Rate Hikes and the Fed’s Goals
Finally, a 1/4% increase in Federal Funds rate. The immediate response from the banks was 1/4% hike in the prime rate to 3.5%. This may have some effect on HELOCs. Adjustable mortgages facing reset may also see some changes. These minor adjustments should however have no direct impact on the real estate market.
As for the 30 year mortgage rate, so far the reaction has been nothing more than normal daily fluctuations. Even if mortgage rates eventually settle at a 1/4% higher level, that is only $30 a month for a $200,000 mortgage, or $60 to $70 a month extra in household income to qualify for the same mortgage. A quarter point should not make much of a difference but what about half a percent or more?
This mansion in Pacific Heights, San Francisco was sold for a record price of $31 m. in 2015 – it netted its owners a $4 m. profit in less than two years. Reportedly no improvements were made to the property. SF is one of the regions in which bubble conditions are not merely noticeable, but are better described as “raging”.
Photo credit: Zilov / MLS
Richmond Fed president Lacker said that four rate hikes in 2016 would be considered gradual. Assuming that each hike amounts to a quarter percent and long rates move up in unison, we may see mortgage rates in the 5% range. Is the real estate market strong enough to support that?
San Francisco Fed president Williams said that the Fed aims to keep the economy running hot in 2016 but will target a 3.25-3.5% federal funds rate for 2017. He also opined that if a shock were to hit the economy and send it back to recession, the Fed would not hesitate to cut rates and perhaps buy more bonds. Is that QE4? At the same time, he acknowledges:
“We are still in a situation where most of our tools are fully employed. It’s like an army that’s got all of your forces out there, you don’t have a lot of reserves,” said Williams. “It’s hard to feel like, well, I’m feeling any kind of sense of victory or something.”
Fed policy is data dependent, so Ms. Yellen has said repeatedly. Is the real estate market part of this “data”? Yellen has also repeatedly stated that real estate is recovering, if too slowly. I am not sure how she defines recovery. Is she hoping for double digit price appreciation and the crazy 2 million per year housing starts we have seen 10 years ago?
Once upon a time, there were private lenders, portfolio lenders, private label MBS, agency MBS and other miscellaneous sources for financing a real estate purchase. Mortgage rates were determined by market supply/demand and only somewhat influenced by the short term rates the Fed controls. That changed after the QE operations. Housing is financed almost entirely by the agencies – Freddie, Fannie, VA and FHA.
Total mortgage debt outstanding for 1-4 single family residences, including non-agency debt, is $9.95 trillion. The first QE program started in early 2009. It took six years and three QE programs for the Fed to accumulate $1.758 trillion in agency MBS. For the entire calendar year, mortgage rates have held steady, fluctuating within a quarter percent of 4%.
During 2015, the Fed has purchased $338.4 billion of agency MBS. These purchases are not additional purchases, they are replacing maturing bonds and pre-paid mortgages. If the Fed were to allow maturing or prepaid MBS to roll off the books without replacing them at the rate seen in 2015, it would take 5.2 years for the Fed’s balance sheet to unwind all QE-related MBS purchases.
Mortgage backed securities held by the Fed – since the end of “QE3”, the number has largely remained fixed, as the Fed continues to replace all maturing securities. If it didn’t do that, the US money supply would deflate – click to enlarge.
The Central Planning Dilemma
What real estate data will the Fed be looking at in the context of monetary policy decisions? Unfortunately for Ms. Yellen, her predecessors have dug a really deep hole for her. Starting with Greenspan, Fed policy has been to accommodate or to accommodate more (see chart below). The real estate market has survived not by low rates, but by the continual lowering of rates.
The Fed, resp. Ms. Yellen have never mentioned a target for mortgage rates, but in theory they can try to park themselves at a specific bid/ask so as to exercise full control over mortgage rates. However, if mortgage rates increase and the Fed starts purchasing more MBS to counter the trend, it may trigger yet more selling and therefore push mortgage rates even higher.
The Fed may also be looking at the Case Shiller national index. Remove the sub-prime mania (the four years ending 2006) and the correction that followed, and the index now is rising above historical trend and at a faster pace than in the last 30 years. Look at the steep rise in prices since 2012. The market is screaming bubble. Is that the green light to tighten monetary policy further?
On the other hand, Corelogic reported that as of Q3 of 2015, 4.1 million or 8.1% of all mortgaged homes still have negative equity. 8.9 million homes have less than 20% equity. Also per Corelogic, 10.2% of all sales in October were of distressed properties. That does not sound very healthy. Should the Fed consider additional accommodation?
As a side note to this, the Mortgage Debt Forgiveness Act has been extended through 2016. In other words, debt “forgiven” in a deficient sale will not be treated as income. Those who have been in that miserable predicament for so many years, should get off their fanny and complete a short sale now. This may be their last chance.
There are so many things that are fundamentally wrong with the real estate market that I will leave most of them to future rants. For now, I would like to point out that the market suffers from an acute supply and demand imbalance, both geographically and in terms of its mix. All the demand in Silicon Valley is not going to help Texas, which may start to reflect the stress of the oil industry.
In high demand areas like coastal California, construction of low cost entry level housing is economically infeasible. As an investor it is more important to understand that if the real estate market heads south, the Fed will do whatever it takes to save it, as if it actually knew how.
I will close the first post of the new year with three observations:
- The market cannot handle a 5% or higher mortgage rate. Refinancing still accounts for over 60% of mortgage applications. At 5% or above, the only refinancing business left would be the government’s HARP subsidies. As for purchases, all stressed out first time buyers with high debt to income ratios and low down payments will be wiped out. Without the entry level, the trade up level is gone as well.
- The Fed is in control of the real estate on/off button, but I am not sure if the Fed or Ms. Yellen appreciate the precarious position they are in. I agree with SF Fed president Williams that all Fed tools have already been fully employed and there is nothing left. Transparency invites front-running. If the MBS market moves up (rates up/bonds down) in anticipation of tapering or more rate hikes, the Fed may have no tools left to effectively counter the move.
- It is impossible to tell what policy makers will do, especially during an election year. Voters will vote for wild unrealistic promises – the wilder, the better. If real estate prices depreciate, resulting in rising defaults and foreclosures, there will be zero chance that any branch of government is going to advocate allowing the free market to correct previous excesses.
In conclusion, it appears the Fed cannot raise rates and the Fed cannot not raise rates either. There are equally strong arguments for and against both steps [ed. note: this in fact a typical example for the central planning dilemma – the planners simply cannot know what the “correct” interest rate is]. Personally, I look forward to the trading opportunities the Fed’s actions will likely bring in 2016.
Charts by: St. Louis Federal Reserve Research
Image captions by PT
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