a cake? We can argue, but at least we can all call it a cake!

Well, most of us, that is. Tatupu70 cannot even agree that what looks like a cake is actually a cake. He is basically saying that bubbles are not bubbles because they are the result of natural free market forces at work. As I've said previously, there is nothing natural or free market about outright manipulation of interest rates. He may however, be right in the purist sense that low interest rates ALONE do not necessarily produce a bubble. I'm at the point where I can agree with that, since it clearly requires other things like availability of credit, etc. We should all stop arguing that point with him, since no one can prove him wrong.

However, to say that no bubble exists is ludicrous, whether it is a housing bubble or an oil bubble. Anyone can see - at least after the fact when prices come down - that we get financial bubbles. The question is: what causes the bubbles? It certainly is not the normal supply and demand cycle as Tatupu suggests. Actual physical demand for oil at $149/barrel was not significantly higher than it was at $40 or now again at $80.

Speculative demand is a different story. But this gets right back to how we are all being played by the powers that be in these bubbles. Those with the power of money - whether it be the Fed, the World Bank, market makers, Goldman Sachs, hEdge fund managers, or anyone else with a financial edge can influence the markets quite severely by seeding it. All it takes is a momentary push out of balance and a trend gets started which can feed on itself.

This kind of thing has been going on since there have been markets. It's just that now, in the age of instant electronic communication, things can happen much more quickly and more severely. That's what we're seeing in the last decade. Is it a coincidence that virtually ALL of the major bubbles of the last 30 years have occurred since the wide spread use of the internet? (1 exception was the crash of '87, but that also is known to have been caused by computer trading programs). Most of the others have happened in the last dozen years since the internet. Markets have become extremely liquid in this era, contributing to an exaggeration of every bull or bear trend. More players, IRAs, 401Ks, all add to liquidity and demand. And all are highly intertwined with electronic information systems. This sets up the conditions for a bubble, needing only the added ingredient of speculation in the mix.

This is where the big players have a major edge since they control the money. They now just have a bigger pool in which to make bigger waves. But these are not the natural waves of free market capitalism. These are market manipulations, pure and simple, instigated by those with colossal assets and seemingly infinite leverage. The Fed is the prime example as discussed in my first 2 posts above. But there are others. I'm starting to see that Goldman Sachs seems to have their greasy fingers in just about every pie (and cake too).

Does it strike anyone else that the most sensible and intelligent independent investors, by and large, are losing their shirts in ALL of todays markets? I'm speaking of the average Joe taxpayer/home buyer/401k holder. He is constantly lured into the notion that he can profit by buying into the latest bubble. The money controllers see to it that he has a stake in the game, whether voluntarily purchasing that new home, or involuntarily participating in a bailout of those that manufactured - and already profited from - the bubble. It's all part of the boom/bust cycle, and this has been going on for a very long time, even before the Fed. The winners are always those who can best manipulate the system, the ones with the power and the money. And they make money both on the way up and on the way down, since they know exactly what's coming. So lets see... who gained the most from the current housing market boom and bust? If we can answer that question, we may not need to debate the ingredients of cake any longer.

He describes a free market economy. Think of oil prices. One day they are $40, then a few years later they are $80. It’s the same oil. But market conditions have changed–namely supply and demand.

In this case, at least, demand had decreased. It was speculation/trading that drove that particular commodity into the stratosphere. It's distortions like this and other X factors that preclude any notions of a free market economy.

You all need to put on some tinfoil hats. Thats right I said you all need to PUT ON some tin foil hats.

in the 21st century western world there is basically nothing to spark the human ambition in a sincere way. We have medicine, food, shelter, water, and energy. We have effortless sexuality no matter where you sit on the fence (asexual, mysogionist, breeder, homosexual, voyer,etc)

All of the subsidies that can be built in, have been built in for just about anyone to live any life they choose regardless of race, color, or creed. And gone past the concept of subsidy. Things like public education, national defense, etc are becoming part of a Jungian shared conciousesness.

That is the worst thing that can happen for the types of people whose personality can only be fed from activism. They have worked themselves out of a job. The only thing sparking thier plugs is to send the economy on a roller coaster ride to get the reactions and profits that can be taken from the friction. Otherwise we'd all just drink 1 gallon of fresh water from the tap every day. 3 glasses of good wine. 3000 calaries of the best food this world has ever seen. Two asprins and call each other in the morning on our cell phones.

Housing is the 4th rail of politics. There is no 5th rail. Get used to manipulation, now and forever.

Rogerer,

That was an excellent post.

>>Tatupu70 cannot even agree that what looks like a cake is actually a cake.

It is a problem that Tatupu70 wants to engage in sophistry rather than talk straight.

>>He may however, be right in the purist sense that low interest rates ALONE do not necessarily produce a bubble.

He was not explicit enough to make it clear that this is what he meant. He did say:

>> Low rates in and of themselves don’t cause a bubble.

He did not claim explicitly that interest rates are NOT a factor, but he did try to argue with data that the correlation between (prime) rates and housing inflation was low, which I took (and I think reasonably) as an argument that interest rates are an irrelevant factor.

Here's what I would say:

Low interest rates are a NECESSARY condition for a financial bubble to form, but not a SUFFICIENT condition. Other factors, such as low lending standards, also have to be present.

But if taken to the extreme, I bet I could ignite one hell of a housing bubble if I was in a position to force mortgage interest to ZERO, and grant loans based on the borrowers ability to pay off the principal.

Rogerer says

michaelsch says

investor90 says

If you just look at a mortgage loan from the perspective of prudent Risk Management loan principles, I would speculate that mortgages should be around 12-13% interest per year.

In a way that’s what it is.

When lenders collect 5% interest on a mortgage inflated 2.4 times they indeed collect 12% interest.

Not sure of the logic of this since they are selling a spread between the cost to borrow - say 1% and the cost to loan - say 6%. That’s a 5% margin on the loan amount. The fact that your virtual interest rate is 12% based on the perceived intrinsic value of the home is irrelevant. What is relevant is the increased risk of reduction of asset value. When the asset value declines and the loan is then sold (to govt or otherwise) then the NEW purchaser of the debt has a virtual 12% interest rate. But by that time the originator has already lost his shorts.

Would it be a free market you would take $150K mortgage with 12% interest rate. Your interest payment and lenders interest would be the same: 18K/year. The lender collects the same as in our current 5% interest world. Obviously the lender invests the same amount of work in creating $360K out of thin air as $150K. And it takes the same risk - namely zero risk, since the risk is passed away.

The lender is taking on much more risk on the 360k/5% mortgage since his margins are lower and his risk of equity erosion is higher. It is never zero risk, unless the originator immediately sells the mortgage on the secondary market at a profit.

In fact most of the "conforming" loans, and (I carefully described a "conforming" loan) are sold very quickly. Mostly to FMA or FMC (i.e. the taxpayer) others - to naive foreign "investors". Those that banks kept are now sold to the Fed. Please don't tell me this wasn't in initial plans of the lenders. Nobody ever made a BAD loan not counting on future bailout.
The cost to borrow is irrelevant as well. In most cases mortgages are considered as valid reserves. (At least in case they are kept by FMA etc., the reserve requirements were never applicable in their case.) The lender only needs to borrow for a very short time and not more than 10% of the amount of the mortgage and even this was never enforced even in case of private lenders. So, again, mortgage money is created out of thin air, it's not borrowed.
That's why the total amount of the mortgage DOES NOT matter. The only thing important to the lender is the total interest it may collect.

4. Those who would otherwise buy homes with cash as well as those who may be able and interested in quickly paying off their mortgages are strongly discourage from doing this. Indeed, why would anyone spend $500K of cash on a property worth less than $200K.

This can actually be WORSE for the high mortgaged investor since he has reverse leverage working against him as prices decline, i.e. he can lose far more than his initial investment when it goes under water. His main advantage is he can walk away and stick it to the bank, whereas the outright purchaser is stuck with the loss.

So... How is it WORSE for the high mortgaged investor? The most he can lose is his down-payment (plus fees and taxes). As long as the losses are higher he just walks away. The bank does not lose much since the mortgage is bailed out. The only loser is the taxpayer and the overall society.

Oh yeah and the lady I spoke with today said that the lower interest rates you have, the lower the home prices will be. She was lying all over the place!! She was an assistant for Centex Homes.

Why, what bakes any bubble is the ability to create BAD credit.

When lenders know they can make bad loan with no risk, when they know they always can pass the risk to somebody else or force a bailout, they always create bubbles. Always, no exceptions!

All the rest: interest rates, lax standards, greed, fraud, stupidity, and the rest of the speculative demand, - all these are just tools and ingredients.

youngniceeyes says

Oh yeah and the lady I spoke with today said that the lower interest rates you have, the lower the home prices will be. She was lying all over the place!! She was an assistant for Centex Homes.

She was not lying - at least about that. She was stating a fact, when comparing differing interest rates to the SAME selling price. After paying down the mortgage for the same number of years and other terms being equal, the lower interest rate will always result in lower total interest costs, resulting in a lower total purchase price at the end of the term. Don't confuse this with what some of us have been saying about lower rates coupled with HIGHER prices.

Justme--

I apologize if I'm not engaging in straight talk. Sometimes I try to be overclever. I think that interest rates had a very minor effect on the bubble. I think poor understanding of risk had a HUGE, major effect. Like I said in my last post--take a look at this bubble. It popped, not because of rising interest rates, but because of defaults/foreclosures. Because there were so many ridiculously crappy loans written.

I will agree that low rates create an environment of rising prices which would probably make a bubble slightly easier to form. But, look again at the housing price history graph--there was a bubble in the late seventies while mortgage rates were high. So I don't think it's a necessary condition.

And your last statement about 0% interest is an interesting one. That gets to the crux of what I'm saying. Housing prices would certainly increase, but they should increase. Just because prices increase, it doesn't mean that's it's a bubble situation. A bubble implies that the free market isn't working and people are acting irrationally.

Hopefully that makes sense and a cake is a cake again.