Why will the Housing Market crash?
November 5, 2022
FED has printed money and the common wisdom is that inflation is going to cause an increase in the price of everything including housing.
In general it is said to be the case that on the long run, housing appreciates as much as the inflation. People think housing will protect them against inflation. But that inflation has already happened for the past decade. Home prices went up at record pace. It is just that the government did not report it as part of inflation statistics. Now it is deflation time in credit dependent sectors. Let’s see why.
Rising Bond Yields
Bond yields are rising again and bond prices are falling.
Here is a look at historical yields which peaked at 1981:
For the last 40 years we had a disinflationary period which has contributed to the asset bubbles.
FED said they wanted inflation. They used housing and stocks for the wealth effect to get inflation. Then they got more than they wished for. In early 2022, ahead of their earlier predictions, the FED has started to increase the FED rate. The treasury rates and the mortage rates are now skyrocketing. FED will again use the stocks and hosuing to dial down the wealth effect, in reverse.
Note that as the free market rates go up, FED will follow the market and will continue to increase the FED rate as well.
Housing is not the FED mandate, inflation and employment are. FED said they will fight inflation with whatever it takes. FED will not hesitate to sacrifice the housing market in order to fight inflation.
FED rate is going up. Higher rates makes borrowing harder. Credit will deflate. This is deflationary for housing. Mortgage rates will go up similar to the chart above.
Why won’t FED just print more money?
It is due to the inflation. For the last 15 years, FED was able to kick the can down the road by printing money. But when inflation showed its ugly head, the road has ended.
Why can’t the FED allow inflation?
US dollar is the reserve currency of the world. About 70% of the US GDP is enabled by this reserve status. With the rise of a competing power block in Asia lead by China and Russia, there are alternatives to the USD being proposed. Countries are switching to other currencies for trade. Petrodollar is at risk. Central banks are hoarding gold. It is possible that a commodity based currency is proposed at a future date. To counter this, the US FED needs to position US dollar as a store of value. Otherwise nobody wants to hold a reserve currency that loses 10-20 percent of its purchasing power every year.
For this reason, FED is likely to follow up with its 10 year quantitative tightening plan. Thus the above chart. Let’s us look closer:
Impact on Mortgage Rates
Let us discuss an example scenario to understand what happens to home prices when yields increase.
Let us assume that Joe bought a 1 million dollar home at 3% mortgage interest. His mortgage is 30K a year which is the limit of what they can afford.
Inflation goes up to 10%.
The price of consumer products goes up 10%.
Joe gets a raise of 10% too. Yay!
Now Joe can afford a mortgage of 33K. Or maybe less, since everything else also got more expensive.
But mortgage rate becomes 12%, slightly higher than inflation to provide a real return to the lenders.
If Joe wants to sell his home, what is the price he can hope to fetch?
If people can still afford only 30K-33K mortgage – for simplicity let’s say 30K, at 12% mortgage, the home price needs to be 250K to be affordable.
If he wants to sell at the price he bought, i.e 1 million dollars, he now needs to find someone who can afford 120K mortgage interest per year. But nobody got that kind of a raise. Thus price has to come down to make a sale.
Thus in this example, if rates go from 3% to 12%, home price has to come down 75% to remain affordable.
If you ask the FED they will say there is no deflation, just like they said there is no inflation for the last few decades while home prices went up, because they don’t include home prices in inflation calculations.
We have lived through a declining yield environment for the last 40 years which has fueled the wisdom that home prices always go up, because our long term memory does not know any other way. But that may be changing in 2022.
Why do home prices fall in a Deflationary Crash?
In this site we have made the argument that Deflationary Crash has started. Stocks, Bonds, Commodities including Gold, Silver, Oil are falling against the US dollar. We believe housing market will join the decline as well.
Layman’s explanation requires us to re-visit how we create money in Debt Based Monetary System.
When we borrow, banks create money. Banks do not lend existing money.
When a population of N goes to borrow X amount each, we create N*X amount of money. Let’s call money supply = M = N*X.
But we promise to pay back with interest I.
Thus total debt is N*(X+I) which is greater than the money supply N*X. Entire money supply is not enough to pay the debt.
If a strong borrower earns X+I, only X-I is left for a weak borrower to earn. Thus, without further monetary expansion, or during deflation, there cannot be enough jobs that allow everyone to earn X+I to pay their debt. The weakest will go bust.
In many locations, the rent does not cover the mortgage. Buyers are betting on price appreciation. Why would the price of an investment increase if the ROI is negative? It is Tulip Mania.
Everyone is hoping that home prices will go up and they will get rich. Everyone hopes to sell to the next sucker at the top. But if this is everyone’s plan, who is the next sucker to buy it from them?
U.S. housing prices have been rising much faster than overall inflation, rents, and wages, which is exactly what happened during the last housing bubble. Correction is inevitable.
2008 Housing Crash
When we borrow from the banks, the newly minted money makes the economy feel good. Everybody earns more in nominal prices, even though the US dollar looses value. Since the creation of the FED in 1913, the US dollar lost almost 99% of it’s value. This is credit inflation.
FED and the government used housing as a way to make people borrow bigger and bigger mortgages and inflated the money supply in order to prop up the economy leading to 2008 [and after 2008 as well].
In order to keep the music playing, the government allowed mortgage interest deduction from income. This is a wealth transfer from tax payer to the bankers. They did not stop there. When they ran out of prime borrowers, they went through sub-prime. They had to increase borrowing exponentially, or deflation would start.
They allowed no 20% down. The more you borrow, the better it was. They let people borrow the closing costs. They allowed liar loans. All was good, sins were forgiven, if you were willing to be a homeowner (aka good citizen). At last they ran out of sub-prime borrowers as well and deflationary crash has started.
They have offered incentives to the homebuyers. First cheap loans, then 8K home buyer credit, then 10K gift if you bought a home. These are schemes to make people borrow so that credit is inflated.
As bank credit contracts, it has the effect of deflating money supply, even though FED may print money. Thus, it is GUARANTEED that some of the homes bought with a mortgage is going to end up in foreclosure. You can go to the court and argue that your mortgage contract is an “impossible contract” if you like.
The moment banks see that principal + interest will not exist, they stop lending. They see that some people will go bankrupt! Credit markets freeze! They are afraid. Borrowers are equally afraid. Deflation kicks in with full power. When that happens, all prices, salaries fall. It becomes very hard to pay back a fixed rate loan! That is what is happening in 2022-23 again! Money supply is shrinking!
Mistakes have been made for the last 70 years. FED has inflated the money supply! The cause is in place. The effect will follow. Money supply will deflate.
To understand the Deflation Problem Download Your Free Report on Inflation and Deflation.