Why the housing market is caught in a liquidity trap

May 9, 2011, 7:27 PM UTC

FORTUNE – In textbook economics, lower interest rates typically spur higher investments.

Money is cheap. So the assumption is that people, banks and companies will spend more, therefore helping the economy grow.

But that doesn’t always work. Sometimes cutting the rate of interest, even to zero, won’t necessarily pull an economy out of a recession. British economist John Maynard Keynes called this the liquidity trap — when virtually everyone becomes so risk averse that banks would rather sit on their cash than offer credit. And even if banks start lending more, people wouldn’t want the credit anyway.

It is a grim scenario. And it appears today that no sector in the U.S. economy has suffered more from the liquidity trap than the housing market.

For all the attention policymakers placed on the Fed’s actions over interest rates, the cost of borrowing is far from the problem. Record-low mortgage rates have done little, if anything, to encourage home purchases or even refinances. And while homebuilders way overbuilt in the years leading up to the 2008 housing bust, the fact that mortgage rates have had little influence over home purchases underscores how weaknesses from the demand side (as opposed to the supply side) is perhaps the bigger problem.

For most of this year, mortgage applications have remained close to a 14-year low, says Paul Dales of Capital Economics. While it’s true that applications rose by 4.1% in April, following a 3.4% gain seen in March, Dales claims the rise was due mostly to a rush to get mortgages before the Federal Housing Administration raised its mortgage insurance fee on April 18. After increasing by 11.8% over the first two weeks of the month, applications dropped back by 13.3% during the last two weeks.

Applications remain weak even as rates for a 30-year fixed mortgage have hovered around 5% or less for the past 18 months.  This is markedly low, given that rates of around 7% were the norm over the past 20 years. “Until the structural factors that are preventing borrowing are removed, which will take years rather than months, the housing market recovery will remain tepid if not non-existent,” Dales says, adding that widespread negative equity and tight credit conditions mean that many households have been unable to get mortgages even if they wanted one.

The housing market’s supply side is deeply troubled. With more foreclosures looming, it could take another five years to absorb the excess supply of homes. But the demand for housing deserves attention. The latest Federal Reserve survey on bank lending practices indicated that, as whole, lending standards and terms generally eased during the three months ending in March. And while demand for loans from businesses increased, demand for residential mortgages continued to fall.

Perhaps that might not come as much of a surprise, since a growing number of homeowners find themselves stuck with homes worth less than their mortgages. According to a survey released today by Zillow.com, negative equity reached a new high mark in the first quarter, with 28.4% of single-family homeowners with mortgages underwater, up from 27% the previous quarter.

This comes as home values fell faster in the first three months this year than any quarter since 2008. The Seattle-based real-estate data company reported that its home value index fell 3% from the fourth quarter of 2010 to the first quarter of 2011. What’s more, home prices this year declined by 8.2% to $169,600 compared to last year.

So however obsessed we are with the Fed’s actions over borrowing costs, it’s likely to have only modest effects on the housing market. In fact, contrary to what most people think, interest rates have historically had limited effects on home prices, according to a 2010 report by Harvard University. The study looked at the 1.3% drop in real interest rates between 2000 and 2006 and found that it was attributable to only a 10% rise in home prices. At most housing markets across the country, prices experienced much bigger increases. Nationally, prices shot up about 30% during the period, with Boston seeing some of the biggest rise with a 54% increase.

“Interest rates are only a small ripple in the giant tsunami of the housing crash,” says Harvard University professor Edward Glaeser, one of the authors of the study.

It’s not that interest rates don’t matter, Glaeser adds. They do. But other factors, such as more lenient underwriting standards (i.e. subprime lending), also matter, although the Harvard study didn’t exactly pinpoint what caused home prices to skyrocket during the housing boom.

The point is that when it comes to the housing market, we can watch the Fed’s actions all we want and guess where mortgage rates might fall. Increasingly, however, that seems to lead most of us nowhere.

Follow me on Twitter @ninhaitseng

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