Know the Warning Signs and What You Should Do Now
BY KIMBERLY AMADEO Updated December 14, 2018
In 2017, a majority of Americans began worrying that the real estatemarket was going to crash. Of those surveyed, 58 percent agreed that there would be a “housing bubble and price correction” in the next two years. As a result, 83 percent of them believe it’s a good time to sell.
Warning Signs of a Bubble
There are plenty of signs that the housing market has been in bubble territory. Most crashes occur only because an asset bubble has popped.
One sign of an asset bubble is that home prices have escalated. National median family home prices are 32 percent higher than inflation. That’s similar to 2005, when they were 35 percent overvalued.
The Housing Bellwether Barometer is an index of homebuilders and mortgage companies. In 2017, it skyrocketed like it did in 2004 and 2005. That’s according to its creator, Stack Financial Management, who used it to predict the 2008 financial crisis. Similarly, the SPDR S&P Homebuilders ETF has risen 400 percent since March 2009. SPDR refers to the S&P Depository Receipts, an exchange-traded fund that tracks Standard & Poor’s 500 Index. It outperformed the S&P 500 rise of 270 percent.
The Case-Shiller national index hit record highs in December 2016. Price increases are concentrated in seven urban areas. Home prices in Denver and Dallas are 40 percent higher than their prerecession peaks. Portland and Seattle prices are 20 percent higher. Boston, San Francisco, and Charlotte are 10 percent above their peaks.
Home prices in Denver, Houston, Miami, and Washington, D.C. are at least 10 percent higher than sustainable levels, according to CoreLogic.
At the same time, affordable housing has plummeted. In 2010, 11 percent of rental units across the country were affordable for low income households. By 2016, that had dropped to just 4 percent. The shortage is the worst in cities where home prices have soared. For example, Colorado’s stock of affordable rentals fell from 32.4 percent to only 7.5 percent since 2010.
In March 2017, William Poole, a senior fellow at the Cato Institute, warned of another subprime crisis. He warned that 35 percent of Fannie Mae’s loans required mortgage insurance. That’s about the level in 2006. In some ways, these loans are worse. Fannie and Freddie lowered their definition of subprime from 660 to 620. The banks are no longer calling borrowers with scores between 620 and 660 subprime. Poole was the head of the Federal Reserve Bank of Kansas who warned of the subprime crisis in 2005.
Another concern is the increase in unregulated mortgage brokers. In 2018, they originated 52 percent of U.S. mortgages. That’s more than the 48 the sector originated in 2007. Six of the 10 largest mortgage lenders are not banks. They aren’t as regulated as banks. That makes them more vulnerable to collapse if the housing market softens again.
In 2016, 5.7 percent of all home sales were bought for quick resale. These “flip” homes are renovated and sold in less than a year. Attom Data Solutions reported that’s the highest percentage since 2006, during the last boom.
Two Reasons Why the Housing Market Has Slowed
New home sales have fallen 22 percent between November 2017 and September 2018. Resales fell 10 percent during that period. The last time this happened was in 2005.
The difference is that home prices haven’t fallen. Instead, they’ve gradually slowed their increase. Many home sellers are disappointed they can’t get the same high prices their neighbors got a year earlier. They are reluctant to lower their prices, and so sales have slowed.
One reason for the slowdown is because average incomes haven’t kept up with home prices. Per capita income rose 25 percent between 2011 and 2018. Home prices rose 48 percent during that period.
Another reason is higher interest rates. The Federal Reserve began raising the benchmark fed funds rate in 2015. At first, it spurred demand as homebuyers sought out mortgages while rates were still low. Now, that demand has dried up.
So Now Will Home Prices Fall?
Despite slowing sales, homebuilders continue to request more new home permits. In 2017, they were granted 1.3 million permits, according to the U.S. Census. That’s lower than the average number in the 1990s.
But it’s 6.2 percent higher than in 2016. That’s less of an increase than in 2015 when they received 12.4 percent more permits. This increase is higher than in the years preceding the financial crisis. Between 2001 and 2005, permits increased just 8 percent per year on average.
They went wild in 2012 when they got 33 percent more permits than the prior year. They received 19 percent more permits in 2013. But they were making up for severe losses incurred during the crash. Housing permits fell from 1.4 million in 2007 to only 583,000 in 2009, a 58 percent decline.
On the whole, builders have not oversaturated the market like they did before the financial crisis. As a result, it’s likely home prices will not fall like they did during the crash.
The 2008 Housing Market Crash
People who were caught in the 2008 crash are spooked that a 2018 bubble will lead to another crash. But that crash was caused by forces that are no longer present. Credit default swaps insured derivatives such as mortgage-backed securities. Hedge fund managers created a huge demand for these supposedly risk-free securities. That created demand for the mortgages that backed them.
As many unqualified buyers entered the market, demand soared. Many people bought homes as investments to sell as prices kept rising. They exhibited irrational exuberance, a hallmark of any asset bubble.
In 2006, homebuilders finally caught up with demand. When supply outpaced demand, housing prices started to fall. That burst the asset bubble.
In September 2006, the National Association of Realtors reported that home prices had fallen for the first time in 11 years. Inventory was high, providing a 7.5 month supply. In November, the Commerce Department revealed new home permits were 28 percent lower than in 2005.
But the Federal Reserve ignored these warnings. It thought the economy was strong enough to pull housing out of its slump. It pointed to strong employment, low inflation, and increased consumer spending. It also promised to lower interest rates. That would give the economy enough liquidity to fuel growth.
The Fed underestimated the size and impact of the mortgage-backed securities market. Banks had hired “quant jocks” to create these new securities. They wrote computer programs that sorted packages of mortgages into high-risk and low-risk bundles. The high-risk bundles paid more but were more likely to default. The low-risk bundles were safer but paid less.
The ticking time bomb was the millions of interest-only loans. These allowed borrowers to get lower monthly payments. But these mortgage rates reset at a higher level after three years. Many of these homeowners could not pay the mortgage. Then housing prices fell and they couldn’t sell their homes for a profit. As a result, they defaulted.
When times were good, it didn’t matter. Everyone bought the high-risk bundles because they gave a higher return. As the housing market declined, everyone knew that the products were losing value. Since no one understood them, the resale value of these derivatives was unclear.
Last but not least, many of the purchasers of these MBS were not just other banks. They were individual investors, pension funds, and hedge funds. That spread the risk throughout the economy. Hedge funds used these derivatives as collateral to borrow money. That created higher returns in a bull market, but magnified the impact of any downturn. The Securities and Exchange Commission did not regulate hedge funds, so no one knew how much of it was going on.
The Fed didn’t realize a collapse was brewing until March 2007. It realized that hedge fund housing losses could threaten the economy. Throughout the summer, banks became unwilling to lend to each other. They were afraid that they would receive bad MBS in return. Bankers didn’t know how much bad debt they had on their books. No one wanted to admit it. If they did, then their credit rating would be lowered. Then, their stock price would fall, and they would be unable to raise more funds to stay in business.
The stock market see-sawed throughout the summer, as market-watchers tried to figure out how bad things were.
By August, credit had become so tight that the Fed loaned banks $75 billion. It wanted to restore liquidity long enough for the banks to write down their losses and get back to the business of lending money. Instead, banks stopped lending to almost everybody.
The downward spiral was underway. As banks cut back on mortgages, housing prices fell further. That sent more borrowers into default, which increased the bad loans on banks’ books. That made the banks lend even less.
Nine Reasons Why a Housing Crash Isn’t Imminent
- There are many differences between the housing market in 2005 and the current market. In 2005, subprime loans totaled more than $620 billion and made up 20 percent of the mortgage market. In 2015, they totaled $56 billion and comprised 5 percent of the market.
- Banks have raised lending standards. According to CoreLogic’s Housing Credit Index, loans originated in 2016 were among the highest quality originated in the last 15 years. In October 2009, the average FICO score was 686, according to Fair Isaac. In 2001, the average score was 490 to 510.
- Tighter lending standards have made a difference in the “flip” market. Lenders only finance 55 percent of the home’s value. The “flipper” has to come up with the rest. During the subprime crisis, banks lent 80 percent or more.
- The number of homes sold today is 20 percent below the pre-crash peak. There’s only a four-month supply of homes available for sale. As a result, about 64 percent of Americans own their own homes, compared with 68 percent in 2007.
- Home sales are lower because the recession clobbered young people’s ability to start a career and buy homes. Faced with a weak job market, many furthered their education. As a result, they are now burdened with school loans. That makes it less likely they can save enough to buy a home. That will keep demand down.
- Home prices have outpaced income. The average income-to-housing cost ratio is 30 percent. In some metro areas, it’s skyrocketed to 40 or 50 percent. Unfortunately, metro areas are also where the jobs are. That forces young people to pay more for rent to be close to a job that doesn’t pay enough to buy a house. Thirty-two percent of home sales today are going to first time homebuyers, compared to 40 percent historically, says the National Association of Realtors. Typically, this buyer is 32, earns $72,000, and pays $182,500 for a home. A two-income couple pays $208,500 on average.
- Homeowners are not taking as much equity out of their homes. Home equity rose to $85 billion in 2006. It collapsed to less than $10 billion in 2010. It remained there until 2015. By 2017, it had only risen to $14 billion. Obamacare is one reason for that. Bankruptcy filings have fallen 50 percent since the Affordable Care Act was passed. In 2010, 1.5 million people filed. In 2016, only 770,846 did.
- Some people point that national housing prices have exceeded their 2006 peak. But once they are adjusted for 11 years of inflation, they are only at the 2004 level. Between 2012 and 2017, home prices rose 6.5 percent a year on average. Between 2002 and 2006, they rose 7.5 percent annually. In 2005, they skyrocketed 16 percent.
- Homebuilders focus on high-end homes. New homes are larger and more expensive. The average size of a new single-family home is almost 2,700 square feet. That compares to 2,500 square feet in 2006.
Five Conditions That Could Cause a Collapse
Higher interest rates have caused a collapse in the past. They make loans more expensive. That slows home building and decreases its supply. It also slows lending, which cuts back on demand. Overall, a slow and steady interest rate increase won’t create a catastrophe.
It’s true that higher interest rates preceded the housing collapse in 2006. Many borrowers then had interest-only loans and adjustable-rate mortgages. Unlike a conventional loan, the interest rates rise along with the fed funds rate. Many also had introductory teaser rates that reset after three years. When the Federal Reserve raised rates at the same time they reset, borrowers found they could no longer afford the payments. Home prices fell at the same time, so these mortgage-holders couldn’t make the payments or sell the house.
Default rates became so high.
The history of the fed funds rate reveals that the Fed raised rates too fast between 2004 and 2006. The rate was 1 percent in June 2004 and doubled to 2.25 percent by December. It doubled again to 4.25 percent by December 2005. Six months later, the rate was 5.25 percent.
The Fed raised rates at a much slower pace since 2015. It raised it to 0.5 percent in December 2015. Then, it raised it one-fourth point by the end of 2016 and to 1.25 percent by June 2017.
The real estate market could collapse if banks and hedge funds returned to investing in risky financial products. These derivatives were a major cause of the financial crisis. Banks sliced up mortgages and resold them in mortgage-backed securities. These securities were a bigger business than the mortgages themselves. So, banks sold mortgages to just about anyone. They needed them to support the derivatives. They sliced them up so that bad mortgages were hidden in bundles with good ones. Then when borrowers defaulted, all the derivatives were suspected of being bad.
This phenomenon caused the demise of Bear Stearns and Lehman Brothers.
The Trump tax reform plan might trigger a fall in prices that could lead to a collapse. Congress has suggested removing the deduction for mortgage interest rates. That deduction totals $71 billion. It acts like a federal subsidy to the housing market. The tax break helps homeowners have an average net worth of $195,400. That’s much greater than the $5,400 average net worth of renters. Even if the tax plan keeps the deduction, the tax plan takes away much of the incentive. Trump’s plan raised the standard deduction.
As a result, Americans would no longer itemize. When that happens, they can’t take advantage of the mortgage interest deduction. The real estate industry opposes the tax plan.
The market could collapse if the yield curve on U.S. Treasury notes becomes inverted. That’s when the interest rates for short-term Treasurys become higher than long-term yields. Normal short-term yields are lower because investors don’t require a high return to invest for less than a year. When that inverts, it means investors think the short-term is riskier than the long-term. That would play havoc with the mortgage market and signal a recession. The yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.
Real estate markets could collapse in coastal regions vulnerable to the effects of rising sea levels. The Union of Concerned Scientists predicts that 170 U.S. coastal cities and towns will be “chronically inundated” in 20 years. Another study found that 300,000 coastal properties will be flooded 26 times a year by 2045. The value of that real estate is $136 billion. By 2100, that number will rise to $1 trillion. At most risk are homes in Miami, New York’s Long Island, and the San Francisco Bay area.
Flooding has hit U.S. coastal towns three to nine times more often than they did 50 years ago. In Miami, Florida, the ocean floods the streets during high tide. Harvard researchers found that home prices in lower-lying areas of Miami-Dade County and Miami Beach are rising more slowly than the rest of Florida. A study using Zillow found that properties at risk of rising sea levels sell at a 7 percent discount to comparable properties. By 2030, Miami Beach homes could pay $17 million in higher property taxes due to flooding by 2030.
Most of the property in these cities are financed by municipal bonds or home mortgages. Their destruction will hurt the investors and depress the bond market. Markets could collapse in these regions, especially after severe storms.
When Will the Housing Market Crash Again?
The next market crash will occur in 2026, according to Harvard Extension School professor Teo Nicholas. He bases that on a study by economist Homer Hoyt. Real estate booms-and-busts have followed an 18-year cycle since 1800. The only exceptions were World War II and stagflation.
In 2017, Nicholas said the real estate market was still in the expansion phase. The next phase, hypersupply, wouldn’t occur unless rental vacancy rates begin to increase. If that occured while the Fed raises interest rates, it could cause a crash.
How to Protect Yourself from a Crash
If you’re among the majority of Americans who are worried, then there are seven things you can do to protect yourself from a real estate crash.
Buy a House to Live In, Not to Flip
Two-thirds of the homes lost in the financial crisis were second and third homes. When the sale price dropped below the mortgage, the owners walked away. They kept their homes but lost their investments.
Get a Fixed-Rate Mortgage
If this means you can only afford a smaller home, so be it. That’s better than taking a risk and losing it later on.
If you have a variable rate mortgage, try to refinance to a fixed-rate.
If You Get a Variable Rate Mortgage, Find Out What the Interest Rate Will Be When It Resets
If you can’t refinance to a fixed rate mortgage, then calculate the future monthly payment when your interest rate resets. Make sure you can afford to pay it with your current income.
Take the difference between that future payment and what you are paying today with the lower interest rate and save it. That way you will have the funds to pay your mortgage if your income falls.
Buy the Worst House in the Best Area You Can Afford
Good neighborhoods aren’t going to suffer as much in the next downturn as poorer areas. They will also bounce back quicker. This will improve your chances of reselling later on.
Make Sure Your House Has at Least Three Bedrooms
If you home has three bedrooms, it will attract families if you need to resell. Two bedrooms or less will only attract retirees and maybe some small families.
The Best Way to Protect Yourself Is With a Well-Diversified Portfolio of Assets
Diversification means a balanced mix of stocks, bonds, commodities, and equity in your home. Most financial planners don’t include home equity as an asset, but they should. It’s the biggest asset most people own.
To Limit the Damage of a Real Estate Collapse, Buy the Smallest Home You Can Reasonably Live In
Looking to secure some capital? Don’t be afraid to invest. Boost your investments in stocks, bonds, and commodities so they equal or exceed your home equity. If there is an asset bubble in housing, don’t succumb to the temptation to refinance and take out the equity. Instead, revisit your asset allocation to make sure that it is still balanced.