Editor's note: This story was originally featured in the December issue of DS News, out now.
In 2008, the economy experienced the historical fall of the housing market and the resulting financial crisis—an epic phenomenon that some feared would grow to rival the Great Depression of the 1930s. Nearly a decade later, hindsight is an invaluable tool for examining what caused the housing bubble to burst, how it has affected the market in the years since, and whether conditions are ripe for another housing bubble.
In an Insight blog post published in November, Freddie Mac laid out three primary warning signs that would precede a new housing bubble. One is skyrocketing home prices, a circumstance on display in markets across the country. However, Freddie insists that the central role of easy credit availability is the oxygen that keeps a bubble alive, and if that oxygen is cut off, the bubble ceases to exist. A second warning sign is a shortage of inventory, a problem currently affecting the industry. Freddie’s third warning sign seems obvious—the bubble actually bursts. “If it doesn’t burst, it wasn’t a bubble,” the report noted.
With home prices rising, inventory shortages common, and CoreLogic estimating that nearly half of the nation’s largest 50 markets are overvalued, this is seemingly a time for the industry to mind the old adage about those that do not learn from history are doomed to repeat it. However, the housing market shows numbers that appear steady. Nor do economic conditions line up perfectly with 2008 when it comes to factors such as unemployment, credit availability, workforce numbers, or wages.
Should the current housing setting ease everyone’s concerns, or does the U.S. economy need to proceed with caution? At what point in the future could the market face similar problems—assuming it will?
The Beginning of the End
Subprime lending, along with irresponsible lending practices, is famous for being the reason for the housing bubble. In 2006, $600 billion of subprime loans were originated, most of which were securitized. That year, subprime lending accounted for 23.5 percent of all mortgage originations, according to the Financial Crisis Inquiry Commission report by Stanford Law School.
However, to understand the full scope of the housing and economic collapse of 2008, one has to look back even further. While the crisis occurred in 2008, the dominoes for that collapse were set in place long before the bubble actually burst.
In 1992, Congress and the President required government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, to meet a certain quota in purchasing mortgages from banks and nonbank lenders. This quota required that a certain percentage of the mortgages the GSEs bought had to be approved for borrowers who were at or below the median income in the places where they lived. Such mortgages were termed subprime mortgages.
The GSEs’ quota was 30 percent at the beginning, but the Department of Housing and Urban Development (HUD) was eventually given authority to adjust that number, and over time, HUD increased it. By 2008, just before the financial crisis, 56 percent of the loans the GSEs bought had to be made to people who were at or below median income. However, it is difficult to find prime mortgages when buying mortgages that are made to people below median income.
Due to these challenges, Fannie and Freddie had to make a change. Peter J. Wallison was former White House Counsel under President Ronald Reagan and served as General Counsel of the U.S. Treasury Department from 1981 to 1985. Currently an Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, Wallison explains that, under this quota, Fannie and Freddie had to reduce their underwriting standards.
“In 1992, before these affordable housing goals were actually adopted, Fannie and Freddie were famous for one thing, and that is they only bought prime mortgages,” Wallison said. “But as the affordable housing goals increased over time, they had to start reducing their underwriting standards, and they did.”
By the late 1990s, the enterprises were accepting mortgages with only 3 percent down payments, and by the year 2000, they were accepting mortgages with no down payment at all. When a borrower has a low down payment for a mortgage, a couple of things occur. First, the person buying the home doesn’t have to place much initial money in the home.
Now what does that do? This pushes up home prices, because more money must be invested by lenders in their houses. This means for first-time homebuyers putting down a 5 percent down payment and borrowing more than is affordable, the situation becomes much riskier.
But when prices in markets with traditionally lower median home prices rise, it forces prices up across the board. So, in the mid-1990s, the U.S. began to experience a housing price bubble. Housing prices were rising at a high rate, about 10 percent per year.
According to Wallison, houses became exceedingly expensive, as more and more people, even those who could otherwise have bought homes with a prime mortgage, had to borrow much more in order to secure homes. Both those below and above median income were suddenly having to borrow more to buy these over inflated homes.
In 2008, the market reached the point where housing prices were so expensive that homes were no longer affordable, no matter how much money a buyer could borrow. Due to the gradual deterioration in loan quality after 1992, more than half of all mortgages in the U.S. were subprime by 2008—at 31 million loans.
Therefore, the price for homes flattened out. Homeowners who were having trouble meeting their mortgage obligations could no longer refinance their mortgage so they could make their payments. They had to default—and when the market tanked, those homes weren’t worth as much.
“If you were to see a chart of what housing prices look like now, their increase over the last six months, compared to where we were in the mid-1990s, you’d see that the lines are just about conjoined,” Wallison said. “Housing prices are beginning to rise very fast for exactly the same reason.”
Today, the continuous market narrative of tight inventory, high home prices, and low mortgage rates has economists debating the potential for a second housing bubble. While there is skepticism, are all the right elements present to form another national bubble?
Economists have studied booms and busts from a historical perspective for many years, such as the Dutch tulip mania of the 17th century or Great Britain’s South Sea Bubble of the 18th century. The common denominator among these events is the disconnect between supply and demand, according to George Ratiu, the National Association of Realtors’ Managing Director of Housing and Commercial Research.
“Looking at the housing markets of 2005-2006, we had a disconnect between the level of home price appreciation and the underlying financing of real estate, which led to the housing crash. In 2017, we are in a very different environment, both economically and from a market perspective,” said Ratiu.
The economy has been advancing at a steady pace for several years; employment gains have boosted both wages and demand. Ratiu believes that current price appreciation trends are driven by strong demand being coupled by insufficient supply. On the financing side, the market is also in a different space, where lenders are much more stringent in underwriting mortgages compared to before.
So what exactly are the ingredients to a potential bubble? According to Dr. Eddie Seiler, Chief Housing Economist at Summit Consulting, there are three characteristics to look out for.
“The first one was demand, which is more economics, but the other two are more related to psychology,” Seiler said. “In the past bubble, there was a belief that house prices would keep going up and up, and that led to a lot of very lax lending, so there was a lot of speculation. So, while we have a lot of demand at the moment, I think there’s less speculation and less exuberance.” Seiler said.
According to Frank Nothaft, CoreLogic’s Chief Economist, today’s home prices are high relative to income and to rent in many markets, just as they were in 2006. However, that’s where he believes the similarity ends.
“For one, interest rates, and capitalization rates, are much lower, so a given income, or rent stream, is consistent with somewhat higher prices,” Nothaft said. “Second, no- and low-doc lending, subprime, and no-down payment lending facilitated by second liens, all of which were common in 2006, have largely vanished from today’s market. Third, the speculative ‘flipping mania’ of 2006 is absent from most metro areas.”
Tian Liu, Chief Economist of Genworth Mortgage Insurance, also recognizes similarities between the past and the present. Liu says the economy is at the mature stage of an economic expansion, just like during the 2005-2007 period.
“The job market is at full employment, with the unemployment rate under 4.5 percent,” Liu said. “During the 2005-2007 period, the unemployment rate was at a similar level. In the current cycle, the Federal Reserve began to tighten monetary policy in December 2016. In the last cycle, it began to tighten in the middle of 2004.”
The market has also been in the middle of a housing expansion over the past few years, just as in the crisis period. Home prices were gaining at 9 to 10 percent per year during 2004 and 2005, versus 5 to 6 percent in the last two years. In both cases, home-price gains accelerated. Homebuilding was then, and is now, also on the rise. In the mortgage-lending industry, lending standards have been loosening, although from very different starting points.
Today, housing is undersupplied with new construction still well below historically normal levels. Home prices are back to the previous peak in nominal terms, but still below the previous peak after adjusting for inflation.
Current mortgage rates are around 200 basis points below their 2005-2007 levels, meaning that housing is more affordable today. Home sales and purchase origination levels are also well below previous peaks. Borrowers are well qualified, with average FICO scores of 745 for Fannie Mae versus fewer than 720 in 2006 to 2007.
The nature of housing demand is different as well, with more potential homeowners and far fewer speculators in the housing market compared to the 2005-2007 period. Liu’s research suggests that first-time homebuyers represented 37 percent of sales in the single-family housing market in 2016 versus 30 percent between 2005-2007.
Rick Sharga, EVP of Ten-X, believes that what caused the last housing bubble wasn’t an overheated economy—it was an overheated housing market, fueled by bad lending practices and exacerbated by an almost insatiable appetite for mortgage-backed securities and exotic derivative products on Wall Street. This enabled lenders to sell off entire portfolios of bad loans to institutional investors.
Borrowers who should never have qualified or who simply weren’t financially ready for homeownership were given extremely risky loans—often with 100 percent financing, adjustable “teaser” rates, and even negative amortization—and sold overpriced homes.
“When home appreciation stopped, interest rates went up, and loans adjusted, the whole house of cards came tumbling down,” Sharga said.
According to Sharga, none of those conditions exist today in a market where lenders are taking on virtually no risk at all. Only the most perfectly qualified borrowers can even get a mortgage loan today, and the Ability-to-Repay and QM rules established by the Consumer Financial Protection Bureau have set guidelines designed to make loans much safer.
While economists may not foresee a housing bubble on a national level, according to Nothaft, bubbles may occur in localized markets, as they have in the past, if the right elements are at play.
“There are at least three features to look out for,” Nothaft said. “The first I would call the ‘affordability flag,’ that is, we should expect that the typical monthly mortgage payment, monthly rent, and monthly family income be ‘in balance’.”
In other words, if home prices rose so high that the mortgage payment is much greater than rent and takes a much larger percentage of income than usual, it will be hard to sustain such elevated prices.
Speculative market pressures also factor into the equation. For example, if there is a rise in investor purchases and sales, especially by short-term ‘flippers,’ then that’s a warning sign. Third, one should look for signs of increasing fraud risk, such as suspicious transactions or errors on loan applications.
According to Liu, the city that stands out is Seattle, Washington, where prices are growing at 13 percent year-over-year.
“It is the only city where home prices are growing at 10 percent or more,” Liu said. “That kind of home price growth will be hard to sustain, and it tells us that the city is experiencing growing pains.”
Future of the Market: Proceeding with Caution
George Orwell, English author and journalist, wrote in his dystopian novel 1984, “Who controls the past controls the future.” That’s the way Americans must progress in response to current market trends.
Despite the need for caution from what the industry has learned in the past, Seiler said he believes in “economic fortitude where people are being very cautious.”
Seiler continued, “When I say people, I mean builders as well, are being cautious. From the time for them to acquire land to getting building permits, to actually building the property. Here, they can build single-family homes in six to twelve months, but I think there’s a lot of caution out there and not enough activity.”
As prices increase, there’s a good opportunity for builders to make strong profits, so construction will enter the market. It takes time, and even if people overcome their memories of the Great Recession, it will take time to actually come back in and build.
Philip Davis, Founder of financial investments company PhilStockWorld, says the most alarming aspect of the future involves the packed portion of home prices and high rising property taxes.
“It’s gone out of control, and that’s really throwing everything off, because we always talk about affordability,” Davis said.
Davis says that both rising tax rates and the increase in what people actually have to pay to be in a home are pricing people out of the market today.
“It’s something someone said to me many years ago that was the truest thing I ever heard in real estate, [that] people don’t buy a home, they buy a mortgage,” Davis said. “But at the time, when he said that to me, taxes weren’t really an issue.”
While the housing market looks good and the banks are pretty solid at the moment, it is easy to put aside fears of another housing bubble. However, the banks have more capital than they had before, and they are buying mortgages.
“But they’re only buying very good mortgages,” Wallison said. “They’re not buying bad mortgages and holding them on their balance sheets. The bad mortgages are being sold to Fannie Mae, Freddie Mac, and the FHA.”
That’s great news for those looking at the market from an economic point of view. But Wallison feels very strongly about the need for the government to implement better policies.
“If we had good underwriting standards, we would have the same homeownership rate,” said Wallison, “and, we wouldn’t have the danger of a crisis.”
Growth in the U.S. has averaged less than 2 percent, according to Wallison—representing the slowest recovery from a recession and a financial problem like the economy had in 2008, where that was followed by a severe recession.
“But in the eight years after that, we usually have a very sharp recovery,” Wallison said. “We didn’t.”
We may not be foreseeing a housing bubble 2.0 in the immediate future, but understanding the facts and proceeding with caution is crucial. Learning from the mistakes of the previous bubble and working to avoid those same missteps could prove key to creating a more stable future for the housing market and the U.S. economy.