Will housing hold back the economy for the next decade?
Housing will be the front lines in the battle over interest-rate policy during the next decade because higher rates will disproportionately impact housing.
The federal reserve signaled their intention to raise rates beginning in 2013. The infamous “taper tantrum” of May 2013, when mortgage rates rose from 3.5% to 4.5% in about 6 weeks, was a direct result of Ben Bernanke’s announcement that zero percent interest rates wouldn’t last forever.
We are now reaching the end of 2015, and to the surprise of most economists (but not readers here) it appears unlikely interest rates will rise this year; however, at some point interest rates will rise. The only questions are when, and by how much.
One school of thought is that rates will only rise as fast as incomes can support higher borrowing costs. Intuitively, this makes sense because if rates rise too quickly and borrowers can’t support the payments, the economy will suffer, and the federal reserve will be compelled to lower rates. Unfortunately, it may be more complicated than that.
Housing is the most sensitive component of the economy to changes in interest rates because housing is almost exclusively financed by long-term borrowing. Even small increases in borrowing costs have a large impact on the amounts borrowed. For example, for each 1% mortgage rates go up, borrowing costs rise 11%. A 1% rise in mortgage rates, similar to what happened in the taper tantrum, would price out a large number of marginal buyers.
So what happens if the strength of the economy warrants or demands higher rates but housing can’t absorb the higher costs? This is the big unanswered question.
If the economy starts to heat up, the federal reserve will be under pressure to raise rates to combat inflation. If they then raise rates, it will cause housing to sputter or tank, and since homebuilding is a significant part of the economy, a decline in housing will drag down everything else and prompt the federal reserve to lower rates again.
I believe the economic drag caused by the impact higher interest rates will have on housing will be the biggest economic story of the next decade. Housing will be the laggard holding back the economy for the foreseeable future.
October 29, 2015, Mike Fratantoni
Lynn Effinger recently wrote an opinion piece here on HousingWire in which he surmised that we are in a housing bubble. He suggests that Fannie Mae and Freddie Mac (the GSEs), the Federal Housing Administration and the Federal Reserve are once again “setting the stage” for another housing crisis.
Lynn Effinger is right to be concerned about how policy has been used to reflate the old housing bubble; however, I have the same concerns with his premise as I have with everyone calling a housing bubble today: this bubble won’t pop. The old housing bubble was reflated with stable loan terms, and although to some that difference is semantic, it’s the difference that makes all the difference.
Regardless of what may happen with interest rates and prices, the people who borrowed money with conventionally amortizing, fixed-rate mortgages over the last eight years will not default. Further, even if we had an economic upheaval rivaling the Great Recession, any defaults would merely be can-kicked until the market regained health, just as lenders did over the last several years.
If anything, the overcorrection by regulators and trepidation by lenders has created an environment where borrowers and private capital are both left sitting on the sidelines, and access to credit remains quite tight relative to historical norms.
This is just wrong. Despite industry spin, mortgage lending standards are not tight. People with FICO scores below 620 can obtain FHA loans with only 3.5% down, and neither the FHA or the GSEs are subject to the 43% DTI cap until 2017. FHA standards are not much above subprime.
Real estate industry lobbyists, like the author of this article, continually support relaxed lending standards. In 2004 they watched all of their dreams come true as all mortgage standards were abandoned causing a large boost in transaction volume and much higher home prices. Rather than being the panacea they envisioned, the abandonment of lending standards inflated a massive housing bubble that pulled forward demand, caused a deep house price crash, lowered home ownership rates to 48-year lows, and caused an 80% reduction in new home construction — a condition the industry has not recovered from.
There is no question that the government remains a larger force in the housing market and is focused on protecting consumers. However recent actions by the FHA, the Department of Justice and the Consumer Financial Protection Bureau are more likely to constrain rather than expand the availability of credit.
They have levied significant penalties to hold lenders accountable and ensure that the mistakes made in the run up to the crisis never happen again. And as such, they have overcompensated and created an environment where qualified, responsible buyers are being kept from the home purchase market.
This is also bullshit.
Affluent commissioned salespeople, self-employed, newly employed, and retirees who don’t have steady paychecks have tremendous difficulty getting a mortgage because they either: report inconsistent income to the IRS, cannot provide extended income history from a new employer, or do not have sufficient current income to qualify but are trying to keep some cash in the bank or delay paying taxes on an IRA distribution. Those borrowers should not be given loans because they are likely to default.
In fact, the homeownership rate remains near a 26-year low in this country,
and credit still remains tight.
We’ve already established this is spin and bullshit.
The Mortgage Bankers Association’s Mortgage Credit Availability Index reinforces the notion that although credit has improved marginally over the last year, primarily for borrowers seeking jumbo loans, it is nowhere near where it was during the housing bubble (Chart here: MCAI Longview).
He is suggesting the complete abandonment of all lending guidelines during the housing bubble is the gold standard we should compare to. This is crazy.
Of course lending standards are tighter today than they were during the housing bubble because back then, we didn’t have any standards — literally. We had a program called the NINJA loan, which means no job, no income, no assets — and lenders actually gave people loans under those qualifying conditions! If you don’t need a job, income, or assets, what do you need? A pulse?
Furthermore, the CFPB’s Ability to Repay/Qualified Mortgage rules have effectively eliminated the unsustainable lending products and instruments that substantially contributed to the 2005-2007 boom, including no-doc loans, subprime, negative amortization, extended term loans, balloons, ARMs with deep teaser rates, among others.
This is true, and this is the primary reason I don’t believe we are in a housing bubble now. The reflation of the old housing bubble is blown with low mortgage rates applied to stable loan products.
Housing markets are driven by underlying changes in housing supply and demand.
And mortgage rates below 4%, which is the primary source of demand.
While new construction has picked up, we remain just above the pace of single-family starts seen at the worst point in the 1990-1991 recession. And inventories of homes remain extremely tight in many markets.
Housing demand is driven by the job market and demographics.
With an unemployment rate of 5.1%, we are approaching full employment. In terms of demographics, the Millennial generation, the largest in history, is now moving out of their parents homes and into their own.
He is ignoring the housing headwind nobody saw coming, the declining labor participation rate.
With the oldest millennials being in their early 30’s, simple math dictates a tectonic sea change is afoot. More housing, both rentals and owner occupied, will be required to meet the needs of the approximate 1.4 million new households annually for the decade ahead.
Compared to the roughly 600k households formed annually during the recession, this huge increase will require new homes that will need mortgages. (Household Formation). And incidentally MBA’s forecast calls for a slow but steady increase to meet this significant demand (Forecast).
These forecasts are overly optimistic, as all industry forecasts are, but the underlying trend he points to is there. We will need more housing units soon. Whether this be rental or owner-occupied remains to be seen, but the need will be there to house the next generation. If there is any bullish case to be made, it rests on this point.
It is not surprising that, given the depths of the last housing bubble, some are looking for an opportunity to predict the next one. A stopped clock is right twice a day.
That’s a pretty strong slam, particularly from an industry shill who completely missed the housing bubble. Consider this gem from a report he authored in 2006: “…even if home prices remain flat or even decline somewhat from their current level, it is unlikely that there will be large numbers of borrowers who are underwater as a result … we do not expect any significant decline in mortgage credit quality.” Prescient genius, right? He couldn’t have been more wrong. As a housing bull, his stopped clock is right again.
However in this case, the current regulatory environment and household formation trends reveals a different reality.
His core reasoning is correct. The current regulatory environment created stability in the housing market. Despite fears of another bubble, I believe house prices will remain stable, and perhaps even appreciate slightly as new household formation drives demand.
Everything depends on mortgage rates. If rates go too high too fast, the demand won’t translate into enough dollars to warrant new construction, but if rates remain low and rise only slowly, sales volume will reflect the demand of new household formation, and price will reflect the intersection between mortgage rates and wage growth.