The Mortgage Finance Bubble
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Credit Bubble Bulletin
by Doug Noland
June 25, 2004
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Understandably, housing markets are these days the subject of much attention, pontification, and absolutely frenetic buying interest. Reminiscent of the late-nineties manic stock market environment, the issue “Is Housing a Bubble” has become a hot topic for newsletter writers, journalists, policymakers and investment analysts.
Research from the Federal Reserve Bank of New York – “Are Home Prices the Next ‘Bubble’?” proves that, despite considerable focus on the issue of asset Bubbles, the Fed has made little progress in comprehending or addressing Bubble dynamics. Amazingly, this report provides not a single mention of what should be the focal points of Bubble analysis – Credit growth, loosened lending standards, speculative psychology and finance, and marketplace liquidity.
I would aver that Fed researchers make a crucial analytical error by using Joseph Stiglitz’s definition of a Bubble:
“If the reason the price is high today is only because investors believe that the selling price will be high tomorrow – when ‘fundamental’ factors do not seem to justify such a price – then a bubble exists.”
“Fundamental factors” is an analytical black hole. During the technology Bubble, price-to-earnings ratios became the focal point of a winless “Is it or is it not a Bubble” debate. The bears argued prices were much too high from a historical perspective, while the bulls retorted that such valuations were justified by stupendous earnings growth and future prospects (and low interest rates!). The reality of the situation was that earnings were grossly inflated by unsustainable financial flows (much of it of speculative character) that were inundating (and distorting!) both the marketplace (the “financial sphere”) and industry (“economic sphere”). Fruitful analysis would have avoided valuation and instead focused on the dimensions and character of the surge in junk bond finance, syndicated bank lending (especially to telecom), margin debt, hedge fund and proprietary trading leveraging in both tech equities and debt, derivative-related leveraging, aggressive industry vendor financings, and the general profligate Credit environment.
As we appreciate, Asset Bubbles are Always and Everywhere a Credit Phenomenon, and to ignore Credit and speculative dynamics is to invalidate one’s research and pontification on the subject. I won’t spend a lot of time on the Fed’s research because it is clearly more propaganda (supporting chairman Greenspan’s view) than serious analysis. From the report: “Our analysis of both cash flow affordability and a simple asset valuation model suggests that, given the steep decline in interest rates, home prices do not appear to be at unusually high levels. Moreover, the housing market does not appear to be driven by expectation of rapid future price appreciation.” Such conjecture is simply at odds with the reality of the marketplace. The proliferation of no downpayment mortgages, downpayment “assistance” programs, negative amortization loans, and adjustable-rate mortgages, leaves little doubt that prices and affordability are major issues for a large and growing number of buyers.
“Our analysis indicated that a home price bubble does not exist. Nonetheless, home prices could fall because of deteriorating fundamentals, and thus it is useful to gauge the magnitude of previous declines. Nationally, nominal price declines have been rare. Moreover, real price declines – an important consideration during this period of low inflation – have been mild. For example, the early 1980s and early 1990s featured weak fundamentals – slow income growth and high nominal interest rates and unemployment – yet real home prices declined only about 5 percent.”
Similar analysis of NASDAQ toward the end of 1999 would surely have been as sanguine. Price collapses would have been seen as rare. There was certainly an overriding perception that prices were supported by truly extraordinary fundamentals –incredible earnings growth, low interest rates, strong economic expansion, low inflation, and confidence in policymakers. But it is the very defining nature of Asset Bubbles to fool the masses and their policymakers with alluring “fundamentals.” And despite the fact that Fed researchers use low interest rates as a primary positive fundamental factor arguing against the housing Bubble scenario, it is an economic fact of life that the greatest Bubbles develop specifically in environments characterized by seductively low consumer price inflation and interest rates.
“As for the likelihood of a severe drop in home prices, our examination of historical national home prices finds no basis for concern.”
Historical models would have forecasted a very low probability for a NASDAQ collapse back in early 2000, while sound analysis of Bubble dynamics would have proffered that the degree of excess dictated that a spectacular bust was unavoidable (although the timing would have been much less clear).
“One reason for the moderate volatility of national home prices is that the housing market comprises many heterogeneous regional markets.”
Researchers and policymakers should tread carefully with this popular line of reasoning. While it is true that housing markets vary by region – and by neighborhood for that matter – housing finance is today a profoundly centralized marketplace and more nationally homogeneous than ever. With huge national banks, the powerful GSEs, the enormous MBS marketplace, the major national home builders, and now the expansive Internet lenders (Countrywide!), a system has evolved that provides basically unlimited mortgage finance and a low national lending rate.
This New Age system is having a profound – and I could argue somewhat uniform - impact on these so-called “heterogeneous” local housing markets. How this “evolution” has altered housing markets would make for a lengthy book. Nonetheless, it is today flawed analysis for the Fed and pundits to mindlessly use historical experience as a guide for the future. Extrapolating asset inflation during periods of Acute Monetary Instability is precarious business, as was the case during the late-twenties, the late-eighties in Japan, SE Asia during 1996, Russia during early 1998, and NASDAQ during 1999. This is definitely the case today with housing. Err on the side of caution.
“Our evidence thus suggests that changing demand fundamentals should cause prices to fluctuate more in California and the northeast than in other areas. Therefore, the strong home price appreciation over 1999-2003 in those areas is a consequence of improving economic conditions combined with relatively unresponsive supply. Our evidence also implies that recent state price fluctuations can be explained through an expanded model of fundamentals.”
Well, the Great California Housing Inflation over the past few years – in the face of a notably weak economic backdrop – strongly suggests factors other than “fundamentals” are at work. First of all, the contemporary mortgage finance system has evolved to the point of supplying unlimited quantities of ultra-cheap finance – Ultra-easy Credit Availability. And Bubble analysis garners us the valuable insight that we should expect the most intense inflationary manifestations in locations presently or traditionally demonstrating the strongest inflationary biases (including speculative impulses/inflationary psychology). This would certainly include markets throughout the Golden State, as well as Greater New York, Boston, and all along the east coast. And, importantly, the nature of the improvident mortgage finance marketplace will also ensure rampant price gains for the most appealing properties throughout “heterogeneous” regional, metropolitan, and neighborhood markets across the country.
Property on creeks, rivers, lakes, bays, oceans or virtually any body of water is prone to strong inflationary gains, from coast to coast. Home prices in the most prestigious neighborhoods will skyrocket, whether it is in Boise, Dallas, St. Louis, or Washington D.C. And while these “heterogeneous” markets will, of course, have varying valuations, the national Mortgage Finance Bubble ensures that the relative prices of choice properties are all bid up to unreasonable extremes.
Housing dynamics in Dallas provide important insights. Virtual buyers’ panic has fueled intense housing inflation in the prestigious “Park Cities” communities. But with vast quantities of developable land in the expanding suburbs (as the circumference of the circle enlarges), regional home price indices post only small gains. I assume similar dynamics mask the extent of housing inflation effects in communities across the country – pricing Bubbles for the limited quantities of the most sought-after properties in established neighborhoods, while over-building prevails in the outlying suburbs. All the while, Fed researchers can examine aggregate price data – especially the OFHEO series that uses only the price-capped “conventional” mortgages that have been previously sold or refinanced – and completely miss the essence of contemporary mortgage finance excesses.
As I have argued for some time, the Mortgage Finance Bubble is the crucial issue. And the evidence of historic Credit excess is anything but inconspicuous. Over the past seven years (Q1 1997 to Q1 2004), Total Home Mortgage Debt has surged 94% to $7.376 Trillion. Total Mortgage Debt, including commercial and multi-family, is up over the same period by 93% to $9.618 Trillion. Looking at the source of mortgage finance, Bank Real Estate loans have doubled in seven years to $2.386 Trillion. Over the past 53 months (for which I have data), combined Fannie and Freddie Books of Business have surged 78% to $3.677 Trillion. Over the past six years, Federal Home Loan Bank Assets have surged 140% to $857 billion.
And while the consequences of this massive inflation of Mortgage Credit are not always obvious, there is certainly sufficient evidence to support a simple Bubble thesis. As was noted above, over the past six years, home sales (New and Existing) Prices have jumped about 50% and Volumes 40%. Dollar transaction volume has doubled. But these data do not do the Mortgage Finance Bubble justice.
Total Mortgage Credit increased $1.0 Trillion last year. This compares to the average annual increase of $206 billion during the first eight (pre-Bubble) years of the nineties. The heart of Bubble analysis lies with the impact this deluge of new Credit has had - and could continue having - on both the “financial sphere” and the “economic sphere.” I would strongly argue – and this is where Bubble analysis is necessarily more an art than a science – that massive inflation of mortgage Credit has been the instrumental fuel behind liquid financial markets, economic expansion, and income growth. And the reason “Bubble” terminology applies is not because home values are detached from “fundamentals,” but rather because of the dangerously self-reinforcing and inevitably unsustainable nature of the underlying Credit expansion, asset inflation, speculative excesses and economic maladjustment.
As mentioned above, the Fed’s housing Bubble research does not mention Credit. Nor does it address speculative holdings of mortgage-backed and agency securities, the ballooning derivatives market, GSE exposure, the mushrooming Current Account Deficit or the underlying structure of the U.S. economy. Yet these are the fundamental issues that will determine the sustainability of The Great Mortgage Finance Bubble.
With interest-rates remaining quite low and housing markets booming, the system is poised to generate the required $1.1 Trillion plus of new mortgage Credit this year (to sustain the financial and economic Bubbles). But with prices being aggressively bid up in California and throughout other markets around the country, next year will require only larger Credit growth to sustain levitated prices, and the year after even more. And, importantly, the nature of this type of Credit inflation will continue to foster over-consumption and severe investment distortions for the “economic sphere.” The pricing structure of the U.S. economy becomes only less competitive, with “investment” spending focused on housing and domestic consumption rather than internationally tradable goods and services. The day that the additional purchasing power associated with $1 Trillion or so of new mortgage borrowings is not forthcoming will be the day the system will be faced with the reality of scores of uneconomic businesses and an enormous amount of problematic debt.
In the meantime, the “financial sphere” is faced with the specter of incessant ballooning to finance this ongoing Credit inflation. The banking system is performing yeoman’s work in this regard so far this year, but for how long? Prolonging the Bubble will require the resumption of GSE balance sheet ballooning, with all eyes on the leveraged speculating community and their massive holdings of mortgage and agency instruments. Let’s keep in mind that the Fed has not yet commenced the process of returning to more “normalized” rates. And with funds continuing to flow to the hedge fund community and ongoing Wall Street expansion, I believe at this point “de-leveraging” is more a myth than reality. But the reversal of speculative flows and the unwind of leveraging is an inescapable aspect of financial Bubbles – when and from what degree of excess, not if.
And while the Mortgage Finance Bubble does possess considerable momentum today, it remains acutely vulnerable to higher rates. The Fed is keenly aware of this dynamic and keenly hoping to administer “Tightening Lite.” And the markets are keen that the Fed’s keen, and leveraging in the U.S. Credit market is at least as popular as ever.
But the dilemma for the Mortgage Finance Bubble at this point – that goes completely unrecognized in Housing Bubble research and pontification – is that there is a major foreign component involved. The requisite $1 Trillion plus annual Mortgage Credit inflation will occasion $600 billion plus current account deficits for the duration of the Bubble. This is assured by the nature of Dysfunctional Monetary Processes – asset and consumption-based lending and Bubble Economy Dynamics. And dollar balances will continue to inundate the world and foreign central banks will be forced to acquire/monetize these flows. As long as these processes hold, the likely upshot will be continuing inflationary effects for China, Asia, and economies across the globe, along with general Monetary Disorder.
This week the dollar weakened against the yen, which conjures up images of Japanese dollar support and a resumption of Treasury purchases, which conjures up marketplace visions of stable to lower U.S. yields, which conjures up hopes for the beloved status quo – the perpetuation of U.S. imbalances, global reflationary dynamics and speculator nirvana. But it all does leave one wondering how high California home prices can go; how big the primary dealer outstanding repurchase agreement position can grow; how long the U.S. financial sector can continue to balloon; how enormous the leveraged speculating community can become; and how long foreign central banks, speculators and investors will play along. Wither the dollar?
The harsh reality is that we are dealing with an historic and quite energized Bubble, and the severity of distress and dislocation associated with the inevitable bust will be commensurate with the degree of excess from the (out-of-control) boom.
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