How the next housing bust will be different

Based on the moral hazard from lessons learned from the last housing bust, future housing declines will experience very, very low sales volumes.

What lesson did lenders learn from the painful losses from the housing bust?

Did they learn they shouldn’t peddle toxic mortgages? Nope.

Did they learn they shouldn’t give loans to unqualified borrowers? Nope.

What they learned is that no matter how foolishly irresponsible their lending gets, they will get bailed out by government cash and federal reserve interest-rate policy, and they can avoid mortgage default losses by loan modification can-kicking until prices rebound. As long as they don’t foreclose and resell for a loss, they can amend-extend-pretend their way out of any lending disaster.

That’s really what lenders learned.

Do you see the potential moral hazard? Since they refused to learn the lessons they should have, and since they learned they can take on unlimited risk with little or no consequence for the future, wouldn’t it be logical to assume that if given the chance, they will return to irresponsible lending to generate short-term gains through fee income?

As long as this moral hazard exists, only vigilant enforcement of regulations will prevent another housing bubble, but how long will that last? How long before regulators are captured by banking interests and a new Ponzi loan virus is released to the market? Five years? Ten years?

If we do have another housing bust, what will it be like?

Low volume followed by even lower volume

affordability_ceilingThe 2014 housing market shows what happens when prudent lending standards are applied to an overheated housing market: sales volumes drop. In 2012 and 2013, the housing market rose about 20% in a 15-month stretch until an interest-rate spike in June 2013 brought down the affordaibility ceiling and stopped the rally dead. Over the last 15 months, the market has flatlined because buyers can’t raise their bids any further with their stagnant incomes, and slow employment gains creates few potential new buyers to keep volumes up. In the past, flat pricing and low sales volumes would have been overcome with affordability products, but with most of these toxic loans banned today, the market goes nowhere.

In a typical housing bust (California has endured three such busts, so we know what typical is), once sales volumes drop, sellers come to realize buyers can’t raise their bids because affordability products abruptly disappeared in a credit crunch. Since much of the inventory used to be must-sell, sellers were forced to lower their price to meet the market bid; thus house prices fell. Depending on the terms of the toxic loans, prices at the peak may be only a little elevated, or they may be extremely elevated.

For example, in the late 1980s and early 90s, that housing bubble was characterized by many conventional mortgages with excessive DTIs, and a moderate sprinkling of interest-only loans, so when lending collapsed back to prudent standards, the aggregate loan balances didn’t drop very much, so the market didn’t have as far to fall to reach stability.

However, the Great Housing Bubble witnessed the proliferation of Option ARMs, which elevated house prices 30% or more above stable price levels. When Option ARMs disappeared, aggregate mortgage balances plummeted, and even the added boost of cutting mortgage rates in half couldn’t make up the difference (see below).


When mortgage balances contracted in the credit crunch of the Great Housing Bubble, lenders also followed their standard loss mitigation procedures, which were to foreclose and resell the REO as quickly as possible. Since there were so many REO, this caused house prices to drop quickly and significantly back to stable levels determined by income and mortgage rates. This quick decline caused by REO sales is also what kept sales volumes up. Imagine what would have happened if lenders kicked the can from the beginning.withheld_inventory

The next housing bust will likely see the same credit crunch induced collapse of aggregate mortgage balances, particularly if lenders are emboldened by moral hazard to develop and proliferate another Ponzi loan like the Option ARM. If that happens again, and if lenders use their “new and improved” loss mitigation procedures, when sales volumes decline due to the credit crunch, rather than signal an upcoming decline in prices, it will signal even further declines in sales volumes. In fact, if we do see another housing bust, I predict we will see sales volumes fall to lows never before measured, even lower than the worst sales years of the most recent housing bust.

Why will sales volumes fall so low? If sellers are trapped in cloud inventory, unwilling and unable to lower price, and if buyers are abruptly limited by lower borrowing power, financed buyers simply won’t be able to transact, no matter how much they substitute down in quality. If financed buyers can’t buy, sales volumes will crater — prices won’t go down much, which is what lenders are after — but sales volumes will necessarily suffer. That’s how I believe the next housing bust will turn out.