The Fed’s Looming Housing Bubble

What Goes Up Must Come Down

I recently posted an article on how the Fed’s reckless Mortgage Backed Securities spending could have caused inflated home prices and pressure on long term interest rates. We’ve got inflated asset prices, cheap credit, and irrational exuberance. That sounds like a housing bubble in the making to me. We don’t have many good historical analogs to understand the ramifications of the Fed’s actions. However, I do know this – there is no such thing as a free lunch.

Housing Bubble Logic Explained

My thought process for why the housing market is overheating is fairly simple.

1. The Fed bought a lot of mortgages.
2. This helped contribute to a suppression in long term interest rates.
3. Borrowing has become cheaper, which spurred a ton of unsustainable demand.
4. Stocks and real estate have become overvalued because of the ample liquidity and cheap borrowing costs.

Doesn’t sound so bad right? Prices are going up, people are making money, everybody is happy. Here’s the catch – the rise in prices is being being fueled just as much by easy monetary policy as it is by fundamental economic strength. It’s being jacked through the roof due to easy monetary policy. When the Fed shifts its monetary policy (like raising interest rates to fight inflation), this can all come crashing down.

So How Does This All End?

We’ve walked through the logic of why there could be a bubble. One of the common adages you hear people say is that “the whole point of a bubble is that you can’t foresee it coming.” This is nonsense. There are clear identifiable markers that prelude a bubble bursting.

Higher Inflation

When you combine a jacked up money supply with strong economic demand, you get inflation. Lots of it. Back in 2020, this was the goal. The Fed wanted (slight) inflation in order to fight against deflation resulting from the pandemic.

However, it’s now clear that the Fed badly miscalculated. We’ve seen record high US inflation due to the Fed’s actions.

The Fed Can’t Exit Its Trade

In January 2023, the Fed owned $3 trillion dollars of mortgage backed securities. With a position of this size, the Fed is stuck between a rock and a hard place. If they unwind their position too fast, they will tank the MBS market. Rapidly selling their position could lead to a sharp market correction. Also, how are you going to generate demand for $3T of toxic debt you took on during the pandemic?

The Fed is in a tough spot here. If the economy goes sideways, Congress is going to be very frustrated that the Fed is taking billions of losses on bad loans. Because ultimately, what this means is that the American taxpayer is acting as the lender of last resort, bearing the brunt of defaults and foreclosures.

How a Housing Bubble Could Unfold

Now that we’ve identified some markets that prelude the housing bubble, let’s examine some of the ways this can play out. Because ultimately, if you don’t put your money where your mouth is, there isn’t much value in predicting an asset bubble.

Home Prices Collapse

Probably the most obvious here… housing bubble = sharp drops in the price of real estate. We’d probably see the most overpriced markets like Sun Belt, hit first and hardest (think Florida, Arizona, Tennessee). It would start with the most overpriced assets, but it’s very possible that we could see a broad real estate market correction.

Real estate declines can reverberate into other areas of the market. Stocks and bonds will likely suffer as Americans are placed under significant financial distress.

Fragility in the Financial System

Ah, the good ole banks. It wouldn’t be a financial bubble without Wall Street. Per usual, certain financial institutions (not all, this isn’t 2008), are invested in sub prime and prime loans. If one bank fails, they can go like dominos.

As we saw in 2008, when banks face severe uncertainty, they pull the plug on lending. When banks stop lending to each other, we get a credit crunch. And Jamie Dimon gets to snag deals of the century. He did it in 2008 and again in 2023 with First Republic.

More Involvement from the Fed

What’s New…

If the housing bubble bursts, there’s a good chance we see heavy involvement from the Fed, like we saw in 2008 and 2020. Central banks will probably backstop financial institutions, slash interest rates, and flood the marketplace with ample liquidity.

Each time the Fed backstops egregious risk taking, they create a moral hazard for the market. Somehow the American taxpayers always get stuck with the bill for Wall Street’s stupidity.

Long Term Reform? Don’t Count On It

The Big Banks have one of the strongest lobbies on Capitol Hill. Outside of Elizabeth Warren and a few others, opposition to the banks is muted in Congress. The banks hire the best lobbying firms and make sure the Super PACs are well funded.

What about all the public outrage… won’t this prompt a Congressional response? It will, but it will be short lived. Congress will hold meaningless hearings to make it seem like they are listening to the people. After a while, the public attention will wane, and outrage fatigue will set in. Without sustained public demand for change, legislators won’t feel compelled to pursue aggressive reforms.

Even if reforms are passed, they will probably be challenged in court. Financial institutions have the resources to mount lengthy and sophisticated legal challenges to any new regulations. With the Supreme Court heavily leaning conservative, change is unlikely.

If you can’t generate change… you might as well get rich.