Monday, October 28, 2013

Real Interest Rates & the Housing Boom

Scott Sumner and Arnold Kling have reacted to this post, where I tried to offer numerical evidence that the housing boom was not a bubble.  Scott seems to generally like the idea.  Arnold pushed back with some good points.  Here is the text from his second post:
Certainly, reducing the down payment requirement does not cause market interest rates to be lower. So between those two variables, causality can run at most in one direction.
You are saying that the real estate industry is not going to push for lowering the down payment requirement in a high interest-rate environment. I can see that if the marginal homebuyer is low on income and low on assets. If nominal interest rates are high, the monthly payment will be daunting, and lowering the down payment requirement cannot help this person.
On the other hand, suppose that the marginal homebuyer has decent income and low assets. Even in a high interest-rate environment, lowering the down payment requirement might help that person. And if interest rates are high because of general inflation, including house price inflation, then from the bank’s point of view it is safer to lower the down payment requirement in this environment than in an environment of low inflation.
I think that the main reason that down payment requirements went down was because the people lending the money at least implicitly assumed rising house prices. In addition, government officials were beating up on lenders for rejecting applicants from what was called the “under-served” segment of the market. (Of course, by 2010, government officials described this segment as “borrowers who were not qualified” and were shocked, shocked that the evil, predatory lenders had forced these people to take loans that they could not repay.)

These are good points. He had commented that aggressive financing methods like low down payments had pushed home prices up.  I responded that the causation went the other way.  Low long term interest rates caused housing prices to go up and also created pressure for reduced down payments.

The reinterpretation I am suggesting reverses the causation at another level also.  There was a AAA-rated securities bubble within the banking sector and, separately, a housing boom.

I think the conventional version of the causality says that low short term rates ("loose money") caused the banking bubble which caused a housing bubble.  I am proposing that low long term rates ("tight money") caused a housing boom (not a bubble) which fed a banking bubble in AAA-rated securities.
Low rates from loose money ---> Banking Bubble ---> Housing Bubble 
Low rates from tight money ---> Housing Boom (not a bubble) ---> Banking Bubble

(I extend the causation pattern here.)

My main point is that homes are like very long term TIPS bonds.  Real rates, even at the long end of the yield curve had decreased by several percentage points over the previous 25 years.  A reduction of 3% in long term real interest rates could justify an increase in home prices of 50% or more.  This factor alone can explain most or all of the rise in home prices.  An excess of aggressive financing might have added some froth at the end, but this factor is not necessary to justify the general price movements we saw.

The accumulation of equity among homeowners and the new subsets of the population who could qualify for mortgages because of low monthly payments were reasonable outgrowths of the boom.  The bubble in banking was the result of institutionally rigid rule sets which regulated banking activity.  Pressures to increase exposure to subprime lending, static rules regarding leverage of this credit, and legal protections for bank creditors were the pathogens, and all this new housing equity was the agar.

1) So, largely exogenous factors led to low long term real rates, which, combined with low inflation due to longstanding Fed money supply policy, led to a sharp increase in home prices.

2) High home prices, together with an unfortunate combination of public banking policies, led to a banking bubble.

3) The Fed countered the banking bubble with even tighter monetary policy, which created a credit crisis that brought down the banks and the housing boom.

4) Because the basic ingredients for increased home prices are still in place, we are now seeing a renewed increase in home prices.  This is happening in the face of credit markets that are still hobbled.  But, the power of low real and nominal rates regarding home prices is so strong that home prices have stabilized and begun to rise again at elevated levels even though a large share of home purchases are from all-cash investors, due to the credit crisis.  This is kind of the opposite of the case from the 1970's that Arnold mentioned, where a low-asset, high-income household might have been willing to lower their down payment in the 1970's in order to establish home ownership.  Now we have banks that are incapable of loaning to a large number of home-buyers, even though the interest rate context would attract them.  So, private equity investors with their own sources of cash are stepping into the market.

The sad irony is that, on the margin, loose monetary policy in the 1970's kept home prices from rising to the levels we saw in the 2000's.  But, public sentiment is going to pressure the Fed to tighten money again as home prices continue to rise.  Tight monetary policy can lower inflation, and at the extreme, lower real incomes, like it did in 2008.  Since lower inflation will only increase real home prices by lowering nominal mortgage rates, if the Fed becomes determined to knock down home prices, it will have to tighten again to the point of damaging real incomes.  That would be unfortunate.


  1. I'm a big fan of Scott Sumner but I found your explanation difficult to believe. Although normally there is a trade-off between down payment and monthly costs, what we saw from 2004-2007 (I will refrain from calling it either a housing "bubble" or "boom" to avoid loaded terms) was a reduction in *both* the required down payment as well as the monthly payment. How can this be? First, the rise in the "affordability" products such as hybrid ARMs, IO's, neg am, and extended term loans reduced the monthly payments without requiring higher down payments. Second, the lower underwriting standards led to low doc and no doc loans that offered mortgages to people by qualifying them at rates that they would not have been able to obtain had they been required to submit actual income verification.

    I'm not sure how monetary policy (either tight or loose) led to either of these consequences. But the whole market monetarism school seems to be on the mark for so much, maybe there is an explanation that merely escapes me for now. Thoughts?

  2. Thanks for your input, Nick. It is difficult to believe, and there are a lot of subtle things going on here. I'll just bulletpoint some possible clarifications:
    1) The trigger for fundamental changes in home prices is the long term real (aka: inflation adjusted) interest rate, which isn't really reflective of monetary policy. It's just a reflection of a complex web of economic factors.
    2) Where monetary policy came into play was that inflation premiums on long term rates were also really low, which, pretty much by definition, is the market expectation of long term monetary policy. This allowed home prices to adjust to their fundamental level. In the 1970's, when real rates had previously justified high home prices, prices couldn't adjust because high nominal rates (due to a high inflation premium) served as an artificial barrier to demand.
    3) In the service of building a narrative, I probably make the bubble issue too much of an either/or issue. First, I think it should be clear that in reasonably functioning markets in ultra-low rate environments like we had, we should expect forces to naturally adjust to match new buyers to mortgages, which would include lower down payments and other mechanisms. Normally, banks would push back against this adjustment in a market where nominal home prices could decline. Because there was a banking bubble, this feedback was not as strong as it should have been. So, there could have been a little bit of bubbliness in the housing market, and it was made much worse by the banking bubble. By showing that home prices at the time could be justified financially and that they are rising again without any assistance from banking, I am attempting to argue that two separate issues are being conflated here, to the detriment of our understanding of the housing market. First, there have been large, but justifiable, fluctuations in the prices of homes. Separately, a banking bubble happened to use housing as an input, with some feedback coming back into the housing market as a result.
    I don't mean to excuse every deal done by every mortgage broker, but to say that, in general, there was nothing unsustainable about home prices as we experienced them. They were more volatile than we were used to because the lack of qualification barriers meant that they could move more freely like bond prices, but it is implausible to expect most observers to immediately adjust their heuristics relating to the housing markets to account for this paradigm shift. But, I believe that if we don't account for that shift, we will badly misinterpret these market phenomena.

    I don't know if I'm addressing your question clearly or not. I hope that helps.

  3. Thanks for the reply. Just continuing on your point #1, I see your plot of real interest rates vs (I assume inflation adjusted) housing values in your next post. Although I agree with the theoretical basis for the inverse relationship between the two, empirically I have never been able to replicate it very well. Using real interest rates from FRED and a well-known HPA index, the plot during the 70's hangs out in the lower left hand corner, as you would predict based on the high inflation of the time, then moves to the right at real rates shoot up in the early 80's, then back down to around 3% as housing values bounce around, until real rates drop to ~2% in the 00's and HPA flys up asymptotically, again, as your model describes. But as real rates drop down to almost nothing, and inflation also goes to almost nothing in 2010-today, shouldn't house values continue to climb asymptotically? Instead, they shift back down onto a high inflation line, which doesn't seem to make sense.

  4. That's a great point. These aren't the only two factors involved. The research Tyler Cowen linked to in my next post considers bank credit market conditions. I think, for the period from about 1970 to 2007, real and nominal rates can explain a lot of home price movement. After 2007, I think the crisis in the credit markets becomes the bottleneck factor that is preventing demand from bidding home prices up to fundamentally justifiable levels. Calculated Risk has documented how much of the buying activity is from all-cash private equity investors.
    Just as the rise of home prices in the late 1970's in the face of double digit nominal rates is a sign of the power of real rates in driving home prices, I think the current rise in prices that is happening while credit markets are still very tight also shows that power. As the recovery continues and the banks re-capitalize, home prices should continue to increase, depending on how high real interest rates rise into the recovery.
    What I am afraid of is the Fed reading that as a bubble and taking unnecessary actions to pull back the economy.