“Wealth Effect” Mucks Up Housing, Costs Homeowners Dearly

Home prices have jumped around the country, in many cities over 10%, and in some over 20% on an annual basis. “Recovery of the housing market,” is what this phenomenon has been called. Everyone from President Obama on down has taken credit for it, particularly the Fed, whose handiwork this is.

The nearly $3 trillion that the Fed has printed since the financial crisis had to find a place to go, and some of it went to private equity firms and hedge funds and REITs, and they’ve been gobbling up vacant single-family homes from foreclosure sales as fast as they could. And this has driven up prices. It’s part of the concept of the “wealth effect” that the Fed has been citing as one of the reasons for the waves of QE. It has worked wonderfully – assets values ballooned across the board. And it fixed the housing market.

But there is a very ugly fly in this illusory ointment. Mortgage applications have been on a brutal decline that started in early May. For the week ending August 9, the Mortgage Bankers Association’s Composite Index dropped 4.7%, with the Refinance Index down 4% and the Purchase Index down 5%. It isn’t a fluke. Mortgage applications have plunged 50% from early May and have hit a level not seen since April 2011.

Average interest rates for 30-year fixed-rate mortgages, at 4.56%, are nearly a full percentage point higher than in early May. These higher rates have been colliding with much higher home prices. Result: a dizzying jump in mortgage payments. Sticker shock for prospective buyers.

So first-time buyers now account for only 29% of total sales; prior to the housing crash, they accounted for up to half. The Fed’s “wealth effect” policies are pushing average Americans out of the housing market. Of course, they don’t have to be homeless. About half of the vacant single-family homes that these private equity firms and REITs have acquired are still vacant – maybe they’d cut some deals on rent.

But people who’ve owned their homes for a few years are better off. For them, the “wealth effect” – obtained by checking the home value on Zillow twice a day – should translate into feeling wealthier, which, according to the Fed’s plan, should arouse the urge to blow some additional money on baubles imported from China. That’s how the “wealth effect” gooses consumer spending (and the Chinese economy) even if strung-out consumers don’t actually have any money to spend.

But housing is a peculiar asset. The money tied up in a home, including any gains, is illiquid and can’t be spent. So if jubilant homeowners want to convert what they have “made” on their home – based on the rising Zillow price – into something that won’t be around in a few hours, days, or months, they have to borrow against their home or dip into their savings or raid their retirement fund or charge it to their credit cards.

If the price of their house then descends again, the money they spent due to the “wealth effect” can’t be unspent. It’s gone. The homeowners are simply poorer, by both, the amount that the price of the house declined, and by the amount that they spent because they briefly felt wealthier. That’s the wealth effect. It’s a Fed inspired way of bamboozling people into spending money they don’t have.

It gets better. After a period of successful “wealth effect,” lucky homeowners might sell their house for a tidy profit. They jubilate and feel richer and spend some of it. But they have to live somewhere. That’s when they discover that the prices of all other homes have gone up as well, that in fact they have gained nothing if they buy an equivalent home. The profit from the old home is getting eaten up without a trace by the higher price of the new home. But brokerage fees that jump with the price of their old house, and interest expenses that jump with the mortgage of their new house, will eat their lunch and leave them poorer.

OK, they could trade down, or move to a cheaper city like Detroit, which would allow them to cash out their profits. Or they could move into a rental unit and give up homeownership altogether. But if enough people did this, it would kick the housing market over the cliff again. And people are doing it….

Or they could upgrade to a nicer home. But it has gained in dollar terms even more than their old home. Now the expenses associated with the “wealth effect” really kick in: in addition to the brokerages fees that jumped in parallel with the price of their old home, mortgage interest rates, now a percentage point higher than in early May, apply to the much larger principal balance to form a painful double whammy for the homeowner.

But there are winners. The state benefits from the wealth effect by being able to collect higher property taxes. Brokers make out like bandits, as their commissions are applied to inflated home values. Banks earn fatter profits on processing the higher mortgages. Whoever ends up owning the mortgage earns a higher yield. And fees that get charged throughout these processes become more remunerative. Ah yes, the “wealth effect.”

What rabble-rousers, economists (those banished from the mainstream media), and bloggers have hammered on for years, a study by the San Francisco Fed finally confesses: QE didn’t do a heck of a lot of good for the real economy. The timing of the study is impeccable: the approaching end of QE – and the market mayhem that an end of QE might cause. Read….  The Fed’s Confession: We Can Avoid A Crash At The End Of QE If Everybody Believes That Everybody Believes In A Mirage….

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