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Interest Rates Without Fed Manipulation


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2009 Sep 21, 1:31pm   16,090 views  57 comments

by Patrick   ➕follow (55)   💰tip   ignore  

Here's a thought experiment: what would interest rates be if the Federal Reserve did not manipulate them?

Perhaps the Fed does actually have a useful function in being "the lender of last resort" during panics, because panics are by definition irrational, so the market is just not working at that point.

But I'm not sure there is any coherent argument for why we need the Fed to deliberately destroy the free market in money itself. Playing with interest rates to suit a few mysterious bankers on the Federal Open Market Committee does not seem to be in the national interest.

The official site of the FOMC says that they "influence the availability and cost of money and credit to help promote national economic goals." Are they really promoting national goals, or are they promoting banker's goals? The Fed has clearly not been effective at the national goal of avoiding the housing bubble and the resultant fallout.

If we had no Fed manipulation of interest rates, we may have had a slower time coming out of the dot com crash because of high interest rates, but we also would not have had this housing bubble. Those who saved would be able to buy, and those who foolishly went into debt would be forced to rent -- not the end of the world.

It seems clear that the Fed's overriding goal is to get as many Americans as deeply in debt as possible, so that banks can earn as much interest as possible. The Fed does not want defaults, but it also does not want Americans to be free from mortgage debt.

These bubbles are not new. Nineteenth century businessman Walter Bagehot's advice during panics to "lend freely but at a punitive rate" seems like the best advice. But it is only half obeyed by the Fed. The Fed lends freely, but at a rate near zero percent. The Fed should be constrained to lend at higher than market rates, or not at all.

#housing

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1   Leigh   2009 Sep 21, 2:38pm  

For naive folks like myself, here is a primer on the Federal Reserve, "Money, Banking, and the Federal Reserve". Sometimes I wonder why I want to learn more when much of it nauseates me!

Here's the link: http://video.google.com/videoplay?docid=-466210540567002553#

2   investor90   2009 Sep 21, 4:20pm  

Patrick- A good thought experiment. I agree!

If you just look at a mortgage loan from the perspective of prudent Risk Management loan principles, I would speculate that mortgages should be around 12-13% interest per year. I am NOT including knowledge about the housing bubble that is still ballooning away, only the large percentage of defaults and walk-aways. JINGLE MAIL---if you will.

If mortgage interest increases even one percent, it would put a brake on buyers, because the monthly PITI payments would be too high. I think a mortgage interest rate of 7% would be a good place to start.

If mortgage interest rates were 7%. house prices woulod need to drop by the same amount of increase in interest, but in dollars. The Realtors, bankers, loan companies, local governments who have been cheerleading for higher and higher house prices, will have screwed themselves again. If we had a 7% interest rate on low end house mortgages, prices wou;d be forced to drop and more people would walk away because NO ONE (including debt slaves) wants to be 80% upside down on an old house. That same house next door would sell for pennies on the dollar.

I know high interest sounds terrible but house prices must and will get back to earth. Realtors will have to go back to their former jobs as fast food help or retail clerks. At least those jobs are honest!!

I agree that a person who works should be able to buy a house, but they should be able to AFFORD IT, that means one thing---HOUSE PRICES MUST COME DOWN.

When housing prices get low enough that a single worker can pay no more than 20% of net to pay rent. We will be on our way to normalizing this used house mess.

3   eric2653   2009 Sep 21, 4:56pm  

The fed is absolutely brilliant. It’s one and true goal is to get the most work out of the people as it can. And it seems to be succeeding. Although this may differ from your goal of retiring early or accumulating wealth...

4   tatupu70   2009 Sep 21, 10:30pm  

Your logic is flawed. How exactly did low interest rates cause the housing bubble? Low rates in and of themselves don't cause a bubble. They don't encourage mortgage brokers to lie on applications, or appraisals. Low rates don't cause Wall Street investors to underestimate the risk in their repackaged residential loan portfolios.

Low rates are good. They encourage investment by lowering the hurdle rate. But at the end of the day, people still have to make decisions. And a bubble is caused by people being stupid and following the herd mentality. Thinking that prices can never go down. Which, of course, is ridiculous.

5   Patrick   2009 Sep 22, 1:04am  

Actually, low rates DO cause Wall Street investors to underestimate risk. Interest rates are a signal about the credit-worthiness of the borrower, among other things. At least in a normal non-manipulated market they are a signal.

I agree that mortgage broker and appraiser and realtor lies were all big parts of the problem, but it was the artificially low rates that made it possible for people to borrow way too much to begin with.

Low rates are good only if they really reflect the market for money. Keeping rates too low is like selling cars below the cost of making them to keep the car companies in business. Yes, you sell cars, but the real cost of production has to be paid by someone so it's still a loss.

For money, the loss is pushed onto savers and taxpayers who are innocent. The gain goes to foolish borrowers, and the banks, who are guilty. It's the opposite of justice.

6   tatupu70   2009 Sep 22, 2:56am  

Patrick--

I guess I just don't see how low rates "make it possible for people to borrow way too much money" People can borrow too much money regardless of the interest rate--all it takes is someone who is willling to loan it to you. Low rates do allow you to borrow a larger sum for the same monthly payment, but that doesn't make you any more likely to default. It just means that you are paying less interest.

Low rates don't allow people to borrow more money than they reasonably qualify for. Poor understanding of risk and fraud are the only things that cause that.

Probably a debate about the usefulness of the Fed is beyond this post, but I hear what you are saying. What you dislike is basically the Fed's charter--manipulating the money supply to achieve macroeconomic goals... Personally, I think they serve a purpose. Maybe they are wrong sometimes, but nobody is perfect. I'd like to see more regulation of Wall Street before messing with the Fed.

7   Patrick   2009 Sep 22, 3:30am  

Larger loans mean higher prices. It's a direct path from lower interest -> bigger loans -> higher prices.

That penalizes savers who do not want to get into debt. Like me.

And those low rates are generally short-term, so people do default when the rate resets. Yes, it is their problem because they didn't think ahead, but it's also my problem now as a saver and taxpayer. I don't think I should have to pay for their bad decisions, so that they can stay in a house they can't afford and so that bankers can keep earning more interest.

I agree about regulating Wall Street more, or even just as much as we used to. The Glass-Steagall Act seemed to work pretty well, until it was repealed in the name of profits.

8   trudylia   2009 Sep 22, 3:32am  

If I understand this correctly, the Fed planted the seeds [low interest rates,] and Govt. Enterprises like Fannie/Freddie and private like AIG provide the soil by underwriting the asset backed sercurities that banks created [thus, banks would not have given these loans if they weren't backed up by FF, AIG, etc...] and developers/real estate agents/nar/etc... watered it whilst end-users bought the poisoned fruit in hopes to sell it to the greater fool?

9   tatupu70   2009 Sep 22, 3:54am  

Sorry, I'll try not to beat this to death. I agree completely that lower rates will cause house prices to go up modestly. Both in theory and in practice, I think it bears out. What I disagree with is that low rates have any correlation with a bubble.

I'm not sure that I agree that periods of low rates penalize savers and help debtors though. Generally, high rates occur during times of inflation--and inflation is the real enemy of savers. And the real hero of debtors.

As to variable rate mortgages--again I would argue that low rates have no direct impact on the likelihood of default upon reset. It's just as likely that someone would default on a ARM that resets during a period of high interest rates as during a period of low rates. The default is caused because the orignating loan officer didn't understand the default risk when he gave the loan. Look at all the defaults happening now--and the rates are about as low as they've ever been. They were just bad loans from the second they were originated--no matter what the interest rate environment was...

10   reniam   2009 Sep 22, 4:08am  

tatupu70 says

They don’t encourage mortgage brokers to lie on applications, or appraisals. Low rates don’t cause Wall Street investors to underestimate the risk in their repackaged residential loan portfolios.

I believe this is analogous to saying drug dealers have no culpability for the drug users delirium temems.

Low rates are good. They encourage investment by lowering the hurdle rate.

Low interest can be good if used wisely, as an investment. And they can be bad. Low interest rates encourage speculation and discourage saving. They can drive assets up (in the most recent example: housing) non-linearly since interest is a compounding function. Refinancing your house to remodel the kitchen isn't an investment; at least economically. Certainly there are many parties responsible for the current recession but, the Federal Reserve created the speculative environment with artificially suppressed rates. Now the Fed believes what will fix the problem is more of what created it. I personally don't believe Homeopathy is the cure.

11   Nick   2009 Sep 22, 4:35am  

From a pragmatic point of view, there should be neither "high" not "low" rates because conceptually the rate is inflation + whatever it takes to allure me to invest my money. And the only reason we have the Fed is to keep inflation as close to zero as possible which enables people to have savings and keep them for decades.

But in real life we know that:

1. The official inflation index is obviously rigged and does not reflect reality for normal people (even basic things like RE or education). So it's not even immediately clear how to reliably estimate real inflation and surely the government will not do it.

2. Although allegedly banks need more capital, CDs pay about 1% nowadays. In a market economy you would expect banks to be chasing depositors with at least what we had a couple of years ago (4-5%). Clearly the government intervention is the only explanation.

In my opinion is definitely means that the system is designed to punish savers and responsible people in general and promote all kinds of debt-based pyramids (from RE to stock market).

12   reniam   2009 Sep 22, 4:38am  

The Fed came out of the Panic of 1907 - a financial bubble very similar to the Panic of 2008. JP Morgan intervened to patch together a solution. Fed supporters at the time felt something needed to be done.

The idea was the Fed would be able to smooth out the boom/bust cycle of capitalism with an "accordion-like" currency. Obviously, they have failed. In my mind their primary problem is they don't smooth the booms and then backstop the busts. Busts, though tough are fair. They punish the imprudent and remind all of the dangers of too much risk.

~0% funds rate really is never appropriate. They're justifying it with the 8-10 multiplier effect. The problem is American companies and citizens don't need, and shouldn't have, more debt. So essentially this is a bank bailout since they will use this money to cover future losses.

13   tatupu70   2009 Sep 22, 5:23am  

Reniam--

So, by your logic--Best Buy is responsible for people maxing out their credit cards because they put Plasma TVs on sale? They created an artifical environment that encouraged people to spend beyond their means.

Or are you saying that low rates cause people to lose their sanity? They stopped doing financial paybacks and IRRs because rates were below some arbitrary %?

Speculation cannot be explained by low rates. It's a psychological thing. I'm pretty sure that low rates didn't cause people to buy tulips in Holland in the 1600s or the South Seas Company in Britain in the 1800s.

Low rates probably did drive housing prices up some. It's an easy exercise to see how housing prices have changed over the last 50 years and then overlay it with interest rates over the same period. Certainly there will be an inverse correlation. But--I just don't see how interest rates explain any of the bubble part of the rise.

If interest rates were a major cause--why was the bubble almost exclusively in CA, FL, Las Vegas and Phoenix? Wouldn't low rates affect every city?

14   reniam   2009 Sep 22, 8:04am  

tatupu70:

Thank you for the reply. I would not absolve consumers, companies, banks, etc of blame. There is plenty of blame to go around.

For your Best Buy analogy: No they are not responsible for the people maxing out their credit card by offering TV's. The low rate on the credit card which was the effect of the Federal Reserve artificially suppressing interest rates had more to do with it; which is the crux of this conversation.

Presumably, a free market would have noticed that the American economy had been hollowed out due to nefarious policies and given that buyer a more appropriate (higher) APR. If credit wasn't cheap, the buyer would have had to buy the TV from accounts receivable. Thus we would not have a population so deeply in debt and a crushing recession. This is the thought experiment laid out in the thread.

And it is not my theory - just thought up. There is general agreement that artificially low rates were a big contributor to the current bust:

http://www.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877331,00.html
http://online.wsj.com/article/SB123414310280561945.html
http://www.law.gmu.edu/news/2009/zywicki_consumer_behaviors
http://mises.org/story/3252

The cause and effect of low interest rates on speculation has been know for many years. Here is a broadside put out by the Century Club in 1892 titled "Cheap Money Experiments In Past and Present Times":

http://tinyurl.com/kpm2dd

There is no general agreement as to whether there was a tulip bubble in 1630. The South Sea bubble was caused by a low interest equity swap for high interest public debt.

15   Diomedes   2009 Sep 22, 8:59am  

This has been Ron Paul's argument all along.

The Fed's manipulation is actually more damaging in my opinion since it is continuously chasing its own tail, thus creating these wild swings.

A good example that an economics professor I read once used the concept of a spring. If a spring is just left hanging from a close line, it will bounce around lightly as minor forces cause it to contract and expand. However, if you attempt to control the oscillation by adding compression or tension, the spring will move more wildly. That is how I see the Fed.
The market is supposed to move freely based on what interest rates the system can currently absorb. Greenspan raised interest rates towards the end of the dot com bubble to stave off inflation that was actually pretty non-existent. And then when the dot com bubble exploded (as it would have anyway without any help from Greenspan), in a panic, he lowered rates to low levels and created a secondary bubble. Now that unwinding is happening and we have dropped rates to zero yet again. But all this is doing is dragging out this malaise for much longer than it otherwise would have.

Personally, I would rather see the market over and under correct itself without Fed intervention since those swings would be much smaller in my humble opinion.

16   chrisborden   2009 Sep 22, 9:13am  

Air tight arguments and all, but the only way to stop this crap is for people to not buy (borrow) in. What could the Fed do? It cannot FORCE people to borrow (although Obama and crew are trying mightily).

17   Vicente   2009 Sep 22, 9:13am  

So the entire theory on which the Federal Reserve is based, is that they are GROWNUPS.

That they will "take away the punchbowl" just when the party is getting exciting to prevent kabooms.

However they have never filled this role in actuality since their inception.

Keynes argued that during the boom times you have to "store nuts for the winter" and that the role of central bankers and ecoomic policy should be to tax & regulate enough during booms that when the inevitable occurs you can smooth it out with your war-chest you've saved up. Again this is never done, they let things run with razor-thin reserves and no savings, they even deride a "savings glut" as being counter to maximizing growth.

If I were a risk manager who had repeatedly failed to manage any of the risks under my perview I'd be fired. It's astounding the persuasive power of these BS artists that they still have jobs.

18   Leigh   2009 Sep 22, 10:14am  

Tatupo70, the bubble surely wasn't limited to those few cities that you mentioned. Oregon felt it from hick town Prineville all the way through Portland and up I-5 through Vancouver and up past Seattle. Friends in Dakota Dunes, South Dakota experienced it as did friends in North Branch, Minnesota, as well as relatives in St. Petersburg, Florida and Grafton, Mass.

Here's a thought process we had in 1999 while looking for our first house. We couldn't save faster than housing prices were inflating in Portland at the time. We jumped in, bought too much mortgage, spouse got laid off in the tech bust, blah, blah, blah, sold at the peak and now watching our little down payment CD collect a whopping 3.2% interest.

People determine what they can afford by what the monthly payment is, that goes for homes, cars, boats, jet skis, plasma TV's etc. Increase the rate and all of a sudden that car, etc doesn't look so inexpensive.

Jack the interest rates on CD's and I bet you'll see folks save for that car, etc and even the rainy day.

19   PeopleUnited   2009 Sep 22, 11:04am  

Tatupo70,

The low interest rates shifted the supply/demand curve. When monthly payments drop, more people are willing to pay the lower price. When monthly payments go up, less people are willing to buy, so there is less demand. It started with low interest rates. From there human emotion and private and corporate greed/stupidity gave more fuel to the fire. But it could not have happened with 12% mortgage rates. Low rates were the spark.

20   tatupu70   2009 Sep 22, 11:05am  

Clearly I'm in the minority at this site--I knew that before I posted, but help me out. I've still not seen one argument explaining why low rates cause excess risk taking or asset bubbles.

Here are two charts: interest rates vs. mo./year and housing prices vs. year

The last few years are obviously not the first time in history that the US has enjoyed low interest rates. And it is also not the first time the US has encountered a housing bubble. And like I expected--low interest rates don't correlate with housing bubbles. The data just doesn't back that theory (eg 1970's bubble)

http://www.businessinsider.com/the-housing-chart-thats-worth-1000-words-2009-2
http://mortgage-x.com/general/indexes/prime.asp

My take--for what it's worth--is that Wall St. greed is almost exclusively to blame for this mess. There was a very good article posted here some time ago explaining credit default swaps and how mortgages were packaged to supposedly lower the risk. Basically, the idiots on Wall St. created an artificial market for these mortgages--they bought as many mortgages as lenders could write without understanding the risk. So, everyone played the game. Realtors, mortgage brokers, ratings agencies, etc. all went along because they knew that AIG would buy the crap. As long as they got paid, noone asked any questions.

And Reniam--you're right. It is widely believed that low rates caused this mess. I just happen to disagree.

21   Leigh   2009 Sep 22, 12:11pm  

Tatupu70, you are mostly right, IMHO. There were many factors that played into it but the baseline factor was low interest rates. Check out the video "Money, Banking and the Federal Reserve." Well worth the 40 minutes.

http://www.youtube.com/watch?v=iYZM58dulPE

Lots of greed and ignorance played into this bubble. Some simply it blame it on the Community Reinvestment Act of the 70's which encouraged lending to minorities. Some blame FHA. Check out the Seattle Bubble for much more details re: FHA

http://seattlebubble.com/blog/2009/09/21/whats-behind-rising-fha-defaults/

Many believed RE only went up and that it was a great investment, thanks NAR.

Some blame too much subprime lending. Though in Oregon we are getting hurt by too many Alt-A loans going bad, ie, interest only, negative amortization, Option ARM, etc by folks with GOOD credit.

Some blame people who used their home as an ATM to live an unsustainable lifestyle.

MBS trading fueled the push to lend to anyone with a pulse thus all the false documentation loans, ie liar loans.

Without the low rates and the easy credit none of this was possible.

How could this have happened otherwise?

I will look into the 70's housing bubble, thanks for the link.

22   Patrick   2009 Sep 22, 12:27pm  

tatupu70 says

I’ve still not seen one argument explaining why low rates cause excess risk taking or asset bubbles.

Low rates -> bigger loans -> asset bubble

23   Leigh   2009 Sep 22, 12:30pm  

Very interesting charts, Tatupu70. I'm sure someone can explain this better but low prime rates do not always equate to low mortgage rates. I can remember a few times that the Fed's lowered the prime rate in the past few years and mortgage rates actually went up...go figure.

I see trends during the late 70's boom and late 80's boom. Rates were trending down when the booms started and then were higher as the boom ended. Note that our current boom has ended even though prime rates and mortgage rates are at historic lows.

It would be interesting to look at the overall economy at those two times also. What was the mentality? Was it similar to today's where everyone is trying to keep up with the Jones' but at McMansion sizes? Were the neighbors in the 70's marveling at the new young couple that just moved in who had two brand new upper end vehicles, vacationed every winter in Cabo, had the $1,000 stroller and never seems to fret about retirement?!?!?

Once you guys get this all figured out can you tell us in Oregon why we always trail the country during these recessions and bubbles. Our housing peak was Aug 2007, almost a 12 month difference from the rest of the country. Our foreclosure rate spiked later, too.

24   homeowner_for ever_san jose   2009 Sep 22, 1:53pm  

interest rate would be same as broad index ( dow jones) returns over time.If not for FED , why would anybody loan be money when they can invest in stock index. The risk level in house is similar to stock index which was proven by the recent housing crash. i would say somewhere around 7%

26   Rogerer   2009 Sep 22, 2:09pm  

Lets face it. We are sheep to be fleeced by the Fed forever, or until their power over the people is taken away by the people. They are nothing but a private cartel of ponzi schemers whose sole role is to profit from the control of the money supply, interest rates, and most importantly - lending itself.

After all, any group that profits by leveraging other peoples money out at fractional reserve ratios of as little as 10% can loan - as a total system over time - up to 10 times the face value of that same money. That means interest rates of 5% actually yield (to the banking system as a whole) up to 50% per annum. And that’s not even taking into account the increase in money supply every year. (Actually, that’s a large part of the mechanics of increasing the money supply - as it effectively creates money out of nothing but thin air!)

The international banking cartel (including the Fed) is the largest criminal organization in the world. Bubbles? They use them to make even more obscene profits. When one bursts, they just blow up another… dotcom, tech, gold, oil, housing, stock market, gold, commodities… oil …. on and on. They make money on the way up and on the way down. It may appear they made a mistake with the real estate bubble, but look how they engineered their way out of that one: Goldman Sachs cronies to the rescue! Bush/Obama doesn’t matter, that’s just the face card they are showing while they hide aces up their sleeves, waiting for the next big pot to build up.

People are just like sheep, lining up for their next mortgage, stock portfolio, or IRA, all the while they are tagged by the shearer. 95% of the wealth is in the hands of less than 3% of the people. Are they really deserving or have they just figured out a way to cannibalize the rest of us and have us accept it as status quo? There is NO hope until many more like Ron Paul raise their heads in the political arena. Until that time, we will be fleeced over and over by the mighty Fed and their cronies.

27   Leigh   2009 Sep 22, 2:09pm  

You know Rogerer, just a few years ago I would be laughing at your post thinking 'what a goofball', now it just makes me wonder about relocating to another country. But where could I go to avoid this? It seems to be all a sham. And with the cost of higher education getting out of hand, my retirement, aka 401K hoax, in limbo, we are really considering a move...but where? I worry about my kiddos future.

28   Patrick   2009 Sep 22, 2:16pm  

I just finished reading a book called "The Origins of the Federal Reserve System" by James Livingston. I can't really recommend it because it's very academic and doesn't really get to the point most of the time.

But I did understand from it that the Fed was created largely to protect the very wealthy capitalists of the time from their biggest fear: deflation. With deflation, the book explains, the working man wins as long as he still has a job. Prices fall, so his salary is worth more.

But deflation means that factory owners lose. Falling prices wipe out profit margins very fast, and capital tied up as factories that cannot make a profit also plummets in value. Society becomes more equal. Capitalists become ordinary people. A nightmare!

And, horror of horrors, banks made using those factories as collateral and those loans fail to get repaid in full. Then as people get nervous about the banks, there are runs on the banks and no one to lend to the banks to tide them over.

So what happens in essence is that over-investment or poor business ideas get very badly punished, and it takes a long time for anyone to get up enough guts to lend again.

The Fed was supposed to prevent all of that, and keep the very rich owners in control no matter how bad or irrational their investments are. That sounds quite a lot like the housing bubble.

I can agree that we need something like the Fed to lend during the panics and get things running again when no one else has the guts to lend. But I think they should do it at high interest rates, so that the businesses need a really profitable and well thought out plan to get a loan.

29   Rogerer   2009 Sep 22, 6:57pm  

If you haven't already, read The Creature from Jekyll Island which talks more about the creation of the Fed, how it had been tried to be installed (and failed) for decades by the "money trusts", and was finally successful during the Wilson administration after a secret meeting between the bankers (JP Morgan and others) and a small group of government co-conspirators. It was a highly guarded secretive meeting (similar to the Bilderberg meetings today) which resulted in a piece of legislation (the Federal Reserve Act). Later the same year on Wilson's watch, the Income Tax Amendment was also passed - which was the other half of the scam.

The institutionalization of a private cartel of bankers in charge of money creation was a direct abrogation of the Constitutional decree that gave only the Congress the power to coin money (U.S. Constitution - Article 1 Section 8). In a scam not unlike today's "credit default swaps" (which are designed to circumvent Federal insurance regulations), the Federal Reserve System (not actually Federal, but PRIVATE and having NO reserves) was put in place in an elaborate scheme whereby the U.S. government swaps debt notes with the Fed for "Federal Reserve Notes" - neither having any real value. since they are both created from nothing. Of course, in this mutual exchange of worthless paper, it is the U.S. Treasury (i.e. taxpayers) that have to pay interest to the Fed for borrowing money which they create out of thin air. It's a crazy smoke and mirrors game whereby debt is collateralized and turned into an asset by the Fed, which proceeds to use that debt as collateral for up to 10 times more debt using today's fractional reserve lending. The practice is nothing more than a legalized ponzi scheme. This is LITERALLY true (see below).

Bernard Madeoff is small potatoes compared to the banking system headed by the Fed. Someone once said that if all the loans of American dollars were to be paid off, all money would simply evaporate before the debts were ever paid in full. That's because there is far more debt in the system than there is money! This is one of the secrets the Fed does not want you to know, since it would reveal the hoax of the entire financial system.

But don't take it from me. See quotes concerning the Fed by ex-presidents, congressmen, famous authors and inventors, economists, etc. by scrolling down to the section entitled "Federal Reserve quotes" on this page about Woodrow Wilson and the Fed. Then continue to educate yourselves on the Federal Reserve System. There is much that is available on the internet. It is one of the most eye-popping disillusionments you will ever have - like taking the red pill in "The Matrix". Welcome to the Real World!

30   Rogerer   2009 Sep 22, 8:13pm  

Tatupu70 said:
I guess I just don’t see how low rates “make it possible for people to borrow way too much money” People can borrow too much money regardless of the interest rate–all it takes is someone who is willling to loan it to you. Low rates do allow you to borrow a larger sum for the same monthly payment, but that doesn’t make you any more likely to default. It just means that you are paying less interest.

Aside from the "greater picture" view of the Fed, the housing bubble was in fact created by a combination of a) low interest rates b) under-regulated lending practices and c) the obfuscatory monetization of mortgage debt instruments by Wall Street.

One thing lacking in your view that a low rate "doesn't make you any more likely to default" is that because the low rates helped push up demand, housing prices rose excessively, hence the bubble that created imaginary "value". Since low rates enabled people to borrow more for less money, they directly contributed to the likelihood of default after the inevitable collapse of the artificial valuation". Regardless of the borrowers creditworthiness at the time of the loan, when bubbles collapse, a domino effect ensues. Peoples' financial positions - whether in real estate, stock markets, or jobs - deteriorates.

There are more and more foreclosures happening every day on fully qualified loans made to able buyers at the time. But whether they were speculative gamblers or nesters, their circumstances including their abilities to pay, have now changed dramatically for the worse. This due in large part to the low interest rates. Some borrowers, by the way, are defaulting completely out of choice, as an alternative to taking an even greater loss by paying effectively high rates for a declining asset valuation. That same $5,700/month payment on a million dollar loan at 5.5% effectively becomes a 13.4% loan on a now $500,000 "asset" with a $500,000 negative equity.

I agree entirely with Patrick in his views on the real estate market bubble. While low interest rates were not the sole cause, they were a major contributing factor.

31   tatupu70   2009 Sep 22, 10:42pm  

Rogerer--

I agree that low rates will cause an uptick in demand and subsequently prices for houses. The magnitude of this uptick is not well defined, because demand is made up of many factors--interest rates are only a part of it. But, this increased demand and prices wouldn't be "excessive" as you state it. Or an "artificial valuation" With lower rates, there is a new equilibrium point on the supply and demand curves and prices rise. The true value of the house has risen. Not a bubble. Nothing excessive. Just how free markets work. When/if rates rise back to "normal" levels, housing prices should go back down as well--at least in inflation adjusted terms. Prices go up and down over time--nothing artificial about that.

The foreclosures on fully qualified loans were most likely people getting laid off from their jobs, I imagine. This has nothing to do with low rates. During recessions, people lose jobs and houses go into foreclosure. It's unfortunate, but it's how the world works.

Finally--I see low rates-->bigger loans. I just can't make the connection to bubble.

fyi--good article here. from todays links
http://business.theatlantic.com/2009/09/a_grand_unified_theory_of_the_financial_crash.php?ref=patrick.net

32   Austinhousingbubble   2009 Sep 23, 12:24am  

House valuations were excessive for one thing because income levels in this country (one of the major determinants in the demand curve) did not keep pace with the level of inflation seen in housing during the boom years.

The law of demand dictates that an individual will buy more of a given commodity when the prices are lower, and purchase less if/when prices rise. This fundamental was forced on its ear during the boom years thanks to loose lending and phantom wealth - but especially artificially low interest rates, which is what really kicked off the hysteria. That's all anyone could talk about during those years. So I guess you could add popular suggestion/propaganda to the list.

33   justme   2009 Sep 23, 2:22am  

Let's see:

tatupu70 joined one day ago and immediately starts sounding like a REIC (Real Estate Industrial Complex) insider with a severe case of denial of responsibility. Would it be impolite to point that out?

I would not waste any time on tatupu70 until said poster starts showing some sense.

Trolls are a waste of time. Just point out where they are wrong, repeat points as necessary and move on.

34   Patrick   2009 Sep 23, 2:57am  

It's not impolite to say you think someone is trolling. Impolite means calling people "asshole" or "libtard". It's the lack of good will that shuts down real conversation.

But I think tatupu70 is actually sincere, and I have another point that might help him see that artificially low interest rates lead to bubbles:

Low rates lead to bigger loans, which leads to higher prices. That much is clear to him. But then those price increases are used as collateral for more lending!

Say interest rates fall by half, so I get twice the loan I would have. I double my bid on a house. I buy it. Now the bank calls that extra 100% in price "equity" when it is not really there. The bank then lends out that extra "equity" as money to the next guy, letting him borrow more, and he bids up the price on another house. More equity!

Round and round it goes with vast amounts of "equity" being creating from nothing. THAT is a bubble.

35   investor90   2009 Sep 23, 4:32am  

Tatupu70- Here might be another way to explain why artificially low mortgage interest causes a bubble.

This is only MY life example. In 2000, I noticed that we were in a housing price bubble. At that time I was renting in a small duplex to save enough money so that I could put down a large downpayment. Several years before, I was upside down on my house during another post bubble, and the only reason I kept the house, is that I had at least 20% down on the house. Why did I use a conventional loan? Because I hate to pay interest , it only increases the REAL house cost and it steals any speculative and inflationary equity that my house accumulates over time. That is when its time to sell in a normal market, I can still have a profit afetr paying Realtors another 6% for doing nothing.

Back to my point. One of the most difficult things for most people to do is to DOWNSIZE their living standard at that same time they can afford a higher standard of living. Why do this? To save on the total cost of the hosuer and not have to worry about being upside down on my mortgage ---like most house owners over the past 5 years.

Now to the point! I told my wife that the best way to save for our new house was to save 100% of the difference between what we were paying for rent and what the normal PITI would be for the same house.

At this time, I have no moral hazard. I am just a prudent saver waiting to accumlate enough cash to put as a downpayment on a house. I would rather have some equity in the house than use other peoples money and a lot of promises. At that time, we were forced to cut back on everything includng food budget jsut to save. But I noticed that Realtors were in a frenzy. Like sharkes in bloody water. I knew people who had NO MONEY, NO SAVINGS and they were looking for a house to buy. Multiply this times millions and you see---we had more buyers than houses. the buyers had no money, but the goverment felt it would help the economy to sell new houses to the homeless even though they couldnt pay. House prices were increasing so everyone can be a millionaire. So I discussed this with a few educated prosepective house buyers. I told them, that all the greed with no money down and extremely low interest only caused the prices to go up. Local houses built before World War I that were in disrepair and had more termites than nails were selling for $400,000. They couldnt give this junk away in the middle 1990's. Some of the selleers were smart and kept the PROFIT and rented. Others got greedy and started flipping. I have always had a good household budget. I thought it was ironic that people who could not save a dime---literally--as in NOT ONE DIME. Were acting like millionares. I knew a part time car wash cleaner who was paid less than minimum wage bragging about all of his "investments". he was getting cash back at closing on houses that he never moved into or paid any money for. He would start advertising them for sale before the house closed.

It was killing me, because the house prices were skyrocketing exponentially. Realtors would tell me NOW IS THE BEST TIME TO BUY---YOU WILL NEVER OWN A HOUSE---YOU ARE A LOSER IF YOU DON'T BUY TODAY.

Then it happened---our personal crisis. We were paying high rent and saving the difference for our future "house downpayment". The owner of our duplex sold to a flipper. The FLIPPER WAS A MORON---I mean a real one. IQ was low 60's. His job was to clean up old houses so they could be sold. He made minimum wages. When the sale closed ---he announced I AM YOUR NEW LANDLORD. I never saw thew man before in my life. I will be raising your rent effective tomorrow! He increased our rent 150%. He said---laughing thats what you get YUPPIES for not buying now. We paid the higher rent---and watched. I noticed that withing days I was getting letters to him from loan companies---toi my address---why because he lied on the county tax form and said it was owner-occupied to get a property tax exemption.

We had to sacrifice more. We sold personal belongings, anything, to get the money we needed to savbe for a downpayment, but houses prices were going up faster than we could save. WHY? because people were NOT BUYING HOUSES. Houses were only a pretext to get the almost zero interest mortgage with no money down. We had millions of almost broke underclass almost overnight refinancing houses when they could not afford to pay monthly house payments.

Our new landlord who would shove his finger in my face and laugh---because he was an idiot and thought he was earning his "wealth". He was "smarter' than I because he had money. First he refied the duplex and showed off his brand new $100,000 custom VIPER convertible. He than showed off his wifes new Mercedes convertible. Expensive toys----but he couldnt make the payments if he ever stopped flipping houses at ever higher prices.

I tried to warn him---that it was dangerous now---because the market was filled with flippers and no one was available to buy. He tried to sell to us. I said NO we are stupid Yuppies.

Bottom line. He found a sucker in the Bay Area who thought it was a "low" price. So I had fun. When they walked through and asked me what I paid for rent in a low whisper ---I lied and told them it was the old rent amount. I am only a stupid renter, saving my money.

A few months later the duplex closed and we and the next door neighbor gave 30 days notice.

We moved to a larger duplex and lower rent.

What happened to Mr. Bigshot landlord. My security deposit check bounced twice. Mr Bigshot with the red Viper. I met him IN HIS BANK and made I made a stink for him WRITING BAD CHECKS when HE HAD NO MONEY JUST BIG CARS. I told him I would have him arrested for fraud. He left, and came back with my CASH---he was very embarrassed. I laughed.

I rana background check on him and learned that he bought SIX PROPERTIES and one well known business in only six months. He also had a custom house built. By the end of the year ---he lost all houses to foreclosure and I added fuel to the banking fires when I told them he was a greedy cheat. He has over $100,000 of IRS tax liens and thousands of state tax liens on him. He is destitute and living in a trailer. His business was taken back and all his fancy cars were repossessed. I on the other hand have enough cash to buy a house outright. But I don't. Here is the reason. The personal misery and savings that I had to experience , the beans, rice, ramen noodles, clothes from the Goodwill---old cars was MISERY. So I learned the value of a dollar. IF YOU WERE IN MY SHOES---and YOU were also honest----you will find it is very difficult to throw your money away on lies and promises from Realtors and other housing cheerleaders.

Its a fact---REALTORS ONLY WANT TO SELL TO first time home buyers who are naive. THEY HATE people who know the score---why? Because they have to be very careful when they lie. Its easier to find a sucker with no money down and lie to closing than it is to deal with a person who refuses to be lied to, BECAUSE THE HAVE LEARNED ABOUT THE LIES THE HARD WAY. THEY PAID FOR THEM.

So, yes when INTEREST RATES DROP, "so-called affordability" in terms of MONTHLY payments go up. When interest rates increase , house prices go DOWN. Why? Because house prices are based on income when the buyers use a long term mortgage. If there were no mortgages houses would probably sell what they are worth or they would not build them. Very few people who buy houses to live in, pay cash.

Notice how house prices go up as mortgage interest rates go down and/or increase the terms of the loan and /or the government provides a tax incentive and /or interest deduction for mortagges? Why are mortgages so special?

If you ever have a family member get sick---and learn that your health insurance does not cover the costs of care---WHERE WILL YOU GET THE MONEY. I get mine by saving, not refinancing a house. It takes a lot of pressure of living.

Did you know that some man agers will use a house to enslave employees? I have. In the past, If I had an excellent worker and could not afford to give them a raise, I will encourage them TO BUY A HOUSE. It makes them feel important---and makes them loyal to me---for helping them buy it. I am not a philanthropist--its just business. An employee is more likely to stay with my company, if they have so much debt they cant afford to look for a different job. I don't take advantage of them, other than to assure they dont start looking for a job with another firm. Beware if your boss tries to "help you" buy a house. A house is a long term commitment and you can't sell them in two days. My area takes years to sell.

36   tatupu70   2009 Sep 23, 4:42am  

Justme--

I'm laughing that you think I'm part of the REIC (that's the first time I've seen that acronym, but I like it). I thought I was pretty clear that I think the vast majority of the bubble was caused by mortage brokers, realtors, and Wall St. flunkies. Where I disagree with most of the other posters here is that low interest rates were a major cause. And I find it funny that I'm one of the few people here who has posted data to back up their points. Whereas you accuse me of being an insider, and without sense. If you think I am wrong--by all means, show me why. But please have some logical reasoning and/or data to back up your arguments. Otherwise, I agree with you--I'd advise you to move on too.

Patrick-- Intersting example, but if I followed it correctly, I have a couple of comments. If interest rates fall by half, I don't think you'll get twice the loan. It's not a linear relationship. But the real problem in that scenario is you're forgetting about the appraisal. Just because you qualify for twice as much loan, doesn't make the house worth twice as much. And that's one of the key pieces that was missing during the bubble. Appraisals came in for whatever number they had to meet to keep the deal on. And banks didn't care because they didn't understand the risk. So, I'd argue that it wasn't the low rates--it was the banks/Wall St. underestimating risk and realtors and appraisers looking the other way...

37   Rogerer   2009 Sep 23, 5:47am  

tatupu70 says

... banks didn’t care because they didn’t understand the risk. So, I’d argue that it wasn’t the low rates–it was the banks/Wall St. underestimating risk and realtors and appraisers looking the other way…

Banks didn't care because they would either immediately sell the loans, or because they, like the market at large, were greedy and wanted to profit from the boom. They did understand the risks, but were seduced by high margins and huge capacity.

tatupu70 says

Rogerer–
I agree that low rates will cause an uptick in demand and subsequently prices for houses. The magnitude of this uptick is not well defined, because demand is made up of many factors–interest rates are only a part of it. But, this increased demand and prices wouldn’t be “excessive” as you state it. Or an “artificial valuation” With lower rates, there is a new equilibrium point on the supply and demand curves and prices rise. The true value of the house has risen. Not a bubble. Nothing excessive. Just how free markets work. When/if rates rise back to “normal” levels, housing prices should go back down as well–at least in inflation adjusted terms. Prices go up and down over time–nothing artificial about that.
The foreclosures on fully qualified loans were most likely people getting laid off from their jobs, I imagine. This has nothing to do with low rates. During recessions, people lose jobs and houses go into foreclosure. It’s unfortunate, but it’s how the world works.
Finally–I see low rates–>bigger loans. I just can’t make the connection to bubble.

It is somewhat ironic that in your quote above, you are arguing that there is no connection between interest rates and a bubble, yet you at the same time admit that housing prices will go back down when interest rates rise to normal levels. Hmmm...

Any time prices rise by 8 to10 times the average annual rate of inflation, when supply is actually outpacing historical demand, then there exists what can justifiably be called "excessive" demand. This leads inevitably to excessively high valuations. You choose to see this as "just how free markets work" but fail to see that when housing prices outpace other basic commodity values by such a disproportionate degree, that by definition is "excessive". That is, it has "exceeded" both the usual % appreciation in the historical sense and also exceeded valuation compared to other markets and economic indicators.

One thing Patrick has brought out clearly and consistently on this site is that house valuations are necessarily and unsustainably "excessive" when they move far beyond the normal cost to own / cost to rent ratios AND far beyond the normal mortgage/income ratios.

As to my use of the word "artificial", I would say that is true in the sense that is was both by design and through interference of influences outside the natural workings of a truly "free market". The arbitrary setting of ridiculously low interest rates is NOT a natural phenomenon occurring in the free market. The Fed has a long history of market manipulation, usually for the purposes of "curbing inflation" or "avoiding a recession" and has now lowered rates to levels even lower than those that helped trigger the boom. How can you not agree that these rates are artificial? And artificial rates lead to artificial demand which produces artificial valuations. The whole cycle is artificial!

Your resistance to what virtually all other commentators agree to seems to be based entirely on historical data in which you see no direct correlation between low rates and a bubble. The missing pieces in this puzzle could be that in all other cases of low rates, there did not exist the following factors:

1. There was never previously such a huge disparity between the prime rate and the mortgage rates - giving lenders an added incentive to go over the edge with new loans (and simultaneously decreasing the risk factor on paper due to the huge margins involved.)

2. Interest rates had never been lowered so significantly and suddenly.

3. Interest rates had not been lowered at a time when the overall economy was doing so well. Greenspan justified this by saying he feared a recession after 911. (He has since admitted this was a mistake "in hindsight".)

This is just a situation where historical data does not have direct relevance to current conditions.

38   reniam   2009 Sep 23, 6:10am  

I don’t think tatupu70 is being a troll. He has a difference of opinion.

I do think though at this point he is arguing just to argue. Almost all have said that low interest rates were ONE OF the many confluent streams involved in making this bubble. There have been plenty of references already provided but he is still putting the onus on others to “prove me wrong”. Even one of his provided references states: “instead, they skyrocketed by 86% due to Alan Greenspan’s irrational lowering of interest rates to 1%...”

It’s fine if you wish to see suppressed interest rates as having minimal effect. That is certainly your prerogative. But please don’t claim you “still [have] not seen one argument explaining why low rates cause excess risk taking or asset bubbles”. Read the references provided to you already. Find the speech given by Senator Elihu Root in opposition to the Banking and Currency Bill. It should take you days to read and contemplate them. In other words, do some of your own research.

39   tatupu70   2009 Sep 23, 6:23am  

reniam--

Fair enough. How about we agree to disagree. You're right that we are going round and round and saying the same things now. I hope I'm not being a troll--I enjoy a civil discussion and disagreement.

40   justme   2009 Sep 23, 6:36am  

Tatupu70,

Ok, I will indulge you just ONCE on this topic. Greenspan himself finally admitted to the following, per Wikipedia.

"Greenspan admitted that the housing bubble was “fundamentally engendered by the decline in real long-term interest rates”,[41] though he also claims that long-term interest rates are beyond the control of central banks because "the market value of global long-term securities is approaching $100 trillion" and thus these and other asset markets are large enough that they "now swamp the resources of central banks."[42]

In addition, there is any number of well-known economists that said the same thing, or made even stronger connections between rates and bubbles. Follow the links people have posted above.

Now, your data about the Prime Rate is not very relevant. It has little to do with mortgage rates, or the fact that LOTS of money was pushed into (low rate) mortgages because the short term interest rate was even lower and there was no other SAFE place (irony alert) for the money to go. Weak lending standards are sometime a function of the demand for loans to buy, again caused by low short-term yields!

Now, do you think the admission by Greenspan himself is wrong? Show me some reputable economists that agree with you, and refer to their arguments. They are going to be hard to find.

My question is, where did you get the idea that interest rates do not matter to bubbles? There just is not any credible evidence for your thesis.

Don't make me cut and paste a quote from Alan Greenspan again. I really don't like the guy at all.

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