oftwominds-Charles Hugh Smith

How Low Interest Rates Fueled the Housing Bubble But Can't Stop the Bust

The standard propaganda is that low interest rates are wonderful because business can expand cheaply, hiring more well-paid workers, Mom can bake more apple pies and it's Morning in America, blah blah blah.

The truth is low interest rates have had a horrendously pernicious effect on the finances of the U.S., as illustrated in this chart:

Please go to www.oftwominds.com/blog.html to view the chart.

To cut to the chase:
1. negative interest rates (lower than inflation) inflated the housing bubble.

2. insanely low rates of return on savings drove money managers into high-risk investments like CDOs, credit swaps and mortgage backed securities.

3. insanely low rates of return on savings created a disincentive to save even as insanely low mortgage rates created powerful incentives to borrow freely and often.

If you want to jump ahead a few years, just go talk to small businesses in Japan, where interest rates have been locked down at 1% or less for over a decade. How are those super-low rates working for Japan? Have they reflated the 1989 bubble in stocks and real estate?

No, they have not, because low interest rates do not make risk go away.

If we glance at the handy chart above, we see that low interest rates push prices, borrowing, saving, investing and risk appetite to extremes.

super-low rates, especially when combined with innovations like adjustable-rates, interest-only payments and and "teaser rates" lower mortgage payments to "nearly free." In response, demand for housing explodes and prices rise. As prices rise, speculation gather steam, further feeding the frenzy.

* super-low rates of return (2% on T-bills and cash, for instance) mean that money managers whose long-term models require returns of 5-6% to survive (pension funds, insurance, etc.) are then forced to seek higher returns wherever they can find them, which meant piling into the trillion-dollar housing bubble market of mortgage-backed securities and its galaxy of derivatives (CDOs, credit swaps, etc.) all of which were sold as "low-risk" AAA-rated securities.

* with rates of return on savings accounts and low-risk investments dropped to near-zero (actually below zero once "real inflation" is taken into account), the incentives to "save up for a down payment" are reduced to zero even as the incentives to borrow vast sums of money right now (no down loans, liar loans, get in now before prices go any higher, etc.) dramatically increase.
* there is something worse than a meager 2% return on investment: a 50% loss on a risky housing-based derivative. Now that the true risks have been exposed, the appetite for risk that was once insatiable has fallen back to Earth. "Repricing of risk" means nobody is dumb enough to buy any housing-based debt or derivatives except at stupendous discounts.

No matter how low the Fed keeps interest rates, it cannot reflate the housing bubble because risk has irrevocably been repriced to reality.

This is in essence what happened in Japan. The same banks which were shoving $100,000 loans at low interest rates onto every business with a pulse in 1989 have pulled back from lending as the borrowers stop making payments and their losses mount. The real risks of making loans which cannot be repaid is now visible and cannot be cloaked, masked or made to vanish.

History is a vector. You cannot turn it around and return to 1989 or 2002. Now we have the pathetic spectacle of the U.S. Congress attempting to reflate the bubble by raising the Federally insured mortgage limits to an astronomical $729,000, in the hope that borrowers and lenders can be convinced to return to that happy place where house prices always rise and there's no risk in lending $729,000 to people with minimal down payments and poor credit histories.

The Federal government agencies and the Federal Reserve have been trying to counter this very rational aversion to risk by buying up billions of garbage/risk-laden loans, hoping that banks and lenders will replace all the garbage they just dumped onto Fannie Mae et al. with billions in new garbage loans which magically won't go bad like the last batch.

Bottom line: you can't force buyers to risk buying a house which is at high risk of falling in value (a capital trap they can never escape) or lenders to make loans which carry a high risk of default, or investors to buy high-risk loans for a pathetically low rate of return.

This is why all the machinations and gambits to "make houses affordable again" via the masking of risk and the lowering of borrowing costs will fail.

The way for housing to become affordable again is for prices to drop in half or more. What could power such a decline? How about mortgage rates rising as global risk repricing shuns real estate-based debt? As that tide rolls in, the sand castles being thrown up by the Fed and Congress to maintain housing values (reflate the bubble) will be washed away by the tide of reality.

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