Is the Fed blowing a new housing bubble?

Reuters

Newly constructed single family homes are shown for sale in San Diego, California March 25, 2013.

Article Highlights

  • More than a trillion dollars have been added to the market value of single-family homes.

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  • Home prices are being levitated by quantitative easing.

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  • The government continues to go to extraordinary lengths to prop up home sales by guaranteeing nearly 90% of new mortgage debt.

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Over the past year, the Federal Reserve has ramped up its policy of quantitative easing, with the result being new stock market highs and surging bond prices. Moreover, housing prices jumped 8%, the biggest annual gain since 2006.

The result is that more than a trillion dollars have been added to the market value of single-family homes. Homeowners are now wealthier and according to what economists call the "wealth effect," they should be willing to spend more, helping the economy.

But there is another, less sanguine view of the housing recovery. Recent data released by the Federal Housing Finance Agency (FHFA) suggest that the increase in house prices is not being driven by a broad-based improvement in the economy's fundamentals. Instead, the Fed's lower rates are simply being capitalized into higher home prices. This does not bode well for the future.

A comparison of FHFA's conventional home-financing data for February 2012 and February 2013 shows that borrowers bought newly built and existing homes in 2013 for 9% and 15% more respectively than in the previous year. Increases of this magnitude cannot be attributed to higher incomes, as these rose a mere 2% over the last year, just keeping up with inflation. It appears that home prices are being levitated by quantitative easing. Because interest rates were .625% and .90% lower on new and existing homes respectively this year compared with last year, the monthly finance cost to purchase a new home remained the same and went up only 3% for an existing home.

While a housing recovery of sorts has developed, it is by no means a normal one. The government continues to go to extraordinary lengths to prop up sales by guaranteeing nearly 90% of new mortgage debt, financing half of all home purchase mortgages to buyers with zero equity at closing, driving mortgage interest rates to the lowest level in 100 years, and turning the Fed into the world's largest buyer of new mortgage debt.

Thus, with real incomes essentially stagnant, this is a market recovery largely driven by low interest rates and plentiful government financing. This is eerily familiar to the previous government policy-induced boom that went bust in 2006, and from which the country is still struggling to recover. Creating over a trillion dollars in additional home value out of thin air does sound like a variant of dropping money out of helicopters.

Will history repeat? When it comes to interest rates, whatever goes down must go up.

The average mortgage rate during the first nine years of the 2000s was 6.3% compared with today's rate of less than 3.5%. If mortgage rates were to increase to a moderate 6% in three years, say, some combination of three things would have to happen to keep the same level of homeownership affordability. Incomes would need to increase by a third, house prices would need to decline by a quarter, or lending standards would need to be loosened even further.

The National Association of Realtors and the rest of the government mortgage complex can be relied on to push for looser lending. The Consumer Financial Protection Bureau recently came out with new rules that would grease the skids for relaxed lending standards, compliments of Fannie Mae, FNMA +7.00% Freddie Mac FMCC +5.45% and the Federal Housing Administration.

Given the continued subpar economic recovery and our past experience with the disastrous impact of loose lending encouraged by federal policies, homeowners would best be cautious about spending their new found "wealth." Americans have seen this movie before and know how it ends.

Mr. Pinto, a resident fellow at the American Enterprise Institute, was the chief credit officer at Fannie Mae from 1987 to 1989.

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Edward J.
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