Update on U.S. property prices in the Fed’s brave new world

The attached policy short was published in the Spring 2016 edition of Housing Finance International, the quarterly journal of the International Union for Housing Finance.

Readers of my last update in Housing Finance International may recall this principle: The collateral for a home mortgage loan is not the house, but the price of the house. Likewise, the collateral for a commercial real estate loan is not the property, but the price of the property.

A key question always accompanies this principle: How much can asset prices change? The answer is always: More than you think. Prices can go up more than you expected, and they can go down a lot more than you thought possible; a lot more than your “worst case scenario” projected. The more prices have gone up in the boom, and the more leverage has been induced by their rise, the more likely are their subsequent fall and the bust.

From this, we can see how dangerous a game the Federal Reserve and other major central banks have played by promoting asset price inflation through their monetary manipulations of the last several years. Unavoidably, among the asset prices affected are those of residential and commercial real estate.

The Fed has tried asset price inflation before. In the wake of the collapse of the tech stock bubble in 2000, under then-Chairman Alan Greenspan, the Fed set out to promote a housing boom in order to create a “wealth effect” that would offset the recessionary effects of the previous bubble’s excesses. I call this the Greenspan Gamble. As we know, the boom got away into a new and far more damaging bubble. It was in fact a simultaneous double bubble in housing and in commercial properties. This is made apparent in Graph 1, showing the decade from 2000-2010. These events stripped Greenspan of his former masterful aura and of his former media title, “The Maestro.”

The economically sluggish aftermath of the twin bubbles brought us, under Greenspan’s successor, Ben Bernanke, the Bernanke Gamble. The Fed once again set about promoting asset price inflation and “wealth effects” to offset the financial and economic drag of the previous excesses. The brave new world of the Bernanke Gamble includes exceptionally low interest rates, years of negative real short-term interest rates, and the effective expropriation of savers, while making the Fed into the biggest investor in mortgage assets in the world. Of course this has inflated real estate prices.

Graph 2 shows U.S national average house prices from 1987 to 2015 and their trend line. The bubble’s extreme departure from the trend is obvious. It is essential to observe that the six years of price deflation, from the peak in 2006 to 2012, while a 27 percent aggregate fall, brought house prices only back to their trend line – there was very little downside overshoot. Since 2012, prices have risen by 31 percent in less than four years, and are now 12 percent over their trend line. This rate of increase is unsustainable. On top of that, the U.S. government is once again, as it did the last time around, pushing mortgage loans with small down payments and greater credit risk. Some politicians have apparently learned nothing and forgotten everything.

The price behavior of commercial real estate has been even more extreme. As shown in Graph 3, while commercial real estate prices peaked in 2008 at a level similar to that of housing in 2006, their fall was much steeper, dropping 40 percent, or about half again as much as house prices. The difference presumably reflects the large government efforts to prop up the prices of houses.

From the 2010 bottom in commercial real estate prices, they have now almost doubled, and the current index is 17 percent above the prices at the peak of the bubble. Cranes are busy, and this so far makes the Fed happy, since it means strong construction spending. But what comes next?

Asset prices need to be understood on an inflation-adjusted basis. Over long periods of time, the inflation-adjusted increase in U.S. house prices is very modest – only about 0.6 percent per year, on average. This means home ownership is a good long-term hedge against the central bank’s endemic inflation, but on average, not a great investment. Graph 4 shows real house price movements over 40 years, from 1975 to 2015, stated in constant 2000 dollars, and the modestly increasing long-term trend line. As of the end of 2015, average house prices are 19 percent above the inflation-adjusted trend – not yet a bubble, but distinctly a renewed boom.

Rapid increases in house and commercial real estate prices is what in the past has induced extrapolations of further price increases, looser credit standards, increasing leverage, and overconfidence among lenders and borrowers. We can only hope that this time they remember that it is the price, not the property, which is being leveraged.

Will the Bernanke Gamble end in similar fashion to the Greenspan Gamble? Will the historical average of a financial crisis about every 10 years continue? We will find out.