Housing: Boom or Bubble?

By Chris Thornberg

To say that housing analysts ‘missed the call’ on the market last year would be euphemistic to say the least. Long before COVID-19 became the predominant story of the global economy, many analysts were predicting a decline in the market. It’s little wonder that the onset of the pandemic recession caused them to up the ante from ‘decline’ to ‘meltdown’. Predictions of massive foreclosures and home price declines have dominated the headlines, as have other apocalyptic predictions of depression-like conditions and years of double-digit unemployment. 

Of course, the ‘zig’ quickly turned into a ‘zag’ and by the start of 2021, the market has experienced the fastest pace of price growth and single-family construction since the pre-Great Recession housing boom. This leads to two major questions: how did the experts get it so wrong, and are current trends sustainable? 

The big miss on the economy was driven largely by the old adage that the General is always fighting the last war. In the run up to the Great Recession, many pundits predicted a minimal downturn given how mild the previous two recessions had been. “The business cycle has been conquered,” so went the conventional wisdom. This time, many analysts defaulted to calling another Great Recession since the last one was so bad. 

In reality, the depth of each recession is determined by the type of shock that caused it in the first place. The Great Recession was so severe, in part, because the economy was highly distorted by the enormous subprime housing bubble that preceded it. The disappearance of bubble-generated fake wealth caused households to cut back sharply on spending to restore their balance sheets, generating an economy-wide malaise in its wake. The net result was that it took almost 9 years for the economy to fully recover.

Rising Sales: This chart illustrates the level of home sales throughout the pandemic. In late 2020, sales climbed levels not seen since 2005-6.

The pandemic recession could not have been more different. It hit an economy that was fundamentally very healthy, with high savings rates, low debt-to-income ratios and very clear mortgage markets. The impact to the economy was a transitory supply shock—people stopped eating at restaurants and going to events and conventions in 2020 not because they couldn’t afford to go, but because they weren’t allowed to go—an incredibly important distinction.

As important has been the Federal response to the crisis. Congress believed the apocalyptic predictions and responded with excessive fiscal stimulus, replacing lost incomes by a factor of well over 2 to 1. During the pandemic, U.S. savings rates have risen at a pace never seen before, and the commercial banking system is bursting at the seams with $3 trillion in excess deposits.

This dynamic has pushed unrequited demand into other parts of the economy, particularly towards consumer goods and housing—explaining how industrial production and goods trade bounced back to pre-pandemic levels in less than a year. The numbers would be even better except global supply chains were not prepared for the surge in demand and parts shortages are a major problem in many industries.

There has been an even more dramatic impact on housing. The nation entered 2020 with a housing market that was cool but that had solid fundamentals, such as a low debt-to-equity ratio, historically clean mortgage markets, record low mortgage debt payments relative to homeowner incomes and fairly low inventories of vacant housing. 

The coolness was driven by increases in mortgage rates in 2019 along with a change in tax policies that capped the mortgage interest deduction. These were mild changes for housing fundamentals, but the industry is always subject to feedback effects. A cool market increases potential buyers’ patience (why rush to buy now when I can wait and see if a better price arises?), further cooling the market. Things were due to pick up this year regardless of the pandemic.

House Price Boom: This table shows annualized home prices increases in major U.S. metropolitan areas beginning prior to the pandemic and running through February 2021.

But then the pandemic hit, shifting demand to housing, which was bolstered by record low mortgage rates and the enormous surge in household savings. The feedback effect quickly reversed because of already low inventories, moving potential buyers from patient to panicked. Today, new units on the market are seeing double digit offers in the first week and offers are coming in far over the asking price even as buyers waive inspections and other contingencies in an attempt to get a leg up on the competition. 

The strong fundamentals at the start of this hot market imply there is still a lot of headroom for the markets to grow. Even at these higher prices, costs are still low relative to incomes. Additionally, the Dodd-Frank rules for mortgage originations are preventing some buyers from over-extending themselves. And with inventories so low it will take years for builders just to catch up with demand. In short, the current boom is sustainable and can last. 

The biggest risk for housing today comes from the other type of excessive stimulus being used by the Federal Reserve. Chairman Jerome Powell’s decision to once again apply rounds of massive quantitative easing is a missed call—since he is not dealing with the same financial problems his predecessors were. As a result, the money supply has grown at a pace never before observed in the United States, not even in the 1960’s and 70’s — the last time the nation dealt with substantial inflationary problems. If inflation begins to heat up consistently (last month’s jump was more about constrained supply than true monetary inflation), mortgage rates will take a similar jump and the market could downshift rapidly. But these effects, if they occur, are very unlikely to be seen within the next 2 years. 

Christopher Thornberg is Founding Partner of Beacon Economics LLC, and Director of the UC Riverside School of Business Center for Economic Forecasting and Development. Learn more at www.BeaconEcon.com and www.ucreconomicforecast.org.

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