Posted on 07/03/2005 8:07:52 AM PDT by ex-Texan
NEW YORK - Are hedge funds fueling a housing bubble? It may not be the first thing that comes to mind, but an increasing number of economists are seeing a connection.
Though the Federal Reserve chairman has yet to come right out and say it, economists are adding hedge fund activity to the list of theories as to why long-term interest rates have baffled markets by remaining near historic lows--failing to rise in lock-step with short-term rate hikes.
The low rates have encouraged continued buying activity in the housing markets, to the point were practically everyone is talking about a real estate bubble.
Economists are pointing at hedge funds as a contributing factor, saying heavy demand is driving yields down. "If there is a lot of money doing that, it could actually affect the market," says Marshall Blume, from the University of Pennsylvania's Wharton School of Business, in an academic research note. "If hedge funds are helping to keep interest rates low in defiance of the Fed's efforts, they are contributing to the housing boom that some believe is becoming a speculative bubble."
Alan Greenspan has called the apparent disconnect between short- and long-term rates a "conundrum." Despite eight increases in the Federal Funds rate since last June, the yield on the benchmark ten-year Treasury has remained at low levels. It fell from 4.38% in January 2004 to 4.24% in December and continued to fall this year, touching 3.89% on June 2 before inching back up to close at 4.11% Monday.
Greenspan has addressed the risks associated with the explosion of the hedge fund industry in the last couple of years, recently telling banks to keep a vigilant eye on credit standards with regards to their dealings with hedge funds.
But in addressing the issue of short- versus long-term rates--what economists call the flattening of the yield curve--the Fed chairman has not put hedge funds in the vanguard. Instead, his theories put foreign investment, pension funds, the increasingly intertwined global economy and worries of a softening economy at the front of the list.
Private economists say it is hard to ignore the influences of hedge funds, however. Once a marginal business involving only the wealthy elite, hedge funds have attracted a broad audience of not-so-rich individuals and even pensions and endowments seeking better returns on their money than the stock and money markets have produced in recent years.
The problem is that the increased number of hedge funds means there are many more managers following like strategies. "There are a limited number of arbitrage opportunities," says Richard Marston, a professor of finance and economics at Wharton. "It's not herd mentality so much as everyone is looking for good ideas, and they often come up with the same ideas."
Simply put, Blume says in a telephone interview, "When you throw a lot of money at the financial markets, you do distort them."
While the yield on the ten-year note has held around 4%, the yield on the two-year bond has risen steadily, from 1.94% in January 2004 to 3.72% as of June 17. The narrowing spread has erased much of the advantage short-sellers of the ten-year would have had.
Richard DeKaser, the chief economist at Cleveland's National City (nyse: NCC - news - people ) said data from the Commodities Futures Trading Commission suggests there could be a connection between speculative interest in the bond market and the direction of interest rates.
Using data on long positions in the ten-year bond, DeKaser calculated the short positions for non-commercial and non-reporting traders. The latter category would include hedge funds. Short positions--those who bet against a rise--in the ten-year Treasury began piling up in September 2003 and reached more than 621,000 short contracts the week of March 22. DeKaser says that's possibly an all-time high. In comparison, as recently as December 28, there were 85,489 short contracts, and last week there were 153,560.
What does this mean? Investors were betting that bond prices would fall (and subsequently rates would rise), and thus that they could make a profit by selling short. But if the reverse happens and prices rise, they'd have to buy. Enough buying could drive up bond prices and force interest rates down.
In March, as the short contracts were piling up, the ten-year yield jumped from 4.38% to 4.63%.
But from March to May there was a sharp drop-off in these short ten-year bond contracts by speculative traders, by DeKaser's calculations. That would coincide roughly with the downgrades of the debt of General Motors (nyse: GM - news - people ) and Ford Motor (nyse: F - news - people ), two events that roiled the bond markets in early May. The yield on the ten-year went from 4.63% on March 22 to 4.0% on May 31.
There was a sharp pick-up in short contracts at the beginning of June. On May 31, there were 8,517 short contracts from speculative traders. That rose to 89,000 the next week and 153,000 last week. Meanwhile the yield on the ten-year has climbed from 4% to 4.11% in the same period.
"I do believe that short-term speculative traders have had a significant influence on interest rates," DeKaser said in a telephone interview.
When people start buying Florida real estate over the internet, site unseen and planning to flip it (as they're doing now,) that does scare me a little.
Nice find. Very interesting and informative.
I see you posting a lot on this topic so I'm interested in your personal view as to how best to prepare for the bubble bursting. Get out of the market? Pay off all debt? Pay off the mortgage? Buy gold?
Many have leveraged their real estate purchase and, if the rise continues, will be wealthy. If the bubble bursts, they will be broke, their loans will be in default and lenders will have big problems.
Today, in San Francisco, 70 year old houses, worth less than $100,000 in most of the rest of the country, are selling for a million two, more if there is a view. This is artificial and can't continue. A sharp increase in interst rates (for variable mortgages) will force many of these houses into default, the lenders will take over and try to resell them.
Wife's grandma bought a small lot in central Florida for $2200 years ago. We get post cards offering $30-$40,000.
This is the Collective Speculative Beanie Baby Syndrome. It's where take something and drive its price beyond its true worth thru collective hysteria. We do this with everything from Beanie Babies, to Dot Coms, to real estate.............
PS: there is no real estate market. Ther are real estate markets, even within the same geographic area.
The hell of it is, banks can get overnight money now at 3.25% and soon that will be 3.5% and higher. Why on earth should anyone buy 10 year treasuries at 4%?
San Francisco is a magnet for European and Asian money, which sees US real estate as cheap and will continue to do so for some time. When the bubble gets popped, don't be surprised if San Francisco and New York prices don't go down all that much. The areas that are going to get killed are remote suburbs where homes have been overbuilt and run up to three or four times what they should be selling for by speculators and desperate first time buyers. San Francisco prices may at worst drop 20-30% (bad enough to trigger a wave of foreclosures, certainly) but prices in new developments in the Central Valley - 100 miles or more from the nearest employment centers - could drop 70%.
The real estate bubble burst will be a suburban economic holocaust. Unfortunately, it's going to hit hardest among just the kind of new Republican voters the 2008 candidate will need to fend off Hillary. It's going to be a neat trick for the Administration to manage the real estate bubble deflation as well as Greenspan handled the NASDAQ bubble deflation - Greenspan's policies shifted the imbalances into real estate...but where is his successor going to move them this time? Chinese government bonds?
Interesting.
Don't you think that "employment centers" are moving out of big cities with traffic moving both directions? Why do companies need cities like San Francisco for their center? Why not the central valley?
In regards to S.F., sounds as though California is becoming much more antagonistic to businesses with every passing year. What do you think?
You would think so, with the rise of the Internet and the relative ease of setting up telecommuting arrangements. In my experience, though, most employers 1) Love big cities (maybe because senior management loves good restaurants) and 2) Remain hostile to the concept of telecommuting - they seem to think that if employees can't be watched, they aren't working. Interestingly, as many former dot com companies have grown larger and stabilized, they have started to take away a lot of the flexible work schedules and telecommuting policies that served them well when they were high-flying startups. Once a senior managmeent becomes accountable to Wall Street, they start getting paranoid about any area of the business that doesn't feel totally under their control.
California is antagonistic to small businesses, but large corporations can generally direct their campaign contributions in such a way that they get whatever favors they need from the Democratic Legislature. Democrats love Big Business (the fastest way for them to realize their socialist dreams is to adopt large corporations as parnters and administrators of their schemes) - it's the entrepreneur that frightens both Big Government and Big Business. In California, the two have made common cause against the entrepreneur. ;)
Not really when you consider that 30,000 people are moving to Florida ever month. Like Cal. there is a lot of demand. Demand is the main force behind the price surges. Are they to high in certain areas, could be. Who knows for sure until the demand side starts to slow down.
the problem is that US Government costs so much
Nobody cares when Greenspan or the government distorts the markets, nor does it make a sexy theory worthy of quoting.
great point; demand is everything. government and/or greenspan certainly cause demand imbalances, but 30K people per month to is going to drive prices. hedge funders just work that demand and make it excessive.
its all part of work and retirement cycles. warm, coastal and mild areas are the preferred destinations. cities have had the work and denmand before.
as mr jeeves says companies can't quite decide if telecommuting works. small(private) business needs to take that money right out of their pockets.
If you are only getting 10 offers for 230.000 condos I would say your bank has a problem.
Not to worry - they will lend you some more!
I hate fear-mongers....
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