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“A house is not an investment.”  

It’s a common lament that I hear from some economists and finance professionals.  Yet, if anything, it’s a sentiment that is wrong-headed in every way.   A home is absolutely an investment, and one that often has greater risks and rewards than your average stock or corporate bond.  America’s great mistake was not treating housing as an investment, but rather pretending that it could be anything other than one.

This flawed mindset has caused us to make many terrible public policy choices over the past eight decades, with the move by the Consumer Financial Protection Bureau (“CFPB”) to tighten mortgage underwriting standards being the most recent example.  These new standards by the CFPB have the potential to adversely impact our economy, exacerbate wealth disparities, and increase the risks of a future bubble.

Before we dive into the CFPB’s latest prescription for our banking woes, it’s first necessary to understand risk in the housing market.   In a simple example, let’s say we buy a $100,000 home with a 5% down payment.  For simplicity’s sake, let’s say this is an interest-only loan for the next three years and we sell the home at the end of that period.

If the price of the home were to increase 20% over that three years, we would make a profit of 400% on our equity position.  That’s more impressive than the returns for nearly every three year run in the entire history of the US stock market!  On the flip side, if the price of the home were to fall 20%, we’d lose 400% and be left with a negative $15,000 equity position, putting us significantly “underwater.”

This math is difficult to ignore and it applies regardless of whether one bought a home to “live in” or “as an investment.”  It showcases how buying a home is as risky as the leveraged buyouts (“LBOs”) commonly employed by private equity firms.   If prices drop 20% to 40% and homeowners are underwater, their economic incentive is to “walk away” and leave the bank holding the bag.  It’s this set of economic facts that can create rocky times for mortgage lenders.

For this reason, it’s not poor underwriting standards that pose the greatest threat to the US financial system.  Rather, it’s lending out to people who buy housing at inflated prices.  The primary reason banks make poor investment choices relates to the massive Federal infrastructure promoting home ownership over other alternatives.   This includes the Federal Housing Administration (FHA), the FDIC, Fannie Mae, and Freddie Mac.  Collectively, this infrastructure is responsible for guiding mortgage standards, which have focused almost exclusively on wage income and gross debt levels of the borrower, rather than attributes that might more effectively gage investment risk, such as price-to-rent ratios of the underlying properties

Meanwhile, the more plausible explanations for rising asset prices are the policies of the Federal Reserve Bank and excessive spending by the Federal government.   Every major housing bubble of the past century has been accompanied either by loose monetary policy and/or large Federal government budget deficits, both of which have the tendency to create excess money growth.   In the past 12 years, we’ve seen this exact scenario unfold, with M2 money supply growing at an abnormally high rate relative to nominal GDP growth during most of the period.

From 2000 – 2012, the US saw 6.4% annual growth in M2 money supply versus 3.2% annual growth in NGDP; that means money growth outpaced economic growth by nearly 320 basis points on an annual basis.  For the prior twelve years, the relationship was reversed with 5.6% NGDP growth versus 4.2% M2 money growth.   That’s a swing of about 470 basis points between the two periods.  While these figures don’t tell the whole story, they do showcase how dramatically our disposition has swung.  This large amount of money growth relative to output also helps explain the abnormal volatility in the housing market that only began to rapidly increase around the late 90’s and early 00’s.

Loose monetary and fiscal policies create a “free lunch” for the banks.  The only catch is the banks have to figure a way to lend out to take full advantage and the significantly subsidized housing market is the ideal way to do so.  The subsidies inherent in the mortgage market create a “free rider” problem that results in artificially high demand for housing loans.  The CFPB’s latest move to tighten lending standards can be thought of as an attempt to artificially lower supply of such loans; it’s rationing more or less.  Yet, we are merely offsetting one economic distortion with another.

So long as we continue creating large monetary and fiscal “stimulus”, asset prices will almost inevitably continue to rise.  The tighter standards imposed by Dodd-Frank, the CFPB, and more informally by the FDIC will do little to halt this process.  Indeed, over the past year, we’ve seen hedge funds, private equity firms, and large institutional investors swoop into to buy housing en masse.   The takeaway here is that the middle class might be getting squeezed in the mortgage market, but wealthy individuals are ready and willing to take their place.  The tighter lending standards issued by the CFPB may slightly shift the ultimate destination of our next bubble, but it won’t stop it.

If we truly want to fix our system, it’s time to treat housing as an investment, and one that the Federal government should not give preference to.   It’s time to slowly wind down the massive Federal housing infrastructure we have in place, and stop handing out “free money” for “qualified individuals.”  New policies need to incentivize the banks to analyze mortgage loans based on a broader range of factors including “investment risk” rather than based on a myriad of arbitrary rules that only look at wages and gross debt of the buyer.

Even more importantly, the Federal government needs to balance its own books and significantly reform the Federal Reserve Bank.  No matter what rules and regulations we have, we’ll continue to see bubbles, so long as we run loose monetary and fiscal policies.

While I do not know for certain where the next bubble may lie, I sincerely doubt that the new CFPB restrictions will prevent it from happening.  More likely, these regulations will widen wealth disparities and limit consumer choice for middle income individuals.  Meanwhile, our housing market will remain broken.