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    Mortgage rate blowout – a new bubble in the making?

    by cmartenson

    Friday, December 19, 2008, 2:45 AM

Between 2002 aand 2005, Alan Greenspan dropped interest rates too low for too long.  This created a property bubble which was really no surprise at all to anybody who follows such matters.

In fact, there are reams of papers written by PhD Fed staffers that explore the unusually tight correlation between real estate and mortgage interest rates. There’s really not a lot of mystery as to why this is the case.

To make an extreme example of it (and leaving the principal payments out of it), if you can afford $12,000 per year towards mortgage payments, at 10% interest you’d be able to afford a $120,000 mortgage whereas at a 1% rate of interest you’d be able to afford a $1,200,000 mortgage.

As a rule of thumb, each 1% reduction in the rate of mortgage interest supports a 10% increase in the price of a house.

So if you’re a government official in charge of cleaning up after the last bubble, what does one do?  Well, if one of the goals is to stem the losses arising from plummeting house prices then driving interest rates down has to be one of the more obvious policy plays.

Recently the Fed has been buying both GSE Agency debt and MBS products.  That is, both Fannie and Freddie debt (to supply them with more cash that they can lend) and their bundled mortgage products. 

This, coupled with the Fed’s extreme support for the US government treasury market has served to push mortgage rates to their lowest levels in the entire data series. 

30-year fixed-rate mortgage at 37-year low
CHICAGO (MarketWatch) — The benchmark 30-year fixed-rate mortgage tumbled to a national average 5.17% this week, the lowest level since Freddie Mac began its weekly rate survey in 1971.

Will these record-breaking low mortgage rates help?  That depends on your position.  Certainly anybody who has a mortgage and is in a position to refinance to these new lower levels will be helped.  And all the ARMs due to reset that are tied to LIBOR and Prime rates will be helped (by lower adjustment resets). 

But all the people who did not participate in the housing bubble and have been patiently waiting for better prices are now ‘fighting the Fed’ which is a lousy place to be.

But will house prices actually go up as a result?  Of that I am less sure.  House prices are a complicated affair relying on other factors besides mortgage interest rates such as jobs and consumer psychology.  I think these last two factors will more than counterbalance the Fed’s attempt to reinflate the housing bubble for some time, probably another 12-18 months.

After that?  It seems extremely likely to me that the another bubble is in the offing because the Fed is determined to create one.  It’s almost as if it’s all they know how to create.

But you and I know that the real reason is that our monetary systems demands continual expansion and so the Fed, as the guardian of that system, will do everything it can to keep the expansion going.  

To some financial observers this is known as the "inflate or die" strategy.

At any rate, this is one example of how the Fed intends to get new credit money flowing back out to the people.   Now if they could just get the banks to play along….

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