An entire generation of homebuyers went missing

The housing bubble pulled forward a generation of buyers; the housing bust cost these buyers their homes and their good credit, removing many of them permanently from the housing market.

Lenders succeeded in manipulating market prices by restricting supply; however, for a true recovery in housing, the market requires resurgent demand from first-time homebuyers and move-up buyers. These two groups are typically the largest source of housing demand, with the first-time homebuyer the bedrock of the housing market; without first-time homebuyers, no move-up market exists.

The first-time homebuyer market propels upward by job growth and household formation; when the economy is strong and creating good-paying jobs, young people form new households and use their new income to bid for real estate, displacing existing homeowners who then execute a move-up trade, often buying a nicer home.

That’s how the market is supposed to work, but the collapse of the housing bubble destroyed the fundamentals underpinning a strong housing market. Household formation dropped from 1.5 million households per year to 500,000 per year. The first-time homebuyer market dried up, and as a result, rather than comprising 40% of sales, today they only make up 30%. Further, with 10% of existing homeowners underwater and another 10% effectively underwater and unable to sell and execute a move-up trade, demand from the move-up market is also down by a third or more. Without the manipulation of inventory by desperate bankers, the housing market would almost certainly see a dramatic downturn.

What happened to the first-time homebuyer cohort? In The Great Housing Bubble, I wrote about the perils of 100% financing, which most young buyers used.

Besides stopping people from saving for down payments, 100% financing harmed the market by depleting the buyer pool. In a normal real estate market, first-time buyers are saving their money waiting until they can make their first purchase. This usually results in a steady stream of first-time buyers that enter the market each year.

When 100% financing eliminated the down payment requirement, it also eliminated any need to wait. Those who ordinarily would have bought 2-5 years in the future were able to buy immediately. This emptied the queue.

This type of financing appears periodically in the auto industry, especially in downturns when it is necessary to liquidate inventory. The term for this is “pulling demand forward,” because it reduces demand for new cars in the next few years. This might not have been a problem if 100% financing would have been made available to everyone forever; however, once down payment requirements came back those who would have been saving were already homeowners, so there were few new buyers available, and any potential new buyers had to start over saving for the down payment they thought would never be required.

The situation was made worse because those late buyers who were “pulled forward” from the future buyer pool overpaid, and many lost their homes. This eliminated them from the buyer pool for several years due to poor credit and newly tightened credit underwriting standards. Thus, most who thought 100% financing was a dream come true found it to be a nightmare instead.