Homebuyers, Beware The Sugar High of Fed Stimulus – Wirepoints

By: Mark Glennon*

For those of us baffled by why the Federal Reserve Bank continues to flood the nation with money created from thin air, perhaps no aspect is more perplexing than one particular means it is using: the home mortgage market.

The harm may be severe in the long run, especially for Illinois, and particularly for the very people it is supposed to help – the working class.

The red-hot housing market has a number of causes, but a big one undoubtedly is the Fed’s unrelenting mortgage buying. Every month, it’s buying $40 billion of mortgage backed securities, or MBS, which are basically packages of home mortgages. That pushes up the value of mortgages for investors, reducing mortgage rates, which in turn fuels higher home prices. It now holds a stunning $2.2 trillion of MBS, about a third of all MBS outstanding, and it was all bought with money the Fed created.

That the housing market is on fire isn’t just from anecdotal or spot evidence. “In real terms, the home prices have never been so high,” says Nobel prize-winning economist Robert Shiller, co-founder of the S&P CoreLogic Case-Shiller home price index.” My data goes back over 100 years, so this is something.” It’s the “Wild West,” he says. According to a recent report by the St. Louis Fed, the nationwide house price-to-rent ratio, a widely used measure of housing valuation, is at its highest level since at least 1975.

It’s true for Illinois, too, though to a lesser degree. Chicago area home prices rose 9% for the year, according the most recent Case-Shiller Index, though national prices rose by 13.2%.

That’s thrilling news for existing homeowners, and new buyers are taking comfort that higher prices are offset by lower mortgage rates.

So, what’s the problem?

It’s that new buyers may be falling into a trap of high prices that cannot be sustained. To think that buying into a home assures you a nest egg as you approach retirement is old school. Home prices have fluctuated harshly in recent decades in most of the nation, often turning investments therein into losers. It has become a whipsaw; if you are in and out at the wrong time you can lose big.

The effects go beyond single-family homeowners. The binge has spiked construction costs for rental property construction as well. Everybody gets hit. Soaring lumber prices alone have added $36,000 to the cost of the average new home. “A stud that was $4 in April in 2020 was $12 in 2021,” said a Peoria builder. “It’s getting difficult to find anything.” Cement, steel, paint and many other construction elements are in short supply.

Meanwhile, here at home, the State of Illinois and cities like Chicago announce program after program to promote affordable housing.

They are fighting the Fed.

Yet we know for sure is that the Fed’s appetite for mortgages isn’t permanent. Federal Reserve President Jerome Powell has often said that its current purchases of MBS and other securities are “unsustainable.”

That means its upward push on home prices is unsustainable as well. New homebuyers, especially those of modest means who have stretched their credit to the max to make their purchase, are therefore at risk. They may benefit from low mortgage rates for the long run if they have locked in their rates, but values may not hold up.

To check whether that’s too pessimistic, I reached out to Joseph Pagliari. He’s a clinical professor of real estate at the University of Chicago’s Booth School of business. “I don’t disagree with you,” he said, “the Fed’s policy of monthly purchasing massive amounts of mortgage debt seems to have reached its past-due date.” He added:

In general, I’m opposed to the Fed’s willingness to provide persistent “assistance”, “support” or whatever name you/they would like to give to a market distortion. While I’m not the first to say it, the Fed’s willingness to attempt to “correct” seemingly every market “dysfunction” simply contributes to making the next crash worse; it’s like the forest fire analogy: If you suppress all the small fires, the underbrush accumulates, which makes the next fire more dangerous. Moreover, the political pressures to forestall any significant “tapering” seem like another consideration to me.

How much influence have Fed MBS purchases had on prices? That’s probably impossible to say, but it’s no doubt very significant.

Pagliari therefore didn’t venture an estimate, but he pointed me to a 2010 study by two Federal Reserve Board Governors on the impact of Fed MBS purchases during the Great Recession. The study found that the Fed program reduced mortgage rates by 100 to 150 basis points for purchasing houses. That means, for example, that a 3% annual mortgage rate would be 4% to 4.5% without the Fed’s subsidy.

That’s huge. A mortgage subsidy that large clearly enables many buyers, especially in the lower priced market, to qualify for a mortgage and pay up at today’s higher home prices.

Pagliari affirmed that point about the working class and lower price homes. “Among the potential impacts of lower interest rates – due to the Fed’s policy of mortgage purchases – is the likely adverse impact on the lower tier of home prices,” he said. He sent along this chart as an example, prepared by one of his co-authors, Mitchell Bollinger, an industry analyst:

The chart shows Chicago area home prices stratified by price. Lower-price homes are the red, which you can see have been whipsawed the most.

Pagliari added this:

Over the last 20 or so years, the volatility of the low tier of home prices is self-evident: the peaks are higher and the troughs are lower than both of the other two tiers. I suspect that average homeowner’s leverage ratio is higher in the low tier of home prices. If so, does the Fed’s mortgage-purchasing policy contribute to the whipsaw of homeowner’s equity? And if true, it would seem likely that there’s a “contagion” effect by which the adverse effects of one or more properties lost to foreclosure (or at least financial distress) casts a pall upon neighboring properties, once there’s a significant downward market correction in home prices.

The Fed’s failure to state its reasons for buying mortgages is particularly frustrating. It “doesn’t have a satisfactory answer for why it’s throwing billions of dollars at mortgage bonds at this point,” as a Bloomberg columnist wrote last month.

Here’s Fed Chairman Powell’s answer when asked to state his reasoning. Read it and ask if he isn’t just saying, “Oh, I dunno. We’ve been doing it so we’re still doing it.”

Yeah. I mean, we started buying MBS because the mortgage-backed security market was really experiencing severe dysfunction, and we’ve sort of articulated, you know, what our exit path is from that. It’s not meant to provide direct assistance to the housing market. That was never the intent. It was really just to keep that as, it’s a very close relation to the Treasury market, and a very important market on its own. And so, that’s why we bought as we did during the global financial crisis. We bought MBS, too. Again, not intention to send help to the housing market, which was really not a problem this time at all. So, and, you know, it’s a situation where we will taper asset purchases when the time comes to do that, and those purchases will come to zero over time. And that time is not yet.

Thinking about Illinois in particular, our home price growth has lagged badly behind national averages. In just one ten-year period, subpar home appreciation cost Illinois homeowners a quarter trillion dollars.

On one hand, maybe that will help. Without the price bubble other states have, there’s less to deflate in Illinois.

On the other hand, the causes of Illinois’ poor home appreciation persist. High property taxes, structural government deficits, corruption, crime and all the rest go on and on with no reforms in sight, so taxpayers continue to flee.

I am not comfortable making predictions on this, but I am about calling out risks. New Illinois homebuyers, particularly at the low-cost end, may end up realizing that they bought into a surge created artificially and temporarily by the Fed. When the Fed’s largess ends, Illinois’ traditional problems, and their impact on home prices, may return with a vengeance.

*Mark Glennon is founder of Wirepoints.