- The previous decade saw an unprecedented housing bubble and an ensuing financial debacle.
- Federal Reserve Policy seemed out of sync, with the Fed feeding the flames of the housing bubble with low rates and then being slow to respond when the bubble popped.
- The Fed has a dual mandate - full employment and stable prices - which it generally follows by measuring the unemployment rate and the rate of inflation.
- Starting in 1983, the measure of inflation was revised so that house prices became irrelevant and "owner's equivalent rent" was used instead.
- Had the old measure of housing inflation been continued, inflation would have appeared early in the decade and the Fed would have tightened earlier and popped the bubble.
Enough time has passed so that we can begin to put the Panic of 2008 into perspective and think through what could or should have been done to prevent it. The evidence is overwhelming that an unsustainable housing bubble emerged and then, when it popped, blew up the financial system. The bubble was encouraged by the availability of cheap mortgage debt on lenient terms. Cheap debt and rising housing prices became mutually reinforcing trends, as the cheap debt fed demand for housing and created higher and higher prices, and the higher prices assured borrowers and lenders that there was little risk of loss on the debt because houses could always be sold for more.
What Just Happened - The Housing Market - The housing market, as measured by reasonably reliable metrics, surged forward in the early part of the last decade at an annual rate in the low-double digits. This advance was occurring even when official inflation data suggested that prices were rising at less than 3% per year. As the "real" (inflation-adjusted) price reached record levels, the growth rate started to head down in late 2004, and housing prices actually started to decline in early 2006. The decline accelerated and became precipitous, hitting a bottom in March 2012 after "false" bottoms in 2009 and 2010. Supporting data can be found here and here.
What Just Happened - Federal Reserve Policy - As measured by the Federal Funds Rate, the Federal Reserve (Fed) had raised rates to 6.5% in the summer of 2000. In the face of low inflation and a soft economy, the Fed started cutting rates in January 2001 - at the very time house prices were surging higher. It continued cutting rates all the way down to 1.0% in June, 2003. Again, this rate cutting occurred just as house prices were moving higher at a rapid rate. Then, the Fed waited until June 2004 to start raising rates at a steady pace, winding up at 5.25% in June 2006. Thus, the Fed continued raising rates after house prices had already started to decline. The Fed took no action in the face of sharply declining house prices until it started cutting rates in September 2007, largely in response to financial institution liquidity problems. Again, the Fed did not cut rates until some 16-18 months after house prices began a sharp decline. The net result is that the Fed poured gasoline on the fire at a time early in the decade by cutting rates to 1% and then leaving them there at the very time when house prices were rising at an unsustainable rate, and then stood still (and even raised rates) as house prices declined. The history of Fed rate changes is based on data from the New York Fed available here.
Why The Fed Blew It - The Fed has a dual mandate to maintain price stability and full employment. It is not officially charged with any duty to prevent asset bubbles or to stabilize prices for investors. Based on these criteria, Fed policy was understandable. At the time the Fed was lowering rates, inflation was contained and the economy was soft. The Fed raised rates as inflation appeared to be a threat, and can justify its decision not to cut rates until September 2007 by the fact that inflation appeared to be rising and was at a relatively high rate even into 2008.
Owner Equivalent Rent - As always, the devil is in the details. Inflation is generally measured using the consumer price index (CPI). Housing is a very important part of the CPI because housing costs are a major expense for households. How could it be that inflation remained low while house prices were surging higher? Until 1983, house prices played a role in CPI calculations, but in that fateful year, a decision was made to use "owner's equivalent rent" rather than house prices to reflect the costs and the increases in costs experienced by households with owner-occupied residences. Essentially, the government estimates the rent I could have charged someone else to live in my house, and then uses it to calculate the "cost" I have incurred by occupying that house myself. Because 65% or so of American households own the homes they live in, this is a big deal. Putting aside the problems associated with estimating what single-family houses would rent for, the change had enormous significance in that inflation rates could now be low even at times when house prices were rising rapidly.
A Counterfactual History Of This Century - If the old formula (or some formula using house prices) had been used instead of the owner equivalent rent, the last 14 years would have been very, very different. Early in the last decade, housing price increases would have produced high inflation numbers, and the Fed would likely have never reduced rates as low as 1% and would have started tightening much, much earlier - perhaps, in 2002. The housing bubble would have been smaller and would have popped earlier - perhaps in 2004 or 2005 - with much less disastrous consequences, because the total outstanding mortgage debt would have been much smaller. Fewer new homes would have been built, and the market would not have been glutted as much. As soon as prices actually declined, it would have shown up in inflation numbers and would likely have led to earlier easing by the Fed. The financial crisis would never have occurred, there would have been no bailouts, no Dodd Frank, Lehman might still be in business, and we wouldn't be living in a strange world with 0% interest rates and sluggish growth.
Why Housing Bubbles Are Special - One of the reasons the Fed may have had limited concern about the housing bubble is that it had just lived through a stock market bubble involving an enormous run-up in share prices from 1982 to early 2000. This bubble "popped" between early 2000 and 2002-03. There certainly was a degree of adverse effect on the economy, but there was no major recession, nor was there a widespread crisis among financial institutions. Even when two large companies - Enron and Worldcom - were revealed to be cooking their books and failed in 2002-2003, the economy seemed to shrug it off and move forward. So the Fed may have had a cavalier attitude toward bubbles induced by the relatively mild consequences of the stock market crash. It should have understood that housing bubbles are very different for at least three key reasons - 1. leverage, 2. household wealth, and 3. residential construction. While stocks are used to secure substantial margin debt, there is much, much more mortgage debt secured by residences, and the leverage is generally much higher (and it became as high as infinity with no money down mortgages during the bubble, so that the ratio of debt to equity was essentially infinite due to equity equaling zero). This means that a sharp decline in prices immediately produces an enormous volume of distressed debt. While stocks tend to be owned by institutions or wealthy individuals, houses are owned by the middle class (roughly 65% of households). The "wealth effect" on these households results in immediate declines in consumer spending. Balance sheet damage also makes it harder for households to obtain auto loans, credit cards, and other forms of financing. Finally, residential construction is an important part of GDP, and the construction and occupancy of a new residence is inevitably accompanied by expenditures on furniture, appliances, carpets, and other household items. A housing crash stops this process in its tracks at the very time other consumer spending is also declining.
Policy Recommendations - The Fed should not ignore housing bubbles in the future. One way to be sure of this is to use an alternative methodology for calculating inflation by essentially reversing the change which was made in 1983. The existing methodology would continue to be used, but an alternative calculation would be made to provide additional perspective. The Fed has already realized that it has to look at the full employment mandate using a variety of analytical tools. The unemployment rate is the most important one, but other factors - like the labor participation rate - also have to be considered. With respect to the price stability mandate, the Fed already looks at "core" as well as "total" inflation. My suggestion would simply add another alternative calculation which included the impact of changes in house prices. With a high inflation number generated by rising house prices in front of it, the Fed would be less likely to make the mistakes made early in the prior decade.
Structural Issues - It is also time to begin an analysis of the structural issues which lead house prices to surge higher even at times when the economy is sluggish and other inflation is low. In this regard, restrictions on development in certain urban areas may be creating a major impediment to healthy economic growth. It is no accident that San Francisco has a housing shortage and ridiculously high prices. It is interesting that while Texas has been growing rapidly, none of its cities have seen the ridiculously high price levels experienced on the West Coast or in some of the Eastern cities. This is likely due to different policies regarding development. In my own city (Washington, D.C.), we have a number of locations near subway stations that would be ideal for high-density development, but where local opposition, obsolete zoning, or "historic" district rules have made such development impossible.
A relatively modest tweak in Fed policy could protect the economy from a repeat of our recent brush with disaster. It is time for the Fed to look at its policy over the past 14 years and make adjustments to prevent another catastrophe.
Investment Implications - The Fed really made two big mistakes in the last decade. It continued lowering rates while house prices were skyrocketing, and thus poured gasoline on the fire of the housing bubble (sorry for the mixed metaphor). Then, when housing prices started a precipitous decline, it continued raising rates for six months, and then sat on its oars for more than a year before actually beginning to cut rates. What does this mean for investors now?
I suspect that there are too many political problems associated with returning to a pre-1983 inflation metric - even if it were only to be used as an alternative. On the other hand, the Fed will likely try to avoid the mistakes of the past decade by keeping one eye (maybe even both eyes) on house prices. We will not in our lifetime see the Fed raising the fed funds rate about 5% at a time when house prices are actually declining (which is what it did in early 2006).
I think that the takeaway is going to be that the Fed will face yet another hurdle before it can raise rates. House prices will have to be at least stable and probably increasing before the Fed will feel comfortable raising rates - even if unemployment and inflation (calculated using post-1983 methodology) seems to be flashing a green light for rate increases. Of course, this may turn out to be a non-binding constraint; we may not get to reasonable employment and inflation numbers unless and until the housing market is strong and house prices are increasing. But it is also possible that we could get inflation from an "oil shock" and have a reasonably low unemployment rate, combined with declining house prices. If this occurs, I think the Fed will be reluctant to raise rates. I guess what this results in is - ok, I will come out and say it - a "Fed put" under house prices.
The other takeaway is less relevant now, but should be noted. If we enter a period of steep increases in house prices, the Fed will feel strong pressure to take corrective measures even if inflation as measured by post-1983 metrics seems to be "under control". I don't see this scenario playing out soon, but investors should file this away for the future.
Essentially, the net takeaway is bullish for fixed income and yield-oriented equities. It may be time to take a look at agency mortgage REITS - like Annaly Capital Management (NYSE:NLY), business development companies - like Ares Capital (NASDAQ:ARCC), and high-yield equities like AT&T (NYSE:T). Equity REITs should also benefit from a low interest rate environment and a kind of "Fed put" under the housing market. In this regard, two of my favorites are Lexington Realty Trust (NYSE:LXP) and Equity Residential (NYSE:EQR). Investors should not assume that rates are about to go up fast, and so, shorting long-term treasuries may turn out to be very risky with very nasty consequences. The "Fed put" under housing prices also implies a strong tailwind for banks in terms of lower default risks - I think that the four mega-banks - JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), Bank of America (NYSE:BAC), and Wells Fargo (NYSE:WFC) are all attractive here for patient investors.