Nov202015

What’s different about the latest housing bubble?

Housing bubble 2.0 is built on stable, fixed-rate mortgages applied to verified wages rather than unstable affordability products applied to borrower lies.

Option_ARM_PlagueThe Great Housing Bubble of the 00s was inflated by mortgage affordability products such as option ARMs that allowed borrowers to obtain mortgages more than double the size they could afford using a 30-year conventionally-amortizing mortgage. These toxic mortgage products proved unstable, evidenced by millions of defaults.

Lenders followed their standard loss mitigation procedures and foreclosed on delinquent borrowers and resold the resulting real estate owned (REO). Since there were so many of these properties, the MLS supply swelled, and lenders liquidated their inventory at fire-sale prices. House prices were crushed.

In 2012 banks went “all in” betting on success of loan modifications. By changing from a policy of foreclosure to one of endless and repeated loan modifications, banks managed to dry up the MLS inventory and force the few active buyers to concentrate their bidding activity on a much smaller number of houses. This bidding pressure combined with low interest rates that allow buyers to increase their bids forced prices to go up sharply, which is exactly what the banks wanted.Option_ARM_Plague_victims

From March 2012 to July 2013, prices rose steeply in most markets as lenders were successful in manipulating house prices. So successful that they recently began ramping up their foreclosure operations again to cash in on higher resale home prices.

So while incomes barely budged from 2006 to 2015, the house prices that were a sign of a massive bubble are now stable and supportable. So what is the difference?

Just like the Great Housing Bubble, the reflation rally of 2012-2013 was fueled by mortgage debt. Yes, cash borrowers were more prevalent, but cash buyers aren’t the majority of the market, and rarely do they set market prices. The financed buyer is still king, and mortgage debt still sets market pricing.

There is one and only one difference that separates the previous, unstable price bubble from the current, stable reflation rally. This time, the loan terms are stable.

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What’s Different about the Latest Housing Boom?

Reuven Glick, Kevin J. Lansing, and Daniel Molitor, November 16, 2015

After peaking in 2006, the median U.S. house price fell about 30%, finally hitting bottom in late 2011. Since then, house prices have rebounded strongly and are nearly back to the pre-recession peak. However, conditions in the latest boom appear far less precarious than those in the previous episode. The current run-up exhibits a less-pronounced increase in the house price-to-rent ratio and an outright decline in the household mortgage debt-to-income ratio—a pattern that is not suggestive of a credit-fueled bubble.

They are right for the wrong reasons. Valuation alone isn’t the key to market stability. It’s the loan terms that really matter.

OCHN_Riverside_Housing_Market_Report_2015-10

Starting in the early 2000s, … An accommodative interest rate environment combined with lax lending standards, ineffective mortgage regulation, and unchecked growth of loan securitization all helped fuel an overexpansion of consumer borrowing. An influx of new homebuyers with access to easy mortgage credit helped bid up house prices to unprecedented levels relative to rents or disposable income. The run-up, in turn, encouraged lenders to ease credit further on the assumption that house prices would continue to rise. …

(See: Housing bubble’s defining delusion: real estate only goes up)

But when the various rosy projections failed to materialize, the housing bubble burst, setting off a chain of defaults and financial institution failures that led to a full-blown economic crisis. The Great Recession, which started in December 2007 and ended in June 2009, was the most severe U.S. economic contraction since 1947 as measured by the peak-to-trough decline in real GDP.

After peaking in March 2006, the median U.S. house price fell about 30%, finally hitting bottom in November 2011. Since then, the median house price has rebounded strongly and is nearly back to its pre-recession peak. In some parts of the country, house prices have reached all-time highs. This Economic Letter assesses recent housing market indicators to gauge whether “this time is different.”

different_this_time

Alarm bells in your bullshit detector should be sounding.

We find that the increase in U.S. house prices since 2011 differs in significant ways from the mid-2000s housing boom. The prior episode can be described as a credit-fueled bubble in which housing valuation—as measured by the house price-to-rent ratio—and household leverage—as measured by the mortgage debt-to-income ratio—rose together in a self-reinforcing feedback loop. In contrast, the more recent episode exhibits a less-pronounced increase in housing valuation together with an outright decline in household leverage—a pattern that is not suggestive of a credit-fueled bubble.

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They use two partial indicators to express the same idea I distill into one indicator. When I compute the cost of ownership for a house or for an entire market, I use both rent and the cost of borrowing money to calculate the ratio of the cost of ownership to the cost of rent. It takes into account the impact of changing interest rates, making it a far more robust indicator of market health.

OCHN_OC_Housing_Market_Report_2015-9

The latest boom is different

When viewing any substantial run-up in asset prices, history tells us that the phrase “this time is different” should be met with a healthy degree of skepticism. Still, the increase in the median house price since 2011 appears to differ in significant ways from the prior run-up. …

An important lesson from history is that bubbles can be extraordinarily costly when accompanied by significant increases in borrowing. On this point, Irving Fisher (1933, p. 341) famously remarked, “over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money.”

The purpose of Dodd-Frank was to ensure the stability of our financial system. The problem exposed by the housing bust was that speculation with borrowed money with little or no loss reserves can imperil the banking system. Without a robust banking system serving as a financial intermediary, the entire economy can grind to a halt.

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While I still believe the bankster bailouts did NOT save us from the second Great Depression, we still need a viable banking sector for our economy to function. Nationalization and recapitalization was a better alternative, IMO, but that isn’t the road we traveled.

Advocates of leaning against bubbles point out that excessive run-ups in asset prices can distort economic decisions, including employee hiring, contributing to imbalances that may take years to unwind…. the housing bubble of the mid-2000s had a profound impact on employment. … given that housing booms and busts can have significant and long-lasting effects on employment and other parts of the economy, policymakers and regulators must remain vigilant to prevent a replay of the mid-2000s experience.

permanently_high_plateauThere is still instability in the housing market. While the loan terms are stable, the interest rates applied to these terms may not be. As interest rates rise, housing becomes less affordable, and with affordability products effectively banned, lenders don’t have the tools available to them to support inflated house prices.

As interest rates rise, house prices may fall because future buyers simply won’t be able to finance today’s high prices.

It’s highly unlikely we will see many defaults because conventionally amortizing fixed-rate mortgages make for stable mortgage payments. And even in the unlikely event we do see a large number of mortgage defaults, banks will merely kick the can again and ride out any recessionary weakness.

As I recently noted, Orange County housing will never be cheap again. Or as Irving Fisher once said, “We have reached a permanently high plateau.”

I trust I won’t be as wrong as he was….


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