The Federal Reserve and Federal Open Market Committee raised the federal funds rate by another .25% yesterday, May 3rd, bringing their target range to 5-5.25%. For a quick reminder, the federal funds rate is the rate that banks charge to each other for bank to bank overnight lending of excess deposits. In short, the way this impacts inflation, monetary policy, etc. is effectively think of it like payday loan system. Imagine you're shorten cash, you know you get paid in a day or two so you go down to the payday loan to get a short term loan until you get your paycheck. Imagine the different risks reward analysis you would asses if one week the payday loan interest rate was 0% then the next week the payday loan interest rate was 20%. I digress, Interest rates are continuing to be nudged up bit by bit in the goal of combating inflation. While this is the correct approach, we are still not where we need to be to bring inflation down to the Fed stated goal of 2%. This action by the Fed was pretty well expected and seemingly priced into the market. There was no real significant reaction per the usual as the Fed essentially always provides some insight as to what they are going to do beforehand. This allows the markets to react. The Fed observes their reaction and if it is not anything too turbulent then they maintain their previously suggested heading. If the market reacts too strongly they back pedal a bit, reiterate their plan, and try again.
Federal Reserve Chairman Jerome Powell also directly addressed the banking sector in what I believe was a complete oversight of the weaknesses in our financial and banking system. He described the banking sector as sound and resilient, indicating the troubles we faced earlier this year were more of a hiccup than anything that we have learned from. The fact that another bank closure made national news on May 1st in itself should be a strong enough indicator that we are not out of the weeds yet, these are not isolated events, and the underlying problems still exist. Going back to the federal funds rate, it had been at or near 0% for a decade. This essentially meant that banks could take depositors money and create low interest car loans and mortgages or buy low yielding “safe securities” like US treasuries and always be covered. If the rate to borrow is 0% and all their books show a pile of investments maturing at 3% then even if their depositors make a run on their bank they can sell their investments since the yield on the investment is higher than current market interest rates. Now interest rates to borrow are higher than the yield on their investments. So long as banks are holding these low yielding securities in a high interest rate environment, they are at risk of becoming insolvent. Again, these securities are mortgages, US treasuries, car loans, etc. They're not short term. The banks can't sell them at a discount on the open market because they have to price in the time value of money. With interest rates rising and inflation still above the fed rate, they are stuck with them to maturity. And they can't borrow short term because if they are borrowing to cover a short in deposits, their books show them in the red since all their securities are under water. The only option the banks have is to create new loans that are future interest rate and inflation resistant while also making up the difference between the yield of their underwater securities and the expected market rates at the time the securities mature.
The banking sector is, on paper, underwater and as a whole they are crossing their fingers while they wait on these securities to mature. Moving forward, with the cost of borrowing increasing we will see a flip in the system that was built on these financial policies and decisions. Housing in particular is going to be in a very problematic spot. With the cost of borrowing money increasing, the cost of financing anything increases. Housing prices will drop as interest will eat into more of the overall price of the home. A home valued at $100,000 with a 3% mortgage existing in an environment where base interest rates are 5% cannot sell at $100,000. The price needs to drop so the mortgage is at or below the value of the home with a 5,6,7+ interest rate. Simultaneously, the credit requirements to buy a home will be higher than they have been over the last decade. A low interest mortgage will now be 7% instead of 3%. There will be less available buyers on the market to bid for houses, easing competition and ultimately bringing housing prices down. At risk buyers will see mortgage interest rates up in the double digits. If they're already at risk buyers that means they can’t afford higher payments of the house with the greater interest rate. The only other option is for the price to come down to a level that can absorb the higher interest rates. Prices are coming down, there's no way around and the government shouldn’t be trying to stop it.
Piled on top of that is a decades worth of low yielding “safe” securities all of these banks are holding and we are at just the tip of this iceberg. As stated, the current holdings of the bank are underwater as interest rates rise. To mitigate any potential future insolvency, borrows today are going to pay for the loose money policies of the past. On top of increased interest rates from the market, there will be margin added to get healthy, future proofed securities on the books. This is going to further push up mortgage rates while pushing down on home prices. There can be advantages of home prices going down though, usually. Usually residential rent prices reflect about 1% of the home value. So you would think that rents will be going down. In this case they won't. With residential properties locked in at low fixed rate mortgages on inflated home values, landlords aren't going to suddenly lower rents by 30% because home values fall. The mortgage still says they owe that price from when they bought it. They can't refinance because even with good credit and cash, the bank isn't going to write a check for the current payoff when it's greater than the market adjusted home value. Even in situations where the payoff has fallen below the home value on paper, no landlord is going refi a fixed 3% for more interest.
Due to a decade of inflationary and supposedly stimulatory economic and monetary policy, the housing market is about to be in a bind never experienced before. Prices are going to fall because mortgage interest rates are going to be raised to cover current market increases as well as a pull to cover underwater securities the banks hold. The number of available buyers are going to start falling off the market in reaction to the same reasons just explained. Rents won't follow because no landlord is going to refi into a higher interest rate and banks won't refi an underwater mortgage without massive cash deposits, that of which would also make no sense from the landlord perspective. Housing prices are going to have to fall enough to where they no longer are looked at as investments (which they're really not) and as liabilities. The beneficiaries of this will be those looking to buy their forever home and aren't as concerned with interest rates and can always refi in the future. Property investors will extrapolate current market conditions out into the future and only buy steals. When they do buy they’re still not going to lower rents as the renting population drastically increases and rent prices will maintain through rent bidding. The overall house value when compared to rent price is going to fall to accommodate the influx of previous buyers who are no longer capable of buying and are also not financially able to afford the rent prices set from the 0% interest rate era. It will be a mess as it all plays out and the government will continue destructive policy prescriptions in the name “this isn't anyone's fault”.
The government already has a head start on this. One that only further the chaos to come. The government has disincentivized responsible borrowers from buying while incentivizing irresponsible borrowers. In my article Hous(ing system) of Cards I explain how the government has implemented additional mortgage fees for responsible buyers. The fees are used to support policy that provides up to $25,000 towards the financing of a home for buyers with less than preferred credit. So one might think that this will counter the issues I discussed above. In all reality all it will do is further lower the value to price ratio. The reason being is because banks know people utilizing this program don’t have adequate credit to buy a house. They will base home buying metrics off payments as that's the only thing that will connect to the person to represent their ability to pay. There will be an influx of buyers who just have $25,000 to drop on houses that the banks will gladly take. But they won’t actually include that in the price. If a less than ideal buyer was only able to afford a $700 mortgage what the banks will do is allow the buyers to buy a house where the mortgage is $700 and just take the $25,000 as the down payment and “interest lowering equity payment”. If they actually took it into consideration the money then the buyer could ultimately buy a more expensive house. They would be putting a $800 mortgage on a buyer that can only afford $700. What is worse about that is you in fact want the opposite. Houses are expensive, you don't want to push home buyers to their absolute maximum capability to pay. As soon as something catastrophic goes wrong the buyer is on the hook. They either don't fix it and allow the home value to take the hit, putting the mortgage underwater. Or they take out greater lines of credit, one way or another, and now they buyer is overleveraged in debt.
The housing market is about to go through a major shift. Even with the added fees as explained, more capable buyers that can absorb that now have to lower their bidding capability from it, further putting downward pressure on home prices. Also putting greater upward pressure on rents as those buying rentals are just going to pass that cost along. It will come in the form of having to buy a lower quality house for the same price as the nicer quality house they could have purchased literally just one month ago. The government tries to push and direct the economic tendencies in the opposite direction as the market. At the end of the day, the market is going to balance out and almost always it hurts the people least capable of absorbing it the most. Politicians say it's in the name of it not being anyone's fault, but that's a lie. What they want is to be re-elected and they promise today with zero regard for tomorrow. When tomorrow is here and the consequences are staring them in the face they kick that can down the road again. They all want to look back and be able to say “that didn't happen on my watch”. They fail to realize any time horizons or moral hazards associated with the policies they bring forward.
Comments