As famously stated by Fed Chairman William McChesney Martin in 1955: “The Federal Reserve, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”
As the Fed is now finding out, removing the punch bowl can be problematic if the party is already past warming up. Since it announced a ¼ point increase in the Fed funds rate on December 16, 2015, the two year and ten year Treasury notes have dropped 33 basis and 54 basis points respectively. The ten year rate is at 1.76%, near its all-time low of 1.58%. 30-year mortgage rates, which are priced off of it, have declined to 3.72%, the lowest level in 9 months and only marginally above the all-time low of 3.35% set in November 2012. Clearly the interest rate punch bowl has not been removed.
But housing finance benefits from a second punch bowl spiked by a plethora of federal housing guarantee agencies— Federal Housing Administration, Fannie Mae, Ginnie Mae, Freddie Mac, Federal Housing Finance Agency, etc. Today these agencies guarantee 85% of all primary home purchase loans. Loan leverage, as measured by the Pinto-Oliner National Mortgage Risk Index (NMRI) for agency home purchase loans, has been steadily increasing on a year-over-year basis since January 2014. Increases in first-time home buyer leverage have led the way, benefiting from the particularly liberal lending standards of the Federal Housing Administration (FHA). Seven in eight FHA loans to first-time buyers have an NMRI rating of high risk. Add in the fact that the FHA, to a great extent, neither prices nor underwrites for loan risk, making this is a punch bowl that can give quite a hangover.
The result has been a rapid increase in real (inflation adjusted) home prices, with prices up nationally about 16.5% since the home price trough in 2012. History teaches us that once the divergence hits 20% or more, the process of reverting to the mean becomes quite painful, as it is achieved through a drop in home prices. Such divergence can continue for a long time—in the recent boom it lasted 12 years and resulted in a 62% increase in real home prices. Of equal concern is that real prices since the 2012 trough have gone up even more—up 19% for entry-level homes. This makes it harder for low-income borrowers to buy without taking out a high risk loan.
It is well known why this phenomenon occurs. Liberalization of credit terms such as lower downpayments, increasing debt-to-income ratios, or declining interest rates increases demand. When undertaken in a seller’s market where supply is constrained (defined as an inventory relative to sales of six months or less), there is a tendency for this liberalization to be absorbed in price increases rather than increased access. The National Association of Realtors has reported an existing home seller’s market for 40 straight months.
The housing market, like others, is subject to the law of supply and demand. In the same 1955 speech Chairman Martin observed: “It is true that in a great emergency we have been willing to make a departure from our market structure…. The law of supply and demand is suspended temporarily, but it cannot be permanently repealed. It is always with us just as is the law of gravity.”
While this situation is bullish in the near term for continued housing price gains, in the end the taxpayer and low income buyers are the ones taking on the risk. It is time for the Fed and federal guarantee agencies to start removing the punch bowls and acknowledge that home prices are subject to the law of gravity—what goes up must come down.
