Is the Fed our friend? Or are their actions hurting more than helping?
The Federal Reserve is using short-term interest rates to lower inflation, but their method is inadvertently increasing the cost of housing. Not only have they turned themselves into a source of inflation, but their aggressiveness could push the housing market over the edge.
The easy money, low-interest rate, and broken supply chain environment that followed the initial shock of the pandemic fueled a climb in inflation mistakenly thought to be temporary. Last year the Federal Reserve had to give up its denial of inflation longevity and use the tools it has to prevent runaway inflation.
Their tools for the job could only cut demand and do by tightening the credit market and soaking up excess cash in the banking system. Both have led to a spike in mortgage rates. Investors are pushing the higher monthly costs onto renters or defaulting on properties that are no longer lucrative.
The Fed has been tightening the credit market by increasing the overnight rates (or federal fund rates) in ten consecutive Federal Open Market Committee (FOMC) meetings starting in March of 2022. The overnight rate is the short-term financing cost to banks borrowing money from central bank depositors to maintain their reserve requirements. It is the benchmark for all other interest rates like bond yields, mortgage rates, credit cards, etc. The cost to hold debt has quickly become more expensive.
The Fed has also reduced liquidity in the market by ending its participation in purchasing Mortgage-Backed Securities (MBS). Not only have they stopped buying them, but they have also started to sell their holdings of these securities. Before this, the Federal Reserve was the largest buyer of MBS. When the Fed stopped, these securities flooded the market, spiking the supply and slashing prices. The market has counterbalanced by raising mortgage rates to attract new would-be buyers.
This rise in mortgage rates is a natural and intended consequence of the Fed’s pursuit to cut demand and level out inflation. The problem is the high amount of variable-rate mortgages purchased when rates were low. Following the initial shock of the pandemic in 2020 and 2021, the real estate market was suddenly a low-mortgage rate environment. During low-rate environments, borrowers typically opt for variable over fixed interest rate mortgages because they benefit if interest rates decrease further (monthly mortgage payments decrease). Borrowers who took on variable rates in that time did not foresee the spike in inflation that would coax the Federal Reserve to start a campaign of aggressive quantitative tightening.
These property owners’ monthly mortgage payments are rising quickly. Most pass the higher mortgage payments onto tenants by raising their rents, accelerating housing inflation. While inflation has slowed in the last few months, Americans are paying the difference in the rising cost of housing.
The Next Real Estate Crash
This rise in mortgage-monthly payments is not just a problem for residential real estate. Commercial real estate investors also picked up variable-rate mortgages during the same period. Around one-third of all commercial real estate lending in the U.S. is under a variable rate.
When Commercial Real Estate investors opt for variable rates, lenders typically require them to hedge their bet against rising rates. Borrowers are required to purchase derivative contracts known as an interest-rate cap. These contracts pay borrowers the difference in monthly payments once interest rates exceed a threshold. But these interest-rate caps only last around three years, meaning many purchased during the pandemic will need to be re-purchased starting this year. That is a problem. As interest rates have spiked in the last year, so have the price of interest-rate cap contracts. They now cost around ten times what they previously cost 12 months ago. An interest-rate cap contract that cost a borrower $100,000 last year will cost them $1,000,000 today.
The extra mortgage monthly payments and the now ten times more expensive interest-rate cap that banks require borrowers to purchase are too much for investors to absorb, and most will choose to default. These are not just small-time investors; large commercial real estate entities will choose to default even if they have the cash. They are more interested in protecting their bottom line than holding an unprofitable property. Expect the number of defaults to jump as this year continues and the interest-rate cap contracts from the low-interest rate environment expire.
The saving grace for these property owners and the real estate market is for the Federal Reserve to cut rates by the end of this year, but the Fed has not communicated that as their trajectory. In the latest Fed minutes released from the May FOMC meeting, some members are considering raising rates further. The Fed will likely keep the federal fund rates steady in the next meeting for the first time in more than a year, but some Fed members will not take rate hikes off the table for following FOMC meetings.
One of the Fed’s mandates has been price stability. But by using their shotgun approach of raising borrowing costs aggressively over the last year, they are inadvertently raising the cost of living for Americans through housing. The Fed is also on the way to driving the economy into another recession led by mortgage defaults and a broad real estate sell-off similar to the 2008 financial crisis.
Investors are obsessed with the Federal Reserve. A single comment from a Fed member can move the massive U.S. market with ease. We should pay attention to them because of their power. The goals of the monetary policy decision body are long-term and reach for sustainable stability. But their methods are imprecise and face too many variables to get there smoothly. The current high-interest rates environment is putting pressure on the economy. Things break under pressure. It pays to pay attention to the Fed.
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Thomas A Crowley
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