Low Interest Rates Contribute to Credit Boom and Record Homeownership Rates

The government has always stressed the virtues of homeownership and taken steps to promote it over the years. But while homeownership may be a worthwhile goal in and of itself, providing credit in excessive amounts to the home mortgage market leads to housing booms and busts. The increases in homeownership may therefore last only as long as the housing bubble does—and the broader financial sector and economy may suffer tremendously when the bubble bursts.

An important contributing factor to the most recent credit boom and the record high homeownership rate it produced were the low interest rates that prevailed from 2001 to the end of 2004, as the Federal Reserve took steps to combat the 2001 recession and prevent deflation.8 Figure 2.20 shows the sharp decline in mortgage rates that occurred during this period.

A second factor contributing to the era of easy credit was a global savings glut. Foreign investors, flush with cash, made record purchases of U.S. securities. Indeed, the United States was the largest importer of

Remarks on Homeownership...

One of the great successes of the United States in this century has been the partnership forged by the national government and the private sector to steadily expand the dream of homeowner-ship to all Americans. .. . Since 1993, nearly 2.8 million new households have joined the ranks of America's homeowners, nearly twice as many as in the previous 2 years. But we have to do a lot better. The goal of this strategy, to boost homeownership to 67.5 percent by the year 2000, would take us to an all-time high, helping as many as 8 million American families across that threshold.. ..When we boost the number of homeowners in our country, we strengthen our economy, create jobs, build up the middle class, and build better citizens. President Bill Clinton

Remarks on the National Homeownership Strategy University of California, Santa Barbara June 5, 1995

[D]uring the past few years, ... low mortgage rates have supported record levels of home construction and strong gains in housing prices. Indeed, increases in home values, together with a stock-market recovery that began in 2003, have recently returned the wealth-to-income ratio of U.S. households to 5.4, not far from its peak value of 6.2 in 1999 and above its long-run (1960-2003) average of 4.8. ... The depth and sophistication of the country's financial markets have allowed households easy access to housing wealth.

Remarks by Governor Ben S. Bernanke

"The Global Saving Glut and the U.S. Current Account Deficit" Virginia Association of Economists, Richmond, Virginia March 10, 2005

capital in the world in 2007 (see Figure 2.21). This influx of capital contributed to lower rates, particularly longer-term rates, than would otherwise have occurred. China, in particular, accumulated massive foreign exchange reserves and invested heavily in the United States. According

Figure 2.20 Did the Fed Lower Interest Rates Too Much and for Too Long? Federal Funds Rate vs. Rates on FRMs and ARMs (Weekly, January 1991-November 1, 2008) Percentage

Figure 2.20 Did the Fed Lower Interest Rates Too Much and for Too Long? Federal Funds Rate vs. Rates on FRMs and ARMs (Weekly, January 1991-November 1, 2008) Percentage

Sources: Freddie Mac, Federal Reserve, Milken Institute.

to Bardhan and Jaffee (2007), "the need to maintain a somewhat undervalued Chinese yuan has caused China to make extensive investments in U.S. Treasury and Agency securities, with the likely result that U.S. mortgage rates have been at least 50 [basis points] lower; indeed a case could be made that U.S. mortgage rates are a full percentage point lower as a result." (See the Appendix, Figures A.7 and A.8.)

As Figure 2.22 shows, the inflow of capital into the United States as a share of GDP increased beginning in 2001, from 3.3 percent to a high of 5.3 percent in 2006, and then declined to 4.5 percent in 2007. Despite even that decline, the United States was the largest importer of capital in the world in 2007, as illustrated in Figure 2.21.

The low interest rate environment from 2001 to 2004 had another effect on many home buyers: they increasingly opted for adjustable-rate mortgages (ARMs) over fixed-rate mortgages (FRMs). As Figure 2.23 shows, the ARM share of total mortgage applications tends to move inversely with the one-year ARM rate—which in turn tends to move positively with the target federal funds rate. In other words, because the

Figure 2.21 The United States Is the Largest Importer of Capital (2007)

Total Worldwide Capital Inflows = $1.4 Trillion

Other countries

United States 48%

Figure 2.21 The United States Is the Largest Importer of Capital (2007)

Total Worldwide Capital Inflows = $1.4 Trillion

Other countries

Turkey

Greece

United States 48%

Sources: International Monetary Fund, Milken Institute.

Turkey

Greece

Italy 4% Australia 4% United Kingdom 8%

Sources: International Monetary Fund, Milken Institute.

typical adjustable rate on a home mortgage is initially set below fixed rates, many individuals choose to fund home purchases with ARMs during periods of declining interest rates and avoid them during periods of rising interest rates.9

Figure 2.22 Capital Inflows to the United States (1983-2007) Percentage of GDP

Figure 2.22 Capital Inflows to the United States (1983-2007) Percentage of GDP

Fixed And Subprime Rates
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Responses

  • caden
    What factors contribute to a credit boom?
    7 years ago
  • Thomas Ostermann
    How does interest rates contributes to booms in an economy?
    7 years ago

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