Quote from OldTrader:
The scenario you paint in terms of interest rates would obviously only apply to those who have adjustable mortgages. And then too, most of the adjustables have an annual cap, so it takes a while to make a major move. Nonetheless, rising rates will impact new buyers. The example I gave was intended to illustrate the impact on a guy who bought right at the top, saw rates rise to the degree I mentioned, and how long it would take to break even in terms of his situation....11 years or so.
If only it were that simple. An interest rate shock would affect everyone, and I do mean everyone.
Once again, there is a bigger picture than simple supply and demand, and larger ramifications than a few guys having to make bigger mortgage payments.
The global real estate bubble is a largely macroeconomic event tied in to the fed's efforts to avoid the pain of the late great stock bubble.
In essence, the stock bubble was inflated by a perfect storm confluence of hot story (the new internet paradigm) , hot money (capital flows dislocated by the asian crisis looking for a new home) and fed fuel (major liquidity injection as just-in-case buffer for y2k). And oh yeah, a blissfully benign inflation environment.
After the stock bubble burst and the enron and worldcom skeletons came out of the closet, the fed was anxious to avoid a crash and burn, so the easy money kept coming to beat back the deflationary monster. And with interest rates at 40 year lows, where did this easy money go? Into the real estate market. Demand coming out of the woodwork. Banks making money hand over fist. Consumer spending through the roof. Everyone feeling flush. And that easy money is
still coming. The spigot is only being turned off a little at a time.
You would typically expect a multi-year cycle of easy money to create inflation, especially if Friedman is right about inflation being an entirely monetary phenomenon. But we've enjoyed a (mostly) goldilocks scenario because all that free flowing cash got mopped up by the stock market... and then the baton was handed over to real estate. Hence the problem and the danger of interest rates today... Greenspan has seemingly done us a favor, but he's also done a great disservice- because the unsustainable debt levels associated with the bubble haven't worked themselves out. In fact, they've gotten worse.
While the bottom of a bear market is usually quite painful, it also has a purpose- a cleansing effect. Companies and consumers with excess debt are forced to take their medicine. Sacred cows are taken out and shot. Balance sheets are cleaned up, the garbage is taken out, and the process of saving begins again. Once consumers and companies have trimmed down and saved up (and the herd has been culled), the next positive cycle can begin again- with new net savings and favorable (low) valuations as the foundation.
We never saw the cleansing effect of the bear because Alan never let it happen. Companies and consumers alike are still loaded with debt. In fact, not only are we not in a position to build a new foundation with our savings, we've essentially doubled down on the debt load we were carrying from last time around. American consumers and companies are like the fat guy at thanksgiving dinner who ate five times too much - we are still gorged on debt, and we have yet to work it off. An interest rate shock will be the equivalent of sticking a finger down our throat... we'll be forced to puke it all up. Not pretty. See more here if you find the topic interesting (interest rates, not throwing up):
http://hussmanfunds.com/html/debtswap.htm
When rates go up, Joe Blow not only has to make a higher mortgage payment... he has to start worrying about his job, because the corporation just saw their liabilities increase and their cash flow take a hit. He has to worry about his access to credit, because the banks are freaked out and they've started getting really tough for some reason. And he has to start worrying about his neighbors' spending habits, because if his business is related to consumer spending, a change in sentiment could cause a chunk of his biz to dry up fast.
Everything affects everything, and we are setting ourselves up for a vicious circle... a potential chain reaction with very ugly consequences. A sharp rise in interest rates would hurt consumers and companies alike, a downturn in consumer sentiment would hit company profits even harder, and layoffs would hit consumers yet again. Down we go.
The real nasty kicker is that we are highly dependent on low interest rates, and yet we are essentially buying those low rates on credit (by buying Asia's goods with borrowed money, our half of the deal). The more stuff we buy on credit, the more we need to buy on top of that- to compensate our bagholder as the bag gets bigger. Not sustainable arrangement. Must be unwound. Unwinding must be done verrrrry carefully.
Obviously this scenario is not good for home valuations. In fact it's pretty much in line with the pending disaster school of thought. Not a foregone conclusion... Asia still has good reason to play along, and the Maestro may be able to pull one last rabbit out of a hat... but it's no time to be complacent. (The Maestro had better be ambidextrous too, because he'll have to manage the dollar with one hand and stave off the potential threat of inflation with the other. Is it any wonder he tried to pass the buck -no pun intended- in a recent speech?)
The other scary factor is that so much of the wealth effect enjoyed by these higher values is a complete illusion. Why is a house that was worth 300K four years ago at a million today? Because people say it is, and the bank confirms it by giving you an equity loan on it or a mortgage to buy it for that much. But when the bids dry up, much of that supposed "wealth" will actually just disappear - poof. Just like when Pulte or whoever those builders are down in Vegas decided to shave 100K or so off their suggested asking price because foot traffic dried up. A handful of leveraged speculators found themselves six figures in the hole - instantly (you can buy a half million dollar house on 4% margin don't you know). Doh! No warnings there. When the bids dry up because the credit got crunched and the sentiment turned sour, we could see hundreds of billions in wealth effect just... disappear. Bye bye. Air pocket city. Just hope we get to come down slow.
(Victor Sperandeo has a great story about two cajun farmers trading a horse back and forth. They keep bidding the price up on each other, making different deals -a cart here, a bridle there etc.- until finally they are trading at multiples of ten from where they started (and on credit from the bank of course). One day a Wharton MBA drives up, does a few quick calculations on the appreciation, and buys the nag for $147,000. The second farmer says 'Pierre, you eediot! Why did you sell? We were making a great living on zat 'orse!")
