Causes of The United States Housing Bubble - Government Policies - Historically Low Interest Rates

Historically Low Interest Rates

According to some, such as John B. Taylor and Thomas M. Hoenig, "excessive risk-taking and the housing boom" were brought on by the Federal Reserve holding "interest rates too low for too long".

In the wake of the dot-com crash and the subsequent 2001–2002 recession the Federal Reserve dramatically lowered interest rates to historically low levels, from about 6.5% to just 1%. This spurred easy credit for banks to make loans. By 2006 the rates had moved up to 5.25% which lowered the demand and increased the monthly payments for adjustable rate mortgages. The resulting foreclosures increased supply, dropping housing prices further. Former Federal Reserve Board Chairman Alan Greenspan admitted that the housing bubble was "fundamentally engendered by the decline in real long-term interest rates."

Mortgages had been bundled together and sold on Wall Street to investors and other countries looking for a higher return than the 1% offered by Federal Reserve. The percentage of risky mortgages was increased while rating companies claimed they were all top-rated. Instead of the limited regions suffering the housing drop, it was felt around the world. The Congressmen who had pushed to create subprime loans now blamed Wall Street and their rating companies for misleading these investors.

In the United States, mortgage rates are typically set in relation to 10-year treasury bond yields, which, in turn, are affected by Federal Funds rates. The Federal Reserve acknowledges the connection between lower interest rates, higher home values, and the increased liquidity the higher home values bring to the overall economy. A Federal Reserve report reads:

Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission.

For this reason, some have criticized then Fed Chairman Alan Greenspan for "engineering" the housing bubble, saying, e.g., "It was the Federal Reserve-engineered decline in rates that inflated the housing bubble." Between 2000 and 2003, the interest rate on 30-year fixed-rate mortgages fell 2.5 percentage points (from 8% to all-time historical low of about 5.5%). The interest rate on one-year adjustable rate mortgages (1/1 ARMs) fell 3 percentage points (from about 7% to about 4%). Richard Fisher, president of the Dallas Fed, said in 2006 that the Fed's low interest-rate policies unintentionally prompted speculation in the housing market, and that the subsequent "substantial correction inflicting real costs to millions of homeowners."

Economist Joseph Stiglitz argues that Greenspan was compelled to cut rates to maintain growth and employment after the 2001 and 2003 tax cuts of the Bush administration failed to lift the economy out of the post-Dot-com bubble recession.

A drop in mortgage interest rates reduces the cost of borrowing and should logically result in an increase in prices in a market where most people borrow money to purchase a home (for instance, in the United States), so that average payments remain constant. If one assumes that the housing market is efficient, the expected change in housing prices (relative to interest rates) can be computed mathematically. The calculation in the sidebox shows that a 1 percentage point change in interest rates would theoretically affect home prices by about 10% (given 2005 rates on fixed-rate mortgages). This represents a 10-to-1 multiplier between percentage point changes in interest rates and percentage change in home prices. For interest-only mortgages (at 2005 rates), this yields about a 16% change in principal for a 1% change in interest rates at current rates. Therefore, the 2% drop in long-term interest rates can account for about a 10 × 2% = 20% rise in home prices if every buyer is using a fixed-rate mortgage (FRM), or about 16 × 3% ≈ 50% if every buyer is using an adjustable rate mortgage (ARM) whose interest rates dropped 3%.

Robert Shiller shows that the inflation adjusted U.S. home price increase has been about 45% during this period, an increase in valuations that is approximately consistent with most buyers financing their purchases using ARMs. In areas of the United States believed to have a housing bubble, price increases have far exceeded the 50% that might be explained by the cost of borrowing using ARMs. For example, in San Diego area, average mortgage payments grew 50% between 2001 and 2004. When interest rates rise, a reasonable question is how much house prices will fall, and what effect this will have on those holding negative equity, as well as on the U.S. economy in general. The salient question is whether interest rates are a determining factor in specific markets where there is high sensitivity to housing affordability. (Thomas Sowell in his book, Housing Boom and Bust, points out that these markets where there is high sensitivity to housing affordability are created by laws that restrict land use and thus its supply. In areas like Houston which has no zoning laws the Fed rate had no effect.)

Read more about this topic:  Causes Of The United States Housing Bubble, Government Policies

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