Traditionally, US housing drives both phases of the economic cycle – sharp cutbacks in construction weaken economic activity, but as soon as the underlying demographic demand restores equilibrium, construction recovers quickly.
This time is different. Four years after the US recession began, housing starts are running at one-quarter of the peak rate.
Housing prices are more than 30 per cent below the peak and no-one is predicting a dramatic recovery. Twelve million mortgages are 'underwater' (when the debt owed is more than the price of the house), which represents more than one-fifth of homes with a mortgage. In Nevada, Arizona and Florida, half the mortgages are underwater. Middle-class wealth has been devastated: $7 trillion has been lost and the ratio of home equity to disposable income has fallen from 140 per cent to 60 per cent.
Central to this boom-and-bust story is the failure of both monetary policy and financial supervision. It was a key element of the Greenspan doctrine that nothing could or should be done to stop asset bubbles. Central banks couldn't identify them, and they had no instrument to restrain them. The most that policy could do was clean up after the bubble burst. This viewpoint kept interest rates abnormally low in the five years following the collapse of the tech bubble in 2001.
The low policy rate pulled 30-year mortgage rates down from around 8 per cent to around 6 per cent, not just providing a dramatic reduction in borrowing costs, but an opportunity for existing mortgagees to refinance their loans at lower cost and take out equity to boost consumption. In 2005, 40 per cent of existing mortgages were refinanced and household savings fell to essentially zero.
But monetary policy shouldn't shoulder all of the blame.
The extra element was the extraordinary innovations in the financial sector. Honeymoon teaser low-interest, interest-only loans were offered to borrowers previously considered to be ‘unbankable’. Loan-to-valuation ratios explored new highs. A whole new class of borrower was brought into home ownership, with the ownership rate going from its historical rate of around 64 per cent of homes, to 69 per cent. All this took place in full view of the various regulators, but no-one saw it as their duty to blow the whistle or try to stop the party.
In response to newly empowered demand and the incentive of ever-increasing prices, housing construction was pulled forward in time, anticipating future demand. The result was not just too much house-building, but too much of it owned by people who couldn't afford it.
The second half of this story focuses on the pro-cyclical nature of financing and the inability of monetary policy to counter this. As soon as the downturn arrived, the easy money disappeared and credit standards were tightened. The policy rate was dramatically reduced to essentially zero, but little of this easing was passed through to over-stretched borrowers.
The variable-rate funding associated with sub-prime dried up. Conventional housing finance – 30-year mortgages – have come down from around 6 per cent to around 4 per cent, but the fall is of little use to many borrowers. In normal circumstances they would be able to refinance their loans at the new lower rate, but this option is not available to six million mortgagees currently stuck with loans at 6 per cent or more. They are ineligible for a number of reasons: the most common is that their loans are underwater; in some cases their circumstances have changed (perhaps they are included in the near-9 per cent of the workforce now unemployed); or their credit score no longer meets the toughened lending requirements.
The government-sponsored enterprises (GSEs), Fannie and Freddie, are caught in the ambiguity of their half-government/half-private status: they can improve their own financial strength by recalling some of the refinancing previously given to other lending institutions (thus improving their own bankrupt position), but in so doing make the overall situation worse. Funding from non-GSE sources has essentially dried up.
In an unusual step, the Fed has just sent a White Paper to Congress setting out the situation and suggesting some measures. Maybe the government can devise more generous ways to spread the current lower mortgage rates to a wider group of borrowers (it already guarantees more than half of them), but it will be at the expense of the investors (including the GSEs) who currently hold the mortgages.
Eventually demographics will reassert themselves: people need a roof over their heads and rents are rising, which will bring out landlord investors. But the high stock of repossessed houses is a glut on the market, and official estimates see more than a million extra repossessed homes added to the market in each of 2012 and 2013.
In due course things will be back where they started. The abiding lesson is that housing drives the cycle. The new lesson is that inadequate financial supervision in the upswing makes things much worse, and monetary policy is a weak instrument for cleaning up the wreckage afterwards.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.