Mortgages: Do We Need Inflation?

Real estate needs a pick-me-up, something of a surprise considering that home values remain below 2007 prices and mortgage rates continue to hover around 4 percent. Bargain prices and discount mortgage rates should result in soaring sales but that isn’t the case: Existing home sales trail 2013 levels and sales to first-time buyers are well-below historic norms, a real red flag.

What can we do to perk-up the housing sector? One answer might be help from the Federal Reserve, but as we are about to see “help” from the Fed invariably produces both winners and losers.

How Low Mortgage Rates Help
In basic terms there are three ways we could boost home sales.

First, we could go back to “affordability loan products” such as option ARMs, interest-only mortgages and no doc loans. In the Dodd-Frank era and after millions of foreclosures that simply isn’t going to happen.

Second, home prices could fall, a nightmare for homeowners and yet declines are already  happening in some communities. The National Association of Realtors reports that in the second quarter home values grew in 122 major metro markets — and fell in 47 others. For large segments of the country declining real estate prices are here today.

Third, we could have low mortgage rates but — whoops — we already have low mortgage rates. Not quite as low as 2012 when they hit 3.31 percent but remarkably low by historic standards. How could rates go lower? Less competition for capital would do the trick but that suggests less economic growth and fewer home sales.

Okay, if the three baseline remedies don’t work how about this one: Have the Federal  Reserve stimulate the economy and with it the housing market.

“A faster GDP growth rate is the essential step to getting broad-based income growth,” says Freddie Mac. “Unfortunately, the economy can’t perform at its highest level until this happens.”

Translation: Some vast financial power — say the Federal Reserve — should nudge the inflation rate higher and with it housing activity.

And now it seems that the Fed may actually take on that task.

How the Fed Reduced Mortgage Rates
In November 2008, in the face of what appeared to be the onset of a massive national depression, the Federal Reserve announced that it would purchase Treasury and mortgage-backed securities worth $600 billion from the nation’s banks, what we today generally call Quantitative Easing 1 or  QE1.

What was the purpose of these purchases? According to the Fed “this action is being taken to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”

In other words we’re trying to push down mortgage rates.

By March 2009 it was apparent that even more needed to be done so additional purchases worth $750 billion in mortgage-backed securities and $300 billion in Treasuries were added to the program.

The March announcement not only increased Fed purchases it also did something else: Now the Fed said it was willing to buy “non-agency residential mortgages and/or other asset classes.” If you were a bank you could sell financial junk to the Fed and get it off your balance sheet.

By 2010 it was obvious that QE1 was not enough so the Fed launched — you guessed it — QE2. This time around the Fed announced that in mid-2011 it would begin the purchase Treasuries and other securities at the rate of $75 billion per month “to foster maximum employment and price stability.”

After QE2 there was, of course, QE3. It was announced in September 2012. It was more of the same, continued purchases from banks in an effort to again “foster maximum employment and price stability.”

The oddity of these announcements is that the Federal Reserve exists to further the banking system, it’s not the Labor Department and it’s entirely uncertain that the Fed moves had any impact on employment.

“Clear demonstrations of QE’s benefits are elusive,” wrote The Wall Street Journal in late October. “Though the jobless rate has declined from 8.1 percent before the latest program was launched to 5.9 percent in September, this is in part due to people leaving the work force and the ranks of those counted as unemployed. Job growth was 2.2 million in the 12 months before the Fed launched the latest round of bond buying and 2.6 million in the past 12 months, but it is hard to prove the faster growth has come even indirectly from the Fed’s efforts.”

While the Fed’s claims of kinship with the working class are dubious, it’s impact on mortgage rates is very clear. According to former Fed Chairman Ben Bernanke, the Fed’s asset purchases reduced 10-year Treasury rates by 80 to 120 basis points, a reduction which by 2012 had pushed mortgage rates to their lowest levels in 65 years.

Do We Need Inflation?
The assorted buy-back programs undertaken by the Fed during the past five years have held down interest rates as well as inflation. In effect, the Fed has chosen winners and losers. For instance, expected interest income has virtually disappeared for those with savings. If you’re a would-be retiree with $1 million in CDs your hoard now earns less than the rate of inflation, you’re losing buying power and you’re not generating the income needed for monthly costs. The result: You don’t retire. If you’re a bank the buy-back program has been a joy, an automatic market for securities which might have sold for a lot less without the Fed’s bounteous purchasing policies.

And who is the Fed to make such decisions?

As the Huffington Post explained, “while the Fed Board of Governors, based in Washington, is a public agency, the regional Fed banks are private sector entities.”

“These branch banks,” said Huffington, “are controlled by their own nine-member boards. Three of those directors are chosen by the banking industry, three are chosen to represent other industries, and three are selected to broadly represent public interests. The president of each branch is named by the corporate and public interest directors.

“In practice, this has meant that banking and other corporate interests are really running the show at most Fed branches.”

The result is that the Fed is a regulator of sorts, one which oversees the financial sector with the lightest possible touch. For instance, it could have banned the use of option ARMs, no doc loans and interest-only financing with the authority it has under Home Ownership Equity Protection Act of 1994 (HOEPA). Unfortunately, the Fed never acted and the result was the widespread use of such products and policies as well as the millions of foreclosures they spawned.

“HOEPA,” explained the Federal Reserve Bank of Philadelphia in 2007, “authorizes the Board to prohibit any mortgage act or practiceif the Board finds it is unfair or deceptive and to prohibit any mortgage refinancing practice if the Board finds it is abusive or not in the interest of the  borrower.”

Inflation and Real Estate
In terms of real estate and mortgages a little inflation is highly desirable. As a homeowner you want inflation because it means that the value of your home as measured in terms of cash is going up. As a borrower with a fixed-rate loan you want inflation because it means you’re repaying the debt with cheaper and cheaper dollars. As a purchaser you want inflation because with it home values  are rising and you want to catch the pricing elevator so you too can benefit. Lastly, as a lender you want inflation because with it equity increases and financially-troubled borrowers can more-easily sell properties without setting off the need for a foreclosure.

With the end of its assorted buy-back programs the Fed has now signaled that it too wants inflation back, at least a little inflation. But in the same way that the decision to lower interest rates produced winners and losers, the new decision to embrace inflation will also have fall-out.

A little inflation should elate homeowners because if dollars buy less it should take more dollars to purchase a home, all things being equal. Higher prices and more equity means fewer foreclosures as home values rise above mortgage debts plus there’s a greater ability to refinance.

However, if the Fed is successful — and that’s not assured — then with a modest increase in the inflation rate one would expect to see mortgage rates rise. That can’t possibly be good for housing, a sector with flat sales at a time when mortgage rates are skimming the bottom at 4 percent or so. Higher rates by their nature will freeze some potential home buyers out of the marketplace and thus reduce demand, sales and asking prices.

The real question raised by the Fed’s assorted “easing” programs is whether we should manipulate the economy — and whether we can. The answer is that there will always be efforts to influence economic results. Whether those efforts will be successful is unclear because surely the definition of “success” depends on whether you benefit from intervention or suffer.

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For the latest real estate news and trends get a FREE issue of our award-winning real estate newsletter, the Housing News Report.

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