Opinion: The seeds of the next housing crisis have already been planted
Opinion: The seeds of the next housing crisis have already been planted
Published: May 6, 2016 9:42 a.m. ET
We’re seeing the same telltale signs that we did a decade ago
Back when the 2005-07 housing bubble was brewing, photos of impossibly small houses selling for insanely high prices famously made the rounds. It was one of those signals that you look back on and say, “Hmmm … that was a clear indictor of trouble ahead.”
So in what feels like déjà vu, it’s worrying now to see a glorified “tool shed” on the market in New York for a cool $500,000. In Brooklyn, no less. Not even in Manhattan.
Here are some other troubling anecdotal signals on the housing market:
- A major financial website recently ran a guide to the best cities to “flip” houses in. (I don’t want to encourage the behavior.) Real estate speculation via house “flipping” was another early sign of trouble ahead.
- A few days later, news arrived that home prices in the Bronx hadshot up by an astonishing 30% in the first quarter. Crazy advances in home values were, a decade ago, also a signal of trouble ahead.
- Ads, then asnow, were running on TV for “quick mortgages.”
All of these signals raise a serious question: Are we getting closer to another housing meltdown that will once again damage your investment portfolio?
To find out, I recently checked in with Stephen Oliner of the American Enterprise Institute and the Ziman Center for Real Estate at UCLA, who tirelessly tracks the housing market for signs of trouble.
His take was not exactly encouraging. We’re actually a lot closer to potential housing-market problems than you might think. The reason? Easy credit is back.
The notion that you need to save a lot of money to buy a house is again being treated as so much “baloney,” said Oliner.
I’ll show you why, in a sec. But first, thankfully, at least a full-blown repeat of the 2008 financial crisis is unlikely. That’s because banks aren’t amplifying the problem via wholesale repackaging of home loans into risky investment instruments. At least not yet.
But that should be small comfort. Because housing-sector excesses are clearly developing, which would dramatically worsen a recession. This is bad news, given that growth for the first quarter came in at well under 1% — pretty close to recession.
Let’s take a look at the signs of trouble brewing in housing, yet again.
We’re just about back to the zero-percent down payment
“No money down” was one of the big problems contributing to the housing bubble 10 years ago. Unlike the 20% down payment of yore, the availability of zero-money-down loans encourages people to buy homes beyond their means. It also means from Day 1, buyers are underwater, taking closing costs into account.
All of this will compound problems if the economy turns downward and people lose jobs, since they’ll have no cushion in the form of home equity. When you’re underwater in your home, that makes it easier to walk away. Conversely, if it forces you to stick it out, you’ll be less likely to sell (for a loss) and move to where your next job might be.
So it’s disconcerting to see that first-time home buyers now put just 3.5% down on their homes, or $8,500, according to Oliner’s numbers.
That’s the median for all first-time home buyers with a government-guaranteed mortgage. Since government agencies back about 80% to 85% of new loans, this covers most first-time buyers. And since first-time buyers make up 58% of the market for primary residences, this covers a big piece of the housing market. (First-time buyers here are defined as anyone who did not own a home for three years before buying, one of the standard definitions in the business.)
For all people buying homes with government loan guarantees — including repeat buyers — the median down payment was 5%, or $12,500. Not much better.
Buyers are stretching their budgets to purchase homes
A lot of people are taking out mortgages with dangerously high monthly payments relative to their incomes. And the problem is getting worse.
Here’s how we know: Government regulators say the debt-to-income ratio (DTI) for home buyers can go up to 43% before they risk running into trouble. The DTI measures all monthly loan payments — for things like credit cards, cars and mortgages — against monthly income. Three years ago, 22% of home buyers were above this limit. In March, that number was up to 28%.
For context, back in the early 1990s, when the fear of housing-market blowups wasn’t yet a “thing” thanks to more conservative lending standards, only about 5% to 10% of loans were at or above the 43% cutoff.
“Many of the mortgages being taken out now don’t make sense in terms of the likelihood of people being able to repay the loans,” observed Oliner.
We see the same thing with credit scores. In March, first-time home buyers had a median FICO score of 706, compared with an overall median of 713.
The upshot: We’re a lot closer to 2007 than you might think
All of these troubling trends are captured neatly in a gauge called the National Mortgage Risk Index (or “NMRI”) co-developed at the American Enterprise Institute by Oliner. To assess how sloppy lending standards are now compared to 2007 — when they were so sloppy they lead to big problems — the conservative-leaning think tank performs a “stress test” on current mortgages. It looks at how all the mortgages being taken out now would perform in a 2007-08–style financial crisis. Oliner does this by comparing how similar loans back then did after the meltdown.
What is the outlook for the real estate market?
“This is a prediction of how many loans would default if the crisis repeated,” he said.
His results are disconcerting. Oliner found that 12.4% of the mortgage loans taken out recently would default, up from 11% two years ago. For context, about 19% of 2007 mortgage loans eventually went bust. To be clear, Oliner is not predicting that 12.4% of recent loans will default in the next recession. After all, the last recession was uncommonly deep.
But his gauge does give us this key insight: Lending standards have slipped so much that we are about two-thirds of the way to the level of sloppiness in mortgage lending that contributed to the financial meltdown. Which is not good news. As a reference point, only about 6% of 1990 mortgage loans would have defaulted in a 2008-style meltdown.
Home prices are rising a lot relative to income
For the past few years, home prices have been rising about 5%-6% a year, but incomes are growing at about 2% or 3%. Why might this create more risk? Because it tells us that housing affordability is worsening. This means that — barring a sudden increase in supply from construction — various players in the housing market have a greater temptation to loosen lending standards further in order to maintain growth.
The pressure will be even greater if the Federal Reserve ever gets around to seriously raising rates. An increase in the 30-year mortgage rate to 6% from 4% reduces buying power by the same amount as a 19% jump in home prices, all else being equal, according to Oliner.
Washington is not helping
Part of the problem here is that the various federal agencies tasked by Congress with promoting home ownership — the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp. and the Federal Housing Administration, for example — are competing with one another for business. This can contribute to a loosening of lending standards, said Tobias Peter of American Enterprise.
Another problem is that Dodd-Frank rules meant to encourage banks to better vet borrowers simply don’t apply to government-guaranteed loans. That’s a big loophole because those loans make up about 80% to 85% of the mortgage market.
One important difference these days, compared with 2007, is that banks are not repackaging mortgages into investment instruments with more leverage layered on, to distribute to banks throughout the world. So there’s less mortgage-related risk built up in the system.
But there’s still a problem.
After all, this economic expansion is getting old. In the first quarter, GDP grew only 0.5%. That’s pretty close to recession. If the economy were to tip into recession, and people started losing jobs, a lot of homeowners would find themselves in over their heads.
Rising defaults would put downward pressure on home prices and make everyone feel poorer. So they’d trim spending, due to the “negative wealth effect.” Rising defaults would damage a lot of personal credit ratings and lead to blighted neighborhoods.
All of this would make any downturn that much worse. Besides, the housing market still plays a big role in the economy, so we don’t need any extra trouble there.
“Mortgage-default rates are currently very low, but that shouldn’t be any source of comfort because they are always low when the economy is doing well and home prices are going up,” said Oliner. “That can turn around quickly if there is a recession.”
A lot more quickly than you might think — now that lending standards are getting sloppier again.