221 Week 4 F /For WIZARD KIM

Interest Rates and the

Real Estate Bubble

Gil Sandler

Gil Sandler is a frequent

contributor and member

of the Board of Editors of

Real Estate Finance. He is

Managing Director of Realvest

Capital Corporation and

affiliates, which specialize in

capital markets financing for

real estate, governmental, and

private clients. Mr. Sandler

may be reached at gsandler@

realvestcapital.com. Portions

of this article contain fictional

material not based on actual

events. The entire article reflects

only the views of the author

and should not be attributed

to Real Estate Finance, its

publisher, or editorial board.

I magine: Immediately after the January

31, 2006 Federal Open Market Commit-

tee meeting, retiring Fed Chairman Alan

Greenspan was seen slipping into a nearby phone

booth to call his wife, prominent TV journalist,

Andrea Mitchell. Choosing the anonymity of

a public phone to avoid satellite intercepts of

cellphone calls (his contacts with foreign central

bankers made the non-FISA Court Hit List),

the Commanding General of the War Against

Inflation was unaware of Homeland Security’s

latest mini-bug—installed for just such candid

“Kodak” moments. Fortunately, the transcripts

of this and other high-alert national security

calls were accidentally declassified and fell

into the wrong hands. (Oh, well, so much for

Homeland Security—as was said about FEMA’s

ex-director, they do “a helluva job!”).

Greenspan: Good day, Liebchin. As you will

soon hear from your friends at CNN, I have

done my patriotic duty and raised rates once

more. I believe my work is done here. The com-

ing recession will be Big Ben’s problem.

Mitchell: Not so fast, Dr. G. What about that

big, fat ugly real estate bubble—brimful of

frothy exuberance? I don’t recall hearing it burst

just yet. Didn’t you say you had to prick the

real estate balloon to curb inflation—our Public

Enemy No. 1?

Greenspan: No worries, Sweet Pea. No real

need to have a “splat.” The bubble is wilting

before our eyes, though I made sure none of us

got hit by flying scraps. One might say this will

be more like a giant soap bubble floating in the

wind than that gooey pink stuff.

Mitchell: Yes, I see, My Leader, but for those of

us mere mortals who are economics-challenged,

please explain again how you did all those won-

derful things.

Greenspan: Elementary, My Dear Mitch-

ell. Listen closely, please. We began with a

recession—NOT MY FAULT! Remember, I

warned them all about bidding up tech-turkey

stocks, but they didn’t listen. (Alas, I had to pass

up the Google IPO to prove I believed in the

Bubble.)

But, as I told W in 2000, and again after 9/11,

the best cure for recession was not to wait for

a trickle-down from a top bracket tax cut, but

to jack up consumer spending and confidence.

It would also help if we could create a few mil-

lion new jobs, real and reportable, and inside

America.

So, after consulting my Ouija Board, I used

my Fed Superhero powers over the discount

rate1 nobody ever uses to cut interest rates.

This would, of course, suck consumers into

grabbing and spending. After all, who could

resist such easy money? Then, with renewed

confidence—soon to be reported in all the

surveys—they could buy new and second

homes, speculate on condos, and trade up

on cars.

Eventually, of course, it gets crazy. Housing

costs will rise, taking the cost of living, CPI,

PPI, etc. with it. So now it looks like we have

APRIL 2006 REAL ESTATE FINANCE 3

4 REAL ESTATE FINANCE APRIL 2006

inflation, a “quelle dommage,” and sadly, we must then pull

the plug. We can and did jack up rates, maybe even a few

more “measured” quarters than necessary for pure inflation

control, but that big hot air balloon lifting real estate above

the clouds will begin to leak and sink like a lead balloon (I

just love blowing up and pricking balloons.)

Even an economics neophyte can see that we played

it perfectly. With 14 raises totaling 3.5 percent, we also

bumped COL and CPI, and by directing the banks not to

lend to risky borrowers at higher future rates, even for first

homes, we could inflict some real pain. So what if the music

stops and those silly amateurs without chairs get caught

sleeping standing up?

Mitchell: Your Mensa mind is wunderbar! But at a more

basic level, that sounds just a tad callous, don’t you think?

What about all the warnings we heard about overdoing that

rate trick? I know you think those whining ’80s throwbacks

were soft on inflation, but how does it help the economy

to wipe out consumer spending power with high home

equity rates? Remember, you’re the guy who told the poor

slobs in middle-America that the economy was moving

forward so they should run out and buy new Gas Guzzlers

and Big Screen HDs with home equity loans. Then you

told them their hidden real estate equity could support

early retirement, so the big employers cut non-farm payrolls

and no longer report higher unemployment claims. Now,

what happens when the banks reset the rates on ARMs?

Won’t that trigger defaults, bankruptcies and foreclosures,

just like the early ’80s and ’90s?

Greenspan: No pain no gain. If you can believe it (I’m not

sure I do), W says jobs are moving and the economy is roar-

ing. (Just between us chickens, I think he heard it on Fox

News, or maybe Dick heard it hunting and slipped it into his

daily intelligence briefing.) The Big Developers and Home-

builders that create non-Asian jobs will be OK because

we’re making their tax cuts permanent and they can always

cut elastic jobs. We’re all set up for the next cycle, if big Ben

doesn’t blow it. Tax savings and excess profits from Big Oil

will trickle right down to consumers over the next 10 or 15

years; the Big Banks will handle mortgage and credit card

defaults just fine under the new bankruptcy law.

And here’s the best of all: Big Developers and Homebuild-

ers can swallow some smaller ones with lower-priced stocks

and pick up bargain-priced land and unfinished projects

in foreclosure. We learned quite a bit from the Great Real

Estate Recession of the ’90s. Now, how’s that for a stable

recovery plan, Mon Petit Cieu?

Mitchell: You are, indeed, a genius, My Oracle, and non-

partisan to boot. I’m starting to get your drift. Let me

guess about how we’ll keep everyone thinking we have full

employment. The DOL reports on job loss claims won’t be

swollen by construction layoffs because so many workers

are illegal and can’t file? Wow, as the Guinness Brothers say

on the tellie: Brilliant!

* * *

Of course, that politically incorrect call never happened,

and none of us really knows what great innermost thoughts

lurked in the mind of our legendary Inflation Fighter. Dr.

Greenspan undoubtedly leaves us with an exemplary record

over most of his tenure, and served most ably under both

Democratic and Republican Presidents.

Nonetheless, the real point of this tongue-in-cheek exer-

cise is that the housing and real estate slowdown data we

are seeing on a daily basis, and the all-too-predictable pain,

could have been caused as posited. The conversation was

pretty silly, but maybe there’s a speck of truth amidst the

fabricated economics lesson.

OK, let’s get back to reality.

FED RATE POLICY AS AN ECONOMIC MANAGEMENT TOOL Yes, indeed Greenspan’s Last Dance was a rocker. The

14th 25 basis point (.25 percent) increase since June 2004

lifted US banks’ prime lending rate to 7.5 percent—at least

2 percent higher than most real estate borrowers budgeted

and lenders underwrote when they made commitments

in the past two years. And a 15th increase occurred at the

early March FOMC meeting. In March, Ben Bernanke’s

New Fed raised the Fed Funds rate an unprecedented

15th time to 4.75 percent, moving the prime rate to 7.75

percent and removing any doubts about his clean accep-

tance of Greenspan’s baton—the commitment to fight

inflation. Finally, the flattened yield curve has ratcheted up

the benchmark 10-year Treasury yield more than 50 basis

points to break the five percent barrier predicted to hold

until year-end. Conventional mortgage rates have followed

with the 30-year conventional rate breaking the 6.50 per-

cent line. Dragging ARM and home equity loan rates up

with it, 15 short-term rate hikes have sucked the air out

of the residential real estate balloon. The unemployment,

jobless claims, and producer price index reports can all be

Interest Rates and the Real Estate Bubble

interpreted as inflationary, but stripped of heavy oil and

energy prices, and adjusted for reporting time lags, other

economic signals are not nearly so clear. Has the Fed gone

too far in using interest rates and the real estate balloon to

manipulate the economy?

The answer is affirmative, if anyone cares to remember

the Japanese central bank’s rate push to burst the real estate

bubble? That bubble burst with the inevitable defaults,

foreclosures and bank failures; before the 1988-93 RTC-

led recession/recovery, but unlike the US technology-led

recovery, Japan endured a massive recession prolonged by

a drop in real estate values. After more than 20 years, real

estate values in many areas remain at historically low lev-

els, and the Japanese central bank was struggling to raise

its rates from the “0” level, which it supported, to avoid

deflation. This may not happen here, with the global pres-

sures against high Treasury yields, but it has already sparked

slowdowns, auctions, and project cancellations on residen-

tial and commercial developments. Further Fed increases

could easily trigger widespread defaults and drawdowns on

already razor-thin personal savings.

In hindsight, it seems clear that money was far too easy

for homebuilders who sucked up every piece of open

land to build for the boomers. It also was too easy for

homeowners sucked into buying a second and third

condo with near-free vacation offers. Now that money

has become costly again, and homeowners and smaller

builders don’t have the cash to repay high LTV loans, we

have begun to see suspended and defaulting projects and

condo auctions.

Remember when real estate was a solid, fundamental

long-term investment? Only recently did it become a

consumer ATM2 or macro-economic management tool.

Remember when future retirees were encouraged to pay

down their mortgages so they could live their golden

years rent-free? Without a doubt, real estate is a logi-

cal source for economy boosting. It has been estimated

that as much as 36 percent of our GDP is related to real

estate—from planning to design to administration, sales,

title insurance, brokerage, financing, and management.3

So promoting real estate activity can and did jumpstart

job growth, even if many of the jobs are temporary, as

well as consumer spending.4

It seems clear that Dr. Greenspan and other Fed policy

pros intended all along to use real estate as their primary

tool to turn the last recession into a boom. Perhaps they

could have found less painful ways than creating the

“froth” they complain of by inflating real estate values

and sticking easy money candy into the faces of “can-

build” developers. The Fed quite deliberately promoted

consumer spending by lowering the federal discount rate,

and dependent rates like LIBOR and prime, just as surely

as it would have with a lower- and middle-class tax cut,

but with one notable difference. Loans need to be repaid,

and they can only be repaid with the proceeds of sale or

successive refinancings—all predicated on ever-increasing

property values. Of course, they knew they also would be

lowering home equity and mortgage rates. What is not so

clear, however, is whether the Fed fully understood the

impact on the US economy of lifting real estate values by

10 percent to 25 percent a year for four years or antici-

pated the predictably adverse impact of corrective rate

increases to a so-called neutral level.

Raising rates, particularly real estate

borrowers’ rates, to limit or

reduce inflation is, at best,

a self-fulfilling prophecy.

At the same time that homeowners’ net worths seemed

to be rising exponentially, housing has become significantly

less affordable in most large markets,5 despite historically

low mortgage rates. The banking industry’s solution was to

craft creative option and negative amortization or “afford-

ability” ARMs, low or no-down payment mortgages, and

negative amortization “choose your payment” loans. This

form of mortgage made huge bets on continuing double-

digit value appreciation,6 much like the thrift loans that led

to foreclosure auctions in the late 1980s and early 1990s.

These high-risk instruments were readily available because

originating lenders could book fee income without hold-

ing and reserving for losses in portfolios after syndicating

and securitizing them.7 Little concern was expressed for

the very real prospect that these loans could eventually

implode when rates returned to normal levels, crushing

consumers forced to spend as much as 50 percent of their

available cash8 on real estate and further dipping into sav-

ings. So long as the recovering economy could turn arti-

ficially bloated homequity lines into cash machines,9 why

worry about savings?

Interest Rates and the Real Estate Bubble

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NEGATIVE IMPACT ON REAL ESTATE VALUES Rising interest rates can burst not only real estate bubbles

and speculators’ paper profits. They can also slash real GDP,

job growth or retention, real net worth, retirement assets,

and obviously consumer spending and confidence. Real

estate net worth could actually decline, if, as we expect, first

and second homes must be sold to generate net proceeds

for retirement, and prices off their bubble tops do not gen-

erate enough net proceeds to pay off the home equity or

negative amortization mortgages used to support the higher

cost lifestyle. In recent years, the policy makers claiming

credit for pulling us out of the techno-bubble recession

have deluded themselves into believing that our economy

is strong and inflation is well-contained, but they missed

the fairly obvious disconnect between the two. The claimed

job growth is really imperceptible, in terms of real income

growth and current purchasing power. Unemployment

rates now being trumpeted as breaking through 5 percent

have long been miscalculated, misstated, or misunderstood

for years because they have not included those whose jobs

cannot be replaced and who no longer remain in the work-

place, neo-retirees living off their newly inflated net worths

or the many illegal and cash-based workers below the radar

of Social Security and tax filings.

Raising rates, particularly real estate borrowers’ rates, to

limit or reduce inflation is, at best, a self-fulfilling prophecy,

and can do more harm than good. Higher rates can indeed

discourage spending, as well as real estate speculation, but

what really contributes to inflation is the interest compo-

nent in prices that, along with ever-higher energy costs,

must be passed on to the consumer.

While we cannot cite an authoritative measure of the

interest component in the prices of finished goods, there

is little doubt that cheap foreign goods benefit from low

foreign interest rates, as much as low labor costs. Moreover,

in recent labor negotiations, labor negotiators have become

increasingly conscious of labor’s cries of reduced spending

power—due in large measure to higher consumer loan

rates. The resulting demand for higher wages, and ardent

opposition to benefits reductions of both current workers

and retirees, is not satisfied by assurances that inflation is

being well-controlled by a vigilant Fed ready to do further

damage by raising borrowing costs.

Now, let’s look at the impact of higher rates on real

estate under development. Most phased planned residential

developments that began construction with 50 percent to

80 percent of their units pre-sold will finish their phases.

Finished collateral is much more valuable to lenders, and

presales are backed by either cash or lines of credit, so

most loans will close, perhaps with a bit more equity or

collateral posted. However, later phases planned at much

higher prices will be suspended indefinitely, as speculators

will be struggling to unload.10 Without the price increases

artificially sustained by developer marketing of subsequent

phases, prices of the initial phases will drift into freefall.

Anyone who remembers the RTC era knows that it wasn’t

just lender foreclosures and thrift failures that triggered 50

percent to 100 percent declines. It was also the massive vol-

ume of units thrown up for sale that even a global auction

market could not absorb.

WHAT ABOUT “THE COMING RECESSION”? A major question is how widely the crunch will be felt.

For the present, the flattened and inverted yield curve, itself

fueled by low global rates and lessened borrower demand,

will enable many homeowners to lock in relatively low

medium and long-term rates for primary residences. If the

economy can survive without major job or wage losses—a

big if as the domestic auto industry struggles with overca-

pacity and inability to reduce fixed costs—defaults will be

limited to the higher volume areas of speculative building.

This could include Las Vegas, parts of Florida, and the Sun

Belt,11 and more than a few urban luxury high-rise proj-

ects, as well as condo-hotels and various forms of interval

or shared ownership that have thrived in the recent lower

rate cycle. High-rise condos could become rentals if rents

rise enough. Paradoxically, rental projects resold at record

low cap rates may be converted to condos at a discount

from planned condo project prices, simply because of the

15 percent to 25 percent (or greater) disparity between

those values.

The growth in new retail and office park projects feed-

ing off residential expansion also will be slowed. Although

there is often a five to ten year lag, as new roads open

new residential projects, they are soon followed, first by

neighborhood and other retail centers, and then by local

office projects to service the emerging population centers.

Self-storage centers are a newer category designed to ser-

vice the downsized condo purchasers and small businesses.

Residential growth also creates demand for both schools

and healthcare providers. Then, too, once the office market

has begun, hospitality projects begin to be planned. All of

Interest Rates and the Real Estate Bubble

these markets and sub-markets will be affected by the slow-

down in residential real estate.

As indicated, the slackening in demand for new resi-

dential product will delay or kill many commercial, retail,

and industrial projects on the drawing boards. Moreover,

continued commercial development will be even more

adversely affected by declines in consumer spending trig-

gered directly by higher consumer loan rates, and by higher

development costs caused by higher acquisition, construc-

tion, and permanent loan rates.

Pension funds will begin to take

profits and redirect new investment

capital to other markets.

Retailers will be less eager to seek new locations when

spending and confidence erode and existing store sales stag-

nate. Office and warehouse projects closely follow retail and

residential projects in the same or adjacent geographic areas,

so they, too, will adopt a more measured growth attitude.

HOW HIGHER RATES IMPACT REAL ESTATE DEVELOPMENT Of perhaps even greater magnitude, however, is the 375

basis point hike in construction loan rates—and counting.

Among the key components of new project analysis directly

impacted by rate movements are the following:

• The higher cost of more equity or mezzanine debt;

• The higher capitalized interest expense;

• The reduced permanent loan proceeds available

to meet (i) minimum debt coverage ratios based

on higher debt constants and potentially lower net

operating incomes (NOI), and (ii) reduced appraisal

completion values; and

• Correspondingly greater amounts of equity that can

provide a market return on investment and net cash

flows on lower NOI.

The present and near-term higher-rate environment will

change both expectations and returns on capital. Large pub-

lic homebuilders have already seen 20 percent to 50 percent

stock declines from growth-driven highs. The industry should

see some consolidation as Wall Street and shareholders press

to maintain earnings by cutting operating and administration

costs and selling off non-core assets. This can only produce

net job losses in the biggest growth industry of the century.

At the same time, wholesale dispositions of undeveloped

properties will feed both potential wholesale buyers and

small developers who can find funding and equity.

The same kind of market cap reductions and earning

reductions seen in public homebuilders likely will spread,

albeit to a somewhat lesser extent, to public equity REITS

that have funded new projects and bid aggressively for

existing, completed projects. Along with higher borrowing

costs for leveraged REITs, fewer bidders will emerge for

new projects and unit resales, further dampening prices and

profit potential for speculators. Mortgage REITS may have

some difficulty obtaining full and timely repayment from

less-capitalized entrepreneurial borrowers and projects to

the extent they have been funded with less than 15 percent

true equity, and workouts will reduce their returns. Pension

funds will begin to take profits and redirect new investment

capital to other markets. At this point, we can look forward

to a new cycle of no or slow development, all due directly

or indirectly to the Fed’s use of interest rate management

to end the last bubble-burst recession, and then to control

barely visible inflation.

We might agree that Dr. Greenspan and his Fed follow-

ers have engineered the much-desired “soft landing,” at

least, thus far. Perhaps, the dire “what-if ” scenarios over the

negative effects of the Fed’s having pushed the rate button

too often will turn out to be overly pessimistic. Maybe the

reversal of the rate cycle will be readily absorbed by our

ever-resilient economy that can handle the Iraqi War along

with domestic recovery programs, and the menace of an

unfunded Social Security system.

AN ALTERNATIVE APPROACH TO RATE-BASED ECONOMIC MANAGEMENT It is tempting to wonder what would have occurred if,

instead of inflating real estate with easy money, only to be

forced to deflate it five years later, the Fed had chosen a

different approach. Could it have encouraged consumer

spending and boosted confidence sufficiently by reduc-

ing rates while, at the same time, using regulatory and tax

policy to promote savings and job creation? Could any of

this have been accomplished without promoting risky real

estate borrowings and cost and value inflation?

Interest Rates and the Real Estate Bubble

APRIL 2006 REAL ESTATE FINANCE 7

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The primary thesis of this article is that the Fed could

and should have recognized differences in this 21st Century

global economy from the recession-inflation cycles of the

last century and modified its approach to recovery and infla-

tion suppression. No lesser light than our next Fed chair,

Prof. Ben Bernanke, recognized a new type of “asset-price

spiral” of stock and real estate prices that is more resistant

than previous inflationary cycles to traditional interest rate

manipulation.12 Once it is understood that bubbles and froth

cause more harm than good by creating a myth of financial

security13 and unaffordable lifestyles, we can approach a

solution. As Bernanke and other economists have observed,

bubble-like increases in asset prices are caused not merely

by low interest rates, but by the combination of low rates

with unregulated loan policy encouraging high-risk loans.14

This, then, suggests the need for additional tools to fight the

adverse attributes of inflation. Rather than using “measured

pace” rate increases to burst bubbles, and inflicting pain across

the broad spectrum of consumer borrowing, the Fed can

apply regulatory constraints to rein in riskier lending.

We know from the Australian example, adopted in part by

the Fed only after three years of rapid, excessive, growth in

housing prices, that careful management of loan underwrit-

ing criteria and tax policy can restrict low-cost mortgage

loans to equity-supported home purchases and justifiable

home improvement, which would discourage speculation

and overbuilding. Yet, the Fed might have fostered its own

inflation scenario by allowing easy and cheap money to

inflate real estate costs and values.

Admittedly, the Fed can pride itself on GDP growth, rela-

tively controlled inflation (other than housing and energy)

and can take credit for ending the recession by making

Americans feel richer than ever, and spending more than

ever. The sad corollary is that real income has declined, real

net worth has declined, and real estate — all too often an

illiquid asset — rather than savings, has become the largest

component of net worth.

A NEW FED POLICY? So much for the Greenspan Legacy. What more can we

expect of his successor, Ben Bernanke? Will “Greenspeak”

simply be replaced by an equally inscrutable “Bernanku-

lar”? We expect no major rate redirection for the short-

term, but Professor Bernanke’s strong academic background

and previous writings suggest a more flexible, multi-fac-

eted approach to detecting and analyzing both the causes

and effects of inflation. Prof. Bernanke is known to have

espoused the use of “microregulatory policy” in tandem

with or in lieu of interest rate policy to control the bubble

effect of inflation.15 For example, restricting mortgage loans

to buyers posting at least 10 percent downpayments and

capable of meeting higher ARM reset rates would reduce

the number of bids on each new or resale unit, without

increasing every homeowner’s monthly payment. Another

option is to return to the more restrictive policy of under-

writing second home and speculative investor loans more

conservatively, and requiring more equity at risk.

It is uncertain whether there will be more rate increases. If

the Fed looks at all the reports of slowdowns in key areas,16

and CPI increases are analyzed without politically sensitive

components such as energy, a rate reduction in 2006 could

be warranted, perhaps even by mid-year, to return to a real-

istically neutral rate. Even a cursory analysis would indicate

that the housing slowdown and its multi-pronged effect on

jobs, real estate values, consumer savings, and spending power

could result in consumer spending and confidence declines.17

These should have a larger overall impact on rate policy than

a simplistic reaction to standard inflationary triggers.

A growing number of respected economists have come

to believe that a core inflation rate in the 3 percent to 4

percent range is well tolerated, and perhaps expected in

a healthy economy. A “neutral” interest rate environment

sounds admirable in theory, but at the current 4.5 percent

discount rate and 7.5 percent prime rate level and still ris-

ing, floating borrowing rates for interim investments are

significantly higher than mortgage rates, and much more

discouraging than neutral. We are at a different point in

long-term economic cycles than the early 1980s when

the Fed could impose, and the market could tolerate a 21

percent prime rate, because primary mortgages and other

essential borrowing could still be done at lower rates.

SOME SUGGESTIONS FOR THE FED The Fed should recognize that much of the economic

and asset price slowdown it has worked overtime to

achieve with rate policy has been caused independently

by higher energy costs, and Hurricane Katrina labor

and materials cost escalations. Even without further rate

increases, consumers must heat their homes and buy gaso-

line for commuting, so they have that much less to spend

on consumer goods. Continuing rate increases can only

aggravate the inevitable slowdown, without necessarily sta-

bilizing inflated asset prices.18 Accordingly, the Fed should

Interest Rates and the Real Estate Bubble

consider both a modification of its inflation targets and

control mechanisms.

Finally, the Fed should recognize that real estate has become

an integral part of personal investment portfolios, retirement

planning for the huge boomer generation, and general well-

being. Home equity loans secured by real estate were not a

primary source of credit in the high rate environments of

either the early 1980s or the early 1990s, and were not a

major source of credit or consumer spending.

However, in 2006, real estate has become a substantially

larger component of net worth. In order to avoid some of

the ill effects of eroding consumer confidence—hopefully

well before we start measuring for the recessionary coffin—

Fed rate policy will need to support continuing real estate

ownership as an integral part of creating and maintaining

a stable economy. Whether rate levels are consistent with

a “neutral” or “accommodative” policy, or for that matter,

whether the slowdown qualifies as a full-blown recession,

will be largely irrelevant if high interest costs, piled onto

higher healthcare, energy, and tax costs, squeeze millions of

future retirees and housing-deprived workers alike.

NOTES 1. Ostensibly, the Federal Reserve has no ability to move free market interest rates, but by

resetting the discount rate at which the Fed lends to banks, and more often, by execut- ing Treasury bill repurchase or “repo” transactions, the Fed can lift or drop short-term market rates. Ultimately, movements in short-term rates are expected to impact Treasury note rates, primarily the two, five, and ten year maturities, although the flat and inverted yield curves since January 2006 have defied that progression.

2. The widespread use of home equity lines has been accelerated by the concurrence of dramatically lower interest rates and the securitization and risk dispersal of bank loans. One report suggests that as much as $887 billion was withdrawn in 2005 through real

estate mortgage loans. R. Gerena-Morales and T. Annett, “Growth May Slow in 2006 As Boom in Housing Cools,” The Wall Street Journal, Jan. 3, 2006, pp A1-A2.

3. D. Gross, “As the McMansions Go, So Goes Job Growth,” The New York Times, Nov. 20, 2005, p. 4 (BUS.).

4. A recent Federal Reserve study noted that rising home prices added $600 billion to consumers’ spending power. See, J.R.Hagerty, “What’s Behind the Boom,” The Wall Street Journal, Nov. 21, 2005, p. R4.

5. The affordability of housing units has declined during the real estate boom at all price levels. See, W. Neuman, “Reading the New York Signposts,” The New York Times, Oct. 2, 2005, p. 13 (NJ RE). Also, while home prices increase by 53 percent since 2001, afford- ability has dropped, especially in high-cost areas such as California where as few as 15 percent of homeowners earn enough to qualify for conventional mortgages by lifting housing costs to 30 percent of their incomes. See, J.R.Hagerty, supra n.4, p. R4.

6. It has been reported that the median downpayment in some markets had dropped to as little as 3 percent from the conventional 10 percent to 20 percent. D. Akst, “Pop Goes the Bubble?,” The New York Times, Sept. 18, 2005 p. 4 (BUS.).

7. Thus, the default risk was off-loaded to CMBS investors and the ultimate time bomb of rate and value correction was deferred. See, L. Uchitelle, “To Fight Rising Prices, Fed Nominee May Need New Weapons,” The New York Times, Nov. 4, 2006, pp. C1, C13.

8. By one estimate, about one-third of homeowners spend more than 30 percent of disposable income on housing, while about one-eighth spend 50 percent or more. See, J.R.Hagerty, supra n.4, p. R4.

9. Family savings of retirees reportedly fell by 23 percent from 2001 to 2004, while home prices rose 22 percent. See, M. Rich and E. Porter, “Increasingly, the Home Is Paying for Retirement,” The New York Times, Feb. 24, 2006, pp. C1, C6.

10. Even commercial projects have begun to feel the heat from higher costs and lower rents and begun to cancel office projects. J. S. Forsyth, “As Costs Climb, Builders Put Off Office Projects,” The Wall street Journal, Nov. 9, 2005, p. B8.

11. Speculators are believed to form a large part of the new unit market in certain areas. Reportedly, 36 percent of home sales in Miami-Dade County, FL, and 40 percent in Clark County, NV (Las Vegas), were for homes sold in less than two years. See, Neuman, supra n.5.

12. See, L. Uchitelle, “To Fight Rising Prices, Fed Nominee May Need New Weapons,” Note 7, supra, p. C13.

13. See, D. Leonhardt, “Don’t Fear the Bubble That Bursts,” The New York Times, Mar. 1, 2006 p. C1-C2.

14. L. Uchitelle, supra n.13. Making larger loan amounts available to buyers with insufficient incomes or equity at risk inflates demand for new housing units and radically shifts the supply-demand balance in favor of higher prices.

15. Bernanke’s views were stated in a little-known interview published in 2005 by the Federal Reserve Bank of Minneapolis. See, L. Uchitelle, supra n.13, p. C13.

16. The housing slowdown and its wider effects are considered one of Prof. Bernanke’s biggest challenges in 2006. See, Gerena-Morales and Annett, supra n.2, p. A2.

17. As the National Association of Realtors reports that sales of existing homes declined for the fifth consecutive month, and unsold inventories continued to increase, consumer confidence also dropped. See, C. Conkey, “Existing Home Sales Fall Again,” The Wall Street Journal, Mar. 1, 2006, p. A2; V. Bajaj, “Sales of Existing Homes Near 2-Year Low; Consumer Confidence Ebbs,” The New York Times, Mar. 1, 2006, p. C3.

18. L. Uchitelle, supra n.13, p. C13.

Interest Rates and the Real Estate Bubble

APRIL 2006 REAL ESTATE FINANCE 9