The single most important factor driving the housing markets nationally is something that began in 2008: the great financial crisis. But not for the reasons you might think.
The GFC, as investment management types call it, was a credit-driven event, not a rate-driven event as we have now. The big banks (such as Wells Fargo) and the non-bank lenders such as Countrywide (may it rest in peace) first eased and then ignored their own underwriting standards, making “no doc” or “low doc” loans (mortgages that required no or little documentation of a borrower’s credit worthiness). Not super smart. And such offenders were many.
When the cookie inevitably crumbled, credit dried up, institutions wobbled, many failed. Bad real estate loans ate through the economy, culminating in the failure of Bear Stearns, Lehman Brothers, Countrywide, and others who had direct and indirect mortgage exposure. Had the U.S. Treasury and the Federal Reserve not intervened, the great financial crisis would indisputably have turned into the second great depression.
Unfortunately, it’s the Fed’s reaction to the GFC that we’re still grappling with, and it’s is the biggest factor in the housing shortage nationwide and in Santa Fe. It may be a challenge to work out of.
A Bit of Monetary Policy History
Let’s backtrack to September 11, 2001. After that ‘exogenous’ shock to the economy, the Fed used mostly conventional measures to try to re-stimulate demand. It lowered the Fed funds target rate to near zero and though it undertook a few other measures that were novel at the time, the Fed stuck to its knitting and mostly just waited it out. The shock proved temporary, and though a brief recession followed, the central bank began to raise overnight rates again in 2004 (the chart below shows that rate from 2001 to 2023). All well and good. A conventional policy response.
Not so in the events that followed the GFC.
During and after the crisis, then Fed chair Ben Bernanke undertook the usual responses of dropping the Fed funds and the discount rates, but it was clear that those measures alone would be ineffective in the face of full-on economic collapse. One of the extraordinary policy responses later adopted is what’s now driving the shortage in housing nationwide. Yep. From all the way back in 2008.
You may (if you were paying attention) have heard of “quantitative easing” or “QE” many times over the past 15 years. Its effects linger. Those of us who were in the investment management business between 2008 and 2020 knew that eventually, the QE piper would have to be paid.
Now the piper’s taking his due. Below I explain how.
Quantitative Easing’s Long-Term, Unintended Effect
On the short end of the yield curve, the Fed traditionally controls rates not by fiat (merely pronouncing what they think the Fed funds target rate should be) but by market action or “open-market operations.” The Fed enters the market and buys enough overnight paper to drive rates down or sells enough to drive rates up. This, the short end of the market, is the Fed’s bailiwick. It’s one it stayed in until it a few more tricks were called for in 2008.
The threat to the economy during the GFC was so great that Treasury and the Fed (acting together, thankfully) realized that cutting short rates wasn’t going to do a thing for an economy on the brink of collapse. Rates needed to be cut across the board: for two-year, five-year, 10-year, and 30-year paper. The emergency called for so many extraordinary measures that dropping rates to these artificial lows was just one of hundreds of policy measures enacted by a very capable team of Bernanke as Fed chair, Hank Paulson at Treasury, and Tim Geithner at the New York Fed. I show below just one page from the New York Fed’s “Financial Turmoil Timeline” covering three months starting in September. See the November 25 entry. It was nuts.
Among many other things, the Fed in November 2008 began a program of buying huge quantities of longer-dated bonds (first mortgage-backed securities, or MBS) in the open market, driving rates to extreme lows and flooding banks with massive quantities of cash, preventing further failures. But the Fed didn’t stop with MBS. Eventually, they would move on to plain ol’ corporate bonds, treasuries (of course), municipal bonds, and virtually everything inbetween. If a promissory note existed, the Fed bought it.
The “buyer of last resort” saved the day, thankfully, helping prevent wholesale economic failure. This was one of the most effective measures.
Addiction is a Terrible Thing
There was just one problem. This QE stuff was something of a drug. As we in the business knew, the economy no longer needed QE by about 2013, when the Fed should arguably have terminated the various QE programs. But the Fed was chicken.
The Fed feared that the economy wasn’t strong enough to handle rising rates, so it kept vacuuming up everything in the long end of the market, year after year after year after year, to the consternation of bond managers and investors, who were sick of 0.50% yields. Homebuyers reaped the “rewards” of QE with mortgages in the 3% range and lower. So began a long, long, bull market in housing, driven not by market fundamentals but by artificially low mortgage rates, rates that were 200 to 600 basis points lower than they would have been if naturally set.
Then Fed “tapering” became the buzzword in the investment management business as it timidly and gingerly began cutting back on the buying. By 2019 or so, the cutbacks had begun in earnest but rates were still too low, still “fake” low and still not at levels the market would otherwise set. What had been a free market at the long end of the curve was now a market dominated, manipulated, and controlled by the Fed behemoth. It was not healthy.
It had an effect that’s proving difficult to manage years later.
By 2019, much of the U.S. population had moved into new and different housing, financed by mortgages at low rates. Then, the other shoe dropped. What happened? The pandemic. That accelerated mobility.
When again threated by events that might devastate the economy, the Fed hit the bottle again, this time with a vengeance. Not only was the easing program on the long end of the curve expanded, it was undertaken with such force that long rates came close to 0% (in some countries they went negative as global central banks copied the Fed’s moves). Thirty-year mortgages hit levels as low as 2.30%. On and on it went, as homeowner after homeowner borrowed for three decades at below 3.00%.
The chart below shows the 10-year U.S. Treasury yield during that time frame. It’s not hard to detect the beginning of the deliberate downward push by the Fed in 2008. What’s important to note is that these levels (from 2008 to 2022 or so) are abnormally low by any historical measure. So the 4.25% to 5.00% trading range that we have seen lately is reflective of fair value and more in line with what the market typically sets. Absent a return to quantitative easing (the bond purchase programs described above), reversion to those levels simply will not happen, and it’d have unwanted economic effects anyway.
Back to our story. Soon 80% of the outstanding mortgage stock in the country was below 4.00%, as I wrote about here. Someone with a 2.35% mortgage, no matter what the cause impelling them to move, does NOT want to move into a new loan at 7.10%. The effect of homeowners staying put because of low interest costs became known as the mortgage-rate lock-in effect, and it’ll persist until those loans are paid down and that mortgage stock works through the system.
Though it might have been good news for those who bought at low rates and for those who refinanced during the 2008 to 2022 period, the artificially low rates have been, in some fundamental respects, not so great for the housing markets. The extent to which it’s now limiting supply is extreme. It does have an effect in keeping prices stable. That’s good. But inadequate supply is inadequate supply, and residential real estate markets will suffer from this for the foreseeable future.
This will have two effects aside from stable prices: new home construction will rise (it already has; see the November market update on Santa Fe) to fill the supply gap, especially in those areas of the country where building is not regulated heavily (my hometown of Houston, for example). The overall size of the residential market will also continue to contract as sales volumes decline. In Santa Fe, residential market volumes are at roughly 65% of their 2020/2021 peaks. The market is plain-old smaller. That’s not necessarily an evil after the frothiness of 2020 and 2021.
It’s important to keep in mind that these effects (rising prices in a declining market, rising new home construction, and contracting sales volumes) are the product not so much of higher rates, but of the artificially low rates that persisted for over a decade.
Homebuyers will adapt to higher rates eventually, and the mortgage-rate lock-in effects may taper off. On the other hand, they may not. Nobody knows.
So, the next time you’re tempted to blame high rates for a market that’s slowing down, don’t. What you’re seeing are free-market rates, not rates manipulated by a central bank through brute strength. A return to those low rates would likely have negative consequences, and this time, the Fed seems to know it and is staying out if the liquor cabinet. Now that free-market forces have returned to the long end of the curve, housing markets may adapt in a healthy, non-distorted way over time.
And that’s a good thing, though we will have to contend with limited supply in the interim.
For grins, check out the New York Fed’s full Timeline of Policy Responses to the Global Financial Crisis. It’s kinda terrifying.
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