Real Estate Economics 156 Foldvary

More on business cycle

The key element in the Austrian-school business cycle theory is the relationship between the interest rate and the structure of capital goods.

The interest rate:

1) equalizes savings and investment

2) allocates production between consumption and investment

3) sets the structure of investment in capital goods.

4) capitalizes income to asset values.

If we interfere with the natural market rate of interest, this distorts and destabilizes these roles.

How does the Federal Reserve system expand the money supply?

When the monetary authority injects money into the banking system, this increases bank reserves and lowers rates of interest.

Investments are made in higher-order capital goods, which later turn out to be bad investments, as costs rise and profits vanish.

So an expansion of the money supply creates an artificial boom, which becomes destabilizing as later prices rise, investment slows down, and the economy falls into a recession.

The real estate aspect is that 1/3 of investment is related to real estate,

and much of the long-run investment sensitive to the interest rate is in real estate.

Speculative buying adds to the demand for real estate construction and purchase.

Much of the gains are based on capitalizing the value of public works and services.

Tax advantages add to the price of real estate.

Also, a lower rate of interest capitalizes up the value of real estate.

Real estate owners have more equity, so they borrow more on that equity.

It’s an upward spiral that is unsustainable, as the price/rent ratio rises,

and as households and enterprises can less afford to buy or even rent real estate.

There is a new element to the business cycle that has created greater economy-wide risk.

Government sponsored enterprises (GSEs), Fanny Mae (FNM) and Freddie Mac (FRE),

buy mortgages from banks.

Loans secured by real estate still have some risk, since it is costly to repossess, and real estate prices can fall.

The bank is the primary lender.

Fanny Mae (FNM) and Freddie Mac (FRE) are secondary lenders.

They sell bonds to raise funds to buy mortgages.

The interest income from mortgages is less than the interest paid on bonds.

The bank can then make another loan.

So economic land rent on a house gets paid as mortgage interest to Fanny Mae which gets paid as bond interest to a bond owner. In the national income accounts, it gets counted as interest.

This can continue as long as real estate owners don’t default.

Fanny and Freddie have gone further, packaging mortgages into guaranteed mortgage-backed securities or bonds, which they sell. To the buyer, it is an asset, a bond paying interest.

These mortgage-backed bonds are bought by insurance companies, pension funds, mutual funds, and banks.

The outcome is a huge increase in debt, with the risk spread wide over the economy.

$5 trillion of asset values held by many companies depends on the ability of millions of homeowners to make their monthly mortgage payments.

If homeowners default, the GSEs are in trouble.

They get less income to pay on their bonds, and they have to pay interest to the guaranteed bonds. The result is a domino series of defaults.

1) the homeowner on his mortgage; 2) GSEs on their bonds and securities,

3) The insurance company, pension fund, etc. has losses, possibly bankruptcies.

4) Their account holders have losses.

American households own $34 trillion in financial assets, not including their homes..

Home mortgage debt $7.5 trillion.

Total mortgages 2003 $9.3 trillion

$15 trillion U.S. houses.

$7 trillion is in pension funds.

Some 52% of household financial assets are exposed to the risks of GSEs.

The whole economy is vulnerable to a big fall in real estate prices and defaults on mortgage payments.

As the boom moves towards its peak, lending standards get looser.

To make more loans, and since they are bought up by GSEs, banks led to subprime borrowers,

those with greater credit risks.

They borrow 80% or more on houses with high prices.

Their mortgage payments are a high percentage of their income.

And they have adjustable-rate mortgages, which increase with rising interest rates.

They default at a higher rate, and they are more likely to lose their jobs in a downturn.

To recapitulate,

The real estate boom is spurred by:

1) tax advantages

2) capitalization of public works

3) low interest rates

4) the secondary market for mortgages.

When interest rates and real estate prices rise, investment falls, incomes fall,

and the economy goes into a recession:

1) Real estate prices fall

2) Owners default.

3) Banks, GSE, and financial institutions can fail.

Is the business cycle natural and inevitable, or created by government policy?

Can the business cycle be eliminated?

If so, what policy would eliminate it?