There have been speculative manias for as long as human beings have been allowed to speculate en masse. US Housing, Dot Com, the South East Asian Tigers, Japan, the South Sea Bubble, Dutch Tulip mania… the list stretches on through financial history.
What do all these episodes have in common? People. The objects of speculative mania have changed, the century in which they have taken place has changed, but people haven’t.
We have a strange, and quite dangerous, propensity to do what everyone else is doing, especially when it involves making a quick buck. Combine this with our general refusal to learn from history, or the wisdom of those who have been there before, and bubbles come to represent the heights of human absurdity and comedic irrationality.
For those riding the bubble rollercoaster, the ride is gloriously exhilarating on the way up, and multiples more terrifying on the way down. For those who have lived through it all before, they present a mixture of frustration and resignation in knowing how it all ends, but being unable to convince those caught up in the mania of the dangers – people tend to learn things the hard way after all.
BBT&T is a Collection that tries to highlight the absurdity of emotionally driven herd behavior, that in retrospect, never fails to elicit sighs of “What were we thinking?!?”. It is our attempt, in full knowledge of its ultimate futility, at showing that bubbles are not driven by an asset’s underlying value, but its perceived value; not by purported rationality, but pure emotion.
Focus on the people, not the assets!
Let’s conclude our discussion on mortgage rates, house prices and epiphenomena with the Fed’s role in the housing market.
By extension, the Fed doesn’t really have that much control over the US housing market, at least not through the interest rate channel.
That being said, the Fed does (or did) exert influence on the US housing market through their purchase of Mortgage Backed Securities (MBS).
While the Fed has called time on making new net additional purchases as it begins to tighten monetary policy, it is still reinvesting principal payments on previous MBS purchases.
This has led many to believe that the Fed is still acting to artificially keep mortgage rates low, thereby contributing to higher housing prices.
While this sounds logical and seductively simple, it isn’t true.
Firstly, most people believe that the Fed’s MBS purchases gives banks carte blanche to make as many new mortgages as possible. This is not the case, as banks must make mortgages in accordance with GSE (Fannie, Freddie, etc) requirements in order to sell them to the GSEs.
The Fed can’t, or rather, won’t, purchase them otherwise.
As such, the Fed does have some influence in that particular subset of the market (GSE mortgages), but not outside of it.
The real driver of the US housing market is total bank mortgage lending, as detailed in our article on QE’s effect on housing.
Bank mortgage lending is in turn determined by two main forces.
First is of course the bank’s willingness and ability to originate new housing loans, and second, the demand for such loans from potential home buyers.
The interaction of these two forces is what truly matters, not the Fed.
Furthermore, we know that the “low rates = high house prices” line of thinking is empirically untrue. This is easily observed, yet somehow missed by mainstream commentators, in the current environment where house prices and mortgage rates have been rising together.
If the Fed’s MBS purchases really did keep rates low, wouldn’t mortgage rates continue to be low even as house prices skyrocketed?
Ultimately, misunderstanding, or grossly overestimating, the Fed’s role in the housing market stems from two different but interconnected sources.
The first is a Fed-centric paradigm, where the Fed is mistakenly perceived as sitting in the center of the financial system, and therefore thought to be omnipotent. (Spoiler alert: The Fed isn’t the center of the financial universe, and it isn’t omni-anything)
The second is a conflation of epiphenomena; the direction of interest rates and house prices, which turns out to be nothing more than a more specific instance of the interest rate fallacy.
Finally, it is important to note that real estate prices are a famously local phenomenon, hence the adage “location, location, location”.
The purpose of this series of articles is to demonstrate the relationship between rates and home values from a broad macro standpoint, hence our use of the National home price index in earlier parts.
If national home prices do fall, it will be for a combination of factors. Chief of which being demand falling due to buyers facing economic uncertainty, or an oversupply of housing, perhaps even a mixture of both.
Mortgage/interest rates will certainly play a part as the cost of financing, but in all likelihood they won’t be the major cause.
If you ever find yourself getting caught up in mainstream narratives conflating rates with house prices, remember Fat Tony words!
Mistaking mortgage rates for the real estate market is what is technically termed an epiphenomenon.
The word simply refers to a secondary phenomenon that occurs alongside a primary one.
Since they occur together, people mistakenly attribute a causal relationship to both, even though this often isn’t the case.
A different, and more drastic example will help to further illustrate the point, courtesy of Nassim Taleb.
In his book Antifragile, Taleb uses the example of the First Gulf War to highlight the dangers of falsely attributing causal links in markets.
As with any war or instance of geopolitical unrest in the Middle East, oil gets caught up in the middle of it, and the First Gulf War was no exception. Taleb recounts, through the character Fat Tony, how the analyst community and financial media were predicting a rise in oil prices should war break out.
Consequently, resources were devoted to studying and trying to ascertain the probability of the US taking military action, and how quickly such action could last.
In other words, they were focusing on the possible event of war, to the exclusion of the oil market itself.
The war here, in the minds of these folks was the primary phenomenon, and the effect on oil prices the secondary one.
In their minds, if war broke out, it would cause oil prices to rise. This is after all, a notion that is both simple and very “common-sense”.
Unfortunately, the opposite turned out to be true.
War did break out, but when it did oil prices tumbled by almost half.
Which also meant that everyone who correctly predicted that war would break out and went long oil ended up losing a lot of money. Ultimately, the oil market had been building up inventory in anticipation of war breaking out, which created too much of a supply overhang.
In the words of Fat Tony himself:
“Kuwait and oil are not the same ting [thing]”Nassim Taleb, Antifragile
In the context of the US housing market, house prices are the primary phenomenon, and interest rates the secondary one.
Focus on what housing prices and rising mortgage rates are telling you, that demand is currently outstripping supply for homes. This imbalance is driving a bull market in housing that is dragging mortgage rates higher in its wake, not the other way around.
Which also means that when house prices and mortgage rates turn, and start to fall together, it won’t be because the Fed raised rates by too much.
Instead, it will be because supply and demand in the housing market have come into some sort of balance, or driven to the opposite extreme of imbalance (supply outstripping demand).
Channeling Taleb’s Fat Tony: Mortgage rates and house prices are not the same thing!
To be continued…
Now that you have a better understanding of how the interest rate fallacy applies to the housing market, let’s take a look at another often misinterpreted chart.
This one shows how 30y mortgage rates have trended down, and US national home prices trended up, since the late 1980s. Note that this chart shows the index value of home prices, and not the change in the index value, as depicted in the chart from Part 1.
These opposite trends, together with the strongly entrenched interest rate fallacy, has led to many people screaming that lower rates are causing housing bubbles.
This may have been true prior to the Great Financial Crisis (GFC), when housing credit availability was much higher (remember banks and subprime lending?).
But, beware the trap of mistaking correlation with causation!
Based on what we now know about the interest rate fallacy and the Housing Credit Availability Index, our post GFC reality is clearly more complicated than what this chart implies.
Yes, mortgage rates have undoubtedly fallen over the past few decades together with US Treasury yields. However, this does not mean that higher rates will cause national house prices to fall in a dramatic fashion.
Firstly because, post GFC, lower mortgage rates have only benefited a small subsection of the overall home buying population – those who are very creditworthy. As such, higher rates won’t be the main factor in popping the bubble of today’s high home prices.
This is due to the fact that the ones doing all the borrowing, buying, and selling are some of the most creditworthy folks in the country. It will take a much larger interest rate shock to drive this particular demographic into mass defaults.
Secondly, and arguably more importantly, real estate is its own market.
What does this mean?
Simply that the financial media likes to point towards a single external factor as causing a particular market to rise and fall, when it’s really the internal factors that matter more.
That is, the supply and demand dynamic in the particular market.
At the end of the day, most, if not all of these examples represent the conflation of correlation and causation. A deeper understanding of these markets and how the external factor supposedly affects them will reveal this.
Now, the same thing is happening in US real estate.
As hysteria over Fed hawkishness mounts, even with uncertainty over the second order effects of war in Ukraine, folks are forgetting that what really drives prices in the housing market is demand running ahead of supply.
For whatever reason, since the onset of the pandemic, folks who are able to get banks to finance them have been piling into the housing market.
No complicated analysis is needed to see this, rising home prices tell the story succinctly. Demand is running ahead of supply.
Until this changes in a significant way, the housing market will remain bullish, regardless of what interest rates are doing.
This implies that folks who are purchasing homes for investment or speculative purposes think that the rate of return they can earn is higher than the mortgage rate they have to pay.
Put another way, would you borrow at 4% to purchase a house that you intend to flip if you think that you can only sell it for a 3% return?
You would only be willing to take out a mortgage at 4% if you think that you can get a return greater than 4%.
All of this is not to say that interest rates have no effect on house prices – of course they do.
How much potential homeowners have to pay to finance their purchase is one of the factors affecting their final decision. If mortgage rates rise to the point where they exceed buyers’ expectations of future returns, the market will obviously be negatively affected (at least for a while).
Ultimately, it is important to remember that real estate is its own market.
Interest rates are but one of the many factors that affect the supply and demand dynamic within it, and should not be seen as the only, or main, factor driving prices.
Thinking otherwise is dangerously reductive!
To be continued…
In order to see why this is the case, let’s go back to our example of her selling her home into a bullish market.
In all likelihood, she will also be selling during a period where mortgage rates are high.
Because demand for homes, and thus mortgages are high during a housing bubble.
Think about this from a bank’s perspective. If more and more people come in looking to take out loans to buy homes, i.e. demand is high, what is the rational business decision to take?
Charge them more, of course!
Which, in terms of a mortgage, simply means a higher mortgage rate.
Consequently, higher mortgage rates don’t necessarily lead to lower home prices. As a matter of fact, higher rates strongly indicate growing bullishness, if not exuberance in the housing market.
If you remain unconvinced, or skeptical by this simple explanation, it’s probably because you are caught up in the interest rate fallacy. This fallacy mistakenly associates higher interest rates with a shortage of money, and lower rates with an excess of money.
In reality, the opposite is true for two reasons.
The first has already been explained above, where banks loan more money (increase the money supply) when demand for loans is strong, and charge more for it (interest rates rise).
Therefore, an increase in money supply comes with an increase in interest rates.
Secondly, interest rates are also subject to the effects of hoarding. But the hoarding of what, and by whom?
It’s the hoarding of loans by banks.
Without getting into too much detail, banks have to hold a certain amount of capital against their assets. The riskier the asset, the more capital it requires. Since mortgages are assets to a bank (because they earn money from the interest), bank managers need to hold capital against the mortgages they make.
More importantly, they also need to ensure that the return on the mortgages they originate is enough to justify the amount of capital held against it, on a risk adjusted basis. If it doesn’t, the bank is better off using that capital to back some other asset with a more attractive risk/return profile.
Consequently, in order to make best use of their available capital, banks need to make mortgages to the most creditworthy clients, since they present the lowest risk profiles.
In other words, banks are hoarding their capital; in terms of only originating mortgages to those most likely to pay them back, and not everybody else.
This is best expressed in the chart below, of the Housing Credit Availability Index (HCAI).
As you can clearly see, mortgage availability has shrunk considerably since the bursting of the US housing bubble in 2007-2008, with lenders becoming increasingly intolerant of defaults by borrowers.
The direct consequence of this hoarding is that banks end up competing for the same relatively small pool of very creditworthy clients.
Lower mortgage rates of course!
How else would a bank tempt a very creditworthy client, who is spoiled for choice of banks to choose from, to borrow from them?
To be continued…
Another way to observe that home prices (in the US, and most likely everywhere else) don’t react in the same mechanical way to changes in interest rates as bonds do, is by looking at their correlation.
Bonds and rates have an inverse relationship. This means a correlation of -1. When one variable goes up, the other goes down.
If this were true for houses and rates, we would see a correlation that, at the very least, remains negative most of the time.
Instead we have this:
The correlation between home prices and 30y mortgage rates continuously cycles between 1 and -1. In other words, the relationship between both constantly changes, as is the case with most other market relationships in a free, capitalistic environment.
Simply put, homes aren’t 30y bonds.
Why is this the case?
The first reason is that the home and bond parallel is one of those comparisons that make a lot of sense of the surface, but doesn’t actually hold up to scrutiny.
Yes, folks do take out 30y mortgages to purchase homes, and if a homeowner rents out her property, the rent could be seen as a coupon payment.
From this perspective it really does seem like homes are, or at least, can mimic the properties of a 30y bond.
But, homes and bonds are fundamentally different.
Bonds pay a fixed coupon, and a fixed repayment of principal (the amount that the bond issuer borrowed) at maturity. The coupon isn’t that important to our discussion since the bulk of a bond’s value comes from the repayment of principal.
This big lump sum repayment that happens in the future is discounted to the present using prevailing interest rates.
For those unfamiliar with this concept, it is simply a time value of money calculation, and is also used in discounted cash flow models to value companies.
As such, higher rates mean lower present values, since the principal amount is discounted by a larger percentage rate.
Mathematically, if the numerator is always fixed (the principal), increasing the value of the denominator (interest rates) will necessarily give us a smaller result. Hence the mechanical and inverse relationship between a bond’s price and interest rates.
However, while bonds repay a fixed principal amount, houses do not.
For the sake of easy comparison, let’s assume a homeowner sells her house after 30 years.
In all likelihood, the amount she gets for it won’t be close to the amount she paid for it, as the price at that point will be determined by supply and demand for homes in that particular location.
If she sells her home when the real estate market is very bullish, the price she gets for it will be higher than what she borrowed to pay for it.
Again from a mathematical perspective, if the numerator is higher, and the denominator is also higher, what will the result be?
It would depend on whether the numerator increased by more than the denominator, or vice versa.
Which means that the relationship between interest rates and home prices isn’t as tight and mechanical as they are with bonds.
But won’t higher rates still mean a lower price for her home today, because she isn’t selling it yet?
To be continued…
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