Oct032016

Four unique features of the new normal in housing

The four unique features are (1) low mortgage interest rates, (2) low MLS inventory, (3) low owner-occupant demand, and (4) high but affordable house prices.

cheap_home_supply2Prior to the housing bubble, the normal state of affairs for the housing market was slowly but steadily rising prices that matched the growth in rents and incomes. From the early 1980s through the early 2000s, house prices rose a bit faster than incomes due to steadily falling interest rates, but generally the rate of appreciation was gentle and predictable.

A normal housing market exhibited a balance between supply and demand. Millions of individual homeowners possessed the equity to sell when they pleased, and banks owned very few properties. Prior to the bust, lenders exerted very little direct impact on the housing market through short sale approvals or REO sales.

The demand for housing also came from millions of individuals, about two-thirds of whom borrowed around 80% of the purchase price to acquire property. New household formation from high-paying jobs prompted builders to provide more rental units and for-sale products wherever job growth occurred, and low unemployment kept house prices steady even in areas of temporary economic distress.

The new normal in housing is very different from the old normal.

1. Low Mortgage Interest Rates

The first unique characteristic of the new normal is very low mortgage rates. For the last several years, the housing market has been subject to one temporary abnormality after another. First, lenders inflated a massive housing bubble by burdening borrowers with nearly double the debt their incomes could support. yellen_raise_ratesThe inevitable credit crunch caused a sudden and dramatic reduction in loan sizes, requiring direct intervention in the mortgage market by the Federal Reserve, who bought mortgage-backed securities to bring mortgage rates down. The Federal Reserve’s activities lowered mortgage rates from 6.5% in mid-2006 to 3.5% in early 2013, significantly raising the amount borrowers could finance on sustainable loan terms.

Looking back to 1971, mortgage rates average about 8%; only looking back 25 years brings this average down to between 6.5% and 7%. The current regime of sub-4% rates is very low by historic standards, but given the need for lenders to reflate house prices to recover on their bad loans, it’s likely below-average mortgage rates will persist for a very long time. This is a feature of the new normal.

2. Low Supply of For-Sale Homes on the MLS

The second unique characteristic of the new normal is unusually low MLS supply. When the housing bubble first burst, lenders followed their standard loss mitigation protocols and initiated foreclosure, mostly on the subprime borrowers whose loan reset first. These standard practices that work well in normal times flooded the MLS with bank REO and initiated a dramatic house price decline in every market loaded with subprime borrowers.

Lenders finally realized in late 2008 that they needed to remove the distressed inventory before their sales pushed house prices back to Great Depression levels, so they lobbied lawmakers and regulators to suspend mark-to-market accounting in favor of mark-to-model accounting so that they could report their bad loans as good assets and alleviate the need to foreclose and liquidate the REO. Unfortunately, this wasn’t enough.

From 2009 to 2011, lenders still foreclosed and liquidated many more REO than the seriously depleted buyer pool could absorb. Finally, lenders embarked on a more aggressive policy of loan modification to obtain income from their bad loans and remove distressed properties from the market. The final piece of the puzzle came together in 2011 when most lenders stopped approving short sales if the borrower possessed tangible assets.

As lenders modified loans and denied short sales, borrowers remained in their homes and kept their homes off the market; thus inventory plummeted, and by early 2012, supply was so depleted that even tepid demand caused bidding wars and forced the housing market to bottom.

distressed-home-inventory-chart

The problems and solutions that lead to our current state of low MLS inventory is also likely to persist for quite some time. Both lenders and underwater borrowers don’t want to lose money on the bad deals they made a decade ago. Lenders can kick-the-can indefinitely, and they can compel borrowers to play along. There are still millions of homeowners who are underwater, so low MLS inventory will be an issue for a very long time. This is a feature of the new normal.

3. Low demand from owner-occupants

The third unique characteristic of the new normal is low demand from owner-occupants. When the housing bubble burst, several million people lost their homes in foreclosures, and several million more ruined their credit scores by defaulting on their loans to obtain loan modifications. This removed several million potential borrowers from the buyer pool, and despite hopes that these boomerang buyers would return in large numbers, they haven’t, and they won’t.

Further, first-time homebuyers, typically the largest demand cohort with an average 40% share, is barely 30% today. With the low wages and excessive student loan debts, the Millennial generation won’t be major housing market participants for another few years.renting_is_better

The housing market enjoyed a brief boost in demand from institutional investors, but now that prices are too high for their return thresholds, that component of demand is absent unless prices go down again.

The boomerang buyers and the first-time Millennial buyers either can’t or won’t participate in the housing market for the foreseeable future. They have bad credit, too much debt, and too little savings — which won’t be changed quickly or easily if at all. Further, those with good credit often can’t finance a large enough sum to pay today’s prices. Owner-occupant demand will be weak. This is a feature of the new normal.

4. Home prices expensive but affordable

Market InSite publishes monthly market reports that document rents and ownership costs for most cities and many zip codes in Southern California, making it possible to determine market trends and gauge relative affordability from the county level all the way down to individual properties.

Relative to rents, house prices stabilized across Southern California at prices very similar to the stable equilibrium from the mid-1990s – and not by accident. The lack of MLS supply caused prices to rise quickly in 2012 and early 2013, but prices hit the ceiling of affordability and stopped dead. Buyers simply can’t raise their bids any higher with the current incomes.

In the past, mortgage affordability products would have restarted the Ponzi scheme, but since these products are effectively banned by Dodd-Frank, rather than restart the Ponzi scheme, sales volumes declined, and many buyers gave up. Unless mortgage rates tumble again, or unless incomes rise significantly, house prices will only rise as fast as wage growth will allow.

After almost of dozen years of volatility, the market has reached a stable equilibrium where prices are high but affordable. Since we aren’t likely to get an influx of supply, and since the lack of affordability products means we aren’t likely to get a surge in demand, we will maintain this equilibrium for the foreseeable future. This is a feature of the new normal.

What’s old is new again

The variety of policies supporting housing today will remain in place for the foreseeable future because the health of the banking sector and housing market depends on it. Despite the overhanging issues, when you look carefully at where we are and how the market is reacting, the new normal looks much like the old. Prices will rise slowly from here always being expensive but attainable, not unlike they were in the 1990s.

Welcome to the new normal.

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