During a recent conference with the chairman of the Federal Reserve, Ben Bernanke, it was noted by the chairman that the housing bubble was not caused by low interest rates. In a monthly survey of mainly Wall Street and other business economists, 42 said low interest rates were partly to blame for the housing boom while 12 sided with Mr. Bernanke and said they weren't. Although we at Keystone State Capital Corporation believe that interest rates were responsible for lifting valuations for houses, we also recognize the importance of high speculation, and how euphoria strengthened the surge in house prices and created a historic bubble.
To begin with, it must be noted that every financial asset is valued through the same mechanism of discounting back profits from the future to their current value, at a particular discount rate (interest rate chosen by the market). The sum of the current values of all these future returns is the current price for the asset. This is true of stocks, bonds, real estate, commodities, etc. Hence, the two key variables in the valuation of an asset are the future expected profits, as well as the average interest rates in the market. For the price of an asset to rise, one or both of these indicators must change in favor of price increases. The interest rate in the market must fall, and/or the future expected profits must rise. The interest rates in the market fell significantly after the recession of 2001-2002 and remained low until 2003-04. This caused the profits on housing (rentals), to be discounted at lower rates, causing the house prices to rise. Also, due to an increased money supply, the rents rose, thus encouraging home buyers to anticipate even further rent increases in the future. These optimistic expectations of higher rents along with lower interest rates provided the necessary fuel to trigger a bubble.
However, interestingly, interest rates started to rise in 2003 and rose until 2005; if interest rates are all that mattered, house prices should have fallen after 2003, but house prices continued to rise until 2006. The graph below indicates that the mortgage originations fell sharply after 2003, corresponding with an increase in the 30 year mortgage rates. So clearly, home prices were driven by positive expectations of rentals from the future. Hence, the blame must be shared by both low interest rates and the euphoria in connection with housing. From this we can also conclude that home prices are not necessarily led by mortgage originations, so the primary emphasis on mortgages as a tool to raise house prices is misplaced.
In addition, we do not accept the claims made by Bernanke about the role played by China in the crisis. Bernanke claims that a savings glut originating mainly from the trade surplus countries like China caused the housing bubble. This cannot be true since the total money supply of the country is controlled by the Federal Reserve, and any increase in the reserves is controlled by the Fed. China may have overvalued the mortgage backed securities since it was a major buyer of those, and buying the MBS at higher price, it could have lowered the yields on them marginally.
Even though we acknowledge the complicity of low interest rates in causing the housing bubble, we do not attribute absolute importance to it. We believe that the unrealistic expectations of home buyers played as great a part in the building up of the bubble.